I recall beginning university and asking my first finance tutor â€will we learn how things are priced on the share market and why those prices move?†I was completely confused. I knew that a share was part ownership of a company, but that was about it. I saw my dad’s online brokerage account and was baffled †I craved a better understanding. However, I had no idea where to begin my quest for knowledge. I tried Google but it just led me to forum discussions regarding technical and fundamental analysis, which had me only more confused. I opted for the â€Dummies Guide to Share Investingâ€, which was a reasonable start. In truth, my understanding grew over time as I studied finance at university, but I wish I’d have had a guide to give me a good understanding of the bigger picture in those earlier years. Reflecting upon this, I decided to have a go at writing a beginner’s introduction to the stock market. Where to Begin: Debt, Equity, and What is a Share? A company has value, which can be measured. To keep it simple, two groups of people invest in a company: debtholders and shareholders. As a result, both of these groups have some claim on the value of the company. Debt is a loan to the company. The debtholder lends an amount of money to the firm, and expects interest payments in return. Equity is the residual (leftover) value. That is, the value of the firm minus total debt. Shareholders are said to â€own equity†in the company. So what is a share? It is simply a fraction of that equity. For example, a corporation may have $1 million of equity, divided into 100 000 shares. Each share is worth $1m 100 000 = $10. As a part-owner of the company, the shareholder expects to receive a portion of profits †these are called dividends and are usually paid semi-annually. Shares are sold on a stock exchange. In Australia, the main exchange is the Australian Securities Exchange (ASX); in America it is the New York Stock Exchange (NYSE). When a company sells shares for the first time on the stock exchange, it is said to have â€listed†on the stock exchange. It can now also be described as a public company (since it is owned by many members of the public), as opposed to a private company (which is owned by only a few individuals). When a company â€goes publicâ€, the original owners sell some of their equity, receiving cash from the new shareholders. They will then invest that cash in the business. After a company is listed, investors can buy and sell its shares on the same stock exchange. The vast majority of transactions on the exchange are between investors, in companies which have been public for many years and have now grown to a considerable size. Why does the share price change? Investors are continually receiving new information regarding companies in which they hold shares. Information may be company-specific (such as dividend announcements, profit estimates, or the resignation of a CEO), or economy wide (such as GDP forecasts, inflation figures, or unemployment statistics). Most of this information will affect the value of the company, and, as a result, the value of investors’ shares. If a piece of information comes out which increases the value of the company (for example, a greater than expected increase in profit projections for next financial year), then investors will be willing to pay more for the share. If, on the other hand, a government report is released which predicts lower than expected economic growth for next year, then the share will be worth less to investors and the share price will fall. There are two main methods used to examine the information available to the market: fundamental analysis and technical analysis. Fundamental Analysis Fundamental analysis is the process of determining what a share is actually worth to the investor †that is, determining the share’s â€intrinsic valueâ€. If the current market price of the share is below this intrinsic value, then the investor has found a bargain and they will purchase the share. If the market price is above the intrinsic value, then the share is said to be overpriced and a fundamental analyst will not purchase it (or sell it if it is already owned). To determine a share’s intrinsic value, an analyst may look at the company’s financial statements and reports, and use various mathematical models to determine future profitability (and hence what each share will earn in the form of dividends). They will also examine the environment in which the firm is operating in, including its’ competitors and the overall economic outlook. The assumption of the fundamental analyst is that in the short run, opportunities may arise to purchase undervalued shares; however in the long run, the share price will move with the true value of the business. The strategy of the fundamental analyst is thus to purchase shares when they are selling for less than they are worth, and hold them until the rest of the market realises their true value. Technical Analysis Technical analysis is not concerned with the intrinsic value of a corporation; instead, it analyses the market itself. Technical analysis does not refute the fact that markets will rise and fall due to business and economic fundamentals. However, it recognises that investor decision making will also be influenced by beliefs and emotions which may be irrational. Technical analysis attempts to analyse the picture of aggregated supply and demand forces †that is, what is actually occurring in the market. Charts are used in order to determine changing investor sentiment towards a company’s shares, and to profit from these swings. The technical analyst will chart many forms of data, but mostly price history and trading volume (the number of shares exchanged in a period of time). They will then seek to identify â€price patternsâ€, or patterns of market sentiment that tend to repeat themselves, and as such gain an insight into whether the share price is most likely headed up or down. The assumption of the technical analyst is that there are a multitude of forces influencing the price of a share, and it is prohibitively difficult to analyse and correctly price each of them. This holds especially true for those factors which are not ground in logic †the average investor’s beliefs and emotions. The strategy of the technical analyst is to determine price patterns as they begin to unfold, buying just before the market decides a share is worth more and selling before market sentiment turns negative. Fundamental and Technical Analysis: A Holistic Approach Neither fundamental nor technical analysis can be used to generate riskless profit. Neither technique will predict the future of the share market, but at best determine high probability scenarios of return. Technical analysis has received much criticism in the academic world, which often prescribes to the Efficient Market Hypothesis (the belief that investors are rational and price reflects value). To a lesser extent, fundamental analysis has received criticism based upon the same theory †if price reflects value, then it is not possible to purchase an undervalued share. However, both techniques are used heavily in the financial industry and by savvy investors to consistently exceed the average market return. Practitioners of fundamental and technical analysis recognise that the share market is in fact not efficient †everyday investors will struggle to correctly price a company’s shares, and their actions will often be determined by emotion rather than rational decision making. An increasing number of investors have come to see these approaches as complimentary and a way to build a more advanced investment strategy. For example, fundamental analysis may reveal that a share is undervalued, and technical analysis that it is yet to fall further. An investor who saw the merits of both forms of analysis would wait until technical analysis forecast that sentiment was about to turn positive and then buy shares in that company. In this way, fundamental analysis can be used to assist the investor to decide which stocks to buy, and technical analysis when to buy them.
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