New investors often become overwhelmed by the number of choices and the amount of information available to them about the stock market. There are thousands of stocks listed on exchanges, along with complicated charts, tools, and metrics for analyzing them. While no strategy is 100% effective for selecting the best stocks to purchase, learning and understanding basic terminology and analysis tools can help new investors start to understand the complicated investing world.
In this article, we’ll help you:
- Learn to analyze stocks to buy.
- Understand business basics.
- Choose between fundamental and technical analysis.
How to Analyze Stocks to Buy
Learning how to analyze stocks to buy helps investors identify potentially profitable stocks to buy. Technical and fundamental analysis are the two most common ways to do this. Fundamental analysis includes several components, including return on equity, book value, earnings per share, and price-to-earnings ratio, while technical analysis looks at how market factors impact stock prices.
The type of stock analysis you decide to implement is a personal decision. Technical and fundamental analysis are not mutually exclusive, and many investors use a combination of both strategies to achieve the best results.
Understanding Business Basics
Understanding business basics, especially those related to financial statements, is an essential first step before you begin analyzing companies for investment potential. The three primary financial statements to consider when evaluating a company include:
- The income statement: Identifies a company’s profit or income by subtracting expenses from revenue.
- The balance sheet: Compares the stockholder’s equity and a company’s liabilities against the company’s assets.
- The statement of cash flows: Breaks down the money a company takes in and doles out according to its purpose, including investing, financing, and operating activities.
Financial statements are integral to fundamental analysis, as they provide investors with the numbers they will use in their analysis. However, it’s crucial to remember numbers aren’t everything. In addition to these quantitative performance factors, investors should look at a company’s annual report, which explains its performance over time and lays out future plans.
Fundamental vs. Technical Analysis
Investors should consider two things when determining the best way to analyze stock market performance and choosing between fundamental and technical analysis:
- Consider the time horizon of your approach. Fundamental analysis is a long-term strategy, while technical analysis is a shorter-term strategy.
- Determine your investment approach. Are you a trader or an investor? Technical analysis is a trading strategy in which individuals are looking to drive returns out of identified opportunities and trends. Fundamental analysis involves investing in different companies and relying on their underlying value to drive returns.
Trading often takes more management and time from the investor. While major firms will invest millions in sophisticated technical analysis trading software, most individual investors are better served focusing on a fundamental analysis investment strategy.
Fundamental analysis looks at a business at its most fundamental or basic financial level, examining key ratios to determine a company’s financial health. Fundamental analysis provides investors with an idea of what a company’s stock value should be by considering factors such as interest rate, the production of a business, asset management, and revenue.
While many investors use fundamental analysis on its own, you can also use it in combination with other stock evaluating tools for investment purposes. Even if doing an in-depth fundamental analysis isn’t something your plan to do yourself, understanding the key terms and ratios can help you follow stocks more accurately and closely.
Fundamental Analysis Tools
While a company’s earnings are important, by themselves they can’t tell you much because they don’t identify how the market values the stock. To build a better picture of a stock’s value, you will need to use fundamental analysis tools such as:
- Earnings per share (EPS): Calculated by dividing net income fewer dividends on a preferred stock by the number of outstanding shares.
- Price-to-earnings ratio (P/E): Compares a company’s current stock price to its per-share earnings.
- Projected earnings growth (PEG): Anticipates a stock’s earnings growth rate for one year.
- Price-to-sales ratio (P/S): Sometimes called the sales multiple, revenue multiple, or PSR, the price-to-sales ratio compares the price of a company’s stock to its revenue.
- Price-to-book ratio (P/B): Also referred to as the price-to-equity ratio, it is the value appearing in a company’s books and equal to the cost of each asset minus cumulative depreciation. It compares the market value of a company’s stock with its book value by dividing a stock’s most recent closing price by the book value per share for the last quarter.
- Dividend payout ratio: Compares the dividends paid out to stockholders to the company’s total net income. It takes into account retained earnings or income that isn’t paid out but retained for potential growth.
- Dividend yield: A ratio expressed as a percentage; it compares yearly dividends with a share’s price by dividing dividends per share paid during a one-year period by the value of a share.
- Return on equity: Sometimes called the company’s return on net worth, it divides a company’s net income by the shareholders’ equity.
What Is Performance?
A company’s fundamental performance does not factor in its stock price. When talking about fundamental analysis, performance refers to how efficiently a company moves toward its goals. Investors use performance to categorize a company as having investment potential (healthy) or investment poison (unhealthy).
Depending on the metric you’re analyzing, you can measure performance in several ways. If you are interested in looking at a company as a whole, for instance, then you want to know about its ability to generate a profit. You can use many ratios and numbers to gauge a company’s performance and health, including price-to-earnings ratio, gross margin, and earnings per share.
Comparing Similar Companies
Comparisons aren’t absolute when evaluating the performance of two companies. For example, comparing a company like U.S. Steel to Google, a technology company that on any given day has a P/E that’s almost four times as high as U.S. Steel, isn’t going to provide you with much useful information. U.S. Steel is in the basic materials sector, which generally doesn’t trade with P/Es comparable to companies in the tech sector.
So how should a new investor just learning how to analyze a stock approach metrics? Use ratios and comparisons only for comparable companies in similar sectors or industries. For example, while eBay might look like a pig (an overhauled and bloated stock) compared to the Bank of New York, these two companies aren’t in comparable fields, making the intrinsic value of their stock no clearer for your comparative efforts.
Technical analysis studies past market performance to gauge what it might do in the future. At its most basic, it’s the study of price. Technical analysis focuses primarily on the study of patterns, trends, and charts and gives little attention to a company’s value. Focusing on a stock’s supply and demand within a market, investors using technical analysis believe a stock’s historical performance indicates how it will perform in the future.
Three Main Tenets of Technical Analysis Philosophy
While fundamental analysis evaluates characteristics of a company to estimate its value, technical analysis takes a different approach. Technical analysis doesn’t care about a company’s value. Rather, it’s interested in price movements within a market and focuses on these three tenets:
- Market action discounts everything. The price of a stock reflects all known information related to a security, including fundamental factors. When new information becomes available, the price reflects this immediately.
- Prices move in trends. Security prices tend to move in observable trends and usually stay in a trend considered to be intact until the trend line breaks. Once a trend is established, future price movements are more likely to go in the same direction rather than against it.
- History repeats itself. When studying what has happened to a security’s price in the past, expect history to repeat itself. Most chart patterns used in technical analysis have been around for 100 or more years. Investors still believe them to be relevant because they show patterns in price movements that routinely repeat themselves.
Many investors use analyst recommendations when analyzing stocks and shares. Analysts perform extensive technical and fundamental research, and they often provide recommendations for buying and selling. Before deciding to buy or sell a stock, many investors use a stock analysis technique in conjunction with analyst recommendations.
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