Understanding where to begin when analyzing a stock is a difficult task for any investor. Most, if not all investors understand that the general rule is that they are hoping to purchase a stock at a lower price than the value of the company’s future profits. But aside from understanding investing’s mantra of buy low and sell high, many investors struggle to find a good starting point.
Investors’ goal when analyzing a stock is to identify stocks whose current price is lower than what they expect the price to be in the future. This means that - based on some sort of supporting evidence from their analysis - the investor believes that the market’s current price is too low and that the stock is due for a positive market correction.
Kinds of Analysis: Fundamental vs. Technical
The reason an investor believes that a stock will rise is a surprisingly sticky and at times theoretical ordeal. Some investors believe that markets can, as a whole, give a stock a "wrong" price. These investors spend their time looking for these attractive mispricings. Other investors believe prices are a true reflection of all information present and try to invest based on cyclical patterns.
Fundamental analysis assumes that stock prices don’t necessarily reflect the true value of a business. Fundamental analysis consists of diving deep into a company’s financial statements and using valuation metrics, and other pertinent information, to determine if the stock is undervalued by the market. This is often used by investors seeking long-term returns.
Technical analysts go pretty much the opposite way here and are short-term in nature. They assume that stock prices are a reflection of all available information on the stock and that prices tend to follow trends. Investors performing technical analysis pay close attention to the stock’s historical movements to predict future ones. These analysts tend to ask what-related questions rather than why, primarily, "What is the current price?" and "What are the stock's historical price movements?" Tony Plummer expertly paraphrases Oscar Wilde in his book The Psychology of Technical Analysis saying: "A technical analyst knows the price of everything, but the value of nothing."
So which of these two is best? Well, much like the great scientific debate of Nature vs Nurture, we don't really know. What we do know is this is likely a question where the answer is closer to both/and, rather than either/or. Some stocks are more well-known and tend to trade in consistent patterns, and others don't actually reflect all of the available information. Time-horizon is the leading factor in which should be the primary approach when making an investment, with shorter holdings leaning towards technical analysis.
Below are some popular metrics used by analysts that every investor should understand.
Price-to-earnings (P/E) Ratio: The P/E ratio is a popular tool used by investors that is derived from the company's earnings. This ratio is popular in fundamental analysis when comparing companies across the same industry with similar growth prospects. The P/E ratio divides the current share price by the company's earnings per share. High P/E ratios denote that the stock could be overvalued, or that investors are expecting high growth on the stock.
Price-to-earnings-growth (PEG) ratio: The PEG ratio takes the P/E ratio a step further by dividing it by the company’s expected annualized growth rate for the next few years. The idea behind the PEG ratio is that a stock could be rendered unattractive to investors by a high P/E Ratio. The PEG ratio adds a weight to the equation that helps investors decipher if the P/E ratio is high because the stock is overpriced, or if it is high because the business is expected to grow rapidly. Low PEG ratios, like the P/E ratio, could indicate that the stock is undervalued.
Price-to-book (P/B) ratio: The P/B ratio compares the company's book value, or the net value of the company's assets, the current enterprise value. Because this ratio incorporates the book value, it is extremely important that companies being compared with this metric are from the same industry, because an attractive P/B ratio in an oil company will be extremely different than one from an industry that has low overhead expenses.
Debt-to-EBITDA Ratio: The debt-to-EBITDA ratio is a great way for investors to look at the overall health of a company's financials. This compares the total debt of a company, as found on the company's balance sheet, to their earnings before interest, tax, depreciation, and amortization. Companies with higher debt-to-EBITDA ratios than their competitors can be a sign that the company is higher risk than its peers.
InvestorsObserver Stock Scores: The InvestorsObserver stock scores are another great tool for investors when analyzing a stock. Our scores take some of the metrics above and in consideration with other factors, ranks each stock against every other stock in the market. The score for a given stock shows how well that stock performs compared to the rest of the market. This means, companies with higher short-term technical scores, for example, have short-term indicators that are more favorable than most other stocks.
Another part of analysis is less numbers driven and more of an assessment of an investor's general belief in the company, its management, and brand.
One of the ways investors analyze a stock without the use of ratios is by identifying the company’s economic moats. This is a competitive advantage the company has over competitors and that likely can't easily be imitated. This could be found in proprietary technology (such as patents), strong brand recognition, or other intangible assets the company may have.
Additionally, companies can create moats through exceptional management and unique corporate cultures. These can be much harder to identify, but can also be a portfolio’s secret-weapon of sorts when successfully identified.