Technical and Fundamental Analysis

Investing Strategies
Technical Analysis
by InvestorGuide Staff

Technical analysis uses a variety of charts and calculations to spot trends in the market and
individual stocks and to try to predict what will happen next. Technical analysts don't bother
looking at any of the qualitative data about a company (for example, its management team or the
industry that it is in); instead, they believe that they can accurately predict the future price of a
stock by looking at its historical prices and other trading variables. Technical analysis assumes
that market psychology influences trading in a way that lets them predict when a stock will rise or
fall. For that reason, many technical analysts are also market timers, who believe that technical
analysis can be applied just as easily to the market as a whole as to an individual stock .

Critics of technical analysis, and there are many, say that the whole endeavor is a waste of time
and effort. They point to academic studies like Burton Malkiel's "A Random Walk Down Wall
Street" as evidence that there is no possible way to predict future prices using historical prices .
Others contend that if any such systems were found to be successful, those who practiced them
would be wealthy beyond their wildest dreams, and yet there aren't any billionaire technical
analysts (yet).

Technical analysts use dozens of different quantitative metrics in order to predict stock prices. In
this section, we'll introduce you to some of the most popular ones and explain to you what they're
all about, but first here are a few key terms you should know about:

• Support Level: The level that the technical analyst believes a stock price will not fall
below (also sometimes called a "floor")
• Resistance Level: The opposite of a support level, the level that the technical analyst
believes a stock price will not exceed.
• Breakout: If a stock surpasses the resistance level or falls below the support level, it is
said to be a "breakout."
• Advance-Decline Line: The total number of advancing issues minus the total number of
declining issues, added to a cumulative total.

Moving Averages

Perhaps the most commonly used variable in technical analysis, the moving average for a stock
is the average selling price for the stock over a set period of time (the most common being 20, 30,
50, 100 and 200 days). Moving average data is used to create charts that show whether or not a
stock's price is trending up or down. They can be used to track daily, weekly, or monthly patterns.
Each new day's (or week's or month's) numbers are added to the average and the oldest
numbers are dropped; thus, the average "moves" over time. In general, the shorter the
time frame used, the more volatile the prices will appear, so, for example, 20 day moving average
lines tend to move up and down more than 200 days moving average lines.

Relative Strength

Technical analysts use what is called relative strength in order to compare the price performance
of one stock to the entire market. The relative strength of a stock is calculated by taking the
percentage price change of a stock over a set period of time and ranking it on a scale of 1 to 100
against all other stocks on the market. For example, a stock with a relative strength of 90 has
experienced a greater increase in its price over the last year than the price increases experienced
by 90% of all other stocks on the market. Some technical analysts like stocks with high relative
strength rankings, believing that stocks which have recently gone up are more likely to continue
going up. Other technical analysts believe that a very high relative strength can be an indication
that the stock is overbought and is ready to fall. Relative strength is really a "rear view window"
metric, measuring only how the stock has done in the past, not how it will do in the future.

Momentum

Momentum investors seek to take advantage of upward or downward trends in stock prices or
earnings. They believe that these stocks will continue to head in the same direction because of
the momentum that is already behind them. The idea relies on the belief that there are a large
number of lemmings in the market who will buy whatever stock is already hot. Momentum
investors do not necessarily believe that momentum stocks will do well in the long run, but they
do think that in the short run people will continue to buy them as they have in the immediate past.
This therefore involves a lot of market timing which of course entails a substantial amount of risk .
Both moving averages and relative strength can be used in order to determine momentum.

Charts

Charts are the main tool that technical analysts use in order to plot their data and predict prices.
Technical analysts may use several different types of charts in order to conduct their tests,
including line charts, bar charts, and candlestick charts. Most of the time, analysts use
these charts in order to look for patterns in the data. Some of the more commonly used patterns
include:

• Cup and Handle: A pattern on a bar chart that is in the shape of the letter "U" over a
period of between 7 and 65 weeks. Once the stock price reaches the second peak of the "U",
technical analysts believe that the price will fall as investors who bought at the previous peak
start to unload their shares.
• Head and Shoulders: A chart formation in which a price exhibits three successive rallies,
the second one being the highest. The name derives from the fact that on a chart the first and
third rallies look like shoulders and the second looks like a head. Some technical analysts
consider it a sign that the stock will fall further.
• Double Bottom: A chart formation that looks like a "W". Technical analysts aim to buy at
one of the troughs and ride the stock higher.

Bollinger Bands

Bollinger bands on a chart have three lines in them: an upper band, a lower band, and a band at
the moving average. The upper and lower bands are placed precisely at two standard deviations
above the moving average and two standard deviations below the moving average respectively
(standard deviation is a mathematical measure of volatility). Bollinger bands will expand and
contract as the market for the stock becomes more or less volatile. If the stock price reaches the
upper band, then the stock is thought to be overbought; if it reaches the lower band, then it is
thought to be oversold.

Volume

Not all technical analysts focus exclusively on price. Many of them think that volume is often
times a better indication of where a stock is heading. Volume is simply the number of shares of a
stock that are traded over a particular period of time (e.g. 1 day or 30 days). Some technical
analysts calculate moving averages for volume, the same way others do for price. Volume is
important because it tells how active the stock was during a particular time, which can in turn
affect a stock's price. For example, if a stock falls precipitously but volume was exceptionally light
that day, this is not necessarily an indication that the stock has fallen out of favor with the market,
since the move was caused by a relatively small number of sellers
Investing Strategies
Fundamental Analysis
by InvestorGuide Staff

Fundamental analysis is a method used to determine the value of a stock by analyzing the
financial data that is 'fundamental' to the company. That means that fundamental analysis takes
into consideration only those variables that are directly related to the company itself, such as its
earnings, its dividends, and its sales. Fundamental analysis does not look at the overall state of
the market nor does it include behavioral variables in its methodology. It focuses exclusively on
the company's business in order to determine whether or not the stock should be bought or sold.

Critics of fundamental analysis often charge that the practice is either irrelevant or that it is
inherently flawed. The first group, made up largely of proponents of the efficient market
hypothesis, say that fundamental analysis is a useless practice since a stock's price will always
already take into account the company's financial data . In other words, they argue that it is
impossible to learn anything new about a company by analyzing its fundamentals that the market
as a whole does not already know, since everyone has access to the same financial information.
The other major argument against fundamental analysis is more practical than theoretical. These
critics charge that fundamental analysis is too unscientific a process, and that it's difficult to get a
clear picture of a company's value when there are so many qualitative factors such as a
company's management and its competitive landscape.

However, such critics are in the minority. Most individual investors and investment professionals
believe that fundamental analysis is useful, either alone or in combination with other techniques.
If you decide that fundamental analysis is the method for you, you'll find that a company's
financial statements (its income statement, its balance sheet and its cash flow statement) will be
indispensable resources for your analysis . And even if you're not totally sold on the idea of
fundamental analysis, it's probably a good idea for you to familiarize yourself with some of the
valuation measures it uses since they are often talked about in other types of stock valuation
techniques as well.

Earnings

It is often said that earnings are the "bottom line" when it comes to valuing a company's stock,
and indeed fundamental analysis places much emphasis upon a company's earnings. Simply put,
earnings are how much profit (or loss) a company has made after subtracting expenses.
During a specific period of time, all public companies are required to report their earnings on a
quarterly basis through a 10-Q Report . Earnings are important to investors because they give an
indication of the company's expected dividends and its potential for growth and capital
appreciation. That does not necessarily mean, however, that low or negative earnings always
indicate a bad stock; for example, many young companies report negative earnings as they
attempt to grow quickly enough to capture a new market, at which point they'll be even more
profitable than they otherwise might have been. The key is to look at the data underlying a
company's earnings on its financial statements and to use the following profitability ratios to
determine whether or not the stock is a sound investment .

Earnings Per Share

Comparing total net earnings for various companies is usually not a good idea, since net earnings
numbers don't take into account how many shares of stock are outstanding (in other words, they
don't take into account how many owners you have to divide the earnings among). In order to
make earnings comparisons more useful across companies, fundamental analysts instead look at
a company's earnings per share (EPS). EPS is calculated by taking a company's net earnings
and dividing by the number of outstanding shares of stock the company has. For example, if a
company reports $10 million in net earnings for the previous year and has 5 million shares of
stock outstanding, then that company has an EPS of $2 per share. EPS can be calculated for the
previous year ("trailing EPS"), for the current year ("current EPS"), or for the coming year
("forward EPS"). Note that last year's EPS would be actual, while current year and forward year
EPS would be estimates.

P/E Ratio

EPS is a great way to compare earnings across companies, but it doesn't tell you anything about
how the market values the stock. That's why fundamental analysts use the price-to-earnings ratio,
more commonly known as the P/E ratio, to figure out how much the market is willing to pay for a
company's earnings. You can calculate a stock's P/E ratio by taking its price per share and
dividing by its EPS. For instance, if a stock is priced at $50 per share and it has an EPS of $5 per
share, then it has a P/E ratio of 10. (Or equivalently, you could calculate the P/E ratio by dividing
the company's total market cap by the company's total earnings; this would result in the same
number.) P/E can be calculated for the previous year ("trailing P/E"), for the current year ("current
P/E"), or for the coming year ("forward P/E"). The higher the P/E, the more the market is willing to
pay for each dollar of annual earnings. Note that last year's P/E would be actual, while current
year and forward year P/E would be estimates, but in each case, the "P" in the equation is the
current price. Companies that are not currently profitable (that is, ones which have negative
earnings) don't have a P/E ratio at all. For those companies you may want to calculate the price-
to-sales ratio (PSR) instead .

PEG

So is a stock with a high P/E ratio always overvalued? Not necessarily. The stock could have a
high P/E ratio because investors are convinced that it will have strong earnings growth in the
future and so they bid up the stock's price now. Fortunately, there is another ratio that you can
use that takes into consideration a stock's projected earnings growth: it's called the PEG. PEG is
calculated by taking a stock's P/E ratio and dividing by its expected percentage earnings growth
for the next year. So, a stock with a P/E ratio of 40 that is expected to grow its earnings by 20%
the next year would have a PEG of 2. In general, the lower the PEG, the better the value,
because you would be paying less for each unit of earnings growth.

Dividend Yield

The dividend yield measures what percentage return a company pays out to its shareholders in
the form of dividends . It is calculated by taking the amount of dividends paid per share over the
course of a year and dividing by the stock's price. For example, if a stock pays out $2 in dividends
over the course of a year and trades at $40, then it has a dividend yield of 5%. Mature, well-
established companies tend to have higher dividend yields, while young, growth-oriented
companies tend to have lower ones, and most small growing companies don't have a dividend
yield at all because they don't pay out dividends.

Dividend Payout Ratio

The dividend payout ratio shows what percentage of a company's earnings it is paying out to
investors in the form of dividends. It is calculated by taking the company's annual dividends per
share and dividing by its annual earnings per share (EPS). So, if a company pays out $1 per
share annually in dividends and it has an EPS of $2 for the year, then that company has a
dividend payout ratio of 50%; in other words, the company paid out 50% of its earnings in
dividends. Companies that distribute dividends typically use about 25% to 50% of their earnings
for dividend payments. The higher the payout ratio, the less confidence the company has that it
would've been able to find better uses for the money it earned. This is not necessarily either good
or bad; companies that are still growing will tend to have lower dividend payout ratios than very
large companies, because they are more likely to have other productive uses for the earnings.

Book Value
The book value of a company is the company's net worth, as measured by its total assets minus
its total liabilities. This is how much the company would have left over in assets if it went out of
business immediately. Since companies are usually expected to grow and generate more profits
in the future, most companies end up being worth far more in the marketplace than their book
value would suggest. For this reason, book value is of more interest to value investors than
growth investors. In order to compare book values across companies, you should use book value
per share, which is simply the company's last quarterly book value divided by the number of
shares of stock it has outstanding.

Price / Book

A company's price-to-book ratio (P/B ratio) is determined by taking the company's per share stock
price and dividing by the company's book value per share. For instance, if a company currently
trades at $100 and has a book value per share of $5, then that company has a P/B ratio of
20. The higher the ratio, the higher the premium the market is willing to pay for the company
above its hard assets. Price-to-book ratio is of more interest to value investors than growth
investors.

Price / Sales Ratio

As with earnings and book value, you can find out how much the market is valuing a company by
comparing the company's price to its annual sales. This measure is known as the price-to-sales
ratio (P/S or PSR). You can calculate the P/S by taking the stock's current price and dividing by
the company's total sales per share for the past year (or equivalently, by dividing the entire
company's market cap by its total sales). That means that a company whose stock trades at $1
per share and which had $2 per share in sales last year will have a P/S of 0.5. Low P/S ratios
(below one) are usually thought to be the better investment since their sales are priced cheaply.
However, P/S, like P/E ratios and P/B ratios, are numbers that are subject to much interpretation
and debate. Sales obviously don't reveal the whole picture: a company could be selling dollar bills
for 90 cents each, and have huge sales but be terribly unprofitable. Because of the limitations,
P/S ratios are usually used only for unprofitable companies, since such companies don't have a
P/E ratio .

Return on Equity (ROE)

Return on equity (ROE) shows you how much profit a company generates in comparison to its
book value . The ratio is calculated by taking a company's after-tax income (after preferred stock
dividends but before common stock dividends) and dividing by its book value (which is equal to its
assets minus its liabilities). It is used as a general indication of the company's efficiency; in other
words, how much profit it is able to generate given the resources provided by its stockholders.
Investors usually look for companies with ROEs that are high and growing.