Fundamental vs Technical Analysis: How to Screen and Pick Stocks
Fundamental versus technical analysis, how P/E, PEG and price-to-sales are calculated with worked numbers, their limits, and how to build a stock screen.
· 8 min read
TL;DR
Fundamental analysis asks what a company is worth, using earnings, sales, growth and debt. Technical analysis studies price and volume to judge timing. P/E, PEG and price-to-sales are quick valuation ratios, but each has blind spots, so they are best used to narrow a list of stocks and then check the business behind the numbers.
Thousands of shares are listed on any major exchange, and nobody can read them all. Investors need a way to reduce that universe to a handful of candidates, then decide whether those are worth buying and when. Fundamental and technical analysis answer different halves of that problem.
Two questions, two toolkits
Fundamental analysis asks what a business is worth. It looks at revenue, profit, cash flow, debt, margins, competitive position and growth prospects, and compares the result with the share price. The aim is to find companies priced below, or above, what the numbers suggest.
Technical analysis asks what the price is doing and when to act. It uses charts, trends, support and resistance, volume and indicators, as covered in what is technical analysis. It does not try to value the company. It assumes the price already reflects what is known and studies how participants behave.
Neither is proven to beat the other, and many people use both: fundamentals to choose what to look at, technicals to choose an entry and an exit. A cheap-looking stock can stay cheap or fall for years, and a good-looking chart can sit on a weak business. The two views check each other.
Three valuation ratios
Price-to-earnings (P/E)
P/E is the share price divided by earnings per share (EPS), the profit attributable to each share over a period. It tells you how many units of price you pay for one unit of annual earnings.
A P/E of 15 means the market pays 15 for each 1 of yearly profit. Trailing P/E uses the last twelve months of reported earnings, and forward P/E uses analysts' forecasts for the next twelve months. Forward figures are more relevant to the future and also more uncertain.
The limits are real. A low P/E can signal a bargain or a business in decline. Cyclical companies, such as miners and car makers, can show a very low P/E at the top of the cycle, just when earnings are about to fall. A company with a loss has no meaningful P/E. Accounting choices, one-off gains and write-downs change earnings, and the ratio is only comparable between companies in similar industries.
PEG ratio
The PEG ratio adjusts the P/E for expected growth. It divides the P/E by the expected annual earnings growth rate, expressed as a whole number of percent. The idea became popular through Peter Lynch's investing books: a fast grower can justify a higher P/E than a slow one.
On this measure company B, despite a P/E twice as high, looks cheaper for its growth. A PEG near or below 1 is often cited as an attractive reading, but that threshold is a rule of thumb. The weak point is the growth estimate. It is a forecast, analysts disagree, and small changes in it change the result a lot. If growth is assumed to be 20% instead of 25%, company B's PEG becomes 1.5. PEG also tells you little about companies with unstable growth, negative growth or high debt.
Price-to-sales (P/S)
Price-to-sales compares the market capitalisation, the share price times the number of shares, with annual revenue. It is useful when a company has no profit yet, since sales still exist.
The limit is that revenue says nothing about profitability. A supermarket and a software firm can both trade at a P/S of 1.5, but a supermarket might keep 2 cents of profit per dollar of sales and a software firm 25 cents. Like P/E, P/S is only meaningful when compared with similar companies in the same industry.
| Ratio | Best for | Main weakness |
|---|---|---|
| P/E | Profitable, stable companies | Distorted by cycles, one-offs and accounting |
| PEG | Comparing companies with different growth | Depends on uncertain growth forecasts |
| P/S | Companies with no profit yet | Ignores margins and debt |
A ratio becomes useful only against a reference point. Compare it with the sector average, with the company's own range over the past five or ten years, and with the market as a whole. A P/E of 12 is low for a software company and high for a bank, because banks usually trade on lower multiples. Also check how the earnings were produced: a profit boosted by selling an asset in one year will make the P/E look lower than the underlying business justifies.
Other measures often sit beside these: dividend yield (annual dividend divided by price, so a 1.80 dividend on a share priced at 60 is a 3% yield), return on equity, debt relative to earnings, and free cash flow. No single ratio is enough.
How to build a screen
A stock screener filters a large universe using rules you set. Most brokers and data sites offer one. Screens do not pick winners. They shorten the list so that your research time goes to companies that meet your minimum standards.
- Start with the market. Choose an exchange or region, which also settles the currency.
- Choose a sector or industry, so ratios compare like with like.
- Set a minimum market capitalisation and trading volume to exclude tiny, illiquid companies where spreads are wide.
- Add valuation limits, such as a maximum P/E or P/S, compared with the sector's typical range.
- Add quality limits such as positive earnings, manageable debt or a minimum dividend yield, depending on your goal.
- Review what is left by reading the company's reports and news, which no screener can do for you.
Each added filter narrows the list, and over-tight filters can leave nothing or selectively fit past data. If you set a very specific combination of limits and test it on history, you can usually find one that looks great and fails on new data. Keep screens simple, and write down the reasons for each limit.
Where technicals come in
After screening and reading about the business, the question is when. A stock can be sound and still be in a downtrend, and buying early is how many investors take losses on cheap-looking shares that kept falling. Technical analysis helps with the timing. Trend direction, support and resistance and the behaviour on pullbacks help set an entry, and a stop beyond a level where the idea is wrong defines the risk. The multi-timeframe article shows one way to structure that.
Remember that fundamentals move slowly and are reported quarterly, and prices react to the surprise against expectations rather than the good or bad news itself. A strong report can still be followed by a falling price if analysts expected better.
Owning shares versus a CFD
Buying a share makes you an owner, with a claim on the dividends and, usually, voting rights. A share CFD is a contract with a broker that pays the price difference. You do not own the shares, and you pay financing on long positions held overnight. Dividends on a CFD are handled through cash adjustments, and the treatment differs between long and short positions and between brokers. Leverage magnifies gains and losses, and a CFD position can lose more than a simple purchase of the same shares would, relative to the capital committed.
None of this is advice about any company or about what to buy. Ratios describe a company's past and present, forecasts can be wrong, and valuations that look low can go lower.
Sources: Peter Lynch, One Up on Wall Street (origin of the PEG idea as popularly used); IAS 33 (the IFRS standard defining earnings per share). Next in the series: Value vs Growth vs Momentum: Bear Markets and High Inflation
Quick answers
What is a good P/E ratio?
There is no universal good number. P/E varies by industry, growth rate and interest rates, so compare a company with its sector peers and with its own history rather than with a fixed figure.
How do I calculate the PEG ratio?
Divide the P/E ratio by the expected annual earnings growth rate in percent. A P/E of 20 with expected growth of 10% gives a PEG of 2, and the same P/E with 20% growth gives 1.
Should I use fundamental or technical analysis?
Many people use both: fundamentals to choose which companies to research, and technicals to decide entry, exit and risk. Neither is shown to outperform the other consistently.
Why can a stock with a low P/E keep falling?
A low P/E can mean the market expects earnings to decline, or that profits are temporarily high, as with cyclical companies. A cheap ratio is a reason to look closer, not a signal to buy.
This article is general information, not investment advice. Trading CFDs, forex, crypto and commodities carries a high level of risk and may not be suitable for everyone. Past results do not guarantee future performance.