Technical Analysis vs. Fundamental Analysis

descarga (31)Technical analysis uses charts, showing stock movements (prices & volumes), as a tool to predict how stock prices will evolve in the future. Chartists believe that the market is only 10% logical and 90% psychological.

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Fundamental analysis seek to determine a firm intrinsic value based on its expected growth rate, dividend payout, interest rates and risks. Fundamental analysts believe that market is 90% logical and 10% psychological.

Technical Analysis

Two main principles:

  1. All information about earnings, dividends and future performance of a company is already reflected in company’s past stock prices.
  2. Prices tend to move in trends, and trends tend to continue until something happens to change the supply-demand balance e.g. if a stock is rising it will continue rising. The prices at what the trend is about to change are called resistance levels.

Fundamental Analysis

Fundamentalist’s primary concern is what a stock is really worth, which is based on the estimation of four key determinants: growth rate, dividend payout, degree of risk, and the level of market interest rates.

Using Fundamental and Technical Analysis together

  1. Buy only companies that are expected to have above-average earning growth for five or more years.
  2. Never pay more for a stock than its firm foundation of value
  3. Look for stocks whose stories of anticipated growth are the kind on which investors can build castles in the air

Further reading

The firm-foundation investing theory

Each investment instrument has an intrinsic value which can be determined by careful analysis of present conditions and future prospects. Investing is then just a matter of buy or sell decisions comparing actual price with its firm foundation value.

From the point of view of the very-long term investor, the worth a share is the present or discounted value of all future dividends he will receive from owning the stock.

Four fundamental determinants affecting value of shares

Determinant 1: expected growth rate

A rational investor should be willing to pay a higher price for a share:

  • the larger the growth rate of dividends, and
  • the longer the extraordinary growth rate is expected to last.

Determinant 2: expected dividend payout

A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company’s earnings that is paid out in cash dividends.

Determinant 3: degree of risk

A rational investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.

Determinant 4: the level of market interest rates

A rational investors should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.

Three caveats

  1. Expectations about future cannot be proven in the present, therefore, prediction of future earnings and dividends implies always a dose of uncertainty.
  2. Precise figures cannot be calculated from undetermined data (the information used to make the calculations is based on estimates).
  3. The fundamental determinants are liable to change depending on market psychology (stocks are bought on expectations, not facts).

Further reading