How to analyse a stock?

There are 2 main methods to analyse stocks: (1) Fundamental Analysis, and (2) Technical Analysis.

FUNDAMENTAL ANALYSIS focuses primarily on the valuation of a company and its relationship with the current share price. Fundamental analysts believe that it is possible to estimate the true value of a company using various valuation methodologies.

If the share price is trading below that value, 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.

TECHNICAL ANALYSIS focuses solely on the share price chart. Technical analysts believe that all information, including those which are not publicly available, is factored into the share price, and that share price behaviour is repetitive in nature and therefore can be used to predict future share price movements.

Based on historical share price data, technical analysts identify share price levels that act as support or resistance. If the share price is moving downwards toward a support level, the likelihood is that the share price will bounce off it. Conversely, if the share price is moving upwards toward a resistance level, the likelihood is that it will hit that level and reverse downwards. Technical analysts also use various technical indicators and chart patterns to help them determine probable future share price movements.

Which is the best? It is important to note that neither methods are fool-proof. Each method has its advantages and disadvantages. In fact, the shortcoming of one method is often the strength of the other. Combining the two methods can produce a superior investment outcome than if you had just relied on one. For example, FA could be used to identify companies with strong earnings growth profile and attractive valuation, while TA is used to confirm the market's perception on those stocks, as well as provide a basis for choosing suitable entry and exit prices.

Written by
Austin Hui, MBA CPA
Senior Investment Analyst

This article was first published in the November 2007 edition of TRADING DAY magazine http://www.tradingday.com.au . TRADING DAY is a free electronic magazine for Australian investors and traders. Subscribe online at http://www.tradingday.com.au .