When investing, a healthy balance of fundamental analysis and technical analysis is necessary to make a well-rounded decision. Both styles of analysis offer a considerable amount of useful information – fundamentals provide insight into the company’s core business model, as well as the overall financial health of the company. On the other hand, technical analysis revolves around the supply and demand for a company’s shares in the open market. When employed properly, investors stand to benefit immensely from the breadth of information made available.
Fundamental analysis is typically employed with a longer-term investment horizon in mind. As mentioned before, the fundamentals focus on the company’s underlying business, and also takes into account any impacts (short- or long-term) to the company’s margins and revenue. Revenue generation and costs are typically what determine a company’s bottom line (also known as net income, or simply earnings) and cash flows. Earnings and cash flows are then used to value the company. Whether the focus be on earnings, or the company’s financial stability, fundamentals helps get a solid picture of the company in question and where it may be headed in the future.
Some widely used fundamental ratios include the price-to-earnings (P/E) ratio, which indicates the company’s value relative to their net income. To calculate a company’s P/E ratio, you simply divide their share price over their earnings per share in the past year. Typically, the S&P 500’s historical P/E ratio has averaged around the mid-teens. Yet with a lot of company’s growing incredibly fast today (e.g., Amazon, Facebook), these multiples tend to be high because they are factoring in expected growth in earnings. Other ratios include the price-to-book (P/B) ratio, price-to-sales (P/S) ratio, and enterprise value-to EBITDA ratio (EV/EBITDA).
Technical analysis, however, is primarily employed in short-term investments. It allows investors to get a feel for the market’s sentiment on the stock. One day, there may simply just be more buyers than sellers – the next day this may change. Despite this, technical analysis is often used to identify trends supporting a long-term investment thesis. There is a myriad of technical indicators, and analysts argue that indicators are most effective when used with each other, as opposed to just selecting one indicator and focusing on that one indicator alone.
Some popular technical indicators include Bollinger Bands, Simple Moving Average, and the Relative Strength Index (RSI). The Bollinger Bands allow investors to see the lower- and higher-end of a stock’s average price over a pre-selected period. A Simple Moving Average obtains a moving average of a company’s share price over pre-selected periods of time. The Relative Strength Index allows investors to identify whether shares are overbought, or oversold. These are just a few of the technical indicators out there. The versatility offered by technical indicators is what makes technical analysis a widely embraced practice, and the reason it will continue to be used well into the future.
Of course, as with many things in life, a healthy balance between the two is best – typically, the fundamentals will be the backbone of investment thesis, with technical analysis playing a key role in the entry and exit. The fundamental and technical aspects of the investment thesis will constantly be re-evaluated. Plenty of fundamental ratios are constantly being monitored to ensure valuations are inline with the thesis, and the company remains safe. The technical analysis portion will portray the market’s sentiment on the security and determine the ideal entry and exit point.
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