Chapter 13

Fundamental and Technical Analysis

FINA 34780: Investments 2

Introduction
Engage in analysis to :

Identify growth sectors

Identify undervalued/overvalued securities
Produce reliable research reports
Know what information to look at and what to ignore

Understand analysis to:

Be a better consumer of financial information

Understand the methods and conclusions of analysts
Understand the limitations of analysis

Learning Objectives
1. Compare and contrast fundamental and technical
analysis, and evaluate the three market theories
explaining stock market behavior
2. Describe how the four macroeconomic factors
affect investor expectations and the price of
securities
3. Analyze how industries are classified and explain
how classifications impact a companys stock
valuation

Learning Objectives
4. Calculate and interpret the intrinsic value of a
stock using the dividend discount model (DDM)
5. Define technical analysis and describe the tools
used in technical analysis

Methods of Analysis

LO1

Fundamental Analysis

Focus is on industries and companies

Macro factors, industry conditions, company financial
conditions, management performance, etc.
Purpose is to evaluate the actual /expected
profitability/cash flows of an issuer

Technical Analysis

Study of historical stock prices and stock market behavior

Look for recurring patterns
Price movement, trading volume, highs and lows over
time

Market Theories

LO1

Efficient Market Hypothesis

Investors react quickly to new information

Therefore prices fully reflect all available information
Thus, fundamental and technical analysis is not worth
the effort

Random walk Theory

New information comes out randomly, therefore price

movements are random
Therefore, technical analysis is useless

Market Theories

LO1

Rational expectations

Investors are rational and will use information intelligently

All have access to all necessary information
Mistakes can still be made, but the mistakes are random
errors neither too often to the downside, nor too often to
the upside

No bias, in other words

Hence prices are called unbiased estimators of the true intrinsic
value of the security

Conclusion from all three: securitys price is the best

estimate of its true value

Evidence

LO1

Studies into all three market theories have mixed

results

No evidence that:

New information is available to everyone at the same time

Investors react immediately to all information in the same
way
Investors make accurate forecasts and correct decisions

Fundamental Macro Analysis

4 broad categories
A. Fiscal Policy
-

Government spending, taxes, and debt

Policy may be broad based or targeted

B. Monetary Policy
-

Interest rates and money supply

Yield curve analysis

LO2

Fundamental Macro Analysis

LO2

C. Flow of Funds
-

Falling interest rates tend to improve the appeal of stocks over

bonds, and vice versa
Typically, when stocks rise, bond prices tend to drop

D. Inflation
- High levels lead to higher interest rates, lower corporate profits and
lower PE multiples

Fundamental Industry Analysis

LO3

Classify industry by 4 different characteristics

1. Product/Service
-

Economy is divided into 10 major sectors

-

Industries are within the sectors, and sub-industries are

within industries

Estimate growth prospects for the industry versus the

economy

2. Stage of Growth

Fundamental Industry Analysis

Emerging

Growth

LO3

Fundamental Industry Analysis

LO3

Emerging Growth usually negative cash flow from

operations and Net Loss

Little more than a good story at this stage

Grow through debt

Growth sales/earnings expanding at a faster rate

than most industries

Grow through retained earnings

Maturity growth closer to overall economic growth

Price competition increases

Dividends become important

Decline none to negative growth

Newspapers, book stores, video rental, TV Networks

Fundamental Industry Analysis

LO3

3. Competitive forces
-

Porters 5-forces model

-

Ease of entry
Degree of competition (fragmented or consolidated)
Threat of Substitute products
Degree of Buyer power
Degree of Seller power

4. Stock Characteristics
-

Cyclical (commodity-based, industrial, consumer

cyclical) do very well in expansions, do very poorly
in contractions

Fundamental Industry Analysis

-

LO3

Defensive dont do as well in expansions but tend to

outperform in contraction
Speculative usually emerging industries or those
with rapid innovation

Biotech/technology

Valuation Models

LO4

Dividend Discount Model

Stocks current price is the NPV of all expected future cash

dividends

3 basic Laws of cash

Sooner cash flows are worth more

Larger cash flows are worth more
Safer cash flows are worth more

PE ratio

High PE growth stock

Low PE value stock
When interest rates decrease, PE ratios tend to increase (multiple
expansion)
Companies within the same industry tend to converge around
specific PE ratios

Technical Analysis

LO5

Study price, volume and time using charts

Look for recurrent patterns

Feel it works because technicians believe:

All information shows up in prices, so no need to find the

information, just watch the tape
Prices move in trends and tend to persist for relatively long periods
of time
The future repeats the past (or at least rhymes)

Technical versus Fundamental

Study price movements versus study the cause of price

movements
Tries to identify when to buy or sell versus what to buy or sell

Tools of Technical Analysis

1. Chart analysis

Very useful for support/resistance levels

Identify regular patterns

Reversals, continuations

LO5

Tools of Technical Analysis

LO5

Tools of Technical Analysis

Continuation Patterns

Break-outs on volume
signal continuation of the
trend

LO5

Tools of Technical Analysis

LO5

Tools of Technical Analysis

When the neckline is broken from above it indicates an

imminent steep price decline.

LO5

Tools of Technical Analysis

When the neckline is broken

from below it indicates an
impending price surge.

LO5

Tools of Technical Analysis

LO5

Tools of Technical Analysis

2. Quantitative Analysis
-

Moving averages (slow versus fast)

Oscillators used when there is no trend

MACD (12 vs. 26 dma) plus 9-dma signal line
-

Crossovers are buy/sell signals

LO5

Tools of Technical Analysis

LO5

3. Sentiment Bull/Bear ratio

4. Cycle indicators
-

Elliot Wave markets make 5 moves up and three

moves down
Fibonacci Retracements

Credits
Mark Meldrum, PhD
(December 2014)

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