In this guide, we aim to give you a one-stop shop for all you need to know about analyzing a stock.

That includes going through the following steps:

1. Know your goals
2. What does analyzing a stock involve?
3. Fundamental analysis
4. Technical analysis
5. Characteristics of a stock
6. Financial metrics
7. The intangibles

The purpose of analyzing a stock is to determine if it is worth buying if you do not own it or selling if you own it already. Put another way, you analyse a stock to help you make a buy or sell decision.

Isn’t this what financial advisors are for?!

Let’s be honest – analyzing stocks is not for everybody! Some people simply do not have the time or inclination to learn the techniques of stock analysis or conduct the analysis themselves. BUT if you are reading this, you are already in the top 1% of people who are at least curious about whether you should be doing your own stock market analysis. 

Ask yourself this. Did you hire an analyst to choose your house or your car? Or which job to get? Those were major financial decisions that you made yourself. Why then would you hand over the very important decisions about how to put your hard-earned money to work in the stock market? And between you and me, financial advisors don’t always advise their clients well! 

Know your goals

There is no free lunch. Not every stock investment needs to be the next Tesla. Tesla is a standout success. It is successfully forcing a revolution in the car market towards electronic vehicles (EVs). But have you heard of Bright Automotive, AMP, Coda or Detroit electric? No? That’s because they were all high growth potential EV car companies that failed.

Of course we’d all like to buy the next big thing at low prices and ride it up – but the process of finding that big winner may not suit what you are trying to achieve. 

If you are looking for very big returns on stocks, it generally means you need to take very big risks. That’s great if you are in a position to take them. But if your goal is to, for example, pay off some credit card debt or have a bit of extra money when you retire in a couple of years- then you may not be able to take that kind of risk. If you have a lot of time until you retire and are comfortable with investing in a lot of non-starters on your road to big success then you can take higher risks. But there are other ways to go about things. There is no sure thing but Coco-Cola has been in business 140 years. If you’re looking for stability and steady income, then this is more the way to go.

What does analyzing a stock involve?

Stock analysis is evaluating all the relevant information about a company and its stock price to make a determination about what the stock price will do next over some period of time. Principally through the analysis of past data and forecasts about future data, investors and traders attempt to get an ‘edge’ over the market. If a stock is trading at one price, the investor hopes through their analysis of the stock that they can learn something the market does not know, which tells them it should be trading at a different price.

Analyzing a stock encompasses everything from the profitability of the underlying business to how much the company pays in dividends to how the price of the stock behaves in different scenarios.

There are two types of stock analysis: fundamental analysis and technical analysis. Fundamental analysis uses data from the company, its industry and the economy. Technical analysis focuses on only the historical movement in the price of the stock as well as trading volumes. 

Fundamental analysis

The data we will use to conduct fundamental analysis comes from financial records, the financial records of competitors, economic reports and statements from management.

Some of the typical financial statements used by a ‘fundamental analyst’ include the balance sheet, the income statement and cash flow statement. Public companies are required to publish these statements as well as a whole host of other information in quarterly or semi-annual earnings reports.

By analysing these financial statements, the hope is to be able to measure a company’s profitability, the amount of revenue (sales) it makes, its liquidity (how much cash it has to fund its operations) and its gearing (or leverage) i.e. how much debt it has relative to its assets.

There is a lot of raw data packed into these financial statements about a company so we can use mathematical ratios to express our findings more concisely. Ratios are easier to compare with averages, data from previous periods and make comparisons with other companies. From this we can determine if the company is in a better position than it was in the past and whether it is better or worse compared to its industry and its peers. We will go through some of the most commonly used and useful metrics soon!

Technical analysis

Technical analysis uses price action as its primary source of data and uses different measures and indicators of how the price has moved in the past to determine where it will move next. The concept behind technical analysis is that all possible knowable information is already reflected in the price of the stock. Therefore understanding all that information is not necessary, it is sufficient to follow the direction of the price.

Charts are the primary tool of technical analysts because they visually represent the change in price over time. There are different kinds of charts including candlestick charts, bar charts and line charts – each with their own advantages and disadvantages. One of the core principals of chart analysis is support and resistance. These are horizontal price levels that have previously caused a change in the direction of the price.

Traders will also calculate mathematical formulas from the price and create technical indicators. A popular example of a technical indicator is a moving average- which looks like a smoothed version of the price chart, typically overlaid with the price. Learn more in our technical analysis series.

Fundamental and technical analysis can be used together or independently but at least one of the approaches should be adopted to avoid trading on just hunches, gut feeling or tips from others that cannot be relied upon to be consistently profitable in your investing over the long haul. 

Characteristics of a stock

When you look at a stock, you will want to think about what kind of stock it is. To this you might look at its market cap, the sector it is part of and whether it fits with the rest of your portfolio. A major consideration is – What do you want this stock to do for you- produce an income or grow in value?

These are five characteristics of a stock to help filter out what you might be looking for 

Market cap

Market capitalisation is the public value of a company, and is the principal way to judge a company’s size. It is calculated by multiplying the number of outstanding shares by the stock price. For example if Amazon stock is priced at $100 per share and there are 10 Amazon shares, then the market cap is $100 x 10 = $1,000. (Actually Amazon was the 2^nd company to reach a market cap of $1 trillion after Apple!).

We can categorise stocks according to their market cap. Small caps are typically valued between $250 million and $2 billion. Mid caps are $2 billion to $10 billion. Large caps are $10 billion and above

Does size matter!? In the stock market it does because companies and their stock have certain similar characteristics at certain stages of their lifecycle. Small cap companies have the most potential for growth because they can grow into mid cap and large caps. Naturally a large cap is already large so the prospects for growth are lower. A small cap company shows lots of potential but they are unproven so the higher potential return comes with higher risk. A large company has already reached its potential but has less of the risk of failure, having already shown the business can be managed well enough to grow and prosper. 

Returning to the idea of knowing your investing goals- large caps tend to grow less and pay higher dividends while small caps don’t typically pay dividends because they are reinvesting profits into future growth. 

Sector

Sector is the kind of business a company does. There are also sub-sectors. For example there is the ‘manufacturing sector’ and an example of a subsector of that is the ‘aircraft parts manufacturing sector’. In the last few years, the ‘tech sector’ has been the area that has grown the most because of our increasing reliance on computers, electronic devices and the internet. The S&P 500 is split into 11 sectors – information technology, health care, financials, consumer discretionary, communication services, industrials, consumer staples, energy, utilities, real estate and materials.

To have a diversified portfolio, it pays to own stocks in different sectors. When picking a stock to invest in from a certain sector, it is helpful to compare it with other companies in the same sector. For example Intel and AMD are both semiconductor chip-makers.

Growth vs. value

Whether an investor will label a stock as a ‘growth stock’ or a ‘value stock’ is a function of past earnings and stock price performance. Growth stocks are those whose earnings and stock price are rising. Value stocks are companies where the price is low and earnings growth has perhaps been slower or even declining. The logic for investing in a growth stock is that it will continue to grow- you could say that the investor is looking to buy high and sell higher. Value investing is with the logic that a good company is being underappreciated by the market and that its fortunes will soon turn around. The investor is aiming to buy low when the stock is unloved and sell it high when it is loved again.

Capital appreciation vs. income

There are two ways to get paid as a stock market investor: 1) the price of the stock you bought goes up and you sell the stock and make the difference as a profit 2) the company pays out regular dividends in return for your investment in its stock. Not all companies pay dividends. As a general rule, larger established companies typically want to encourage long term investment in their stock by returning some of their profits to investors as a dividend because the stock price is unlikely to grow enough to provide investors with a big enough return by itself. While smaller growing companies offer investors enough opportunity for future capital appreciation (market cap rising over time) that investors don’t need to be incentivised to invest with a dividend.

Whichever one of these two ways you expect to earn money will determine what you are looking for in your stock analysis. The core of it is that if you expect to earn your money through capital appreciation (i.e. the share price going up) you are looking for evidence of growth like rising sales, new product launches etc. If you expect to be paid mostly through dividends, your analysis will concentrate on the company’s ability to continue paying out the dividends. Here you are looking for things that the company might need to pay instead of the dividend. This might include whether the company has enough free cash flow or the amount of debt it owes.

Individual stock vs. fund

Here we are going slightly off-track because we are not talking about ‘stock analysis’ but rather ‘fund analysis’. These days it is very easy to invest in ETFs – an exchange traded fund – that trades on a stock exchange just like an individual stock – but it is in fact a fund. A fund is essentially a portfolio – or group of stocks – put together by professional investors. The advantage of a fund is that it offers diversification. You do not need to analyse and pick one stock but you can pick a group of stocks based on the same kind of criteria we have already mentioned (size, sector, growth or value, dividends or even location). Because the performance of this group of stocks is spread out, it means your potential return is reduced but so is your risk.

Must-know financial metrics

Let’s take a moment to think about what we are trying to do. We want to buy stock in a company that is well-managed, profitable (or with a path to profitability) at a reasonable price.

Ultimately this all comes down to money. We as investors want to invest into a company that is making money so that some of that money comes to us. To understand how money is flowing in and out of a company we must look at its accounts- or in a broader sense its ‘financials’.

This guide is aimed at investors looking to buy stock in public companies. Public companies are required as a condition of being public to publish their financial information. In the US, companies make their financial information available to the Securities and Exchange Commission (SEC), in the United Kingdom it’s to the Financial Conduct authority (FCA) and in Switzerland it’s to the Swiss Financial Market Supervisory Authority (FINMA). However, a lot of this information is available from the companies themselves in the ‘investor relations’ sections of corporate websites – or on third party financial websites like Yahoo Finance, investing.com etc

Without further ado- what are the main financial metrics used to analyze a stock?

1. Revenue 

Revenue is the total amount of money a company makes from the sales of its goods and services. As an investor we want to see revenues rising and ideally rising at an accelerated pace each quarter. If revenues are falling, we want to see signs that the decline is decelerating and maybe about to begin rising again.

2. Net income

Gross income is how much a company makes from its sales after subtracting expenses. Net income is how much a company makes from its sales minus expenses and taxes. Quite often new companies will be loss-making because more is being invested in the business than is being made in sales. Established companies must be making a profit in order to pay dividends and in order to reinvest for future growth. Again, ideally net income should be rising each quarter to demonstrate growth and increasing profitability. 

3. EPS

Earnings per share (EPS) is calculated by dividing net income by the number of listed shares in the company. It literally tells you how much each of the shares you own is earning. For shares to rise in value over time, it goes hand-in-hand that those shares need to earn more in the future- so a rising EPS each quarter is a sign that the shares are becoming more valuable.

4. ROE

Return on Equity (ROE) is as the name implies shows what return a company is getting on its shares. Put another way it is how well a company is turning equity into profit. It is calculated by dividing net income shareholder equity. 

NOTE: Shareholder equity (otherwise known as the book value) is the accounting value of the claim stockholders have on a company’s assets. It is a similar but different idea to market cap- which is the market value of all the company’s common stock. You can compare how the market values the equity of the company to how the company values its equity using the price-to-book ratio.

5. P/E ratio

The Price-to-earnings ratio (PE ratio) tells you how much investors are paying for each dollar earned by the company. A high P/E ratio shows the price is high relative to earnings, whereas a low P/E ratio shows the price is low relative to earnings. Investors will also measure price-to-sales otherwise known as the revenue multiple. This is the same thing but contrasting price with sales instead of earnings- and is more useful when analysing fast-growing unprofitable companies.

For example, if the P/E ratio is 10, it means investors are willing to pay 10 CHF per 1 CHF of earnings (or whatever currency you are investing in). A high P/E means the company is richly valued because investors expect the company to grow its earnings fast. Sometimes the P/E will rise too much and the stock gets ‘overvalued’. This can be a sign it is time to sell the stock. A low P/E means investors have low expectations for future growth. If the P/E drops too low, the stock is undervalued and this can be an opportunity to buy the stock when it is cheap. 

Comparing the P/E value of a stock compared to other stocks in its industry can give you a good sense of how it is valued. Certain sectors or industries tend to be priced differently so what might be a high P/E in one sector could be perfectly normal in another sector. For example it is quite normal for a software company to have a P/E ratio of 30 or above but a manufacturing company will often have a P/E of less than 20. In summary, when looking at a stock’s P/E ratio, we are trying to decide if the stock is under, over or fairly valued.

6. Gearing (leverage)

Gearing is British English for leverage. It is all about understanding how much debt the company uses to fund its operations. Arguably, the most famous ratio used is the debt-to-equity ratio (D/E ratio). It is simply how much debt the company has (or its total liabilities) relative to its equity (or shareholder value). A high D/E ratio shows the company uses more debt than equity to fund its investments. A low D/E ratio shows a company uses more equity to fund its investments. As a rule of thumb, a D/E ratio of 1 or LOWER shows the company can cover its debts, while a D/E ratio over 1 means the company is at higher risk of default if it falls on hard times.

7. Beta

Beta is one of the most common measures for how volatile a stock is. It compares the volatility of the stock to the rest of the market. For example, if the stock market rises by 1%, a stock with a beta of 1 will rise 1% too. A stock with a beta over 1 will rise or fall more than the overall market; a stock with a beta of less than 1 will rise or fall less than the overall market. Volatility in and of itself is neither good nor bad. What you have to assess is what level of volatility you’ve got the stomach for and what level of volatility is necessary to reach your goals.

The intangibles

There are some things about a company and its stock price that cannot be measured by a ratio from a financial statement. These are the qualitative features of a company’s stock versus its quantitative features.

Earnings calls and analyst reports are two of the best sources of information to help think about what it is the company is actually doing and trying to achieve. These include things like new products, consumer trends, industry headwinds, regulations, and above everything else the quality of management. Warren Buffett once said he’d rather invest in a bad company with good management than a good company with bad management!

Conclusion

Today we have gone through the process of what investors must think about to analyze a stock. That starts with thinking about our own investing goals (how much money do we want to earn and in what timeframe and how much risk are we willing to take to get it?). Then we think about what sources of information and type of analysis we will use. Next we filter through what characteristics we want in our stock (market cap, sector etc). Finally once we’ve found a company we wish to research, we look at its major financial metrics (like its revenues, earnings, P/E ratio etc) as well as the more qualitative factors (product releases, management style etc). Thanks for reading and good luck investing!