Fundamental analysis is more theoretical as it seeks to determine the underlying long-term value of a security.
Fundamental and technical analysis are the two different bodies of literature, which help investors to take an informed investment decision. They help investors to take a call whether to buy, hold or sell an asset which could be a share or commodity or any type of asset which is traded in a regulated market. But both the disciplines are different from each other in terms of approach, assumptions and applications. Let us discuss which is best suited for investors.
Fundamental analysis is an approach towards stock selection based on economy, industry and company and it is often called as top down approach. By this approach, an investor can identify the intrinsic value or true worth of a share. Accordingly, if the current market price of the asset is less than the intrinsic value or true worth, one should buy the same and vice versa.
One of the major assumptions of fundamental analysis that the price in the stock market does not fully reflects a share’s real value owing to information asymmetry. To become a fundamental analyst, one needs to have good understanding of basic economics; understand the businesses model especially with respect to the industry in which it operates; understand the basic financial statements especially how the cash flow is generated for the business and other allied aspects.
It is a separate branch of study which is very different from fundamental analysis. It assumes and operates on a simple principle that price discounts everything. It means that all of the factors considered by a fundamental analyst are reflected in the price of a financial instrument through buying and selling activity. Accordingly, supply and demand determine prices; changes in supply and demand cause changes in prices; prices can be projected with charts and other technical tools.
This field of study uses the data generated from the market such as price, volume, etc., which is often graphically displayed, in decision-making. The first recorded use of technical analysis was in Japan in the 1700s, where it was used to analyse trading in the rice market. Though this is the oldest tool being used by the Japanese, these tools were translated and widely understood outside Japan only in the 1980s.
Which one is best? Technical analysis approach derives the value, solely from price and volume data generated from the market. But, fundamental equity approach arrives at the intrinsic value differently. It predicts security price movements, by analysing various economic, industry and company data and incorporates data that are external to the market. A key distinction between technical analysis and fundamental analysis is that the technical analysis uses more concrete and actual data, primarily price and volume data.
The financial statements analysed under fundamental analysis are not objective data but are the result of numerous estimates and assumptions that have been added together to arrive at the line items in the financial statements. Fundamental analysis is more theoretical because it seeks to determine the underlying long-term value of a security. Technical analysis can be considered to be the more practical because it studies the markets and financial instruments as they exist, even if trading activity appears, at times, to be irrational.
To conclude, fundamental and technical analysis are both useful and valid, but they approach the market in different ways. You can use any one of the above or both as long as you are making money.
(The writer is associate professor of finance & accounting, IIM Shillong)