One of the most common questions I have been asked is how to research stocks for beginners. There are a lot of variables that go into evaluating a company as a possible place to invest money. This guide has been put together as a starting point for those just getting into investing and stock research.
The stock market is a tough place for beginners. It can be hard to know how to play the market or what companies are good investments. The more you research a company, the easier it will be to achieve a higher return on your investment. If you want to learn more about researching stocks, continue reading.
Learn the two basic types of stock analysis
When it comes to analyzing stocks, there are two basic ways you can go: fundamental analysis and technical analysis.
- Fundamental analysis is based on the assumption that a stock price doesn’t necessarily reflect the true intrinsic value of the underlying business. Fundamental analysts use valuation metrics and other information to determine whether a stock is attractively priced. Fundamental analysis is designed for investors looking for excellent long-term returns.
- Technical analysis generally assumes that a stock’s price reflects all available information and that prices generally move according to trends. In other words, by analyzing a stock’s price history, you may be able to predict its future price behavior. If you’ve ever seen someone trying to identify patterns in stock charts or discussing moving averages, that’s a form of technical analysis.
One important distinction is that fundamental analysis is intended to find long-term investment opportunities, while technical analysis typically focuses on short-term price fluctuations. We generally are advocates of fundamental analysis and believe that, by focusing on great businesses trading at fair prices, investors can beat the market over time.
Investment time horizon
Time horizon is important as it allows investors to identify which types of stocks may align with their goals. For example, many young investors with long time horizons are willing to take on more risk when it comes to an investment portfolio. These types of individuals will often prefer more aggressive portfolios which may include growth stocks that carry more expensive valuations.
Because of the longer time horizon, these investors can usually tolerate larger swings in the market. The opposite would be true for shorter time horizons (under five years) as these investors have less tolerance for large drawdowns in the portfolio, as larger adverse market movements can create a long-lasting effect for someone nearing retirement that may need to soon begin drawing income from the portfolio.
Risk levels
Risk ties in with time horizon as investors use these two components together to help identify which types of stocks to invest in. Higher risk-seeking individuals will often prefer growth stocks such an Amazon or Tesla; whilst risk-averse investors usually head towards value stocks which often carry lower P/E ratios. These value stocks might be considered as undervalued and potentially attractive for long-term investing.
Regardless of investment style, it’s important to practice good risk management so that the investor can aim to benefit from upside movement while attempting to minimize downside risk.
Learn some important investing metrics
With that in mind, let’s take a look at four of the most important and easily understood metrics any investor should have in their analytical toolkit to understanding a company’s financials:
- Price-to-earnings (P/E) ratio: Companies report their profits to shareholders as earnings per share, or EPS for short. The price-to-earnings ratio, or P/E ratio, is a company’s share price divided by its annual per-share earnings. For example, if a stock trades for $30 and the company’s earnings were $2 per share over the past year, we’d say it traded for a P/E ratio of 15, or “15 times earnings.” This is the most common valuation metric in fundamental analysis and is useful for comparing companies in the same industry with similar growth prospects.
- Price-to-earnings-growth (PEG) ratio: Different companies grow at different rates. The PEG ratio takes a stock’s P/E ratio and divides it by the expected annualized earnings growth rate over the next few years to level the playing field. For example, a stock with a P/E ratio of 20 and 10% expected earnings growth over the next five years would have a PEG ratio of 2. The idea is that a fast-growing company can be “cheaper” than a slower-growing one.
- Price-to-book (P/B) ratio: A company’s book value is the net value of all of its assets. Think of book value as the amount of money a company would theoretically have if it shut down its business and sold everything it owned. The price-to-book, or P/B, ratio is a comparison of a company’s stock price and its book value.
- Debt-to-EBITDA ratio: One good way to gauge financial health is by looking at a company’s debt. There are several debt metrics, but the debt-to-EBITDA ratio is a good one for beginners to learn. You can find a company’s total debts on its balance sheet, and you’ll find its EBITDA (earnings before interest, taxes, depreciation, and amortization) on its income statement. Then turn the two numbers into a ratio. A high debt-to-EBITDA ratio could be a sign of a higher-risk investment, especially during recessions and other tough times.
Understand the company product/service
Familiarising oneself with the company’s product/service will assist in the later step of competitor analysis. Knowing what makes the company’s product/service unique, which includes the cost factor, is crucial for future forecasts.
Many companies have a diverse product/service offering which then makes this step more central to stock research. For example, with multiple products/services, investors need to understand how each offering affects the company with regards to cost, revenue and the future potential of each.
Look beyond the numbers to analyze stocks
This is perhaps the most important step in the analytical process. While everyone loves a good bargain, there’s more to stock research and analysis than just looking at valuation metrics. It is far more important to invest in a good business than a cheap stock. With that in mind, here are three other essential components of stock analysis that you should watch:
- Durable competitive advantages: As long-term investors, we want to know that a company will be able to sustain (and, hopefully, grow) its market share over time. So it’s important to try to identify a durable competitive advantage — also known as an economic moat — in the company’s business model when analyzing potential stocks. This can come in several forms. A trusted brand name can give a company pricing power, patents can protect it from competitors, and a large distribution network can give it a cost advantage over peers, just to name a few.
- Great management: It doesn’t matter how good a company’s product is or how much growth is taking place in an industry if the wrong people are making key decisions. Ideally, the CEO and other main executives of a company will have successful and extensive industry experience and financial interests that align with shareholders’.
- Industry trends: Investors should focus on industries that have favorable long-term growth prospects. For example, over the past decade or so, the percentage of retail sales that take place online has grown from less than 5% to more than 11% today. So e-commerce is an example of an industry with a favorable growth trend. Cloud computing, payments technology, and healthcare are a few other examples of industries that are likely to grow significantly in the years ahead.
Financial reporting
Publicly traded companies publish financial reports which give a quantitative overview of the company. These include Earnings Announcements, which provide vast amounts of information about a company’s financial health and performance. From the company’s publicly filed reports, investors can identify potential red flags/risks within the company, management capability, debt management and income sources.
Competitor and industry analysis
There are regular instances whereby companies have direct competitors with the same/similar business models. Therefore, it is a good idea for investors to compare and analyse stocks between these competitors to find discrepancies which could further uncover potential investment opportunities.
The same applies to the industry as a whole. Often there are times where a company within an industry outperforms the industry and its competitors, or vice versa. Delving into why these seemingly perplexing patterns may occur can broaden understanding of how a stock or industry behaves under certain conditions.
Competitor and industry analysis are seen as obvious comparisons to make when researching stocks but, it may be prudent to analyse other markets as well. For example, Royal Dutch Shell Plc may do direct competitor analysis against a company such as BP Plc, but another comparison may be to overlay these companies with that of the underlying oil price. This major commodity (oil) is heavily correlated to the business model, therefore looking outside the scope of the equity markets may uncover some valuable insight.
Research platforms and terminals
The use of research platforms and terminals such as Bloomberg can give investors/analysts a plethora of additional analytical tools and techniques. These can help investors with efficiency and access to many other financial markets and stocks for comparative purposes.
Quantitative tools are also available on such platforms for more complex types of analysis. These platforms can be costly, so before investing in one, the investor should make sure to consider the expense factor relative to their expected benefit.
Follow industry experts
A great way to further stock research is by following industry experts, such as highly regarded equity analysts. These experts often publish in-depth stock research which can be a good way to draw comparisons between individual and expert analysis. This is also a good way for investors to broaden equity analysis techniques by studying the analyst’s approach and what they look for in making investment decisions.
Stock order types
After the research has been completed, investors will need to place the order to buy the stock. Knowing how order types work in the stock market can help investors to better focus the execution of their strategies.
Liquidity is another concept that can result in varying spreads and pricing. Stock market liquidity refers to the ease at which the company shares can be bought and solid without experiencing large price fluctuations. Large companies with high liquidity such as Apple Inc will often have tighter spreads with a larger volume of shares available to buy/sell at a given price.
Broker fees
An important but often overlooked portion of the stock investment process is that of broker fees or commissions. Brokers have differing fees so investors should become familiar with fees in order to avoid any unwanted surprises. These should be available on the broker website and should be transparent.
Conclusion
Stock market investing can be very challenging, especially if you are new to the game. Learning how to research stocks is an important part of your learnings. This way you will know if you want to invest in the company before you buy the stock. I’m just now beginning to dabble in stocks, so I wanted to do some research on my own about how to research stocks.