How to Analyze Stocks: A Step-by-Step Guide
Buying stocks without performing an analysis beforehand means we are not investing but rather speculating.
Stock analysis is crucial to assess the potential profitability of stocks, so investors can decide which stocks can be considered good investment opportunities and which are not worth investing in.
There are various stock analysis methods available, but the most popular ones are technical analysis and fundamental analysis.
In this tutorial, you will learn all you need to know about analyzing stocks, and by the end of this tutorial, you'd have learned about:
- Technical analysis vs. fundamental analysis
- How to perform fundamental analysis on stocks
- Different technical analysis approaches and their implementations
- Important investing metrics to measure when analyzing stocks
And more. Let us begin this tutorial by discussing the definitions and key differences between technical and fundamental analytics methods.
Fundamental Analysis vs. Stock Analysis: Concepts and Key Differences
Technical analysis and fundamental analysis are two primary methods used to research stocks and make investment-related decisions.
While discussing the two can be a pretty deep subject on its own, the basic difference between the two analytics methods would boil down to:
- Technical analysis is performed by statistically analyzing market metrics such as transaction volumes, price movements, etc.
- Fundamental analysis is researching and analyzing financial and economic factors influencing a business's performance.
Technical Analysis in Stock Investing and Trading
Technical analysis refers to analyzing the available market data (i.e., transaction volume, price movements) to evaluate the current performance of a stock and predict its future value.
At the core of the technical analysis is the basic principle of economics: supply and demand. A stock with high supply but low demand would go down in value, and vice versa; securities that are high-demand but low in supply would increase in value.
Typically, stock analysts and investors use charts and other analytics tools in an attempt to identify and understand different patterns that might help them make investment decisions.
Technical analysis in stock investing is based on several key assumptions:
1. Prices move in trends. A very important assumption in technical analysis, the stock you analyze will follow a certain past trend rather than move randomly. Stock prices move based on short-, medium-, and long-term trends.
2. Only market price matters. Technical analysis only considers price movements, assuming that the stock's price already reflects everything that has or could affect a company's performance (and thus, the stock's performance.) With technical analysis, the stock analyst doesn't need to be concerned with fundamental factors like geopolitical and economic situations and only needs to be concerned about price movement analysis.
3. Repetitive nature of price movements. Another key assumption in technical analysis is the belief that market history tends to repeat itself due to market psychology. This is why evaluating historical data, and chart patterns is a core part of technical analysis in an attempt to analyze market emotions and understand market trends.
Technical Analysis Approaches Top-Down vs. Bottom-Up
In performing technical analysis for stocks, typically, there are two main approaches to choose from: top-down or bottom-up.
1. Top-down approach
In a top-down technical analysis, the analyst would first perform a macroeconomic analysis that analyzes the price history of the whole economy before analyzing the individual stock.
For example, the analyst would first focus on analyzing economies, then sectors, then industries, then the company.
The investors using this approach typically focus on gaining short-term rather than long-term investments.
2. Bottom-up approach
As opposed to the top-down approach, the bottom-up technical analysis approach focuses on analyzing the individual stock's price history first before looking at the macroeconomics.
A typical use case of this approach is when an investor identifies an undervalued stock that is currently in a downtrend (via fundamental analysis), then uses bottom-up technical analysis to identify potential entry and exit points for this specific stock.
In most cases, investors looking for short-term profits may use the top-down analysis approach, while medium-term and long-term investors may be more comfortable with the bottom-up approach.
Fundamental Analysis in Stock Investing and Trading
In fundamental analysis, a stock analyst or investor analyzes various quantitative and qualitative fundamental factors (i.e., economic, financial, geopolitical, etc.) in an attempt to determine a stock's intrinsic value.
The basis of fundamental analysis is the belief that microeconomic and macroeconomic factors like industry conditions, geopolitical situations, and the company's management proficiency can cause a stock's value to go above or below its intrinsic value.
Thus, the main objective of fundamental analysis is to determine the stock's intrinsic value (how much the stock should be worth) and compare it with the current market price of the stock to determine whether the stock is currently undervalued (and, thus, should buy more), or overvalued (and should ideally sell.)
Here are the basic steps of performing fundamental analysis of stocks:
- Understand the company: A very important first step of any fundamental analysis is to have a thorough understanding of the company you are evaluating. In this digital age, it's relatively easy to gather information about a company by visiting its website and social profiles, as well as studying publicly available reports and statements of the company.
- Analyze financial statements: A key aspect of fundamental analysis is a thorough evaluation of the company's financial situation (revenue, expenses, operational costs, cash flow statements, profit/loss statements, balance sheet, and so on.) Evaluate whether the company's financial situation is healthily growing year by year.
- Competitive analysis: Evaluate a company's performance compared to its competitors. You should invest only in companies that are performing better than their competitors both in the present and in the future (better future projects and plans.)
- Evaluate debt: A stock of a company with a lot of debt won't be able to perform well, even if the other financial factors look healthy. In general, investors should look for a company with a debt-to-equity ratio of less than 1.
- Longevity: Fundamental analysis is more useful if you are going to commit to long-term investment. Evaluate whether a company is future-proof (i.e., whether its product/service would still be in demand 20 years in the future, expansion plan, diversification plan, etc.)
Another key consideration when using fundamental analysis in stock investing is that it shouldn't be a one-off thing, but you should review and stay updated about the stock you have invested in from time to time.
This is important to offset the limitation of the technical analysis that solely focuses on price history. Stay updated about the stock's financial performance, and don't hesitate to sell if there's a problem in the company.
Fundamental vs. Technical Analysis: Key Differences
As discussed, technical analysis is only focused on analyzing historical price movements to predict future prices, while fundamental analysis is about analyzing the microeconomic and macroeconomic factors that influence the company's performance.
With that being said, there are two key factors in which fundamental analysis and technical analysis differ from each other.
Short-term vs. Long-term
Fundamental analysis is more geared toward long-term investment. The main objective of fundamental analysis is to wait until a stock's current price is undervalued when compared to its intrinsic value, which can take a long time.
On the other hand, in technical analysis, the stock chart can be delimited to identify short- to medium-term trades where the investor can earn quick profits.
Analysis instruments
The main analysis instrument in technical analysis is the stock charts, with the key assumption that the company's price history already reflects everything that has or could affect the company's performance (and thus, stock price.)
In fundamental analysis, on the other hand, the main analysis instruments are the company's financial statements: balance sheets, profit/loss statements, cash flow statements, and so on. The goal of studying these financial statements is to determine the stock's intrinsic value, mainly by discounting the value of future projected cash flows to the net present value.
Important Metrics in Fundamental Analysis
As discussed, the fundamental analysis relies on evaluating various metrics in the financial statements, with the objective of identifying the stock's intrinsic value.
Here are some of these important metrics:
Earnings per Share (EPS)
A company with high earnings per share typically translates into a higher intrinsic value since investors tend to purchase a stock when earnings are high.
Price-to-earnings (P/E) Ratio
The price-to-earnings ratio, or P/E ratio, is the company's stock price divided by its annual per-share earnings.
The P/E ratio is useful in fundamental analysis to help identify the intrinsic value of a stock by comparing the stock's P/E ratio to its competitors and industry standards.
The lower the P/E ratio is, the less expensive the stock is relative to the earnings it is expected to deliver.
Price-to-earnings-growth (PEG) ratio
The PEG ratio is calculated by dividing a stock's P/E ratio by the expected growth rate of the annual earnings over the next few years (typically the next five years).
For example, a stock with a P/E ratio of 10 and 10% expected annualized earnings growth over the next five years would have a PEG ratio of 1.
A low PEG ratio, especially if it is less than 1, is often seen as a good value opportunity.
Price-to-book (P/B) ratio
The price-to-book ratio is a company's stock price divided by its book value.
The "book value" is the net value of a company's assets. That is, if the company closes its operations today and sells everything, the book value is the amount of money it would theoretically have.
A low P/B ratio is a sign that the stock is potentially undervalued (and could be a good buy).
Debt-to-EBITDA ratio
As discussed above, a key element of fundamental analysis is to evaluate a company's debt, and the debt-to-EBITDA ratio is among the most useful metrics to do so.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and the debt-to-EBITDA ratio can be calculated by dividing the total debts on a company's balance sheet by the EBITDA.
TA high debt-to-EBITDA ratio may signify that the stock is a high-risk investment.
Return on Equity (ROE)
Return on equity, or ROE, is calculated by dividing the company's net income by the average shareholders equity.
In fundamental analysis, we can evaluate the return on equity to determine how well a company generates positive returns on its shareholders' investments. In short, companies with high ROE are profit generators.
Investors would like to find companies with high ROE that is continuously increasing.
Qualitative Factors to Consider in Fundamental Analysis
Besides the quantitative metrics, there are also qualitative factors that you should watch in fundamental stock analysis:
Management quality
No matter how well a company is currently performing financially, it won't sustain its performance if it's managed by the wrong people. Evaluate whether the management team behind the company has adequate expertise and experience.
Also, align whether the company's main executives have financial interests that align with shareholders' interests.
Sustainable growth and competitive advantages
Evaluate whether the company will be able to sustain and grow its market share over time by having a sustainable advantage over its competitors.
Durable competitive advantage (known as the economic moat) can come in many different forms: powerful distribution network, patents and trademarks, and so on.
Industry and sector trends
Evaluate whether the company is in an industry or sector with high potential long-term growth. If it's in a relatively slow or dying industry, you should be reasonably cautious.
Wrapping Up
Stock analysis is crucial when making investment decisions to determine whether a stock is worth investing in.
There are two popular stock analysis techniques leveraged by many investors and traders: fundamental analysis and technical analysis, both useful in achieving different financial objectives with our investments.
In general, fundamental analysis is more useful in long-term investment situations, while technical analysis is more often used in short- and medium-term trading.
By following this guide, you should be able to understand the logic behind both technical and fundamental analysis and properly use them to aid your investment decisions.
