What To Look For When Analyzing a Stock
Wesley Grant
It’s easier than ever to invest in the stock market, but it’s not so simple to choose good investments. Researching a stock can lead to information overload given the sheer volume of opinions out there. That’s why it’s important to listen to the most valuable opinion of them all: your own.
But sorting out the metrics and indicators that analysts use to forecast stock movements can be a daunting task. While you may not have the time or the inclination to dive deep into every stock, it’s important to understand key factors about a company so you can pick stocks that fit with your investment strategy.
Fundamental vs. technical analysis
There are two main ways to analyze a stock: fundamental analysis and technical analysis. Fundamental analysis is based on the concept that a stock’s price doesn’t always reflect what a company is actually worth. By sifting through a company’s financial data, fundamental analysts hope to find stocks that are selling at a bargain so they can buy and hold them long-term.
Because a stock’s price represents so many factors, internal and external, technical analysts believe that the price alone should be the focal point for investors. Technical analysts follow price movements and chart the patterns because they’re looking to make short-term profits off of swings in price.
While each method has its benefits and drawbacks, there’s nothing stopping you from using both methods to analyze a stock. It’s important to remember that fundamental and technical analysis have the same goal: to identify ways to make money in the market.
Fundamental analysis overview
Fundamental analysis is a way of double-checking the market to make sure a stock is priced right. Analysts look at key metrics and indicators taken from the company’s quarterly and annual reports to measure a stock’s value independent of the market. Of course, there are plenty of external factors to consider like the strength of the company’s sector and the overall health of the economy.
The overriding idea is that a company’s value can be determined by looking at the revenue, profits, growth, and cash flow. Another belief is that the market will eventually figure out if an undervalued company is on the rise, and the stock price will rise along with it.
Metrics and ratios used in fundamental analysis
Price/Earnings (P/E) ratio
A P/E ratio is a very common way to get a handle on a company’s value. It measures the stock price in relation to its Earnings Per Share (EPS). A P/E ratio of around 1.0 means that a company is valued dead on the money.
On the other hand, a higher P/E value could mean the stock is overvalued. P/E ratios function best when they’re used to compare a company against itself over time or to measure a company against its direct competitors.
Year-Over-Year (Y/Y) revenue growth
Y/Y revenue growth tells us the percentage change in revenue versus the revenue from the same timeframe one year ago. If a company is making more money this year than last, it’s a pretty straightforward indicator that a company is growing.
Price-to-Book (P/B) ratio
Because the market can inflate stock prices based on future growth estimates, the P/B ratio aims to capture how far away the market price is from the book value (the actual value of the company).
A value around 1.0 indicates that the stock is on par it’s book value and, much like the P/E ratio, the higher the number goes the more overvalued a company is. In a perfect world, fundamental analysts would find companies with P/B values under 1.0 and invest in them.
Debt-to-Equity (D/E) ratio
Debt is a fact of life for most companies, but businesses that rely too highly on debt to fund their daily operations will be paying back their lenders instead of their shareholders. A D/E ratio is calculated by dividing a company’s liabilities by its assets. A high D/E ratio can be a red flag that a company has too much debt.
Free cash flow (FCF)
FCF measures how much cash is left over after a company pays the bills. A rise in FCF over time means that the company is able to use more of its profits to drive future growth and deliver dividends to its investors.
Price/Earnings-to-Growth (PEG) ratio
A P/E ratio measures the current state of affairs but, because investors are trying to predict the future, the possible growth of a company should be considered as well. The PEG ratio factors in earnings growth and gives a better estimate of a stock’s future outlook. A PEG value under 1.0 means that a company may be undervalued.
Fundamental analysis example
Dollar Tree, Inc. (DTLR) is a discount retailer that operates nationwide and also owns the Family Dollar and Dollar Bills brands. Here is a look at the metrics for DTLR:
Y/Y Revenue Growth3.18%P/E Ratio25.71P/B Ratio4.35D/E Ratio1.81FCF-84.21%PEG Ratio1.38
These numbers don’t look so good given the basic definitions we know about these values. So let’s take it a step further and compare the numbers to DLTR’s leading competition: Dollar General (DG).
Y/Y Revenue Growth1.4%P/E Ratio22.31P/B Ratio8.52D/E Ratio3.2FCF-40.85PEG Ratio1.9
This gives you more perspective on where DLTR is in relation to its main competitor and, depending on the value you favor, can help you make a decision on whether to invest in one or the other (or neither) of these companies.
It’s important to recognize that though neither of these stocks looks great given the numbers alone, there are a lot of other factors to consider. For a discount retailer like DLTR the fact that the economy isn’t great (and is expected to worsen) is reason enough for some investors to buy in. That’s because they expect more consumers to turn to cheaper retailers in the hard times ahead.
Technical analysis overview
Because market price and market perspective on a stock can be so far away from a company’s actual value, technical analysts view companies through the lens of public sentiment. They also believe that past stock activity is an indicator of future stock activity, and invest accordingly.
Technical analysts will examine indicators like the volume of trading activity and price volatility and then they will develop chart patterns of a stock. Based on chart movements and public opinion, technical analysts make short-term moves, even as short as a few minutes, to take advantage of price swings.
Methods used in technical analysis
Mapping a stock’s journey over time can be done with a pencil and paper or with highly complex, highly expensive software. Either way, analysts look for key benchmarks as signals to move in and out of trades.
The 50-day moving average of the S&P 500, for instance, has been used as a gauge for investors. When the index moves above the 50-day moving average and stays there, conventional wisdom is it’s likely to keep on moving up.
Because technical analysis is geared toward the short term, there are charts that break down stock movements over periods as short as five minutes. Candlestick charts are another charting tool that documents price changes during an hour as well as a day. Indicators like pivot points, the price where a stock stops moving up or down, are also used as guides for technical analysts.
Technical analysis example
The 50-day moving average for the S&P 500 is $3,972.92. The S&P reached that level around January 20, 2023, and it did not pull back. Given that knowledge, a technical analyst might have invested in the S&P 500, which at the time of this writing is valued at $4125.04.
Even though that trade may have worked out, it’s important to understand the limitations of technical analysis. Mainly, past performance doesn’t always dictate future performance. But this caveat also holds true for fundamental analysis, which is mostly based on past financial data.
What to look for when analyzing a stock
Fundamental analysis tells you what a company’s value is relative to the market. Technical analysis tells you what the market sentiment is relative to the company. As a savvy investor, it’s critical to use all of the tools at your disposal to make sure you’re setting yourself up for financial success.
It’s important to remember that all stock analysts attempt to do the impossible: they try to predict the future. While there will always be unforeseen obstacles, having an understanding of how traders analyze stocks will help you pick investments that give you the best chance for future wealth.
Written by:
Wesley Grant is a business and personal finance content writer who has worked with leading brands from across the globe. His passion is creating valuable content that will inform business owners and educate consumers. Wesley earned his MBA from the University of South Carolina.
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Posted Jun 6, 2023
It’s easier than ever to invest in the stock market, but it’s not so simple to choose good investments. Researching a stock can lead to information overload gi…
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