Whether you are experienced or a relative novice in the world of investment, analysing a stock can seem challenging. We have put together a step-by-step guide on researching stocks, covering the information available and how to use it.
Akin to a jigsaw, if you look at the various elements of stock analysis in isolation, you can bring them together to create an informed opinion. This will include the basic financials, company leadership, expansion plans, etc and whether the company’s philosophy fits with your investment strategy. The more pieces of the jigsaw available, the more informed your decision!
Go in with a plan
Many people make the mistake of buying into individual stocks without having an endgame, an exit strategy. Unless you know where you are going, how do you know when you have arrived? It is just as important to have an exit strategy as an initial investment strategy. We all have different financial backdrops, different aims and aspirations reflected in our investment plans.
Decide your investment horizon
Before you make any investment, it is crucial that you have a timescale in mind. This may be dictated by issues such cash flow, future financial commitments, etc. Your preferred timescale will impact your investment strategy:
- Long-term value: History shows that long-term investment in individual companies/sectors can be lucrative if you do the initial groundwork. The likes of Warren Buffett nurtured impressive returns investing in the likes of Coca-Cola, American Express and Apple. While there will be bumps in the road, there may be substantial long-term gains if a company’s potential remains intact. The key to fulfilling the strategy is to keep an eye on the long-term prospects and ignore short-term volatility.
- Short-term trade: When looking at a short-term trade, timing is of the essence. You often want to take advantage of favourable price movements. In a perfect world, that would mean investing just before a down trend is reversed and selling when the recovery is complete. Unfortunately, it is not as easy as that, and you may need to compromise – remember the trend is your friend. To coin a phrase from famous investor Nathan Rothschild: “I never invest at the bottom, and I always sell too soon”.
Decide what you’re going to invest in
The financial sector is one of the most innovative you will come across, offering many ways to invest directly and indirectly into companies, industries and economies. The traditional options include:
- Direct equity investment: When looking to invest directly into stocks, it is essential to do your research and understand what moves markets. This tends to involve a top-down approach, market trends, sector trends and specific company trends. While there are more significant risks involved in direct equity investment than collective investments, there is the potential for substantial outperformance.
- Collective investments: Whether looking at exchange-traded funds (ETFs), unit trusts, or other similar collective investments, the exposure to a specific stock is reduced. In effect, these funds will invest your money across a range of stocks with the aim of performing in line with a chosen index. Of course, you will pay a management fee with this type of investment, but it is generally seen as less risky and traditionally less volatile than individual stocks.
Diversification
As we touched on above, if you’re looking for reasons to buy or sell a stock, you will likely find them, often ignoring counterarguments. Consequently, it is essential to ensure that your investment portfolio always has a degree of diversification. This may involve relatively “boring” long-term steady investments together with short-term trading opportunities. Just remember, don’t put all of your eggs into one basket – no matter how attractive that “once-in-a-lifetime opportunity” appears.
Investing in individual companies
If you prefer to invest in individual companies, here’s what you need to consider before buying a company’s stock.
Examine company reports
Listed companies are legally obliged to regularly provide shareholders with company reports and accounts. While these are very useful, it is essential to remember that the figures reflect the financial position on a half, quarter or year-end basis. Even though these figures are audited, it is not difficult to bring forward sales and delay an element of expenditure. Instantly, the company’s financial position may look a little more optimistic than it is.
While we’re not suggesting you dismiss the financials in the company report accounts, it may be more helpful to focus on the comments of the chief executive officer. These comments will summarise the recent past and also focus on the future. Due to legal obligations, these comments need to be backed by cold hard facts and not be overly speculative.
Review the financials
Many people shy away from reviewing a company’s financials because, on the surface, it can look relatively complicated. However, if you look at each financial calculation/ratio in isolation, it gives you a valuable indicator of the company’s finances. Many experts use a range of different metrics when reviewing prospects for a particular stock, including:
- Net income: This figure is significant when considering cash flow. It is simply gross sales minus company expenses. Monitoring the long-term trend of net income can give you an idea of the company’s current direction. When net income turns negative, this is often an indicator that the company is struggling.
- EPS: Earnings per Share (EPS) is calculated by dividing net income after tax by the number of existing shares. For example, if a company made $1 million after-tax with 1 million shares in existence, then the EPS would be one dollar per share. The EPS figure is instrumental because it will reflect the issue of new shares (known as dilution) rather than investors depending on the headline profit after tax. Analysts will issue EPS forecasts going forwards based on their knowledge of the company and understanding of the prospects.
- P/E ratio: Otherwise known as the Price-Earnings ratio, the P/E ratio is simply the stock price divided by the earnings per share. Using the example above, if the company share price were $10, this would equate to a P/E ratio of 10. As a rule of thumb, but not always, you tend to find that stocks with a relatively high P/E ratio have expectations of significant growth in profits. On the flip side, those stocks with a low P/E ratio are unlikely to experience any significant short-term growth.
- ROE: The Return on Equity (ROE) calculation offers an insight into the level of net income created as a percentage of a company’s net value (shareholders equity). It is very similar to the yield on a savings account, the greater the yield, the better the performance. Therefore, where some companies have a disappointing ROE, there may be a case for selling off non-performing assets to reinvest into the business.
- Stock beta: The beta of a stock is a volatility measurement compared to an appropriate stock market index, such as the Dow Jones Industrial Average. A beta of more than one indicates a greater degree of volatility than the underlying index. Conversely, a beta less than one indicates a low degree of volatility compared to the market. Many people use the beta calculation when looking at diversification within their portfolios.
- D/E ratio: The Debt to Equity ratio (D/E ratio) is a valuable measure of the degree of company debt compared to shareholder funds (net value of the company). A relatively low D/E ratio would indicate a more conservative risk-free management strategy. On the other hand, a relatively high D/E ratio might indicate a company struggling and using debt to fund growth. There is no hard and fast rule concerning D/E ratios as some companies will use debt to create significant net profits. However, it is a helpful indicator to monitor the trend in company debt.
Look for any red flags
Even though it is relatively easy to attach a degree of emotion to stock analysis, this can be dangerous. The best way to think of an investment is an empty box; you buy the box and look to sell it at a higher price.
This strategy is advantageous when looking for potential red flags which may prompt a degree of concern about investing in a particular stock. There are numerous common red flags which include:
- Management changes: Constant changes in a company’s board of directors may indicate internal issues which can impact company performance. Many people become concerned when the founder of a company leaves abruptly with no meaningful explanation. It is also essential to look at the experience of those who are coming into the company. Do they have historical success in similar fields? Those companies with a relatively stable management team tend to focus on growth strategies.
- Relative values: Whether looking at P/E ratios, net income or the D/E ratio, it is essential to compare these with companies operating in the same sector. For example, the P/E ratio of a high-growth technology company is likely to be far higher than that of a traditional banking operation. When you compare like-for-like, this will highlight performance relative to peers. You’ll also find that financial ratios vary depending upon a company’s stage of development, i.e. is it a start-up, growing company or a mature business.
Explore analyst reports
While analyst reports can offer several interesting nuggets to consider, occasionally, they can be biased. Therefore, it is crucial to see whether the analyst has a formal relationship with the company in question as this can influence their opinion. Where there is no relationship, you tend to experience a more balanced report, which can help highlight the pros and cons going forward. So, while analyst reports can be helpful and often influence the market, they are just one part of a large jigsaw.
Piecing it all together
On the surface, stock analysis appears relatively complicated with an array of issues to consider. However, it becomes more manageable when you isolate the individual elements, giving you a greater understanding. The more pieces of the stock analysis jigsaw you have, the more informed your decision.
It is also important to “listen to the market” when considering an investment in any stock. If you see the stock market as an information exchange, this will give you a greater understanding. Information in the public domain and effectively inside information come together within the exchange, influencing the price of individual stocks. On occasion, the analysis of a stock may highlight several positives, but a falling share price suggests otherwise. So tread carefully when going against the market!
It is also good practice to watch different stocks, sectors, and markets before investing. This allows you to “get a feel” for a particular stock and, using elements of your stock analysis, arrive at an informed decision about investment.
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