What is fundamental analysis, and how is it different from technical analysis?

Investors use metrics such as a company’s profit & loss statement, balance sheet and cash flow statements to arrive at this estimation. While evaluating companies, an analyst or an investor can also take into account macroeconomic conditions to project a company’s growth trajectory. For instance, an increase in global demand for steel will likely cause the price of the commodity to go up. This will benefit steel producers, who will then hope to sell their products at a higher price.

In effect, investors use fundamental analysis to decode a company’s financials, better understand the factors behind those numbers and use other metrics such as business environment or economic situation to understand if the market is correctly reflecting its value, and to project the business’ future.

There is a big reason why fundamental analysis is a powerful tool if used well.

As you know, thousands of companies are listed in the market, and their price keeps moving up and down every few seconds or minutes. Why does this happen? Because investors buy and sell shares of companies because they may have opposite view on the companies’ future growth. Or they don’t care about the company’s business, they will use other studies (such as technical analysis, which we will briefly talk about below) to predict that its stock will move higher or lower and they will try and profit from it. In fact, many investors even use their gut feeling to trade on stocks or on patterns they observe and believe in. (They might think: “I believe xyz stock falls in the morning but rises after lunch”).

What does this mean? Pick up any large company and look at how their stock has performed over the past one year, and you will see at least a 30% to 50% variation in highest and lowest price. Now, the second question to ask is — do companies’ business prospects increase or decrease that much over one year? The obvious answer is no.

So, if you are able to estimate the fair value of a company, and you sit tight, the market’s short-term gyrations will soon enough give you an opportunity to buy it cheap and profit from an upswing in price later.

Fundamental analysis will also give you the skills to identify and the confidence to remain invested in companies that will grow at a strong pace over several years, allowing you to build wealth as companies’ share prices tend to mirror its long-term growth.

Fundamental analysis is not the only technique that is used by market participants.

The other prominent field of study is called technical analysis.

Technical analysis is the use of price and volume data to predict future prices. Technical analysis ignores a company’s fundamentals by assuming that they are already priced into a stock. That is, if a company does well, its price will sooner or later do well at which point its price action will give you a buy signal.

So how should you use fundamental analysis and technical analysis?

While fundamental analysis tends to work over longer-term periods, ranging at least a few months to, in many cases, several years, technical analysis can be used to predict short-term price movements.