What are the various analytical approaches for valuation of stocks?
For investing, an investor can use an approach based on either fundamental analysis, technical analysis or quantitative analysis.
What is Fundamental Analysis?
It is the process of looking at a company's business from an investment point of view. The process involves analysing a company's management capabilities, its competitive advantages, its competitors and the markets it functions in. As part of the analysis, you would look at examining key financial ratios like the net profit margins, operating margins, earnings per share and so on. After examining the key ratios of a business, one can come at a conclusion about the financial health of a stock and determine the value of the stock. It further focuses primarily on the valuation of a company and its relationship with the current share price. Combining all this, the analyst arrives at a valuation for a stock. Fundamental analysts believe that it is possible to estimate the true value of a company using these financial valuation methodologies. If the share price is trading below the value arrived at by a fundamental analyst, investors should buy the stock, in anticipation of the share price rising to the true value in the future. Conversely, if the share price is higher than the estimated true value, investors should sell.
What is Technical Analysis?
This technique focuses on the past to predict the value of the future, using share prices and volumes traded in a stock. It does not look at fundamentals or financial results at all. Technical analysts believe that all information about a company is factored into the share price. According to them, share price behaviour is repetitive in nature and hence can be used to predict future share price movements. Based on historical share price data of a company, technical analysts identify share price levels that act as support or resistance. They try to identify support, resistance and breakout levels for stocks. Technical analysts also use various technical indicators and chart patterns to help them determine probable future share price movements.
What is quantitative analysis?
With the advent of computers, a third type, namely quantitative analysis, has come up. Quantitative analysis seeks to understand behaviour by using complex mathematical and statistical modelling, measurement and research. It is a process of determining the value of a security by examining its numerical, measurable characteristics like sales, earnings and profit margins. Pure quantitative analysts look only at numbers with almost no regard for the underlying business. Although even fundamental analysis look at numbers from a balance sheet, their primary focus is always the underlying business, the environment in which the company is operating and so on. Quantitative analysts create mathematical algorithms, which help them arrive at buy and sell decisions.
Which is the best?
The different analytical tools have different uses. For instance, fundamental analysis could be used to identify companies with a possibility of strong earnings growth in the future. Technical analysis could be used to decide when to buy this stock. When you combine technical and fundamental analysis it is called techno-fundamental research. Depending upon your style and time frame of investment you could choose among them.
