When it comes to the stock market, there are generally two types of participants: Investors and speculators.
The investor category can be broken down into smaller categories such as active and passive. The active investor will try to pick individual stocks by focusing on a company's fundamentals such as revenue, profit, cash flow, balance...etc. On the other hand, the passive investor will invest in an index fund such as an ETF or mutual fund and simply try to capture the market average.
The most popular index fund is the SPY which tracks the S&P 500 and has averaged an 8-10% annual return since its inception. Investors typically have a long time horizon which ranges from 1 year to a lifetime.
Unlike investors, the speculators base their buying and selling on price patterns and have much shorter time horizons. A speculator will generally hold a stock for as little as a few seconds to as long as a few months. Often times, charts are used in order to discover and track historical patterns in an attempt to anticipate a stock's next movement in price.
Although there are many different styles for both investing and speculating, for this article I will be focusing on only 2 main styles: Value Investing and Technical Analysis.
What is Value Investing?
Simply put, value investing is a strategy where an investor tries to buy stocks at a discount to their intrinsic value. Value investing has worked very well in the past and will continue to work well in the future because it's based on common sense. The beauty of this approach is that it makes the investor think like an owner of a business rather than just a person buying shares in the hopes that they will appreciate in value.
If you were to buy a business outright to have 100% ownership, which companies would you prefer, the ones who are seeing losses grow and have a lot of debt or the ones who are seeing their profits grow with low debt? Although there are no guarantees, this perspective will definitely help weed out those terribly volatile companies that usually end up bankrupt or see massive declines in value.
How to Value a Company
Value investing is tricky because what one investor sees as value another sees as garbage and that's what makes a market. There are many different methods for determining the intrinsic value of a company. However, these methods can be grouped into 2 categories: absolute and relative value.
Absolute value is estimating what the price per share ought to be based on a company’s fundamental analysis. The discounted cash flow model (DCF) is the gold standard for valuing companies. The way it works is that an investor will estimate future free cash flows, discount them back to present and then add it all up. The sum of these cash flows represents the intrinsic value of the company being analyzed.
For example, an investor wants to determine the absolute value of company A using a 10% discount rate. Let’s assume the company will generate $100 in free cash flow in year 1 followed by a 5% increase every year up to year 5 after which it will be reduced to 2% per year. The calculation would be as follows:
100/1.10 + 105/1.10^2 + 110.25/1.10^3 + 115.76/1.10^4 + 121.55/1.10^5 + 123.98/0.08 = $1,965.80
Or
90.90 + 86.78 + 82.83 + 79.07 + 75.47 + 1549.75 = $1,965.80
Therefore, we now know that the company is potentially worth $1,965.80. If its current market cap is $1,000 then we can say that the company is undervalued.
Example of Discounted Cash Flow analysis.
On the other hand, relative value is when a company is compared to key competitors in order to assign an appropriate multiplier based on its market position relative to the other companies. Commonly used multipliers include price to earnings, price to free cash flow and enterprise value to EBITDA. The higher the multiple the more expensive the stock is.
For example, let’s say we are looking at 3 different competitors in the retail industry and we want to use the price to earnings ratio (P/E). Company A is trading at a P/E of 10, company B a P/E of 20 and company C a P/E of 25. While analyzing the companies, we determine that company B is actually a stronger competitor than Company C. Since company C is trading at a higher multiple despite being weaker than company B we would conclude that company B is undervalued whereas company C may be overvalued.
Example of comparing a company to the rest of the industry.
What is Technical Analysis?
Technical analysis is a method that uses patterns in market data to identify trends and make predictions. Unlike value investing, the underlying fundamentals of a business are not usually considered by most traders.
The advantages of using technical analysis is that it can capture the current market sentiment of a stock. Important indicators used by traders track patterns related to volume, price movement, moving averages, oscillators, momentum, support levels and resistance levels.
A common strategy is to watch for the crossovers of the 50 day and 200 day moving averages. If the 50 day moving average crosses above the 200 day then it is considered a positive indicator. If the 50 day MA crosses below the 200 day MA then it is considered a negative indicator. There are hundreds of different indicators that can be used and combined to create trading strategies.
Combining Fundamental and Technical Analysis
Most investors and traders tend to focus on either fundamentals or technicals alone. However, it is much more beneficial to combine the two as it will maximize returns and save you some headaches.
For technical traders, digging a little deeper into a company’s fundamentals can potentially make price movements more predictable because there are generally underlying reasons for price directions. For investors, understanding technical analysis can potentially help pick better price entries for investments. For example, although a stock may be cheap, if the technical indicators are pointing towards a continued decline in stock price then entering the investment may be very painful for investors in the short to medium term.
Technical Analysis can be tricky but relatively easy to learn and understand the basic concepts. Fundamental investing on the other hand can be more sophisticated and much more time consuming because the investor has to take deep looks into quarterly/annual filings.
If you find yourself not having the time or interest to look into a company’s fundamentals then try our stock reports where we summarize hours of research onto just 2 pages. https://www.stockbrosresearch.com/stockresearchreports.html
This will allow you to quickly analyze the most important factors relating to fundamental analysis without reading 100-200 pages worth of quarterly and annual filings.
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