How to Analyze a Stock: A Beginner’s Guide

It’s not a coincidence that legendary investors like Warren Buffett and George Soros are voracious consumers of financial data and news. Indeed, successful investing in stocks often comes down to who has the best information. Research and analysis can help any investor make smarter decisions.

Tips on researching stocks

Stock research can start simply by scanning the web for reports by securities analysts. What does their research indicate about a particular company and its share price? Some analyst research reports are free online; others require a subscription or fee for access. Major brokerages and fund companies provide account holders access to research reports, which focus on hard data such as dollar figures, percentages, and ratios.

Articles in authoritative publications such as The Wall Street Journal, Barron’s, Bloomberg, and Reuters aim to inform investors about executive leadership and challenges.

Investors can also go directly to a company’s mandatory filings with the Securities and Exchange Commission (SEC) to get detailed information about its business, risks, and full financial reporting. Some important filings include:

• The annual report (SEC Form 10-K).

  This includes a full description of the company’s business, industry and competition, management discussion of performance and business development, risks, and the three key financial statements: income statement, balance sheet, and statement of cash flows.

• The quarterly (Form 10-Q).

  Here investors will find the three key financial statements and some management discussion of the quarter’s business performance, with a possible forecast.‍

• The current report (Form 8-K).

  This report must be filed any time an unexpected event, such as a court ruling or judgment against the company, could change how investors view a company’s prospects.

Fundamental vs. technical analysis

There are two primary methods of analyzing stocks: technical analysis and fundamental analysis. Technical analysis shows how a stock’s price swings, but doesn’t explain why. Fundamental analysis seeks the why—it wants to draw a conclusion about the company’s prospects. Here’s a closer look at how they differ:

• Technical analysis.

  This approach relies on charts to assess historical trends or patterns in the stock price, to bet on future price direction. The study of the stock’s moving averages (say, for the past 50 trading days) considers whether the price is likely to move above or below the average. Technical analysts care little about a company’s fundamentals such as earnings growth, ratios, or management quality. Their focus is on short-term changes in the stock price.

• Fundamental analysis.

  With this approach, the company’s operations, financial condition, management and industry are considered. Fundamental analysts ask: What makes this company tick? Then, after many observations, number-crunching, and best-guess assumptions, they estimate a true value for the company.

To analyze stocks, investors can use a combination of these two methods, but typically they spend more time on the fundamentals, because this information can often help them assess and understand the company’s market valuation.

Fundamental analysis: Quantitative metrics

Analysts doing fundamental research divide their analysis into two parts: quantitative and qualitative. Quantitative analysis focuses on the company’s financial statements, which are evaluated using dozens of important ratios, such as:

• Price-to-earnings ratio (P/E).

  This is the current stock price divided by earnings for the past 12 months, typically a multiple. For example, Amazon’s stock price was $3,200 as of mid-August 2021, and its earnings per share for the trailing 12 months were $57.53, so the P/E is 3,200/57.53 = 55.5. A high ratio means the stock is relatively expensive and investors have higher expectations for the company’s growth.

• Price-to-sales ratio.

  This is the company’s total market capitalization divided by its total sales or revenue for the trailing 12 months. This ratio is useful for companies that aren’t yet profitable or have temporary losses.

• Price-to-cash-flow ratio.

  This is the company’s stock price divided by its operating cash flow per share. Useful for companies that have little or no net income after non-cash expenses for depreciation and amortization.

• Price-to-book ratio.

  The current stock price divided by the per-share value of shareholders’ equity, or market value over book value. A ratio below 1 suggests the company is undervalued.

• Profit margin.

  This is a basic way to evaluate whether a company is controlling costs while generating sales. Investors may use net income, operating profit, or EBITDA (earnings before interest, taxes, depreciation and amortization) as the basis.

• Return on equity (ROE).

  This is net income divided by shareholders’ equity. Higher ROE means a company is making good use of shareholder equity to generate earnings.

• Return on assets (ROA).

  ROA refers to net income divided by total assets. Like ROE, it’s a measure of how efficiently a company uses its resources to generate earnings.‍

• Debt-to-equity ratioand debt to total capital.

  Debt-to-equity is a company’s total debt divided by shareholder equity. Debt to total capital is debt divided by debt, plus equity, since debt is treated as capital.‍

• Debt to EBITDA.

  The company’s total debt divided by earnings before interest, taxes, depreciation, and amortization. Debt is often several times larger than EBITDA, which investors use as a proxy for the company’s cash flow. Debt/EBITDA gauges a company’s ability to repay its debts. The lower the multiple, the better; the higher the multiple, the more stretched the company’s cash flow to make debt payments.

Fundamental analysis: Qualitative metrics

Qualitative analysis examines soft metrics that can be essential for success but are hard to quantify, such as:

• Competitive advantage.

  Does the company have one? Does it have brands that help sales?

• Leadership.

  What is the track record of the chief executive? The chief financial officer? Has the company grown during their tenure?

• Industry trends.

  Is the industry growing, stagnant, or shrinking? Is the company moving in line with the trend, or standing out from the trend? Winning example: the growing e-commerce industry led by Amazon as more shoppers go online. Losing example: department stores.‍

• Business model.

  How does the company plan to generate sales and turn a profit? What are its products and services? What are the company’s target markets, geographic and demographic? Winning example: Apple, which changed the mobile phone industry with the iPhone. Losing example: Eastman Kodak, which missed the advent of digital cameras.

Putting together the findings

After looking at all the quantitative and qualitative data, the investor needs to make a decision. Stock analysis typically leads to one of two investment approaches:

• Value investing.

  This approach hopes to determine the intrinsic value of a stock, below its current market price. It favors undervalued companies—those with fundamental measures that may not be recognized or appreciated by other investors. ‍

• Growth investing.

  This approach applies to companies usually with high price-earnings ratios, justified by high growth expectations. Growth stocks can have more volatile price swings when companies don’t meet investors’ expectations.

Real-world examples of stock analysis

Here are some real examples of how an investor might analyze two companies in the same industry.

An investor is weighing an investment in a maker of computer chips:
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*For 2021 vs. 2020
**Based on five-year expected growth rate

Intel has a higher profit margin, but earnings are expected to decline. AMD has a more expensive P/E ratio, which may be justified by a higher return on shareholders’ equity and expected earnings growth.

As for qualitative comparison, an investor might ask: Does Intel, the longtime leader in the chip industry, still have any competitive advantage? Can AMD continue its resurgence under Chief Executive Lisa Su after nearly falling into bankruptcy a decade ago?

Basic technical analysis, however, takes an entirely different tack: It shows that AMD stock has been trading above its 60-day moving average price for the past two years, while Intel has swung above and below its moving average in that time period and is now slightly below. Do the chart patterns of Intel suggest that its stock price may be poised for an increase, above the moving average again? Or do they suggest AMD is overpriced and the stock is headed for a decline back to the moving average?

The investor is also looking at pharmaceutical makers:
‍

*For 2021 vs. 2020
**Based on five-year expected growth rate

Pfizer has a less expensive P/E ratio and higher expected earnings growth. Merck has a higher profit margin and return on equity, and its debt/EBITDA ratio is lower.

Ratios aside, which company has a more promising number of drugs in development, a key qualitative measure in the industry? Among drugs already being sold, is Pfizer’s Covid-19 vaccine likely to remain a big sales generator? Or will Merck now take center stage after successful trials of its Covid pill, the first oral medication for the virus?

A quick study of price charts for Pfizer and Merck for the past year show that Pfizer is trading within the statistical range of deviations from moving averages (known as Bollinger bands) while Merck has climbed above its range of deviation after the bullish news about its Covid pill. Does that mean Merck’s price will retreat to its moving average?

The bottom line

As these examples show, analyzing stocks is a difficult and time-consuming process. For these reasons, investors might consider using a registered investment advisor who has the experience and tools to provide efficient analysis toward investment decisions.