Stock Analysis Methods

Let’s take a look at the two methods most analysts use to predict a stock’s future performance. Of course there are other methods of evaluation – in fact new ones are being thought up every time there is a bull market. Often though these newer methods are used to artificially inflate a stock’s value and are discarded once the boom is over.

Just to recap from a previous article, the two most prevalent theories for asset valuation are the firm-foundation theory (focuses on determining intrinsic value of an asset exp. a stock, and uses that as benchmark when to buy or sell), and the castle-in-the-air theory (focuses on crowd psychology and buying/selling trends to predict when to buy or sell). For a more complete explanation of these theories please read my previous article entitled Asset Valuation Theories.

Knowing these two asset valuation theories, let’s take a closer look at the two most widely used methods of analyzing stocks: the technical or fundamental analysis methods.

The technical analysis method is used to predict the appropriate time to buy/sell a stock based on the castle-in-the-air view of stock pricing. The fundamental analysis method is the technique applying the value-based approach of the firm-foundation theory to the selection of individual stocks.

Let’s look at each method in more detail including some of the related possible pitfalls.

Technical analysis is essentially the making and interpreting of stock charts (hence followers of this method are called chartists). The movements of common stock prices and trading volumes are studied in order to discover clues to the direction of future change. In accordance with the castle-in-the-air theory chartists consider the market to be 10% logical and 90% psychological. So studying what other investors are doing, interpreting that information (and entering it into charts) to try and anticipate what the crowd is likely to do in the future, is how technical analysis is applied.

Charts are created by indicating the highs and lows of a stock as well as the day’s closing price on a vertical line. So when charting a stock’s performance in this fashion over a period of time, trends begin to emerge on which chartists base their analysis. Technical analysis is based on the belief that prices tend to move in trends: so a tock that is rising tends to keep rising, whereas a stock at rest tends to stay at rest.

And inherent problem with the technical analysis method is that stocks are bought and sold only after trends have been established and charted and thus the right entry or exit point may be missed. In addition, researching a company’s growth expectations, future opportunities, industry forecasts etc. may yield inside information to a fundamentalist that allows him to buy into a stock early exp. if a fundamentalist finds that a pharmaceutical company is close to approval of a major new drug, he/she can buy in early before a stock’s price has shot up. Those price changes can occur so quickly that the process of technical analysis becomes too slow and ineffective.

Another consideration is that investing in stocks based on technical analysis may require you to buy/sell quite often. The associated fees with frequent transactions will probably wipe out any profits you have made fairly quickly.

Fundamental analysis on the other hand focuses on determining an issue’s proper value by looking at expected growth rate of earnings and dividends, interest rates, and risk. By estimating factors such as the future growth of a company, fundamental analysts (or fundamentalists) arrive at an estimate of a security’s intrinsic value or firm foundation of value. Fundamentalists believe the market to be 90% logical and 10% psychological, believing that eventually the market will reflect accurately a security’s real worth. The overwhelming majority of Wall Street analysts subscribe to this method of stock analysis.

In order to estimate a stock’s worth or value, a fundamental analyst has to look at many different criteria, such as a firm’s sales level, operating cost, corporate tax rates, depreciation policies, the sources and costs of its capital requirements, income and balance sheets, investment plans, the management team and more. Also, since the general prospects of a company are strongly influenced by the economic position of its industry, the analyst has to look at industry prospects as well.

There are four basic determinants a fundamentalist uses to estimate a stock’s value: 1. The expected growth rate (including compound growth), 2. The expected dividend payout, 3. The degree of risk and 4. The level of market interest rates (the higher the interest rate, the less attractive stocks may become).

Of course these determinants or guidelines are not set in stone - there are many factors and variables that play into a successful estimation of a stock’s future performance. Never forget that these analysis methods are based on past performance indicators and estimations of future growth and earnings. So there is no such thing as a guarantee or no-risk situation when investing in stocks.

There are three potential flaws in the fundamental analysis method. First, the information and analysis may be incorrect. Second, the analyst’s estimate of value may be faulty and too optimistic/pessimistic. Third, the market may not react as expected and the stock may not live up to its value estimate.

In the end it depends on the individual, which method makes you comfortable. You may want to use a combination of both methods to arrive at your estimation of a stock’s value and future performance. Understanding and applying these methods and theories will help you a great deal towards building a successful portfolio.