Before making any investment decision, you should start by evaluating the strength of the security. Below, we present a useful guide when conducting an investment analysis.
Types of Analysis
There are two main types of security analysis: fundamental analysis and technical analysis.
Fundamental analysis looks at profitability measures and earnings ratios to analyze whether or not a stock is priced lower than its “true” value. This type of analysis is well-suited for investors focused on long-term returns.
Technical analysis involves analyzing a stock’s price history to try to predict short-term price movements. Examining stock charts, moving averages, and trends are all techniques used in technical analysis.
While these types of analyses are great for attempting to value stocks and the companies they represent, it’s just as important to consider factors such as industry trends, company management, and the products and services a company offers.
How to Find the Information Needed
While you can obtain stock charts with a simple web search, finding the rest of the information takes a bit more digging. Companies are required to file two types of reports with the SEC to help you complete your analysis: a 10-K and a 10-Q report.
10-K’s are annual reports audited by an independent certified public accountant. This document provides thorough details into a company's financials, which gives you plenty of information to do a deep dive into nearly everything about a company.
10-Q’s are filed quarterly, but unlike 10-K’s, they are not audited at all. While companies are required to report information it believes to be true on a 10-Q, the lack of an audit means the accuracy of the report is not guaranteed. This report is good for staying updated on both shareholder voting results and company financials throughout the year.
Both reports will illustrate the company’s financials needed to complete the necessary analysis. Additionally, brokerage and major finance websites often highlight important information and financial ratios on their website. These reports can be found on the SEC website.
Let’s look at a few valuable metrics to consider when analyzing a security. You should note that these metrics will differ across industries, so they should be used to compare businesses in the same industry or a single business against industry averages. These metrics alone should not be used to select investments, rather they should be used as part of a well thought out analysis process.
Net Income - The amount of money a company makes after subtracting all expenses and taxes. This number gives you a picture of how well a business is operating. Stock prices tend to follow a company’s earnings, making this number critical to watch. You can look at quarterly earnings reports to monitor a company’s net income.
Price- Earnings (P/E) Ratio - This is calculated by dividing the company’s stock price by earnings per share (EPS) over the past year. The higher the P/E ratio, the more expensive a stock is relative to its earnings. A company with a high P/E ratio is either overvalued or investors have high expectations for growth. On the contrary, a stock with a low P/E ratio can be undervalued or a mature company with less room for earnings growth. As this metric heavily values short-term data, it is not recommended to use P/E as a standalone metric. This ratio is not used to determine whether or not a stock is a good purchase, it only shows the stock’s price in comparison to its earnings.
Price to Earnings Growth (PEG) Ratio - This metric is calculated by dividing the company’s P/E ratio by the annualized expected growth rate of earnings of the company. It shows you a more complete picture by analyzing both a company’s earnings today and expected earnings in the future. The lower this number is, the more undervalued a stock is theoretically, assuming it’s expected growth rate is accurate.
Looking Beyond the Numbers
As mentioned previously, it is critical to look at the company as a whole and the industry they operate in. Let’s take a look at a few more factors that should influence your investment decision.
Competitive Advantage - Essentially, this is what makes one product or service superior to its competitor. There are many forms of competitive advantages such as low costs, innovation, ease of use, or better quality. You can find a more complete list here.
Management - For a company to thrive, it needs to have good management. As competitive advantages can make or break a company, so can company leadership. If you are investing for the long term, you need to know if a management team is equipped to lead the company well into the future. See how poor management can negatively impact a company by reading about the Wells Fargo scandal here.
Industry Trends - Consumer needs and desires are constantly changing. Looking at industry trends can help you identify both dying and thriving industries. You can learn a lot from companies that failed to adapt such as BlockBuster. You can also learn a lot from current companies such as Amazon, who constantly seem to be ahead of the curve.
Putting It All Together
The investment selection process can be daunting, but luckily there are resources to help you make educated decisions. Building your knowledge of investment analysis will help you discern good vs. bad information, ultimately helping you make better investment decisions.
Looking for help with next steps? Talk to our advisors at Finwell to help understand all of your options and create a plan to reach your goals. Get started by emailing firstname.lastname@example.org today.
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