Investing in stocks can be a rewarding experience if you analyze them. Analytical methods can be used to find stocks that are trading at a discount to their true value when researching stocks. You can take advantage of this in the future to make market-beating returns.
Knowledge and information are two critical success factors in stock investing. People who plunge headlong into stocks without sufficient knowledge of the stock market in general, and current information in particular, quickly learn the lesson of the eager diver who didn’t find out ahead of time that the pool was only an inch deep. In their haste to avoid missing so-called golden investment opportunities, investors too often end up losing money.
In this article, we will discuss the best ways to research stocks.
1. Learn the Basics of Accounting and Economics
Stocks represent ownership in companies. Before you buy individual stocks, you want to understand the companies whose stocks you’re considering and find out about their operations. It may sound like a daunting task, but you’ll digest the point more easily when you realize that companies work very similarly to the way you work. They make decisions on a daily basis just as you do.
You can better understand companies’ finances by taking the time to pick up some information in two basic disciplines: accounting and economics. These two disciplines, which I discuss in the following sections, play a significant role in understanding the performance of a firm’s stock.
Accounting Concepts For Stock Investment
1. Assets minus liabilities equals net worth
In other words, take what you own (your assets), subtract what you owe (your liabilities), and the rest is yours (your net worth)! Your own personal finances work the same way as Microsoft’s (except yours have fewer zeros at the end).
A company’s balance sheet shows you its net worth at a specific point in time (such as December 31). The net worth of a company is the bottom line of its asset and liability picture, and it tells you whether the company is solvent (has the ability to pay its debts without going out of business).
The net worth of a successful company grows regularly. To see whether your company is successful, compare its net worth with the net worth from the same point a year earlier.
2. Income minus expenses equals net income
In other words, take what you make (your income), subtract what you spend (your expenses), and the remainder is your net income (or net profit or net earnings — your gain).
A company’s profitability is the whole point of investing in its stock. As it profits, the business becomes more valuable, and in turn, its stock price becomes more valuable. To discover a firm’s net income, look at its income statement. Try to determine whether the company uses its gains wisely, either by reinvesting them for continued growth or by paying down debt.
3. Do a comparative financial analysis
If you know that the company you’re looking at had a net income of $50,000 for the year, you may ask, “Is that good or bad?” Obviously, making a net profit is good, but you also need to know whether it’s good compared to something else.
If the company had a net profit of $40,000 the year before, you know that the company’s profitability is improving. But if a similar company had a net profit of $100,000 the year before and in the current year is making $50,000, then you may want to either avoid the company making the lesser profit or see what (if anything) went wrong with the company making less.
Economic Concepts For Stock Investment
By understanding the basics of economics, I (and you) can filter the financial news and separate relevant information from irrelevant information in order to make better investment decisions. Take note of the following economic concepts:
1. Supply and demand
How can anyone think about economics without considering supply and demand? The concept of supply and demand can be simply defined as the relationship between what is available (the supply) and what people want and are willing to pay for (the demand).
For a stock investment analysis and decision-making process, you need to understand this equation as it is the main engine of economic activity.
2. Cause and effect
Upon seeing a prominent news report stating, “Companies in the table industry expect plummeting sales,” would you rush out and invest in companies that make chairs or tablecloths? Cause and effect are exercises in logical reasoning, and logic is a key element of sound economic thinking.
3. Economic effects of government actions
Governmental and political decisions affect the economy. The government, in fact, has a greater impact on investing and economics than anything else. Taxes, legislation, and regulations are common examples of government action. In addition, they can take on an ominous appearance, such as the threat of war. Willfully (or accidentally), the government can cause a bankrupt company, a disruption of an entire industry, or even a depression. It controls the money supply, credit, and all public securities markets.
2. Learn the Basic Types of Stock Analysis
There are two basic approaches to analyzing stocks: fundamental analysis and technical analysis.
Fundamental analysis assumes that a stock price does not necessarily reflect the intrinsic value of a company. It is the primary tool that value investors use in their search for investment opportunities. The criteria used by fundamental analysts to determine whether a stock is attractively valued are valuation ratios and other factors. Those interested in the long-term benefits of fundamental analysis use it.
Technical analysis assumes that the price of a stock reflects all available information and that prices tend to move according to trends. So you can predict the future price of a stock by analyzing its price trend. You may have seen someone analyzing stock charts or talking about moving averages. That’s technical analysis.
The main difference between fundamental analysis and technical analysis is that fundamental analysis is used to identify long-term investment opportunities. Technical analysis, on the other hand, is usually concerned with short-term price changes.
3. Learn Some Important Investing Metrics
Here are four of the most important and easily understood metrics every investor needs to know to understand a company’s financial statements:
Price-to-earnings (P/E) ratio: The P/E ratio is the ratio between the price of a stock and the company’s earnings. P/E ratios are widely followed and are important barometers of value in the world of stock investing. The P/E ratio (also called the earnings multiple or just multiple) is frequently used to determine whether a stock is expensive (a good value). Value investors (such as yours truly) find P/E ratios to be essential to analyzing a stock as a potential investment. As a general rule, the P/E should be 10 to 20 for large-cap or income stocks. For growth stocks, a P/E no greater than 30 to 40 is preferable.
Price-to-earnings-growth (PEG) ratio: P/E ratios do not always show if the P/E is appropriate for a company’s expected growth rate, even when using forward earnings estimates. As a solution to this limitation, investors turn to the PEG ratio. The PEG ratio measures the relationship between the price/earnings ratio and earnings growth in order to provide investors with a more comprehensive picture than the P/E ratio alone. By analyzing both current earnings and the company’s projected growth rate for the future, the PEG ratio tells investors whether a stock’s price is overvalued or undervalued.
Price-to-book (P/B) ratio: To compare the market capitalization of a firm with its book value, companies use the price-to-book ratio (P/B). Stock price per share is calculated by dividing book value per share (BVPS) by stock price per share. The book value of an asset is equivalent to its carrying value on the balance sheet, and companies calculate it by netting the asset against depreciation.
Intangible assets, such as patents, goodwill, and liabilities, are subtracted from the book value to arrive at the tangible net asset value. When calculating an investment’s book value, expenses such as trading costs, sales taxes, and service charges may be deducted or added. This ratio is also known as the price-equity ratio, a less common term.
Debt-to-EBITDA ratio: The debt/EBITDA ratio, which measures income before interest, taxes, depreciation, and amortization, is a measure of how much income is generated and available to settle debt before covering interest, taxes, depreciation, and amortization costs. Debt to EBITDA measures a company’s ability to repay incurred debt. When a ratio is high, it could mean a company is carrying too much debt.
The covenants for business loans often include a debt/EBITDA target, and the company must maintain this agreed-upon level to avoid defaulting on the loan. Credit rating agencies commonly use this measure to assess whether a company will default on its debt, and companies with a high debt/EBITDA ratio may not be able to service their debt properly, leading to a lower credit rating.
4. Checking Out a Company’s Fundamentals
When you hear the word fundamentals in the world of stock investing, it refers to the company’s financial condition and related data.
When investors (especially value investors) do fundamental analysis, they look at the company’s fundamentals — its balance sheet, income statement, cash flow, and other operational data, along with external factors such as the company’s market position, industry, and economic prospects. Essentially, the fundamentals indicate the company’s financial condition.
Sales: Are the company’s sales this year surpassing last year’s? As a decent benchmark, you want to see sales at least 10 percent higher than last year. Although it may differ depending on the industry, 10 percent is a reasonable, general yardstick.
Earnings: Are earnings at least 10 percent higher than last year? Earnings should grow at the same rate as sales (or, hopefully, better).
Debt: Is the company’s total debt equal to or lower than the prior-year? The death knell of many a company has been excessive debt.
A company’s financial condition has more factors than I mention here, but these numbers are the most important. I also realize that using the 10- percent figure may seem like an oversimplification, but you don’t need to complicate matters unnecessarily. I know someone’s computerized financial model may come out to 9.675 percent or maybe 11.07 percent, but keep it simple for now.
5. Analyze stocks beyond the numbers
In the analytical process, this is perhaps the most crucial step. A good bargain is always welcome, but stock research and analysis go beyond just looking at valuation metrics. Investing in a good business is more important than buying a cheap stock. In that regard, here are three important components to watch in stock analysis:
A strong company in a growing industry is a common recipe for success. If you look at the history of stock investing, this point comes up constantly. Investors need to be on the alert for megatrends because they help ensure success.
A megatrend is a major development that has huge implications for much (if not all) of society for a long time to come. Good examples are the advent of the Internet and the aging of America. Both of these trends offer significant challenges and opportunities for the economy. Take the Internet, for example. Its potential for economic application is still being developed. Millions are flocking to it for many reasons. And census data tells us that senior citizens (over 65) will be the fastest-growing segment of the U.S. population during the next 20 years.
Companies that have established a strong niche are consistently profitable. Look for a company with one or more of the following characteristics:
A strong brand: Companies such as Coca-Cola and Microsoft come to mind. Yes, other companies out there can make soda or software, but a business needs a lot more than a similar product to topple companies that have established an almost irrevocable identity with the public.
High barriers to entry: United Parcel Service and Federal Express have set up tremendous distribution and delivery networks that competitors can’t easily duplicate. High barriers to entry offer an important edge to companies that are already established. Examples of high barriers include high capital requirements (needing lots of cash to start) or special technology that’s not easily produced or acquired.
Research and development (R&D): Companies such as Pfizer and Merck spend a lot of money researching and developing new pharmaceutical products. This investment becomes a new product with millions of consumers who become loyal purchasers, so the company’s going to grow. You can find out what companies spend on R&D by checking their financial statements and their annual reports.
The management of a company is crucial to its success. Before you buy stock in a company, you want to know that the company’s management is doing a great job. But how do you do that? If you call up a company and ask, it may not even return your phone call. How do you know whether management is running the company properly? The best way is to check the numbers. The following sections tell you the numbers you need to check. If the company’s management is running the business well, the ultimate result is a rising stock price.
Return on equity: Although you can measure how well management is doing in several ways, you can take a quick snapshot of a management team’s competence by checking the company’s return on equity (ROE).
You calculate the ROE simply by dividing earnings by equity. The resulting percentage gives you a good idea of whether the company is using its equity (or net assets) efficiently and profitably. Basically, the higher the percentage, the better, but you can consider the ROE solid if the percentage is 10 percent or higher. Keep in mind that not all industries have identical ROEs.
To find out a company’s earnings, check out the company’s income statement. The income statement is a simple financial statement that expresses this equation: sales (or revenue) minus expenses equals net earnings (or net income or net profit).
Equity and earnings growth: Two additional barometers of success are a company’s growth in earnings and growth of equity.
Insider buying: Watching management as it manages the business is important, but another indicator of how well the company is doing is to see whether management is buying stock in the company as well. If a company is poised for growth, who knows better than management? And if management is buying up the company’s stock en masse, that’s a great indicator of the stock’s potential.
6. Noticing who’s buying and/or recommending a company’s stock
You can invest in a great company and still see its stock go nowhere. Why? Because what makes the stock go up is demand — having more buyers than sellers of the stock. If you pick a stock for all the right reasons and the market notices the stock as well, that attention causes the stock price to climb. The things to watch for include the following:
Institutional buying: Are mutual funds and pension plans buying up the stock you’re looking at? If so, this type of buying power can exert tremendous upward pressure on the stock’s price. Some resources and publications track institutional buying and how that affects any particular stock. Frequently, when a mutual fund buys a stock, others soon follow. In spite of all the talk about independent research, a herd mentality still exists.
Analysts’ attention: Are analysts talking about the stock on the financial shows? As much as you should be skeptical about an analyst’s recommendation (given the stock market debacle of 2000– 2002 and the market problems in 2008), it offers some positive reinforcement for your stock. Don’t ever buy a stock solely on the basis of an analyst’s recommendation. Just know that if you buy a stock based on your own research, and analysts subsequently rave about it, your stock price is likely to go up. A single recommendation by an influential analyst can be enough to send a stock skyward.
Newsletter recommendations: Independent researchers usually publish newsletters. If influential newsletters are touting your choice, that praise is also good for your stock. Although some great newsletters are out there and they offer information that’s as good as or better than that of some brokerage firms’ research departments, don’t base your investment decision on a single tip. However, seeing newsletters tout a stock that you’ve already chosen should make you feel good.
Consumer publications: No, you won’t find investment advice here. This one seems to come out of the left-field, but it’s a source that you should notice. Publications such as Consumer Reports regularly look at products and services and rate them for consumer satisfaction. If a company’s offerings are well received by consumers, that’s a strong positive for the company. This kind of attention ultimately has a positive effect on that company’s stock.
Look at past market winners, especially those during the bull market of the late 1990s and the bearish markets of 2000–2010, and ask yourself, “What made them profitable stocks?” I mention these two-time frames because they offer a stark contrast to each other. The 1990s were booming times for stocks, whereas more recent years were very tough and bearish.
- Pick a company that has strong fundamentals, including signs such as rising sales and earnings and low debt.
- Make sure that the company is in a growing industry.
- Fully participate in stocks that are benefiting from bullish market developments in the general economy.
- During a bear market or in bearish trends, switch more of your money out of growth stocks (such as technology) and into defensive stocks (such as utilities).
- Monitor your stocks. Hold on to stocks that continue to have growth potential, and sell those stocks with declining prospects.
A company’s financial situation does change, and you, as a diligent investor, need to continue to look at the numbers for as long as the stock is in your portfolio. You may have chosen a great stock from a great company with great numbers in 2021, but chances are pretty good that the numbers have changed since then.
Great stocks don’t always stay that way. A great selection that you’re drawn to today may become tomorrow’s pariah. Information, both good and bad, moves like lightning. Keep an eye on your stock company’s numbers!
Learn more about the best investment strategies.