Markets can be analyzed in broadly two ways – fundamentally and technically. Let’s understand the differences in the two approaches.
The valuation of business is effectively the stock price. If the underlying business is perceived to be more than the current market price the stock is considered cheap, if it is trading at par then it is the fair value else the stock is expensive. A business can be valued on an absolute basis or on a comparative basis.
There are different metrics to calculate the fair value of a business. Discounting future cashflows at the required rate of return is the most common approach. An Indian citizen currently earns around 4-6% savings bank return and around 6-8% return on fixed deposits. Hence the risk-free rate is around 6% for Indian markets. Anyone getting into stocks would desire a higher rate of return for assuming risk of volatility when buying a stock. On an absolute basis, if a person buys a stock for Rs 100 over time the capital appreciation and dividend yield should beat 6% which will only happen if the return on equity capital is more than 6% over the longer run. Return on equity is profit remaining after paying off interest costs. The other way to look at business on an absolute basis is ownership of its assets. The asset value held by the business if are more than what the current stock price reflects, then it’s available at a discount.
Also Read :- Use Fundamental Analysis to Select Right Stocks
The other approach in fundamental analysis is to compare business across similar sectors or similar market capitalizations and assess risks based on the market averages. Price to earnings, price to book etc are common ratios used to compare stocks. Growth, debt and dividend are important factors which can cause differences in high and low ratios. Price to cashflow and interest coverage ratios are other metrics used to assess the strength of the underlying business and its strength of balance sheet. Quality of management also generally comes under the purview of fundamental analysis.
An example would be to study the price to earning ratio of Nifty50 which has historically ranged from 12-28 (trailing PE) and has an average of 18 times. Currently it trades closer to 25. Investors can judge the relative level of the index using historical levels of such ratios.
Price and volume define technicals. It’s about looking for historical patterns and charting tools to predict price movements. Moving averages, Fibonacci, supports and resistances etc are a part of this game. The basic idea is whenever a certain price action or volume behavior is observed, the future prices are likely to behave in a certain manner. The game becomes about probability and numbers. Defining stop losses and price targets are important in this approach. The underlying argument is market psychology and sentiments remain same and history repeats itself. The key metrics – quality of technical indicators, emotional strength and discipline to follow technical rules, and understanding that high probability does not guarantee success.
Example of Technical Analysis
The highlighted pattern in the above chart shows a “doji”. The red candles show lower closing compared to open, the white candles show a higher closing vs open. The market was in clear uptrend before the “doji” was formed. A doji is a pattern where opening and closing are almost equal. When formed after a trend, it reflects tug of war between the bulls and the bears. In this case, it signifies the bulls got an equal fight from the bears after a sustained move upwards. This is the point where bears started matching the bulls. The next strong red candle showed that bears continued their onslaught the next day as well which in technical analysis is a trend reversal pattern. We can see after the doji candle the trend got reversed and market moved downwards after that.