The Fundamental/Technical Combination

For many investors and traders, the choice of a method for selection of stocks and timing is a matter of passionate belief. The true believers in one system are likely to completely ignore the other approach.

A fundamental analyst makes a mistake, however, by ignoring or discounting the valuable intelligence found with technical indicators. Using technical signs to bolster a fundamental program is valuable for several reasons:

Key Point

Volatility does not change spontaneously or for no reason. It is usually traced back to something changing in the fundamentals.
Three additional combined indicators are also worth studying. These are return on equity (ROE), return on invested capital (ROIC), and return on assets (ROA).

ROE is an important expansion of fundamental analysis and comparisons between companies. ROE tests and tracks the trend in how effectively the capital invested by shareholders is used to create profits. To some, this relationship is obscure or indirect; however, it does provide a monitoring ratio that reveals how well the company applies its capital to generate profits. The formula requires dividing net return by shareholders' equity:
net return ÷ shareholders' equity = ROE
If equity levels have changed significantly during the year due to new issues of common shares or retirement of previously outstanding shares, an average number of outstanding shares should be used for the year to accurately reflect the relationship.

A second combined ratio is the return on invested capital (ROIC). This is similar to the ROE, but adjusts for dividends paid out during the year. The theory in this ratio is that dividend payments reduce the net return, so using this net is a more accurate indicator than ROE.

The formula for ROIC is:
(net return âˆ' dividends paid) ÷ total capital = ROIC
This formula is also called return on capital. A variation of the formula calculates 'total capital' to mean 'total capitalization,' in which case the long-term debt is added to shareholders' equity. This is a significantly different formula than ROIC, however; in comparing ROIC between companies, make sure that the same definition of 'total capital' is being employed.

Key Point

Total capital and total capitalization are vastly diff erent values. Be sure you know which one is being used to calculate return on invested capital.
The third combined ratio is called return on assets (ROA). This is a comparison between net return and total assets. Several variations of this are used, adjusting both sides of the equation, so—as is the case with all ratios compared between different companies—make sure the information employed is uniform in each case.

ROA is calculated by dividing the period's return by the ending value of assets:

net return ÷ total assets = ROA
The net return may be adjusted to add back the interest expense for the year, on the theory that interest is a nonoperating expense, especially when it is related to repayments of bonds and other long-term debts. It is also possible to remove intangible assets from the equation so that net return is compared only to tangible assets; the greater the dollar value of intangibles, the greater difference this makes. However, if long-term debt is exceptionally high and was used to invest in capital assets, this may also distort the calculation. For this reason, a comparison between net return and equity is a more reliable test.

Key Point

Return on total assets is flawed; when long-term debt is high and proceeds were used to buy capital assets, the calculation is misleading. Comparing net return to equity is much more reliable.

The many forms of combined ratios demonstrate that there is value in combining indicators. This applies to fundamental and technical comparisons like P/E, as well as to ratios comparing income statement to balance sheet values.A technical analyst also makes a mistake by ignoring fundamentals. The historical record may be outdated by the day's ever-changing price trends, but you will discover that the predictability of year-to-year results directly affects price volatility. Technical analysts can make good use of fundamentals in many of the same ways as fundamentals analysts use technical signals. These include:

Key Point

Changes in fundamental trends, even subtle ones, are eventually going to affect technical trends as well. So the fundamentals can provide early clues about coming trend reversals.

Key Point

Even the most dedicated technician can learn a lot about volatility by starting with the earnings report issued each quarter.

Key Point

It may surprise some to learn that fundamental and technical trends are directly related. But they are, and the more you study both the more you see the connection.

By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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