Investing can be fun and rewarding, but it’s useful to be able to perform some kind of stock analysis. Otherwise, you may be gambling with unnecessary risk. Being able to assess a company and carry out some basic fundamental analysis will give you a better chance of becoming a successful investor.
Let’s take a look at what’s involved.
Being able to analyse a company before you invest will put you ahead of many investors in the market.
Performing analysis is a good way to remove emotion and bias. Advertising and brand power are real, and they can sometimes cloud our judgement. Analysing a stock helps you to wipe away the hype.
However, financial analysis won’t tell you everything. It’s still important to use context and to consider the bigger picture.
Types of analysis
There are two main methods of stock analysis: fundamental and technical.
Fundamental stock analysis
This relies on you looking at financial records. You might choose to look at a number of a company’s statements, including its:
- Balance sheet
- Income statement
- Cash flow statement
- Earnings report
By looking at these, it’s possible for you to get an idea of a company’s current situation. You can then build a clearer picture of a company’s:
- Growth trajectory
This is obviously quite a lot of information. So if you’re new to investing, it might be wise to start by researching just a handful of stocks. New investors looking to diversify their portfolios often choose to avoid this process entirely in their early days by investing in an index fund, investment trust, or OEIC.
Technical stock analysis
This tends to focus on a stock’s trends and patterns. It’s more to do with the past and present price action of a stock rather than underlying fundamentals. The two main things you should consider are a stock’s:
- Trading volume
It’s in this analysis that you might see complex graphs and hear terms like ‘support’ and ‘resistance level’. This is largely used by investors when day trading or looking for short-term buying and selling opportunities.
Using fundamental stock analysis
Because this method tends to focus on the long term, it can be a good option. It could be months or years before the share price properly reflects the company’s true value.
This is a fairly reliable way to judge a company. However, it’s important to recognise that it’s not a silver bullet for beating the market.
Key tools to learn
Many people spend years learning stock analysis skills. However, understanding a few key metrics could help in your early days of making investments. Here are some useful metrics you could use:
Price to earnings (P/E) ratio
This is a common way to analyse and compare similar companies in the same industry.
The P/E ratio is calculated by dividing a company’s share price by its annual earnings per share (EPS). EPS is how a company reports its profits.
A lower P/E ratio can mean a stock is good value, but it can also mean that investors aren’t confident in the company. A P/E ratio of 15 is about average for a big company, whereas over 25 can be worrying territory.
Price to earnings growth (PEG) ratio
This divides a stock’s P/E ratio by the expected yearly earnings growth rate. Doing this can help factor a fast-growing company’s growth potential into the analysis.
Bear in mind, though, that analysing expected earnings means heading into the realm of speculation.
Price to book (P/B) ratio
Book value is the total value of all of a company’s tangible assets. The P/B ratio is when you compare the stock price with book value.
A low P/B ratio of under three could be a good sign of value, but it could also signal an issue with the company. Stock analysis showing a good or bad P/B ratio will vary between industries.
Debt to equity (D/E) ratio
Calculated by dividing a company’s total liabilities by its shareholder equity. The main purpose of doing this is to evaluate a company’s financial leverage.
Leverage just means how much of the business is financed using borrowed money. Ideally, this number should be lower than two, but what’s acceptable will vary depending on the industry.
Stock analysis takeaway
These methods aren’t foolproof. It’s important to remember that unexpected things happen in the stock market all the time. These days, one poorly judged tweet from a CEO can tank a stock.
However, using some analysis will mean you’re doing what you can to assess the available information before making an investment.
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