wikiHow to Analyze Market Trends

Two Parts:Using Fundamental AnalysisApplying Technical Analysis

Investors use several methods to analyze stock prices. Stock analysts apply tools to decide whether they should buy or sell a stock, given the current market price. Fundamental analysis looks at the financial performance of the company, particularly the firm’s profits. Technical analysis, on the other hand, considers trends in the stock’s price and the volume of shares traded. Both types of analysis are used to decide whether to buy or sell a stock.

Part 1
Using Fundamental Analysis

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    Use the value-investing concept to make decisions about stocks. The goal of value investing is to purchase stocks at a lower price than their true value. The value investor expects to be rewarded with an increased stock price as the firm’s fundamentals improve.[1]
    • Fundamental analysis considers the financial performance of a company. The goal of this analysis is to find a company’s intrinsic value.
    • Intrinsic value is a company’s true value. That value is based on the firm’s ability to generate profit and cash flows. Say, for example, that Acme company has been a publicly traded stock for 20 years. During that time, they have increased sales at average rate of 15% per year. Because of growing sales and smart decisions about expenses, the firm’s profit has increased at an average rate of 5% per year.
    • Acme’s performance provides value to investors in two ways. First, the growth in profits allows Acme to pay an increasing dividend amount to shareholders. Second, Acme can decide to keep some of the profits and use those dollars to grow the business. These are two components of intrinsic value.
    • The fundamental investor believes that the financial results will eventually be reflected in the price of the stock.
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    Analyze a company’s discounted cash flows. Fundamental analysis states that a company’s true value is the sum of its discounted cash flows. Investor perceptions of a business impact the stock’s price. However, the fundamental analysis asserts that a stock’s value should be based on these cash flows.[2]
    • Earning a profit generates cash flows into a business.
    • Once the company collects cash from its sales and pays it bills, any remaining cash represents profit.
    • The cash flows are discounted into today’s dollars using the time value of money. You can learn more about this calculation using this link: Do Time Value Money Calculations. The time value of money assumes that cash flows received in future years will be worth less, due to inflation.
    • Consider the Acme example. Assume that the firm’s profits are expected to increase at an average rate of 5% per year for the next 10 years. Also assume that the inflation rate will be 3% per year for 10 years.
    • To compute the present value of the cash flows, you would first compute the total dollar amount of profit earned each year, using the 5% growth rate. Next, you would discount those future profits into today’s dollars. You would use the 3% inflation rate to discount the payments into today’s dollars.
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    Apply the discounted cash flow method to analyze a stock’s price. The future cash flows generated by company profits are all discounted using the time value of money. The sum of those cash flows is the true value of the stock.[3]
    • The (true value of the stock) divided by the (number of common stock shares held by investors) equals the true value per share. Calculating a value per share allows the investor to compare the stock’s true value to the current market price.
    • If investors push the market price of the stock below the true value, fundamental analysis states that the stock is undervalued. Investors should buy the undervalued stock.
    • Assume that the future value of Acme company’s earnings is $3,000,000. Acme has 300,000 common stock shares held by investors. The true value per share is ($3,000,000 earnings) / (300,000 shares) = $10 per share.
    • If the market price of the stock is below $10 per share, fundamental analysis states that the stock’s price is undervalued. On the other hand, a market price above $10 per share indicates that the stock is overpriced.

Part 2
Applying Technical Analysis

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    Go over the technical analysis method. Technical analysis does not consider the financial performance of a company. The profits and cash flow of the business are not considered in this analysis.[4]
    • Technical analysis considers statistics that relate to the market activity of the stock. Technical analysis is not aimed to discover what investors think, but what they do by looking at buys and sells of securities. Two widely used statistics are the stock’s historical change in stock price and the stock’s trading volume.
    • A technical analyst believes that historic trends in a stock’s price can be used to predict a future change in the stock’s price.
    • Trading volume refers to the number of shares of a stock that are traded each day. Technical analysts also believe that changes in trading volume can be used to predict a change in a stock’s price.
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    Use a stock’s moving average in price to determine a market trend. Moving average simply adds up the price of a stock for a certain period and divides that total by the number of trading days in the period. Moving average is a statistic used to chart a trend in a particular stock’s price.[5]
    • Assume, for example, that you add up the prices where IBM stock traded for the first trading 10 days of October, then divide the total by 10. The average price is $150. Trading days refers to the weekdays that the stock market is open.
    • You then repeat the calculation each trading day. On October 11th, you calculate the moving average for prior 10 trading days- including the 11th. Drop the first day and add the 11th day to maintain a ten day average. Each day’s moving average calculation will be slightly different.
    • Say that your analysis shows moving average prices of $150, $150.75 and $152. You technical analysis concludes that, over time, the trend of the stock price is slowly increasing.
    • If the moving average starts increasing at a faster rate, that change indicates that a technical investor should buy the stock. On the other hand, if the moving average decreases at a faster rate, a technical investor may sell the stock. The trend is considered broken when the stock price breaks the moving average line.
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    Research the price of a stock using trading volume. Trading volume refers to the number of shares that trade during a specific period of time (Day, week, month).[6] Trading volume results are usually combined with other types of analysis to make a decision about buying or selling a stock.
    • Assume that IBM’s common stock normally trades 100,000 shares per day. If the number of shares traded increased or decreased sharply, that may be an indication of a trend.
    • Say, for example, that the trading volume increased to 150,000 shares per day. At the same time, the stock’s moving average began to increase sharply. The increases in both of these technical indicators may present a signal to buy the stock. Technical analysis shows that the stock price is moving higher. Increasing volume with an upward trend indicates accumulation, while increasing volume with a downward trend means liquidation. Most technicians consider movement without volume has little value.
    • If the trading volume increased and the moving average declined sharply, that may indicate a downward trend for the stock. The technical analyst may conclude that more people are selling the stock, due to the increase in trading volume and the price decline.
    • Other technical indicators that technicians consider to determine buying or selling opportunities include short interest and support and resistance levels. Short interest measures the total number of shares of a stock that have been sold short without being covered or closed out. A high short interest is a red flag.[7] Support and resistance levels refer to price levels beyond which the price of an asset will not go in a certain direction.[8]

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