Price predictions
If you've spent time reading about the ASX share market and following stocks, you've probably come across some bold analyst predictions.
Maybe you read an article entitled something like, Broker says these ASX 200 shares can rise 20% to 50%, and wondered how analysts could develop such specific price forecasts.
Well, they likely used one of two main styles of stock market analysis: fundamental and technical analysis.
In this article, we cover these two analysis styles so that you can better understand how experts make their price predictions (and maybe even do some analysis of your own!)
What do we mean by stock analysis?
The stock market is a lot like a trash and treasure market. Some genuinely valuable antiques and rarities lie hidden amongst the bric-a-brac and moth-eaten old clothes. Within both the stock market and the trash and treasure market, you aim to try and find the best deal. But this requires research.
In the share market, we do this through stock analysis – think of it like reading up on old vinyl before you go to the trash and treasure market. It's the tool we use to determine if a stock is overpriced or a valuable bargain.
But there are different approaches you can take to analysing a stock. The two main styles are fundamental and technical analysis.
We Fools prefer fundamental analysis for making sound long-term investment decisions. It examines the company's business and financial performance to determine if the market is undervaluing it.
Technical analysis involves analysing stock charts to try and predict where the market will move in future.
Let's unpack fundamental analysis
Fundamental analysis uses data about the company's financial performance and business operations to develop a valuation for the company.
Fundamental analysts will often use complex financial models that incorporate information about broader industry trends and macroeconomic factors into the analysis. Continually developing and recalibrating these models is what professional equity analysts do all day.
We can compare the company value generated by the analysts' models against the stock's market capitalisation to determine whether the share is currently under, over, or fairly valued by the market. If the analyst believes the market significantly undervalues the stock, it signals that the share is a good buy. In other words, most of the market is ignoring a great bargain!
Fundamental analysts can use all publicly available information about a company in their analysis. That can include both quantitative and qualitative data.
Which data?
Quantitative data is all the numbers and figures about a company. The obvious source of quantitative data is a company's financial statements. Fundamental analysts can use information about a company's sales, assets, profits, and share price movements to calculate all sorts of metrics and ratios to help them value the company.
A good example is the price-to-earnings (P/E) ratio. We calculate this by dividing a company's share price by its earnings per share. It effectively tells you how much investors will pay for a dollar of the company's profits. We can compare the P/E ratio of one share against another to determine if one might be relatively undervalued.
The other type of data some fundamental analysts rely on is qualitative data. If quantitative data is all the numerical data about a company, qualitative data is everything else. It might be information about how consumers feel about the company's brand or its corporate values and aspirations.
The holistic view
Fundamental analysts form a holistic company valuation by combining quantitative and qualitative data.
But you don't need a finance degree to use fundamental analysis techniques in your investing strategy. You can be a fundamental analyst if you understand how to interpret standard financial metrics. And we have you covered here at the Fool, with plenty of information in our Education Hub.
In fact, fundamental analysis is our preferred method of valuing companies. Here at the Fool, our philosophy is that investing should be for the long term. We try to use fundamental analysis techniques to identify tomorrow's best companies today. Then, we buy and hold them – even if things get volatile – to reap the future rewards of compound returns.
Not every stock we pick will be a winner, but holding a diversified portfolio of promising shares is the best way to achieve long-term financial security.
This means we aren't massive fans of technical analysis. This technique, which we'll explain in the next section, uses ideas about behavioural finance to try and profit from temporary movements in share prices.
Here at the Fool, we're long-term investors, not short-term traders, so we rarely use technical analysis. Still, having an understanding of the technique can be helpful on your investing journey, as many analysts do use it.
What is technical analysis?
Technical analysts use information about a stock's price and trading volume to predict where it will move in the future. If their analysis suggests that the share price will likely rise, the stock is a buy.
However, as the price moves and conditions evolve, the share could quickly change into a sell. It means technical analysis best suits active traders who can monitor their positions constantly.
Technical analysis relies on the idea that past movements in a company's stock price can provide insights into its future direction. So, they will look for repeating patterns in share price movements and then execute their trades when they believe one of their identified patterns is about to start over again.
Technical analysts even have evocative names for the most commonly observed stock chart patterns, like the 'head and shoulder', 'rising wedge' and 'cup and handle'.
This form of analysis incorporates key aspects of behavioural finance – namely that investor fear, greed, and excitement drive movements in a company's stock price. Technical analysts believe this behaviour is predictable, resulting in similar price movements each time.
Whether you are drawn to technical analysis may depend on your view of the markets (and perhaps even humanity!). If you think history often repeats itself, and human behaviour is relatively predictable, you might find that aspects of technical analysis appeal to you.
However, others might think that's all rubbish and the only way you can value a company is by taking a long look under the hood to see how the thing actually runs.
You know which camp we're in!
Foolish takeaway
In this article, we've covered the two main styles of stock analysis – fundamental and technical. We've also provided many links to our other educational resources to investigate these techniques further.
Understanding these two approaches to stock price analysis can help you on your investing journey.
And remember, you don't need to be a full-time analyst to use fundamental analysis techniques. Many metrics, like the P/E ratio, are freely available on sites like ours – so let us do all the number-crunching for you!
As long as you understand what some of the most common metrics tell you about a stock, you can still use them to help guide your investing decisions.
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This article is part of Motley Fool Australia's comprehensive Investing Education series, covering everything from budgeting and saving to basic investing concepts and how much money you'll need to start.
Packed with easy-to-understand and regularly updated information, our articles contain the answers to your most frequently asked questions about share market investing.
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