Probably the most essential skill that is needed to start investing is knowing how to find the right investments. Before you make any stock-picking decisions, you need to know exactly in which company you are about to invest in and what the reasons for you are to invest in those businesses.
The truth is that analyzing a company usually requires a decent amount of time and research but certainly isn’t any rocket science, to begin with.
The following is going to introduce you to a few key takeaways which are essential to get you started on analyzing a stock and ultimately deciding if the particular company that you are analyzing is worth your investment or not.
The Two Types of Analysis
You can generally differentiate between two types of analysis when you try to determine a good investment within the stock market: Fundamental analysis and Technical analysis. Both are very different from each other since each of them focuses on a specific set of factors that indicate a good stock.
Let’s go briefly through both of them to determine which one you probably should use.
Technical analysis heavily relies on the price movements and behavior of a stock. Instead of looking at the underlying company and its characteristics, technical analysts focus on stock charts to find any patterns which could indicate how a stock price is going to move in very short time frames usually within hours or days.
People who are utilizing technical analysis are usually traders who try to buy and sell stocks within very short time periods to make returns from those profits. Trading is very different from investing and has much more to do with speculation, timing, and luck.
Chances are that as an investor, you want to stay away from any stress and frustration that comes from the attempt of timing stock prices and speculation.
As opposed to technical analysis, fundamental analysis is the approach of evaluating investments and their values by looking at fundamental financials and other characteristics of the company itself. When you do the fundamental analysis you examine several different sections of a business including its financial health, business model, future outlook, and growth prospects.
Now that you’ve understood the two schools of approaching stocks, let’s go through some of the fundamental aspects that you should look into when you analyze a company.
How to Identify a Great Company
1. Analyze the Company’s Financial Health
The financial health of a company is essential for the business to make it through financial hardships and economic downturns, and thrive in the long run.
Ideally, you want to invest in a company that stands in a solid financial position, in order to lower your downside risk within your portfolio and increase your upside potential.
The best way to analyze the financials of a company is to take a look at the three primary financial statements of the business: the balance sheet, income statement, and cash flow statement. Every publicly trading company in the U.S. is required to provide those financial statements to the public.
In those, you will find nearly all necessary financial information about the business that you’re analyzing.
While analyzing financial statements is a huge topic on its own, essential indicators that a great company should have are:
- Low amounts of debt relative to the company’s equity: Most companies need debt to leverage growth but too much debt can be dangerous to the company’s financial health.
- High-profit margins: The higher the margins of a company’s operations, the more efficient it is in generating profits.
- Consistently growing revenues and earnings: Earnings are one of the key drivers for a company’s value and its stock price in the long run.
- Good amounts of free cash flow: Free cash flow is the amount of cash that is ultimately left to the company to increase shareholders through share buybacks and dividends.
You should especially put emphasis on consistency. Companies that are growing on a persistent basis are much more likely to continue to do so in the future as opposed to businesses that may sometimes have enormous earnings in one year but negative profits in other years.
2. Understand the Business
Understanding how a business operates and makes money is critical to help you make the right investment decisions. At the least, you want to avoid picking stocks that you only know a few things about.
Many people are making the mistake of blindly investing in businesses without even knowing more than one thing about the company in the first place.
The best way to understand a business is to read its annual reports. Every publicly-traded company is required to state all the necessary information regarding the business to the public. In those reports, you will find plenty of information regarding the company and its operations.
Information that you should look for about a business that you’ve invested in include its business segments, prospects, risk factors, competition, and management. To tackle those aspects, you could ask yourself several questions to get started:
- How exactly does the business make money?
- What operational segments does the business consist of?
- Which part of the business is generating the most amount of profits right now?
- How does the competition look like? Can the business defend its market share from competitors?
- Is the business likely to continue growing within the next 20-30 years?
- How long has the management been leading the company? Is it trustworthy?
- How high is the risk for me to lose money when I invest in this company?
All the questions above can be answered from the information that is provided in the annual reports and financial statements of the company. At first, it will take a while to get used to finding all the necessary information but after some time and practice, it will become easier.
Nowadays, nearly all companies provide their financial statements and reports online on their investor relations webpage. In most cases, a quick search on google will do the work.
Alternatively, you could also search for all the companies and their filings on EDGAR, which is the official electronic system of the SEC.
3. Use Valuation Metrics
The Chances are that it won’t be enough to just identify great businesses and blindly invest in them. Nowadays, everyone knows that companies like Alphabet, Apple, Facebook, or Amazon are extremely strong businesses and likely to dominate their industries in the foreseeable future.
In order to find companies that are worth investing in, you also need to look at the price at which you buy them. You want to avoid investing in overvalued companies and look for stocks that are trading at undervalued entry points.
There are many different ways to determine if a stock is overvalued or undervalued. The most common approach is to use valuation metrics to compare a company’s value with other similar businesses or its own historical records.
»Learn more about determining if a stock is undervalued or overvalued
Arguably the most commonly used metric is the price-to-earnings (P/E) ratio. You can calculate the P/E ratio of any stock by dividing the current stock price by its earnings per share (EPS) but nearly all financial platforms will state the P/E ratio of each company automatically calculated for you.
The lower the P/E ratio, the more undervalued a company might be. A lower P/E will indicate that you are getting more earnings out of a business relative to its current stock price.
Throughout time, the P/E ratio is going to change according to any fluctuations in the company’s stock price and earnings. One way to analyze a company’s P/E is by comparing it with historical values.
For instance, if company XYZ is currently trading at a P/E ratio of 15 but the historical average P/E ratio for the business is 25, that would be a good indicator that the business is currently undervalued.
The other way is to compare the company’s P/E ratio with other similar businesses that operate within the same industry.
Only comparing similar businesses with each other is crucial because different types of companies can also have very different P/E ratios. A tech stock, for instance, doesn’t have to be overvalued even if it has a P/E of 50 or 60.
The P/E ratio will only tell you something about a company’s value relative to other comparable performances. That being said, it is still a powerful metric that can quickly give you a better idea of the current value of a company.
»Learn more about using the P/E ratio.