The two major ways stock market experts arrive at price targets

There has always been a deluge of misinformation going around about the functioning of stock markets. So much so that people who lack knowledge about it often liken it to a gambler’s den. But, as we will try and explain in this piece, there is a method to the madness that the markets are. Those of you, who have only had a ringside view of the stock markets till now, must have surely wondered about the techniques that the market participants to use to arrive at the stock price targets.

The market analysts may be broadly classified into two categories

1) The Fundamental Analysts

2) The Technical Analysts (also known as the “Chartists”)

Let’s a have brief look into the two types of analysis without going into much details

Fundamental Analysis: This usually involves a three stage process. The first stage involves comparison of the economies around the world to find out the ones which are likely to outperform the rest. Now, a bit of good news for those who think that the first step involves a tedious and a long drawn process. Leading economists around the world believe that India’s GDP is poised to grow at a healthy rate of 7-9% in the next 8-10 years to come. So, it is seems a safe option to place your bets on India and directly move to the second step. After identification of the strongest economies is complete, the 2nd stage involves the identification of industries in the best performing economies. For example, at some point of time you may decide that the prospects of steel companies look good, given the strong sales registered by automobile companies or the banking sector has performed well in the past and there is no reason why such a good performance may not be repeated in the future. The third step involves comparison of different companies in a particular industry (selected in the step 2). Comparison of companies involves comparison of business models, sales growth trends, profit margins trends (whether growing or declining) and a host of other factors. The analyst may also conduct a SWOT analysis (Strengths, Weaknesses, Opportunities and Threats) of various companies of the industry selected. This step involves a good deal of number crunching and company financial statements (Balance Sheet, Profit and Loss statement and Cash-Flow statement among others) are a major input to the process. The analyst then arrives at the intrinsic value of the share of various companies. The intrinsic value is the value the number that “should have been” the price of the stock as opposed to the price at which its currently selling i.e. Current Market Price (CMP). If this value is above the current market price the analyst buys the stock for himself or issues a BUY call for the others to follow. This is because fundamental analysts that markets behave in a rational behaviour and they believe that sooner or later the actions of the various market participants will eventually make the market price equal to the intrinsic value. If several stocks within an industry are good buys to the analyst, he/she may restrict himself to issuing buy calls for only 1/2/3 stocks depending upon the percentage difference between the CMP and the intrinsic value. Some of the famous fundamental analysts include Warren Buffet, Benjamin Graham and our own Rakesh Jhunjhunwala.

Technical Analysis: There is a fundamental difference between how technical analysts and fundamental analysts analyse securities (pun intended). Pure technical analysts don’t feel the need to look at the state of the economy, or the state of various industries or the financial situation of various companies. They try to predict the new price of the share from the stock charts (Hence the name Chartists). That is, they attempt to use the past price movement (among other factors) to forecast new prices. Technical analysts aim to cash in on the price trends .i .e. at any point of time the stock may be in an uptrend, downtrend, or maybe displaying no significant trend. Also a stock that may be in a “long term uptrend” may simultaneously be in a “short term downtrend”. Some of the indicators that indicate the establishment and strength of a trend are MACD, RSI, DMAs so on and so forth. As of now we won’t delve deep into these indicators. The concept of support and resistances however can illustrate one of the causes as to why technical analysis may work. Suppose it is observed in the past that the stock of XYZ Corporation hovers between Rs 80 and Rs 100 .i.e. the stock exhibits a strong tendency to fall upon rising to the level of 100 and stock exhibits a tendency to bounce upwards upon falling to 80, 80 becomes a support as it offers a support to the price of a stock and 100 becomes a resistance as it offers resistance to the upward movement of the stock. The reasons for existence of supports and resistances are not far to seek, if a technical analyst has observed twice the stock bouncing back from 80 in the past, he will start thinking it will bounce back again once it hits 80.Now imagine hundred and thousands of analysts(some with extremely deep pockets) sharing the belief and starting to buy when the price touches a support(i.e 80 in the current example), the price will have a tendency to move up due to improved buying and the support becomes a self-fulfilling prophecy. Some of the famous technical analysts are Charles Dow(he founded the Dow Jones index), John Lane (who famously said “Make trend your friend”) and Ralph Eliott.So, we hope that armed with this knowledge, you pray to God every time somebody proclaims that investing in the stock market is “satta”, “jua” or “gambling” and say “God please pardon them , for they know not what they are saying”.