Selection of stocks or bonds involves a fair amount of understanding and research. When professionals undertake research work on stocks, shares or corporate bonds, they will use either fundamental or technical analysis.
Fundamental analysis predicts the likely performance of an equity investment by assessing the underlying profitability and outlook of a corporate. This is the analysis of the financial status of a company to establish the intrinsic value of the shares. Fundamental analysis of equities uses a series of valuation ratios such as Earnings Per Share (EPS), Price / Earnings (PE), etc. Each ratio can uncover value or the underlying attractiveness of a stock.
Fundamental analysis is a long-term approach as the market usually takes time to fully price in the value of a stock. Ratios are used together (and not in isolation) to decide on the suitability of investment in a particular stock. They should be used in comparison to prices of stocks in the same industry / sector or against the broad market.
Here are some examples of the most frequently used valuation ratios with brief descriptions of how to calculate each of them:
- Earnings per share: This is the portion of a company's profit allocated to each share issued by the company. This measure is calculated by taking the net income and dividing by the number of outstanding shares issued by the company. It is used to calculate the PE ratio.
- Price / Earnings ratio: The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company’s stock; it measures the current share price relative to its per-share earnings. This is the most popular measure of stock price valuation because it relies on easily available information. P/E ratio is measured by dividing the share price by the earnings per share. Professional and individual investors generally use the 12-month forecast EPS figure.
- Share price/ sales per share: The P/S, or price to sales ratio, is another popular method of measuring how much value is apportioned to a share price per rupee of the company’s sales. The ratio is calculated by dividing the 12-month forecast sales by the number of shares outstanding to achieve sales per share, then dividing the share price by the sales per share.
- Dividend yield: This ratio is useful for income investors; it measures the value of the share by the amount of dividend it pays per share. It is calculated by dividing the annual dividends per share by the price per share.
Technical analysis measures the likely success or performance of an investment (stocks, bonds, as well as foreign exchange, commodities and other products) based on charting price movements and predicting the likely next movement.
Professionals use charts and macro-economic indicators, as well as other elements such as volatility, pricing movements and volumes traded to model the price movements of indices and stocks. This form of analysis is often used for short-term trading as it attempts to chart short-term price movements.
Technical analysis is based on three major concepts: that the market discounts everything (or includes all aspects of a company in the price of its securities), that price movements tend to repeat themselves, and that trends dictate price movements.
Which analysis should I use?
Generally, fund managers use fundamental analysis while (stock or bond) market traders and those who make regular or high volume trades, use technical analysis. There are cases where both types of analysis can be used in tandem; for example, in the case of equities or corporate bonds, it is possible to analyze the share price movements (technical analysis) after company results or updates (fundamental analysis).
Where there are external factors such as global market shock, it can be difficult to use these tools as share price movements will be decoupled from both fundamentals and the usual technical patterns.