Picking the Direction of Shares a Guide to Fundamental and Technical Analysis
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Essential Guide to Picking the Direction of Shares A guide to fundamental and technical analysis Proudly Sponsored by To order your free copy of this or other Essential Guides, go to www.smhshop.com.au/freeguides Guide design by mosaiccollective.com Important information The Sydney Morning Herald Essential Guide to Picking the Direction of Shares is published and distributed by Fairfax Media Publications Pty Ltd, ABN 33 003 357 720, the publisher of The Sydney Morning Herald. It is intended to provide general information of an educational nature only. Any information contained in this guide does not have regard to the financial situation or needs of any reader. Neither the publisher, Fairfax Media Publications Pty Ltd, nor the sponsor, TradersCircle, ABN 65 120 660 497 which is a corporate authorised representative of Emerald Financial Group AFSL 241041, intend by this guide to provide financial product advice and information in the guide cannot be relied upon as such. All readers should consider obtaining independent advice before making any decisions concerning financial products or services. All information correct at time of Publication (April 2010). To have The Sydney Morning Herald home delivered phone (02) 9282 3800. General Editorial enquiries [email protected] Essential Guide to Picking the direction of shares A guide to fundamental and technical analysis Contents Introduction 2 What drives growth? 3 The analytical techniques on offer 3 Types of charts 10 ‘The trend is your friend’ 12 Common patterns 14 What’s the best approach? 18 A final word on portfolio construction 20 Introduction Share ownership in our country is So what is so good about shares? among the highest per capita in Shares – which quite literally represent a share, or portion, of a company – are a the world. Many Australians first growth asset. This means that besides their became shareholders by default potential to generate income in the form of dividends, they also offer the chance of as a result of receiving shares in capital growth; increasing the value of your companies such as the NRMA initial investment. In this way, like property, they can help combat inflation, or the slow or AMP when they floated, while creep of rising prices that erodes the value others initially bought shares in of your money. This is something that asset classes such as deposits and fixed income the heavily promoted privatisation investments cannot do. of Telstra. For many it has since But there is a downside to this additional profit potential: you have to take on become a preferred path to additional risk. Just as share prices can building long-term financial go up, they can also go down. This was demonstrated all too clearly in the global security. financial crisis when sharemarkets around the world plummeted and billions of dollars were wiped off the value of shares. However, some shares weathered the financial storm better than others, and some have already surged above their previous highs. The trick to investing is to identify those shares that are going to withstand the pressures – and grow your money. 2 What drives growth? The analytical techniques Two broad variables are considered to on offer influence growth: macro-economic factors The techniques for choosing shares broadly and micro-economic factors. fall into two categories: fundamental analysis Macro-economic factors are the big and technical analysis. picture influences that exert a top-down Fundamental analysis is basically number effect on share prices. These include crunching. It involves using information such variables as the prevailing economic gleaned from company results and conditions, the outlook for a particular announcements to make a call on whether industry sector and market sentiment. For the share price is poised for growth. Figures example, if the economy is in recovery mode contained in these communications can and consumer sentiment indicators show be used to calculate ratios that indicate that people are getting set to reopen their whether the stock is fairly valued, how much wallets and spend up big, you might look the company is returning to shareholders to buy discretionary retail stocks such as and the strength of its balance sheet. Harvey Norman. Conversely, if growth is Micro-economic analysis usually relies subdued and consumer sentiment poor, you heavily on fundamental ratios. might favour non-discretionary retailers such Technical analysis is different altogether. as Woolworths. In its purest form, it involves making all buy When considering specific stocks, it is and sell decisions on the basis of share also important to consider micro-economic charts, with no regard for what a company factors, which will impact on the share is or does. The price charts used might, for price of that particular company. These example, be simple line graphs based on include such variables as profit results, closing share prices, or they may be more company news and announcements, and complex representations, showing not just management strength. There are a plethora closing prices, but also opening prices of factors you could consider here, some of and the price range within that period in which we will look at later. an effort to more accurately identify a price Macro-economic and micro-economic trend. Volume – or how many shares have factors can be considered together to been bought or sold – is also sometimes select shares. For instance, once you have depicted. identified a sector with growth potential using big picture, macro-economic analysis, you can look at individual company specifics to narrow your choice to those individual stocks offering the greatest chance of delivering that growth. Here’s how... 3 Fundamental analysis basics It is calculated by dividing a company’s net The building blocks of fundamental analysis profit after tax by the number of shares on include a company’s share price, its issue. market capitalisation or size, its earnings Example: Company XYZ earned $1 million and dividends. Pricing information is freely in net profit for the year and has 1 million available on the Australian Securities shares. Exchange website, www.asx.com.au, and is 1,000,000 / 1,000,000 = $1 earnings per also published in many daily papers. These share sources also calculate and list some of the So for each share on issue, XYZ is earning simpler fundamental ratios. Information $1. needed to calculate other ratios is contained The measure can be based on forecast in company reports, which can most easily profit for the current year or a future year be found on the company’s website. – called estimated earnings per share – or In this introduction to fundamental analysis, on profit already declared, that is, historic we will look at commonly used ratios that earnings per share. measure a company’s valuation, its growth, As with most sharemarket ratios, the its income and its rate of return. change in earnings per share over time is more telling than a simple snapshot. Earnings per share Naturally investors should be looking for The earnings per share ratio (EPS) tells you earnings per share to be growing rather the amount of a company’s earnings that than falling – and steadily so. Rapid earnings can be attributed to each individual share growth can be positive provided it flows held. As such, it allows investors to directly through to earnings per share. compare one potential stock investment with another. 4 Price/earnings ratio Most importantly, before applying the The price/earnings ratio (P/E) is the most P/E valuation technique, you need to think popular way of determining whether a about the nature of the stock. If Company company’s shares are over-valued, fairly XYZ is trading on a P/E of 10 while other valued or under-valued. Naturally investors companies in the same industry sector have try to find one that is the latter. an average P/E of 15, it might be considered The ratio is calculated by dividing a under-valued or cheap. But you then need company’s share price by its earnings per to consider why it is cheap. Is it a stock share. The earnings per share figure can with unrecognised potential and therefore be either estimated or historic, giving an one that merits further investigation? Or is it estimated forward, or historic price earnings simply a bad company? ratio. P/E growth Example: Company XYZ shares are Another useful valuation method which trading at $10 and the company has historic may help shed light on whether a stock is earnings per share of $1. expensive or cheap is the P/E growth – or 10 / 1 = 10 PEG – ratio. So XYZ has a historic price earnings You calculate the PEG ratio by dividing the ratio of 10. Note that this is not a currency P/E multiple by the expected rate of growth amount or percentage, but a multiple. in the earnings per share. A PEG ratio of 1 The lower the P/E, the cheaper the stock. implies a stock may be fair value; a figure However, a company with a high P/E might closer to 2 suggests it might be over-priced. have good growth prospects. Example: Company XYZ has a P/E of 10 In any case, in isolation a P/E ratio means and an expected rate of earnings per share nothing; for a meaningful analysis you growth of 10 per cent. need to consider it next to its peers. Some 10 / 10 = 1 industry sectors routinely carry much lower In this case Company XYZ may indeed or higher P/Es than others, and this can represent a good, inexpensive buy. But, of change throughout the economic cycle (for course, there’s more to analysing a stock example, cyclical stocks, such as those than just the share price.