Two common stock valuation methods
Technical analysis and fundamental analysis are the two main approaches to valuating stocks in an effort to determine how prices might move. These approaches are actually complete schools of thought and as usually happens with the various disciplines studied in our society, the proponents of each are at odds with one another.
Fundamental analysis is the examination of the underlying forces that effect the well being of the economy, industry groups, and companies. At the company level, fundamental analysis involves examining the company’s financials and operations, especially sales, earnings, growth potential, assets, debt, management, products, and competition. Fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the stock market or technical analysis data.
At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy.
To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock’s current fair value and forecast future value.
If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately move towards fair value.
It is a very time consuming endeavor, and if the truth were known, the amount of time required to do a proper fundamental analysis likely accounts for much of the argument against its use. In our tutorial series on stock valuation, we went to great length describing methods of corporate financial statement analysis because it is at the heart of fundamental analysis.
It can be argued you are not really investing unless you apply fundamental analysis. This is because any alternative approach is basically gambling, at least in the mind of those who believe it unwise to place money without fully understanding or at least trying to understand where you are putting it.
Fundamental analysis then, is similar to the type of analysis made by the banking industry in an application for a corporate credit line. When the objective of the analysis is to determine what stock to buy and at what price, fundamentalists maintain markets might misprice a stock in the short run but the correct price will eventually be reached. So, profits are made trading the mispriced stock, then waiting for the market to recognize its mistake and re-price the share price.
The opposing school of thought – the technical analysts – maintain all important information is already reflected in the price of the stock price, so fundamental analysis is a waste of time.