The stock market can be a confusing place, and part of the reason why so many people are confused when they first begin investing is because there are so many different opinions. One stockbroker might say Telstra is worth buying, but another might tell you to steer clear. How can this be?

One reason for this disparity of views is that different people will use different types of analysis to come to conclusions about stocks. There are two major types of analysis: fundamental and technical.

Number crunching

Fundamental analysis is frequently used by traditional stockbrokers and fund managers, and involves an assessment about a company’s operations. A number of factors will be considered in a fundamental assessment of a company.

These factors include profits, the outlook for the industry the company operates in, forecast profit, key personnel in senior appointments, and who is on the board of directors.

In fundamental analysis, cash flows are particularly important, so the analyst pays close attention to sources of revenue and whether they can be consistently relied upon in the future, plans for business growth to name a few.

The assumptions of the technical analyst

Technical analysis is widely used by private traders, although many stockbrokers and an increasing number of investment funds also utilise this form of analysis. Basically, technical analysis is only about the price, and understanding how is moves today should give us an understanding about how it might move tomorrow.

The use of technical analysis and its effectiveness is based on a number of assumptions about the way the market operates. They are:

- The market price calculates the impact of all the news that drives buyers and sellers

- Human nature is constant, so investors generally react in similar ways to similar situations, which in turn creates repetition in certain price patterns

- Prices are not random and will generally move in trends for significant periods of time.

It’s all in the price…

Technical analysis assumes that all the factors that influence the price of a security have already been factored into place.

This is why technical analysts never concern themselves with why prices go up or down. More interestingly, this is also one of the reasons why often the price will be a leading indicator of published information.

The question is, of course, which form of analysis should you use? Unfortunately, there’s no clear cut answer.

At the Australian Stock Report, we use both forms of analysis, but with an understanding that you need to make sure the analysis you are using suits both the company and the timeframe in which you want to hold the stock.

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Fundamental stock analysis can seem scary to most newcomers to the market – and with some reason. Looking at some of the 30-page reports from broking houses, about just one company, can seem stupefying to the best of us.

However, one of the reasons it appears terrifying is that analysts can make it as complex as they like: there’s virtually no end to the level of calculations you can perform.

Importantly, when it comes to numbers, there’s a simple four-step process to fundamental stock analysis of companies. First, is the company likely to still be around in a year? Second, is there cash coming in? Third, is the company making money from this cash? And, last, are you likely to get any of that cash?

1. Balance Sheet

A balance sheet is a snapshot of a business’ financial condition at a specific moment in time. From this, analysts try to identify whether the company is financially healthy, especially in relation to debt.

A balance sheet comprises assets, liabilities, and owners’ or stockholders’ equity. Assets and liabilities are divided into short and long-term obligations including cash accounts such as checking, money market, or government securities.

At any given time, assets must equal liabilities plus owners’ equity. An asset is anything the business owns that has monetary value. Liabilities are the claims of creditors against the assets of the business.

2. Cash Flow Statement:

This is a financial document detailing the exchange of cash between a business and the outside world. The flow is categorised as:

-       flow “in” from Operations (cash the company made by selling goods and services)

-       flow “in” from Financing (cash the company raised by selling stocks and bonds)

-       flow “out” to Investing (cash the company spent investing in its future growth)

Each of these flows can actually flow both ways. It is a measure of a company’s financial activity. Investors like to see that the company can cover its spending with cash from operations, without having to turn to financing.

The cash flow statement also has to reconcile the net effect of these flows with the difference in its cash holdings at the beginning and end dates of the reporting period.

3. Earnings per Share (EPS)

Total earnings divided by the number of outstanding common shares. Great companies have earnings that are growing quarter by quarter, year on year.

However if the number of shares have increased markedly or there has been a merger, the earnings per share can be diluted. Therefore, earnings per share are more important to the investor than total earnings.

4. Dividends

Dividends are distributions of money, stock, or other property a corporation pays you because you own stock in that corporation. Most are paid in cash, but you can also be paid in shares.

Basically dividends constitute the element of profit the company does not reinvest back into itself.  Shareholders will pay income tax with respect to their dividend income.

These four measures aren’t the full story, however. A company might look great, but it might be very expensive. The next step in stock analysis is to understand how much you are paying for the company.

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Stock analysis can be formed in a number of ways, but the end goal is determining a stock’s value.

As a brief summary, these are the stock value techniques most often used in the Australian stock market:

Discounted cash flow - is the most complex of valuation techniques but also among the most commonly used in stock analysis.

Under this technique, an investor or analyst will use a range of variables to try to accurately predict profit results for future years. These future earnings are then discounted back to their present value (value in today’s dollars) to give an estimate of what the company is currently worth (as a whole, or per share).

This technique is best used for companies in which earnings are expected to fluctuate or grow, start-ups, and companies with limited life spans.

Earnings before interest, tax, depreciation and amortisation (EBITDA) – should be used when most comparable companies are based overseas. For example, analysts rating telecommunications companies will often use this technique.

This technique strips out much of the financing and taxation effects from a company’s performance and leaves you with an indication of a company’s core earnings power. This method is also handy for valuing infrastructure companies.

Price-to-earnings ratio – one of the most commonly used valuation methods for stock analysis. P/E ratios are used when companies have relatively stable earnings and there are a number of comparable companies in the local market. Banks are often valued according to P/E ratios.

Net realisable value – is used for stock analysis when things get gloomy. An analyst will value a company according the amount the company’s assets are worth if sold (rather than the earning these assets generate) when the company is making sustained losses or is close to liquidation.

These methods mentioned above are all types of fundamental analysis, the pursuit of getting to the “fundamental” heart of a stock and analyse its worth.

Fundamental analysis observes the way a company runs – analysing the financial data that is “fundamental” to a company – its earnings, its profits, its dividends.

On the other hand, many traders instead use technical analysis, which involves analysis of stock charts in order to determine an understanding of the way prices move.

There is no “right” way in terms of approaching stock analysis, though most analysts will use a combination of both fundamental and technical analysis in their approach.

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The S&P/ASX 200 index (also known as the XJO) is the main benchmark for the Australian equity market (replacing the venerable All Ords as the industry standard).

The index is made up of 200 of the top stocks, which boast a total value of around $1.1 billion (end of March 2010).

While there are around 2000 stocks listed on the ASX, these top 200 stocks make up almost 80% of the total value of the market.

The XJO provides investors and fund managers with a benchmark, a level of performance to compare their own Australian share trading to.

The index also forms the basis for futures contracts such as the Share Price Index (SPI).

Piece of the pie

The index is weighted by the float-adjusted market capitalisation of each stock, which means a 1% move in one of the bigger companies, moves the index more than a 1% move in a smaller company.

The finance sector makes up around a third of the index (by market cap, not number of companies), mostly through the big four banks.

Around 25% of the index is made up by mining stocks, and BHP, the market’s biggest stock, accounts for around 12-13% of the index just on its own.

Wild ride

Started up on 31 March, 200, the XJO began with a value of 3133, which was the value of the All Ordinaries at the time, and there has been plenty of action since then.

The XJO hit a low of 2693 in March 2003, just before the start of a bull market.

Over the next four and a half years, the XJO rose by over 150%, hitting a high of 6852 in November 2007.

This is when the global financial crisis (GFC) kicked in, sending the XJO spiraling lower over the next 18 months.

After hitting a GFC low of 3120 in March 2009, the XJO rose by around 50% over the next 12 months.

This party is invite only

To be eligible for inclusion in the ASX 200 index, a stock must meet market capitalisation, liquidity and listing criteria.

Market capitalisation is determined using a function of current index shares, the latest stock price and the investable weight factor (known as IWF).

IWF is negatively impacted by strategic holdings that are corporate, private or government in nature, meaning shares owned by founders, directors of the company and other companies are excluded.

The liquidity requirement for inclusion in the ASX 200 is that the trading volume (in dollar value terms) and the number of stock transactions must be higher than 0.025% of the total trading volume of all eligible securities.

Lastly – and this goes without saying – a company can only be listed on the ASX 200 if it is listed on the Australian Stock Exchange (ASX).

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One common way to classify stocks is to make an assessment as to whether they are “cyclical” or “defensive”.

These two terms represent, as you can probably guess, two types of industry or stock that are at stark odds with the other.

Let’s take a deeper look at what these terms mean, and how they interplay with the stock market.

The terms cyclical and defensive are used to show how closely correlated a company’s share price, or a sector’s performance, is to fluctuations in the economy.

Cyclical stocks are those whose fortunes are tied to the strength of the economy. They perform well when the economy is strong, and will decline when the economy is performing badly.

In other words, cyclical stocks perform according to the big picture, where as defensive stocks generally perform solely on their own merits.

In general, defensive stocks tend to offer more steady products and services. Business doesn’t necessarily boom when the economy is strong, but also doesn’t suffer too badly when the economy is struggling.

Defensive stocks are non-cyclical because they experience solid profits regardless of the motions of the broader economy.

Defensive stocks, as we noted above, are not considered to be tied to the market. However, their fortunes are still party tied to how the broader economy is going.

Defensive stocks are seen as safer, and should perform better in a bear market. Even if they don’t manage to go up during a bear market, they shouldn’t fall by as much as cyclical stocks in bad times.

Because defensive stocks and cyclical stocks are polar opposites, when cyclical stocks are doing poorly, defensive stocks tend to do well.

An example of defensive stocks to choose in a bear market would include those that are in the healthcare industry, namely CSL Limited which is a biopharmaceutical company.

Additionally, other sectors that are generally considered most defensive in a bear market are officially known as the consumer staples and the utilities.

Generally, some experts believe defensive sectors include industries such as drugs, healthcare, information technology and food on a wider spectrum.

Defensive stocks are defensive in nature because the demand for them tends to be strong no matter how the general economy is performing. This is because defensive stocks produce items considered necessities, and product demand should continue regardless of the big picture.

For instance, people will always need electricity in their homes, so utilities companies tend to perform steadily over time; it’s not like you will buy twice as much electricity when times are good!

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Contract for Difference (CFDs) are becoming an increasingly common investment strategy for those wanting to make money from the Australian Stock Exchange. For people who are new to the market, however, they can be difficult to grasp at first glance.

Firstly, let’s get one thing straight in this lesson on CFD education: CFDS aren’t shares. In fact, CFDs have all the benefits of trading shares, without you actually having to physically buy, own or sell the shares.

CFDs are almost like a board game version of trading real shares in the market. They mirror the performance of a share, or an index. With CFDs, you make an agreement with a provider (like IG Markets or like CommSec) about the opening and closing price of a share or index you’re looking at. You are making a deal with the CFD provider to exchange the difference between the opening and closing prices of the share or index.

Say you see a company you think is going to crash. You can contact your CFD provider to specify the price of the company’s shares (the beginning of the contract) and what level you think the shares will fall to (the close of the contract). If and when you hit your target, the CFD provider will pay out cash on the difference between the starting share price, and when the contract is closed.

It doesn’t take a lot of CFD training in order to get your head around the CFD concept. You can advance your CFD knowledge by checking out the Australian Stock Reports CFD Report.

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When asking yourself the question, “What shares should I buy now?” it’s important to do some research on companies that have caught your eye.

When you’re looking at what shares to buy, you’re examining the company, its sector and its place in the overall market, if you’re doing your job correctly.

A major part of fundamental analysis is researching a company you want to buy shares in. As the name suggests, this form of analysis is the way to get to the “fundamental” heart of a company and analyse its worth. If you’re looking at what shares to buy, what better way to go about it than to analyse your preferred companies? This is what fundamental analysis really is – analysing the financial data that is “fundamental” to a company – its earnings, its profits, its dividends.

Fundamental analysis can help you identify some bargain stocks out there that have been caught up in the market maelstrom – and sold off well past their value simply because of the negative market sentiment. Of course, when you’re researching what shares to buy, technical analysis is equally important – looking over the company’s chart, and identifying trends.

The best way to “suss out” what shares to buy is to combine fundamental and technical analysis to give yourself some perspective on a company. This is also the best way to build an individual strategy to trading and investing, using whatever approach is personally suitable.

Also remember when you’re asking yourself what shares to buy now, look at the company’s role in its industry and the greater perspective. You might want to buy shares in a company that looks strong with a good balance sheet and decent fundamentals – but the industry may be facing toughness, and this could weigh on the company.

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Learning about the stock market isn’t difficult, with the mechanisms not being as complex as you might think.

A stock market is a public market for the trading of company stocks and derivatives at an agreed price. These are reflected as securities listed on a stock exchange as well as those only traded privately. Stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organisation, whose job it is to bring together the buyers and sellers.

Major countries have their own stock exchanges, and ours is the Australian Stock Exchange (ASX). The Aussie sharemarket doesn’t have a physical trading location, such as a trading floor. You instead buy and sell shares using a computerised trading system which links stockbroking firms
around the country.

Learning about and understanding the stock market can be an important tool for you to make money, as history suggests that Aussie shares have performed other types of investment over the long-term.  There are over 1500 companies on the ASX, covering most sectors of the economy, including financial services, industrials and healthcare.

If you decide to invest in the stock market, you can decide how much money you invest, into which companies and which sector, thus controlling your future. As you learn more about the stock market and understand how it works, you’ll be able to decide what shares you want to buy, and what shares you’ll want to sell or hold. When you buy or sell shares, your orders are entered into the computerised system at your stockbroking firm. The system finds a seller in the market that is willing to trade shares for the price you want to buy them. Your order is then placed in the order it is received, and voila! – you’ve made a footstep into the stock market.

Learning about and understanding the stock market is easy. For more information, you can visit our website, check out the education centre at the ASX website or speak to your broker if you open an account.

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Buying and selling shares in the stock market isn’t the same thing as buying or selling at a physical market, say like a food shop or market stall.

The Aussie sharemarket doesn’t have a physical trading location, such as a trading floor, like you see in films about Wall Street. You instead buy and sell shares using a computerised trading system which links stockbroking firms around the country.

Of course, before we start to invest, we need to know how to buy shares.

First, you need a stockbroker to do so for you, and there are more than 90 stockbroking firms across Australia – some offer financial advice, and are called full service brokers. To set up an account with a broker, you’ll need a minimum amount of money to put into your account, pay a brokerage fee, be over 18 years of age and of course fill out all the paperwork. When you buy or sell shares, your orders are entered into the computerised system at your stockbroking firm. The system finds a seller in the market that is willing to trade shares for the price you want to buy them. This is how we buy and sell shares – by finding other buyers and sellers waiting to ‘match’ your order.

Now that you know how to buy and sell shares, you then need to know how to pay for them! Payment is made within three days of the broker executing your order, and if you have sold shares you need to provide access to the shares so they can be given to the new owner. The money will come out of an account with your broker or through a linked bank account.

When you buy shares in a company, you are both financially and personally invested in that company for as long as you stay in the trade.

After you sell your shares, you’ll still be affected by your former stake – by being either poorer or (ideally) richer.

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