June 8, 2023


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What Is Stock Analysis? Financial Experts Explain Their Go-to Strategies

Picking stocks is like playing the claw machine: It’s really hard to win, but you still hold out hope every time that you’ll walk home with a giant stuffed Jigglypuff.

Financial market experts agree that identifying stocks that’ll beat the overall market is hard. That’s why investors often throw their money in index funds, an easy way to build a diversified portfolio while guaranteeing you’ll at least match the market’s returns.

Yet many of us, after building a diversified portfolio, still have an itch to invest in companies that we think will hit it big. The question is how to spot those stocks before their values skyrocket, like Amazon. On the last day of 2005, just a few months after Amazon Prime launched, the stock traded for about $47; now, it’s trading above $3,000, up more than 6,000{de3fc13d4eb210e6ea91a63b91641ad51ecf4a1f1306988bf846a537e7024eeb}.

A word of caution

If you’re set on discovering an undervalued stock that few others have already found, it’s probably not going to happen. Emma Rasiel, an economics professor at Duke University, gave it to us straight with no chaser.

“There are thousands of professional equity analysts out there who are doing this all day,” she said. “It’s incredibly unlikely that somebody who spends a few minutes a day looking at it is going to find or see something that somebody else hasn’t already spotted, and is therefore not already in the price.”

Brutal, but true. And it’s not like the Bloomberg Terminal scanning equity analysts get it right either: A MorningStar analysis found that in 2020, only 42{de3fc13d4eb210e6ea91a63b91641ad51ecf4a1f1306988bf846a537e7024eeb} of the actively managed US stock funds outperformed comparable passively managed funds.

Every expert we talked to said some version of the same thing: Don’t pick stocks because you think it’s your path to summering in the Hamptons. Research, analyze, and invest in individual stocks because you love studying financial markets, have some money that you can afford to lose, and want to have some fun.

Now that you know the risks, here’s how the pros approach stock analysis.

Choose your (analysis) fighter

Investors take a fundamental, technical, or blended approach to analyzing stocks. The method you employ depends on your goals, Phil Huber, the CIO at SavantWealth, said.

Fundamental analysis involves determining the company’s intrinsic value from the bottom up, from examining historical financial statements to imagining the company’s future. You then compare your estimate to its current price in the market and decide whether it’s a good buy. 

That’s opposed to technical analysis, which takes a more “dispassionate” approach, Huber said. It’s more about finding patterns in the stock price that investors can exploit. They care less about the company’s intrinsic value and more about how the stock price will shift in the future. 

In general, fundamental analysts are looking for long-term investments, where technical analysts want to turn quick profits. A blended analysis gives you the most holistic understanding of a stock.

Review the numbers

No matter your approach, it’s a good idea to take a look at the company’s financials before investing. Investment analysts have already crunched the numbers, so you can put away your TI-83. We’ll walk you through some of the numbers you’ll find whirring around Finance Twitter.

Publicly traded companies are required to publish their financial results each quarter, which is when investors compare their expectations with the company’s actual performance and decide to buy, hold, or sell. That’s why you often see higher trading volume around earnings reports.

You can find company financials through the SEC EDGAR portal. Here, for example, is Berkshire Hathaway’s EDGAR page. You won’t find any analysis there, so head over to a site like Yahoo Finance to see what investors are thinking.

First, take a company’s pulse by looking at its liquidity and profitability ratios. These ratios only have value when they’re compared to a benchmark, either a company’s direct competitors or an industry average, so make sure to have those handy.

  • Quick ratio: Current assets, excluding inventory, divided by current liabilities. It determines whether a company has enough money and short-term investments on hand to cover its upcoming debts. In general, you want a quick ratio higher than 1.
  • Net profit margin: Net income divided by revenue. An important metric in mature companies, net profit margin shows you how much money a company actually earns for every dollar in sales. You want to see this number growing—or at least not dropping—over time.
  • Return on assets (ROA): Net income divided by total assets. It’s a sign of efficiency and how much the company is earning relative to its resources. Like all ratios, the industry and direct competitors will dictate what constitutes a strong ROA.

Then, move onto valuation ratios, which compare a company’s financial results to its price in the market. Analysts from major financial institutions put out their predictions ahead of companies’ earnings announcements, and a company’s goal is for these metrics to meet or exceed analyst expectations.

  • Earnings per share (EPS): Earnings divided by the weighted average number of shares outstanding. If a company has $1 million in earnings and 1 million shares outstanding, its EPS is $1. It helps to look at EPS when you’re trying to choose between a few stocks; the one with the highest EPS theoretically offers the highest value.
  • Price to earnings ratio (PE): Share price divided by annual earnings per share (EPS). If the same company is trading at $20 per share, the PE ratio is 20. If someone says a company’s share price is “20 times earnings,” they’re talking about the PE ratio. 
  • Price to sales ratio (PSR): Market capitalization divided by annual sales. If the company’s market cap—or total value in the market—is $50 million and sales were $5 million for the last 12-month period, the PSR is 10. This one’s a good ratio for “growth stocks,” or businesses that haven’t yet turned a profit. 
  • Enterprise multiple: Enterprise value divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), where enterprise value is the company’s market capitalization plus debt minus cash. Saira Malik, Global Equities CIO at Nuveen, said this ratio is broad enough to be relevant to any company, because it can adjust for “different capital structures and the variety of accounting policies.”

These are by no means the only metrics you should consider when evaluating a stock, and they’re not always relevant in every analysis. Analysts often associate industries with specific ratios that best depict a company’s financials.

Do your own research

At first, financial statements can look like they’re written in Klingon. It’s OK if you’re feeling this way, because there’s more to a stock price than the numbers. See what analysts—and even your friends—are saying about the company’s future in qualitative terms.

Much of what’s built into a company’s stock price is investors’ expectations of the future, from new product lines to shifting market conditions. Some companies’ valuations, like Tesla’s, are largely built on feelings and expectations.

“Tesla’s market valuation is hard to justify purely on the numbers, but who’s going to bet against Tesla,” Rasiel said.

Vincent Glode, a finance professor at the University of Pennsylvania’s Wharton School, said that looking beyond the numbers can help you feel more confident about the stock.

“If you’re unfamiliar or uncomfortable with the numbers, you need to think that the future of the company is brighter than what the price is,” he said.

Here are some signs of a company with a blossoming future:

  • Lasting edge in the market: You want to invest in a company that has some competitive advantage in its sector. Maybe it has a proprietary technology or can do the same thing as a competitor but at half the cost.
  • Growth prospects: Your parents might have told you to look at the future trajectory of your dream job before you locked in your major in college. It’s the same thing with picking stocks: You want to invest in companies that are part of a growing industry.
  • No ominous lawsuits: Pay attention to current lawsuits that might affect the company’s future. Big corporations are constantly involved in lawsuits, but you’ll want to study the ones that make headlines to see how management and financial analysts are reacting.
  • Impressive management: Good companies can suffer under terrible management (looking at you, Enron). Take a look at who’s at the helm, including the executive suite and the board. Research their backgrounds to see what they’ve accomplished, and listen to investor calls each quarter to see what they’re planning for the future.
  • Positive consumer sentiment: Markets have feelings, too. Take stock—pun intended—of what your friends are saying and feeling about companies you’re eyeing.  “A big piece of the investing market is psychology,” Rasiel said. “Psychological views of companies can last a very long time.” 

Put it all together

This is where investment analysts take their research, create a financial model, and forecast the company’s future financials before making a trading decision. Unless discounted cash flow analysis gives you a thrill, this is probably where your analysis ends.

One last reminder: You’re probably not going to get stupid rich by investing in individual stocks. You’ll pick a bunch of losers, but you might find a few winners, too. Chat with a financial advisor about the most responsible way to fit stock trading into your portfolio.