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Stock Valuations: Fundamental Analysis vs. Technical Analysis

By Bret Hartman

There are several ways to evaluate a stock, two of which are fundamental analysis and technical analysis.

Fundamental analysis assumes that markets are efficient and that consumers behave rationally to various events that could impact a stock’s price. This analysis uses financial reports, industry analysis, social variables and political issues to analyze a stock. Fundamental analysts then use these tools to come up with a future estimated target price or a future outlook with the given current information.

Technical analysts (technicians) will only use trading data, which includes historical prices and volume levels. Volume is simply the amount of shares that trade hands over a specific time. They use this data to analyze trends that have occurred and that they believe will occur again. Without the assumption that these trends will occur again, technical analysis can be dismissed. Technical analysts believe that irrational human behavior is the reason why trends have been established and their belief is that consumers will continue to act irrationally. Technical analysts do not need to know in-depth knowledge about a company before they analyze it. They can use previous trends and volume levels to generate target buy and sell prices.

Arguments For Technical Analysis:

Technical analysis assumes that the stock market reacts to changes six months prior to the economy reacting. This is confirmed by the stock market being classified as a leading indicator. In simpler terms, the argument is that technical analysis is superior to fundamental in the belief that fundamental analysts are working off old information. Technical analysis is useful in the valuation of investments that do not offer financial reports. For example, a direct investment in a commodity (oil, gold, or natural gas) is better served using technical analysis as financial reports are unavailable.

Arguments Against Technical Analysis:

Have you ever read the fine print on an investment prospectus that says “Past performance is not an indicator of future results”? This fine print is the main argument against technical analysis. If a certain price trend has continued to occur over the past ten years, it does not necessarily mean that it will happen again next year. Although it can be helpful to know how a stock has reacted in the past to certain events, the circumstances will likely change in some way.

For example, summer in the U.S. has been a historical time of higher oil prices. A technical analyst may make an assumption that oil prices will rise steadily from May to the end of August. This analyst would make his valuation without regard to current business cycles or changes in the oil industry. We are experiencing a major change right now with oil. Supply has greatly overcome demand, thus leading to a decrease in oil prices. Another key argument against technical analysis is that consumer’s behaviors can change. With a change in consumer sentiment or any psychological change, trends will not repeat themselves in the exact same manner.

Arguments For Fundamental Analysis:

Fundamental analysts try to gauge a stock’s future outlook given the current information available. This includes a company’s current earnings per share, debt levels and numerous valuation ratios. The price-to-earnings (PE) ratio is a popular tool used by many investment professionals, including Gross Investments. If two companies in the same industry have the following PE’s of 10 (Stock A) and 11 (Stock B), we can conclude that investors are willing to pay $10 for every $1 of earnings in Stock A and $11 for every $1 of earnings in stock B. If these are two very similar companies in the same industry, we can conclude that Stock A has better value. Of course this is assuming all things are equal. (Hint: they never are.)

Lets go back and reference the “Arguments For Technical Analysis”, and the discussion on valuation of commodities. For fundamental analysts to overcome this hurdle they can analyze a stock that has a large portion of its business tied to a commodity. For example: Fundamental analysts could analyze an oil company or mining company to reach a forward-looking valuation.

Arguments Against Fundamental Analysis:

When using the PE ratio comparison, it is important to compare stocks that are similar. For example, comparing stocks in the same industry, same market cap size or comparing stocks with similar dividend yields (which has its grey areas). Let’s say you are considering investing in two different stocks: Netflix and Johnson & Johnson. Netflix has a forward PE of over 100, while Johnson & Johnson has a forward PE of 17. A first time investor would say Johnson & Johnson has a better value. They would be correct in that statement, but it is not relevant given the glaring differences in the two companies. The two stocks are in different industries, different stages of their business cycle, different business models and both have completely different growth expectations. The comparison of Netflix and Johnson & Johnson would be like an NFL scout comparing an established quarterback to a rookie kicker.

 

Our Verdict:

At Gross Investments, we have sided with the use of fundamental analysis. We are a firm believer that past performance does not indicate future results.

Future earnings multiplied by the forward PE will equal future stock price (fundamental analysis). It is our job to create our best estimates as to what these variables will be. By analyzing current financial statements and understanding domestic/global headwinds we can set target buy and sell prices confidently. Although technical analysis has its advantages, we believe that a forward-looking approach is the best fit for our clients and the most proactive.