The two main ways analysts derive stock prices and position trades are through technical analysis and fundamental analysis. Both methods have their merits. Technicians use technical analysis to indicate when to buy a stock, whereas fundamentalists use fundamental analysis to determine whether the stock is worth buying.
Technical analysis focuses on trading patterns and levels of volume to determine when a stock should be bought or sold. "Resistance" and "support" are ubiquitous vocabulary words in technical trading. These levels show patterns of when stocks are overbought or oversold, and when to time trades.
Ratios are used extensively in fundamental analysis. This type of analysis determines the value of a stock based on financial statements, earnings reports, and economic analysis. Price to earnings, or P/E, is the biggest ratio used in valuing equities.
Financial statements are a major part of fundamental analysis. The balance sheet is used to determine assets and liabilities, and to report on a company's financial condition. The income statement shows profitability and the cost of operating the business. The cash-flow statement is used to determine future cash flows and reveals how a company spends its money.
Although fundamental analysis is supported by mathematics, technical analysis is more of a pseudoscience or predictive methodology. Stock analysts use the fundamental approach when issuing research reports, but technical analysis is not used as a solid foundation for reports.
- Getting Started in Fundamental Analysis; Michael C. Thomsett
- Economics; Walter J. Wessels
Daniel Cross resides in Florida and has been writing investment and financial articles since 2005. He holds the Chartered Financial Consultant designation from the American College in Bryn Mawr, Pennsylvania.