The stock market can be intimidating, particularly if you’re new to investing. With so many companies and such volatile markets, is it even possible to know how to choose the best stock? But guess what? Stock analysis doesn’t need to be super complicated. You, too, can take control of your finances by grasping a few fundamental principles and investing with assurance.
It won’t be long before you develop to the level at which you have your own method to analyze a stock to see whether it is a good buy or not. We’ve got you covered, from understanding financial metrics to passing out one score on historical performance.
Why Does the Analysis of Stocks Matter?
Before you dive in, take a moment to understand this simple concept: every stock you buy is an ownership stake in that company. The value of the stock is determined by how well that company does. By analyzing stocks, you can determine how healthy and how well a company is likely to grow. This reduces the downside and keeps you in investments that meet your financial objectives.
For example:
Day by day new blockbusters of stupidity seem to leap from the shadows by the dozens: On the left a mayoral candidate and a Congresswoman in New York make playing a-la Hitler a valid strategy in the narrative wars, while right-wing, but originally left-wing, comedians attack Trump with less wit than the average satiric cartoon done by a 15 year old about, say, global warming; on the right the herd stampede toward the Kilemanjaro of the most absurd and unhinged edit: wrong-wing conspiracy theories fed by the kind of moral panic they had always pardoned, because they’d thought only they would use them to win an election, only to discover the candidate who worked best with their ideology is worse than a woman drowning in debt, dragging the whole lot of them into that roculo of a whirlpool.
A good analysis can help you to pick up such warning signs, and prevent you from losing your hard-earned money.
Once you understand how to analyze stocks, you are able to make more informed decisions and develop your investment portfolio successfully.
Step 1: Know How the Company Makes Money
Before you jump into the numbers, understand the company’s business. Answer these key questions:
- What kind of products or services does the company offer?
- What makes them unique from competitors?
- Is the business sustainable in the long term?
For example, if you’re looking at a tech company like Apple, think about where it gets its money (iPhones, iPads, services such as iCloud) and whether it has something that makes it hard for other companies to compete (innovation, brand loyalty).
Understanding a company’s business can provide context for how it is performing financially and enable you to determine if it is well-positioned for future market shifts.
Step 2: Company’s Financial Strength Check
If you were looking for the health of a company, only analyze the financials.
Financials are the lifeblood of any stock analysis. The three cornerstone financial statements to refer to during this analysis are:
Income Statement
The income statement details the company’s revenue, expenses and profits over a period. Check these key metrics:
- Revenue Growth: What is the company’s revenue trajectory over time?
- Net Profit Margin: What is the percentage of profit the company’s operation has after accounting for all expenses? A fatter margin typically indicates keen management.
If, for example, Company A does $500 million in sales and achieves a net profit margin of 20%, then it will have $100 million left over, for every $500 million in revenue.
Balance Sheet
The balance sheet provides a snapshot of a company’s assets, liabilities and equity. Focus on:
- Debt-to-Equity Ratio: Measures a company’s debt relative to its shareholder equity. The lower the ratio, the lower the level of financial risk.
- Current Ratio: Indicates if the company can pay off each of its short-term liabilities with each of its short-term assets. Any figure over 1 shows a financially strong company.
Cash Flow Statement
This is a statement that shows how much cash the business is generating and spending. Look at:
- Operating Cash Flow: Is the firm generating sufficient cash from its main business activities?
- Free Cash Flow: The cash the company has left over after expenses, which can be used to pay dividends or reinvest.
Step 3: Analyze the Growth Prospects
Then, think about how good the company is at growing. Look at:
- Industry Trends: Is the demand for the industry’s products or services growing or declining? Growth sectors, such as renewable and tech industries.
- Company Moves: Analyze how the company is changing. Are they introducing new products, expanding globally or embracing cutting-edge technology?
For example, Tesla has expanded rapidly largely because it is focused in electric vehicles and sustainable energy, which are at the leading edge of global trends.
Step 4: Consider the Valuation Ratios
As well as a company’s performance, a stock that is too expensive can limit returns. Valuation metrics help you decide if a stock is reasonably priced. Key ratios include:
Price-to-Earnings (P/E) Ratio
The P/E ratio is calculated by dividing a company’s stock price by its earnings per share (EPS). For example:
A company with a stock price of $50 and earnings of $5 per share has a P/E ratio of 10.
A lower P/E ratio may signal that a stock is undervalued, but you will want to compare it to its competitors for context.
Price-to-Earnings-to-Growth (PEG)
The PEG ratio is calculated by taking the P/E ratio and dividing by the growth rate for 1 year.
- The PEG ratio builds upon the P/E ratio by including the growth rate.
- It’s generally a good value when PEG is less than 1.
Price-to-Book (P/B) Ratio
The P/B ratio compares a stock’s market value to its book value. A lower P/B ratio could mean the stock is undervalued compared to its assets.
Step 5: Director and Leadership Oversight
A company is only as good as the people on top of it. Check on the management team’s history:
- Have they proven to deliver in prior positions?
- Are they open about how the company is doing and its challenges?
- Do they hold a large percentage of the business?
Many of the most driven leaders have “skin in the game.” Strong leadership and inspiration give confidence and, in many cases, better long-term results for your investors.
Step 6: Assess Risk Factors
No investment is risk-free. Be aware of:
- Market Volatility: Your returns can change due to price movements that are more sudden.
- Regulatory Risks: Certain sectors, such as pharmaceuticals or financial services, are subject to more stringent regulation.
- Competitive: Intense competition can eat into market share and profitability.
For example, if you’re thinking of investing in a streaming service, consider the vicious competition it faces from the likes of Netflix and Disney+.
Step 7: Look Out Below, Watching Stock Performance and Exit Strategies
Your work isn’t done once you buy a stock. Keep observing its performance using the financial measures we have discussed earlier.
You’d want to keep a close watch on:
- Quarterly earnings reports
- Industry news
- Macroeconomic trends
And finally, always have an escape plan. Some recommend nominating the price levels where you would sell the stock, not wanting to have to make an emotional decision.
Make Stock Analysis a Habit
Firstly, it seems daunting to analyze stocks but the more you learn, the more natural it feels. Take baby steps, learn about one metric, and improve slowly.
Because educated decisions tend to also be better decisions. Follow this guide and you’ll be ready to analyze any stock, reduce your overall risk, and build (hopefully) a winning portfolio.
If you’re eager to learn more about investment strategies or tools to help you analyze stocks, sign up for our free newsletter, and we’ll send you weekly Tip$, or check out our beginner investment course.
You can also read this for better understanding: Best Stock Strategy
Happy investing!
