There are an overwhelming number of stocks for an investor to choose from, as well as tools for analyzing them. Analyzing stocks can help investors make more informed decisions, compare stocks to one another, and build a strong, diversified portfolio.
There’s no one investing strategy or tool that can predict with 100% accuracy which stocks are the best to buy or when to buy stocks. But learning a few basic methods can help investors gain an understanding of companies and stocks. It can also be good practice to come up with a personalized way to analyze stocks, so that one can make comparisons and save time. In this article we will cover a number of different ways to analyze stocks.
Ways to Analyze a Stock
Understanding Financial Statements
The first step in understanding stock analysis is knowing the basics of business reporting. There are three main types of financial statements that an investor may need to look at when doing analysis. These are:
• Income Statement: This statement shows a company’s profits, which are calculated by subtracting expenses from revenue.
• Balance Sheet: The balance sheet compares a company’s assets, liabilities, and stockholder equity.
• Statement of Cash Flows: This statement outlines how a company is spending and earning its money.
In addition to these statements, a company’s earnings report contains information which can be useful for doing qualitative analysis. The annual report includes the company’s plans for the future and stock value predictions.
Quantitative vs. Qualitative
The next step in stock evaluation is deciding which type of analysis to do—quantitative, qualitative, or both.
The two main categories of quantitative analysis are technical analysis and fundamental analysis. Fundamental analysis looks at a company from a basic financial standpoint. This gives investors a sense of the company’s financial health and whether its stock may be under- or overvalued. Technical analysis is another method for analyzing stocks that looks directly at a stock’s supply and demand in order to make investing decisions.
Fundamental analysis is generally better for long-term investing, while technical analysis can be useful for shorter-term trades. While we’ll focus mainly on the tools of fundamental analysis in this article, it’s useful to have a broad overview of technical analysis, too.
This form of analysis takes the stance that all information needed is present within stock charts and analysis of history and trends. Day traders tend to focus on technical analysis to try and capitalize on short term price fluctuations.
A few key focal points of technical analysis are:
• Stock prices move in trends
• History repeats itself
• Stock price history can be used to make price predictions
• Stock price contains all relevant information for making investing decisions
• Technical analysis does not consider intrinsic value
Trend indicators are one of the most important parts of technical analysis. These indicators attempt to show traders whether a stock is going to go up or down in value. Uptrends mean higher highs and higher lowers, whereas downtrends mean lower lows and lower highs. Some common trend tools include linear regression, parabolic SAR, MACD, and moving averages.
Technical analysis also uses leading indicators and lagging indicators. Leading indicators signal before new trends occur, while lagging indicators signal after a trend has ended. These indicators look at information such as volume, price, price movement, open, and close.
Fundamental analysis takes the stance that a company’s stock price doesn’t necessarily equate to its value. There are a number of key tools for fundamental analysis that investors might want to familiarize themselves with and use to get a fuller picture of a stock.
Earnings Per Share
One of the main goals for many investors is to buy into profitable companies. Earnings per share, or EPS, tells investors how much profit a company earns per each share of stock, and how much investors are benefiting from those earnings. Companies report EPS quarterly, and the figure is calculated by dividing a company’s net income, minus dividend payouts, by the number of outstanding shares.
Understanding earnings per share can give investors guidance on a stocks potential movement. On a basic level, a high EPS is a good sign, but it’s especially important that a company shows a high or growing EPS over time. The reason for this is that a company might have a temporarily high EPS if they cut some expenses or sell off assets, but that wouldn’t be a good indicator of the actual profitability of their business.
Likewise, a negative EPS over time is an indicator that an investor may not want to buy a stock.
While EPS relates directly to a company’s stock, revenue can show investors how well a company is doing outside the markets. Positive and increasing revenues are an indicator that a company is growing and expanding.
Some large companies, especially tech companies, have increasing revenues over time with a negative EPS, because they continue to feed profits back into the growing business. These companies, such as Amazon, can see significant stock value increases despite their lack of profit.
One can also look at revenue growth, which tracks changes in revenue over time.
Price-to-earnings (P/E) Ratio
One of the most common methods of analyzing stocks is to look at the P/E ratio, which compares a company’s current stock price to its earnings per share. P/E is found by dividing the price of one share of a stock by its EPS. Generally a lower P/E ratio is a good sign.
Using this ratio is a good way to compare different stocks to one another. One can also compare an individual company’s P/E ratio with an index such as the S&P 500 Index, to get a sense of how the company is doing relative to the overall market.
The downside of P/E is that it doesn’t include growth.
Price-Earnings-Growth (PEG) Ratio
Since P/E doesn’t include growth, the PEG ratio is another popular tool for analyzing stocks and evaluating stock performance.
To look at EPS and revenue together, investors can use the price-earnings-growth ratio, or PEG. PEG is calculated by dividing a stock’s P/E by its projected 12-month forward revenue growth rate.
In general, a PEG lower than 1 is a good sign, and a PEG higher than 2 indicates that a stock may be overpriced.
PEG can also be used to make predictions about the future. By looking at PEG for different time periods in the past, investors can make a more informed guess about what the stock may do next.
Price-to-Sales Ratio (P/S)
The P/S ratio compares a company’s stock price to its revenues. It is found by dividing stock price by revenues. This can be useful when comparing competitors—if the P/S is low, it might be more advantageous to buy.
Although profits and revenue are important to look at, so is a company’s debt and their ability to pay it back. If a company goes into more and more debt in order to continue growing, and they’re unable to pay it back, it’s not a good sign.
Debt-equity ratio is found by dividing a company’s total liabilities (debt) by its shareholder equity. In general, a debt-equity ratio under 0.1 is a good sign, while a debt-equity ratio higher than 0.5 can be a red flag for the future.
Similar to debt-to-equity, debt-to-EBITDA measures the ability a company has to pay off its debts. EBITDA stands for earnings before interest, tax, depreciation, and amortization.
A high debt-to-EBITDA ratio indicates that a company has a high amount of debt that it may not be able to pay off.
While a stock’s price can vary significantly from day to day, dividend payments are a way that investors can earn a consistent amount of money each quarter or year. Not every company pays out dividends, but large, established companies sometimes pay out some of their earnings to shareholders rather than reinvesting the money into their business.
Dividend yield is calculated by dividing a company’s annual dividend payment by its share price. The average dividend yield for S&P 500 companies is around 2%. One thing to note is that dividends are not guaranteed—companies can change their dividend amounts at any time, so if a company has a particularly high dividend yield it may not stay that way.
Price-to-Book Ratio (P/B)
Price-to-book ratio, or P/B, compares a company’s stock market value to its book value.
This is a useful tool for finding companies that are currently undervalued, meaning those that have a significant amount of growth but still relatively low stock prices. P/B ratio is found by dividing the market price of a stock by the company’s book value of equity. The book value of equity is found by subtracting the company’s total liabilities from its assets.
Company Reports and Projections
When companies release quarterly and annual earnings reports, many of them include projections for upcoming revenue and EPS. These reports are a useful tool for investors to get a sense of a stock’s future, and they can also affect stock price as other shareholders and investors will react to the news in the report.
Wall Street analysts regularly release reports about the overall stock market as well as individual companies and stocks. These reports include information such as 12-month targets, stock ratings, company comparisons, and financial projections. By reading multiple reports, investors may start to see common trends.
While analysts aren’t always correct and can’t predict global events that affect the markets, these reports can be a useful tool for investors, keeping them up to date on any key happenings that may be on the horizon for particular companies. The information in the reports can also result in stock prices going up or down since investors will react to the predictions.
When considering how to analyze a stock, it’s also a good idea to look at whether the company behind the stock is really a good business. Qualitative analysis looks into factors such as a company’s leadership team, product, and the overall industry it’s a part of.
A few key qualitative metrics to look at are:
• Competitive Advantage: Does the company have a unique edge that will help it be successful in the long term? If a company has patents, a unique manufacturing method, or broad distribution these can be positive competitive advantages.
• Business Model: Analyzing a business model includes looking at products, services, brand identity, and customers, to get a sense of what the company is offering.
• Strong Leadership: Even a great idea and product can fail with poor management. Looking into the credentials of the CEO and top executives of a company can help evaluate whether it’s a good investment.
• Industry Trends: If an industry is struggling or looks like it may in the future, an investor may decide not to invest in companies in that industry. On the other hand, new and growing industries may be better investments. This is not always the case, as there are strong companies in weak industries, and vice versa.
There are a number of ways to analyze stock, with technical, quantitative, and qualitative analysis. The more an investor gets comfortable with terms like P/E ratio and earnings reports, the more informed they can be before making any decisions.
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