Do you know how to analyze a stock?
What comes to mind when you hear terms like personal finance, retirement, and financial freedom?
If you are like most people, you think about the stock market.
The stock market is where people get rich, right?
Regardless of how we do it, we all want to take care of our finances, retire, and achieve financial freedom.
So, what is the problem?
The problem is that our crappy jobs do not pay nearly enough to achieve any of those goals.
Well, I will speak for myself on that point – but if you are with me – continue reading this article.
If you read the news, you know the stock market can be wild, going through its share of ups and downs.
However, when it comes to our money, we want precisely none of that excitement.
We want our money to go UP, and never go down.
But with over 6,000 publicly traded companies, how can we determine which stocks to choose and which to avoid?
Well, no one can make that determination with 100% accuracy.
There is no single infallible strategy that can guarantee your success as an investor.
If someone tells you otherwise, look that person dead in the eye and scream “LIAR!!”
But this fact does not mean that you cannot grow your wealth at a faster rate through the market.
In fact, you can come out on the winning side of your investments more often than not.
For this reason, we have crafted this tutorial to teach you how to analyze stocks to make you more accurate when investing.
The topics in this article will cover:
- Various strategies for selecting stocks
- Specific criteria for selecting stocks
- What not to do when selecting stocks
The goal of this tutorial is to give you an idea of which approach to use going forward.
From this point on, ignorance is no excuse!
You WILL know how to analyze a stock before spending your hard-earned money.
You will not pick stocks with 100% accuracy…
…but your chances of success will improve dramatically.
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Fundamental vs. Technical Analysis
Stock analysis involves two primary schools of thought: Fundamental analysis and technical analysis.
Fundamental analysis involves using concrete information about a company to find the “true” value of the stock.
When you look at “fundamentals,” you are looking at a company’s overall financial health.
Conversely, technical analysis is all about analyzing how market factors will impact a stock price.
You can choose whichever approach you are most comfortable applying to your investment analysis.
At first blush, many investors are inclined to use fundamental analysis as it focuses on the company specifically.
However, you cannot underestimate the importance of investor sentiment which can cause stocks to trade in any direction.
Fortunately, fundamental and technical analysis are not mutually exclusive from one another.
Therefore, you can use a mix of both strategies if that is what you need to achieve the best results.
We will cover fundamental analysis in the upcoming section, but be sure to stay tuned for technical analysis afterward.
Fundamental Analysis: Theory
Most long-term investors use fundamental analysis to analyze a stock.
Market trends can impact stock prices, but strong companies normally prevail in the end.
So, if you are looking to buy and hold stock, you should pay close attention to this section.
With fundamental analysis, the goal of analyzing a company’s stock is to uncover the stock’s intrinsic value.
Intrinsic value is what you believe a stock is truly worth, as opposed to what the market says it is worth (technical analysis).
For example, if you believe a stock is worth $100, but it is trading for $50 – you may have found an undervalued stock.
So, what do you do when you find an undervalued stock?
You buy the stock, of course!
Now, there are numerous methods of finding the intrinsic value; however, these methods come together with the same premise.
The premise is that a company is worth the sum of its discounted cash flows.
But what does “the sum of discounted cash flows” mean?
In layman’s terms, the sum of discounted cash flows means any company is worth all future profits added together.
Additionally, you must discount future profits to adjust for the time value of money.
Time value of money says that $1 today is worth more than $1 in the future.
Any amount of money is worth more the sooner it is received because it can be used to earn a return.
In summary, discounted cash flows values an asset based on how much profit it can generate in the future.
The idea behind intrinsic value is that a business is worth what it can make in profit (i.e., revenue minus expenses).
Here is an example of fundamental analysis
You own a small business, and you want to pay dividends to all of your investors at the end of the year.
The investors are:
- 50% You
- 50% Your Mother
But how can you pay dividends if there is no money leftover?
Answer: You can’t!
You must pay supplies, equipment, salaries, and all other expenses before taking money for dividends.
Thus, if you earn $60,000 in revenue and pay $58,000 in total expenses, you have made a $2,000 profit.
You get $1,000, and your sweet mother gets $1,000 for investing in you, as well.
Bottom line: If you are not in it for the profit, you are doing it wrong!
Fundamental Analysis: The ‘Greater Fool’ Theory
Let’s be clear, not everyone uses financial statements or other defined metrics to evaluate stocks.
You likely have numerous friends, family, and colleagues that are “fools” when it comes to investing.
These investors purchase stocks without any attention to their quality.
And, if ‘greater fool’ theory is correct, the investor can sell these stocks to another “greater” fool at a net gain.
The greater fool will then flip the stock to an even greater fool for more than they paid for it.
This type of trading is not determined by a company’s value, but whether you think you can sell for more to another investor in the future.
Just avoid being the greatest fool!
Financial Statements
Before you begin to analyze companies for investment potential…
…you need to understand the business basics, particularly as they relate to the financial statements.
Financial statements provide the main data points that you will use to assess a company’s overall health.
Therefore, if you plan to analyze a stock, you will need to pay attention to a company’s financial statements.
You can find most quantitative factors used in fundamental analysis in the financials.
Specifically, you should become familiar with the balance sheet, income statement, and cash flow statement. Here is an overview of each statement:
- The income statement adds revenue and subtracts expenses to get the company’s profit.
- The balance sheet presents a company’s assets, liabilities, and shareholder equity.
- The statement of cash flows shows the money coming and money going out, by purpose (i.e., operating, financing, and investing activities).
These statements will be the foundation for determining your key metrics when analyzing a stock.
However, the numbers do not provide the total picture when it comes to fundamental analysis.
In addition to quantitative data, companies are required to provide substantial amounts of qualitative information.
You can look at a company’s annual report where management explains past performance and plans for the future.
The annual report should not be taken lightly as it adds additional explanation to the numbers you will be analyzing.
Fundamental Analysis: Ratio Valuation
Financial ratios are calculations that are generally based off figures from the financial statements.
Depending on which measure you are looking at, performance can be measured in many ways.
For example, you can look at return-on-assets (ROA) to get an idea of the performance of certain assets.
You can use these rations to gain a better understanding of a company’s value.
Here are 5 metrics you can use to valuate a stock:
Price-to-Earnings Ratio (P/E)
The price-to-earnings ratio is used to measure the current share price relative to its earnings per share.
The price-to-earnings ratio will show you the dollar amount you will pay in order to receive one dollar of the company’s earnings.
To determine the value of a stock, investors compare P/E ratios between competitor and industry standards.
Additionally, you can compare the P/E ratio with a benchmark like the S&P 500 index.
Earnings Per Share (EPS)
Earnings per share are the amount of a company’s profit paid to each share of commons stock.
Thus, a company’s earnings per share show how efficiently revenue is being delivered to investors.
An increasing or higher, earnings per share indicates more value because the firm shows higher profits.
Price-to-Earnings Growth Ratio (PEG)
You can use the price-to-earnings growth ratio to determine a stock’s value while factoring in the company’s expected earnings growth.
This metric is like the traditional price-to-earnings ratio but provides a more complete picture of the stock.
To calculate, divide the price-to-earnings ratio by the 12-month growth rate.
You can estimate the future growth rate by looking at the company’s historical growth rate.
A price-to-earnings growth rate lower than 1 is generally considered a good sign.
Price-to-Book Ratio
You can use the price-to-book ratio to compare a company’s market to book value.
This ratio is commonly used to uncover high-growth companies that are undervalued.
To calculate, divide the price per share by book value per share.
Return on Equity (ROE)
You can use return on equity to determine how efficiently a company produces profits for its shareholders.
This metric is commonly used to find companies that excel at generating profits.
To calculate, divide net income by shareholders’ equity.
Technical Analysis: Theory
Technical analysis focuses on the supply and demand to analyze a stock.
The supply and demand in the market depend largely on changing attitudes toward economic, monetary, political, and psychological factors.
Investors that use technical analysis believe the notion that a stock’s historical performance indicates its future performance.
Technical analysts use price charts and other analytical tools to forecast a stock’s future price changes.
Investors that use technical analysis believe:
- The stock price reflects all relevant information.
- The stock prices move in trends
- The price history can help predict the future.
You can use fundamental and technical analysis, but technical analysis does not consider intrinsic value.
Technical analysts focus solely on past trends and use data, charts, and indicators to invest in companies they may know little about.
This method of investing is generally for more active traders.
Active traders hold stocks for short periods and capitalize on stock price fluctuation.
Here is an example of technical analysis
You are a self-proclaimed technical analyst reviewing 200-day moving averages.
You hope to make it out of your mother’s basement by trading stocks. Your mother has zero faith in you.
But you proceed undeterred because you are an expert at finding trends.
You realize that Amazon is trading well above its 200-day moving average, and as a result, you pull the trigger.
You recognized momentum on Amazon stock before the rest of the market and made your profit.
In technical analysis, you want to be the trendsetter – not the copycat!
While technical analysis may seem complicated on the surface, the technique boils down to an analysis of supply and demand.
Technical analysts try to understand the market sentiment behind prices trends rather than analyze the fundamental aspects.
Technical Analysis: Technical Indicators
These technical indicators are based on metrics like price movement and volume.
All technical analysis indicators use security prices, such as open, high, low, close, and volume in their calculation.
There are two categories of technical indicators: Leading and lagging indicators.
- Leading indicators lead the price movement and signal before a new trend occurs.
- Lagging indicators follow price actions and signal after the trend has started.
As discussed above, you can use historical data to predict future price movements.
Indicators from both categories include trend, momentum, volatility, and volume.
Let’s take a closer look at some of the different types of technical indicators:
Trend
Trends are quite possibly the most critical concept in technical analysis.
Trend indicators are used to show investors the trend or direction of the asset they are analyzing.
An uptrend is a series of higher highs and higher lows, whereas a downtrend consists of lower lows and lower highs.
The trend of an asset can be downward (bad), upward (good), or sideways (neutral).
Indications include moving averages, MACD, parabolic SAR, linear regression, and more.
Momentum
The momentum indicators measure the speed at which the value of a security is moving in a given period. Momentum traders seek out assets that are moving significantly in one direction on high volume.
Indications include stochastics, CCI, relative strength index, Chande’s momentum oscillator, and more.
Volatility
Volatility indicators are the relative rate at which the price of a security moves up or down. High volatility occurs when a stock price moves up and down quickly over a short period.
Indications include: Bollinger bands, average true range, standard deviation
Volume
Volume is the number of shares or contracts that trade over a specific period. The volume indicators can confirm a continuation or change in the direction of a stock.
The strength of any price movement is measured mostly by volume.
For example, let’s say a stock jumps 10% in one day of trading after trending downward.
What is the reason behind this trend?
If the volume was below average, the price move was likely a fluke. If the volume as above average, then this could signal a trend reversal.
Indications include: Chaikin oscillator, OBV, rate of change
Each of these indicators can be applied to any market, including the stock, futures, Forex, and options markets.
Thus, by looking at price patterns and statistics, technical analysts determine the market’s overall sentiment and learn where prices are likely to move.
The Takeaway
There are a few reasons why none of these strategies is the “correct” strategy:
- There are many factors that impact a company’s stock that it is impossible to create a formula that will predict success. You can measure a stock in many ways, but it is difficult to determine which exact numbers are relevant.
- There are factors that impact businesses that cannot be measured. These factors include qualitative factors like competitive advantage and reputation.
- Keep in mind that there is a major human element to picking stocks. This human element (i.e., emotions) can cause stocks to change in price for no good reason.
So, how do you develop a winning strategy?
You should choose factors that you find essential to formulate your “best guess” on how to invest.
You can use one method for analyzing stocks, or you can use a combination.
One significant factor that you can control is aligning your strategy with your goals.
For example, if you are planning to invest for retirement, you want a stock with strong financials – not one that is simply trending upward in the market.
However, if a company with strong financials is trending downward, you may want to do some additional research to determine the reason behind the downward trend.
Thus, to align your strategy with your goals, you should consider these factors:
- Personal outlook (e.g., how do you feel toward investing in general)
- Time horizon (e.g., retirement is 25 years away)
- Risk tolerance (e.g., high, low, or somewhere in the middle)
- Personal effort (e.g., how much time will you invest?)
Remember, fundamental analysis is better for long-term investments and technical analysis applies more to short-term investments. And both strategies can be used to complement one another.
The more time you spend learning the market and understanding your finances, the more efficiently you will be able to increase your wealth.
What is your investment strategy?
Let us know in the comments below!
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