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Fundamental and Technical Analysis – what do these terms mean anyway?
Fundamental analysis and technical analysis are the two major schools of thought when it comes to approaching the markets and picking shares to trade or invest in.
Both methods are used for researching and forecasting future trends in stock prices, and, like any investment strategy or philosophy, both have their advocates and adversaries. Investors and traders typically swear by one or the other.
Fundamental analysis – Guessing the future based on past trends and current observations
Fundamental analysis is a way of evaluating shares by trying to find their ‘intrinsic value’ or what they are really worth.
There are a number of ways to do this.
You can determine this via ratio analysis, valuation through discounted cashflow and other methods.
The problem with this is that we always need to look at past data – and don’t know exactly what’ll happen in the future. So analysts need to make assumptions, estimates and use some ‘educated guesswork’.
So a valuation or share price forecast is only as good as the assumptions that are made to get to it. And these can literally change every day.
That’s why investors like Ben Graham
for instance liked to have a ‘margin of safety’.
That means only investing in a company when the ‘value’ that was determined for it is 35% or even 50% higher than the current share price. This limits the downside.
Technical Analysis – using ONLY price data to predict share price movements
Technical analysis is concerned with looking at the share price charts of companies to predict their future price movements.
Many different techniques can be used here. A moving average line of the share price can be drawn. Indicators can be created from share prices, and volumes traded.
Trend lines, resistance and support lines can also be drawn in. There are even some patterns that have been identified to give you better success rates than others.
In short Technical analysis is about playing the odds. For instance, it’s been found that a certain pattern will give a share price a 70% chance of shooting upward. So if you look for this pattern and invest using it you will likely have good success.
But there’s a caveat…
Technical analysis requires a ‘liquid market’. That means there needs to be sufficiently high trading volumes in the market for the share price chart to contain the detail necessary for analysis.
That’s not a problem for highly traded shares like Naspers or Anglo. But when it comes to small cap
and penny stocks it is a problem. Most penny stocks don’t have high enough trade volumes to make technical analysis accurate. In fact, many penny stocks barely trade every single day! That means big swings in price, and gaps in the chart making technical analysis imprecise.
Which of these strategies will work for you?
Fundamental analysis is a great way to seek out companies that are good to invest in.
It gives you a mid-term, and long-term outlook on companies.
Once you have picked companies to invest in – you can use technical analysis to time your entries or at least check if there’s not a threatening drop in price on the horizon.
In short this means technical analysis is more suited to help you make short term decisions such as one week, one month or three months…
While some investors prefer the use of a single analysis method to evaluate long-term investments, a combination of fundamental and technical analysis is the most beneficial.
If you’re wondering about some fundamental analysis criteria to look at when picking a stock – I’ve compiled a short list of items you should start with.
At first all the financial terms might seem a bit much for you but the secret to investment success in the long run comes down to learning as much as possible – and understanding what you invest in.
So, in case there are any terms I use you might not have heard of, I’ve decided to give you a breakdown of some terms we often use as investors.
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Five investment terms you need to know about
Investment Term #1 – Revenue
There are a number of terms here that mean the same thing, they could be:
• Sales or net sales
• Total fees earned
Basically, revenue refers to the amount of money invoiced by a business in a particular time period from its customers or clients. You always need to remember that revenue is not cash in the bank.
As soon as a company invoices a client for services or goods it recognises the amount of the invoice as revenue – even before it has received payment. So while revenue is an important indicator of how much business a company does – it does not always show whether the company did well or not – because there could be a lot of unpaid accounts.
Investment Term #2 – PE Ratio
The PE ratio is also known as the Price/Earnings Ratio. This ratio gives you an idea how many times a company’s earnings (profits) can be divided into the company’s value.
So why does that matter?
Well think of the situation of buying your own business. You want to use the profits from the business to pay back what you paid for it.
So if the business cost you R1 million rand, and it makes R200,000 in profit each year the ‘PE ratio’ will be R1 million divided by R200,000 = 5. That means in five years the profit from the business will cover what you paid for it.
So obviously the higher this number the more expensive the share price is in comparison to the profits the company makes.
A high PE ratio can sometimes be due to a high expected growth rate of a company. If the company’s profits double next year – the PE ratio that year will be much lower – and so will be the ‘payback’ period of the initial capital compared to annual profits.
Investment Term #3 – Earnings per share
In order to calculate a PE ratio you need to know about earnings per share. Earnings are the profits a company makes. And to get earnings per share you divide them by the number of shares a company has in issue.
So, if a company has 1 million shares, and its earnings for a year is equal to R5 million, then the company’s earnings per share are R5 per share.
Investment Term #4 – Dividend Yield
Dividends are the portion of a company’s profits that are paid out to shareholders.
If a company’s share price is R10, and it pays you R1 per share in dividends then you can calculate the dividend yield by dividing the dividend amount with the share price and multiplying it with 100 to get the %.
So R1 / R10 * 100 = 10%
This gives you a way to compare the dividends a company pays you to interest you would’ve received in a fixed deposit or other investment.
Investment Term # 5 – Net asset value
The net asset value (NAV)
represents the net value of a company and is calculated as the total value of the entity’s assets minus the total value of its liabilities.
So if a company owns R1 billion worth of assets, and R100 million in debt it has a net asset value of R900 million. If the same company has 100 million shares in issue it will have a net asset value per share of R9.
Now, if the share price is R5, it means the company trades at a R4 (or 44%) discount to its net asset value.
For arguments sake, if this company were to sell all its assets and return the cash to shareholders they would receive around R9 per share – whilst only having paid R5 a share.
I hope these terms clarifies some aspects of investing for you today.
Remember – while we invest to make money for a certain goal such as an overseas holiday, early retirement or funding a certain lifestyle we can’t achieve that goal without learning a thing or two along the way!
Here’s to unleashing real value,
Editor, Red Hot Penny Shares