Stock prices are the first point of reference for an investor to invest in stock markets. But just looking at the price is not enough. Investors need to have the basic knowledge to analyse the stock prices so they can make effective investment decisions to maximize their returns. There are essentially two ways of analysing the stocks and thereby predicting the stock price. There are two widely used methods of analysing a stock price. Read on to know more.
Methods of Stock analysis
- Fundamental Analysis
- Technical Analysis
Here are further details on these methods that help the investors carry out their research before making an investment decision on a particular stock.
What is fundamental analysis?
Fundamental analysis is essentially getting to know the value of the stock by studying factors that could affect its price. It could be internal or external factors. While internal factors could be anything like the financial health of the company, future prospects, the market that it operates in, the management, the prospects of the sector it operates in and the overall global and national economic conditions.
There are two ways fundamental analysis is generally done.
Top Down Approach
As the name suggests, a top to down approach is adopted. The analysis begins with overall conditions of the economy, narrows down to sectors poised to perform well depending on the various factors playing out in the economy (Like pharma sector was expected to do well as the Covid-19 pandemic spread out), and then individual stocks are chosen from the narrowed down sectors.
This is the opposite of the top-down approach. Here, you start by identifying a company that you could be interested to invest in and then go upwards. Check on the sector that it is operating in and then take stock of the general economic conditions of the country or regions the company operates in.
Commonly used metrics in Fundamental analysis are
The fundamental analysis puts the use of many financial ratios to analyse the position of the company. Some of the commonly used ratios like P/E Ratio, Dividend Payout Ratio, Earnings per share, Return on Equity, etc. These ratios are compared to the industry average or to the peers in the same industry to rate the performance of the company. This will help the investors in analysing if the stocks of the company are overpriced or underpriced and if buying the stock of the company is profitable or not.
Given below are some of the ratios that are used to make fundamental analysis.
- Earnings per share
Earnings per share is the earnings that are earned by the shareholders for each share held by them. A higher EPS than the industry average indicates that the company is performing better than its peers in the industry. A company consistently providing higher EPS will be a preferred stock by the investors.
- Price to Earnings ratio
Price to Earnings ratio is one of the traditional methods to analyse the company performance and predict the prices of the stock of the company. This ratio considers the market price of the shares of the company and the earnings per share (EPS) of the company. If the PE ratio is favourable than the industry standards, the company is considered to be in a better position than its peers. It is a relatively outdated tool that is not used anymore by most analysts as a primary measure to predict the stock prices.
- Return on equity
The return on equity is one of the most important measures of a company’s profitability. A higher ROI will assure the investors of the profitability of the company and will eventually lead to an increase in the trade volume and prices of the stock.
- Price to Earnings to growth ratio
Price to earnings to growth ratio is the addition to the price to earnings ratio. This ratio provides a better yardstick to measure the performance of the company and thereby predict the prices of the stock. The main feature of this ratio is that it considers the growth of the company to measure its performance and eventually predict the stock prices the following day.
- Price to book ratio
Price to book ratio is the measure of the market value of the shares compared with the book value of the shares. The mathematical formula for this ratio is dividing the market value of the shares by the book value of the shares. This ratio helps the investor to find the organizations having the highest growth potential in any industry. The book value of shares in this case is arrived by deducting the book value of liabilities from the book value of assets. A company having a low P/B ratio reflects on the undervaluation of the stock.
What is Technical Analysis?
Technical analysis is the measure of the company’s performance through certain technical parameters. Technical analysis is the analysis of the current day’s performance of a stock and based on certain parameters to predict the movement of the stock in the following day. This type of analysis is mostly used by expert analysts and not by average investors. The technical pointers or indicators help an investor in analysing the stock better and making investment decisions that can maximize their returns.
Common metrics used in technical analysis
Simple Moving averages
By using this metric, you try to even out the day-to-day movements of the stock by taking averages for a certain number of days, say 1 week, 10 days, 1month, 3 months etc.
Exponential moving averages
An exponential moving average is a weighted moving average that assigns more importance to recent price movements than the older ones.
In this metric, candle stick like images are plotted for each day of trade for a stock. It involves data points like opening price, closing price, the range, etc. When candlestick images are plotted for a number of days, there are patterns that emerge based on which trading/investing decisions are taken.
This metric involves identifying a pattern when the stock breaks out of its set patterns with huge volumes. This signifies a change in the trend of the stock price.
Several metrics that indicate the momentum of the stock like Stochastic Oscillator, Relative Strength Index, Moving Average Convergence Divergence are also used as metrics to predict if the movement in stock prices is a change in trend or a range bound movement, or an insignificant movement.
There is no correct way to predict the stock prices with 100% accuracy. Most expert analysts on many occasions fail to predict the stock prices or the prediction of movement of stock with even 60% to 80% accuracy. Investors should consider multiple parameters to ensure that they can predict the stock price to the closest possible range and accordingly make investment decisions. In most cases, the human intelligence factor is one of the most important decision making parameters in predicting the stock prices for the next day.
1. Fundamental analysis is suited for which type of investment horizon?
Fundamental analysis is best suited for an investor looking for a long term investment horizon.
2. Which stocks are relatively less risky?
Stocks that are fundamentally strong are relatively less risky than technically strong stocks.
3. Is it necessary to monitor technical strength of a stock on a daily basis?
Yes and no! There is no straight answer to this. Few investors do like to keep a track of daily movements. Traders are more likely to monitor technical strength of the stock. On the other hand, investors take long term positions in a stock, so they are not much affected by short term variations or daily stock movements.