Trading in shares and wondering how to value your portfolio or potential investment?
Two basic techniques are used to calculate a shares fair value or intrinsic value and trade the shares.
Fair value or intrinsic value means relates to what the company is actually worth instead of the price assigned by the stock market.
The two ways to measure value for stock traders are technical analysis and fundamental analysis. These can be broken down into two different techniques.
We will look into both of them and try to see what’s best.
Technical analysis is the study of past market action to try to gauge what the market might do in the future. At its most basic, it is a study of price. Technical analysis doesn’t care about the value of the company, it assumes that whatever is happening in the market is accurate. It is based on the efficient market theory.
Technical analysis is based on 3 principles:
- Market action discounts everything
This is the most important statement and forms the basis of technical analysis. Unless this statement is fully understood, you won’t be able to make sense of the following things.
All the known information is already priced into the price of the stock including its fundamental factors.
As soon as the new information comes out, it immediately reflected in the price of the stock.
The price action should reflect shifts in supply and demand. If the news is good, then the demand will increase and the price will go up and if the news is bad, the supply will go up and the price will fall.
This statement is then turned into a conclusion where if the price rises, the fundamentals of the company must be bullish and If the price falls, the fundamentals must be bearish.
- Price moves in trends
The whole purpose of charting is to create trends in stock price action. There is a belief that price moves in trend motion and are more likely to continue than to reverse.
- History repeats itself
Much of technical analysis is based on the study of human psychology. Chart patterns, for example represent the bullish or bearish psychology of the stock market. These patterns have worked great in the past 100 years and therefore it is assumed that they will continue to work well in the future as well.
These charts are based on human psychology that tends not to change.
Once you understand these three factors you can learn technical analysis with ease.
Fundamental analysis believes that the efficient market theory doesn’t work in the real world and that people overacted to news and therefore overprices certain stocks and undervalues certain stocks.
On the other hand, fundamental analysis is a technique where you need to learn about the company and study the company’s financials like balance sheet and cash flow statement to see how the company makes money.
Once you have a good understanding of the company, you can fairly value the company by estimating how the business model will hold over the future and will the company will be able to earn money using that model if the conditions remain the same.
Then you need to consider the external factors that can affect the industry and more importantly your company.
I know this sounds like a lot of work in the beginning but it may be worth doing this hassle.
Once you do this and you like it, it could become like a game to you that you will enjoy.
The benefits and payouts are the best in the fundamental analysis as it tries to project long term value when looking at long term, compound interest sets in that give you a better return than anything else.
The biggest drawback of this is that, if you don’t do the analysis properly, you will not get an accurate fair value of the company.
For this exact reason, there is a technique that allows you to make a little mistake and still make a profit.
This technique is called a Margin of Safety (MOS) which means that if the value of the company is 100 then you only buy the company if the company price falls below the fair value.
Generally, 20-30% MOS is acceptable but if you can get a 50% MOS then you may have found a winner that can earn you a lot of money provided you understood the company well.
The method you chose is up to you based on your comfort zone and interests.
I like using fundamental analysis to value a company and I know a lot of people who like technical analysis and have done great with their investments.
There is no perfect method and it all depends on you.
Let me know which method you liked and are thinking of implementing in your investing strategy.
Aryan Agarwal is currently pursuing a degree in MBA. Read more on his blog Financetasy which focuses on the topic of personal finance and investing.