Beginner's Guide to Stock Investing
Table of Contents:
Benchmarks
It is important to be aware of the applicable investment benchmark for your stock as an investor. All types of investment asset classes have benchmarks. A benchmark is an index created to include multiple securities to represent some aspect of the total market.
Equity - The 2 most popular benchmarks in the equity market are the S&P 500 and the Dow Jones Industrial Average.
Fixed income (bonds and bond funds) – Top benchmarks for fixed income assets include Barclays Capital U.S. Treasury Bond Index, Barclays Capital U.S. Corporate High Yield Bond Index, and Barclays Capital U.S. Aggregate Bond Index
It is important to compare any investment against the appropriate benchmark for that investment asset class.
Stock Analysis
Before buying a stock, bond, or other investment vehicle it is important to analyze the investment and to get as complete of an understanding of the financial health, prospects, and trends of the investment as possible.
There are 2 theories of stock analysis: Fundamental stock analysis and technical stock analysis. This article focuses on the former (fundamental stock analysis) and provides the basic steps of fundamental stock analysis.
Fundamental Stock Analysis Steps
There are 4 primary steps to analyze an equity (stock) investment.
- Gather information about the Company – Grab the Company financial reports, financial ratios from investment sites such as Yahoo Finance, and any relevant financial data you can find about the company
- Review the Company's Financial Metrics & Data - Understand the company’s financial reports, data, and prospects
- Understand the Company - Strengths, business model, management, etc.
- Determine Best Investment Opportunity - Get as complete a profile of the company as possible and compare to find the best investment opportunity
1. Gather Information about the Company
- Review the latest annual report (Form 10-K) for the company.
- Review the company’s balance sheet, income statement, and the statement of cash flows.
- Read the company quarterly report (Form 10-Q) which reviews the quarterly operational and financial results.
- Research financial data on the company through investment or brokerage websites such as Yahoo! Finance or Vanguard.com.
2. Review the Company's Financial Metrics & Data
Focus on the following information and metrics in the financial reports and data. This will allow you to understand the inner financial workings and health of the company.
Note and references to ttm you find means trailing twelve months.
Return on Equity – this is how much profit a company generates with each shareholder dollar invested in percentage terms. Calculated by dividing the company’s annual net income by shareholder equity. This is a measure of how efficient a company is at generating profits.
Return on Assets – shows the percentage of the company’s profits generated with each dollar of assets. It is calculated by dividing the company’s annual net income by total assets. Again this is a measure of how efficient the company is at generating profits.
Beware that a company can artificially inflate return on equity by buying back shares to reduce shareholder equity and likewise can inflate return on assets by taking on more debt to increase the amount of assets.
Price-earnings ratio (P/E) – The P/E tells you how much investors are willing to pay to receive $1 of the company’s current earnings. The company’s trailing P/E ratio is calculated by dividing a company’s current stock price by its earnings per share (over the last 12 months). The forward P/E is calculated by dividing the stock price by the Analyst’s forecasted earnings.
Revenue – Revenue can be itemized into “operating” and “non-operating” revenue. It is the amount of money a company received during the specified reporting period and is referred to as the “top line”.
Operating revenue is generated from the company’s core business so that is the most important revenue.
Non-operating revenue usually comes from a one-time event such as selling an asset.
Net-Income (Earnings) – This is the total amount of money a company made after operating expenses, taxes, and depreciation are subtracted from revenue. This is referred to as the “bottom-line”.
Earnings per share (EPS) – Earnings (net income) divided by the total # of shares available to trade. This shows a company’s profitability on a per-share basis.
Earnings are not a perfect financial measure since it doesn’t tell you how efficiently the company uses its capital.
There are several balance sheet metrics that are good to look, also, such as long-term debt to equity. Cash on hand versus short term debt.
Additional financial metrics and ratios exist to get a good understanding of the inner financial workings of a company. The ones listed are the basic ones to start with. And as you mature as an investor you will likely look at other metrics such as Operating margin, the Quick ratio, Dividend yield, PEG ratio, etc.
3. Understand the Company - strengths, business model, etc.
The fundamental analysis and data in step 2 helps to understand the financial profile of the company but it doesn’t tell you the basics of the business and the industry characteristics the business operates in. It is important to understand the advantages and disadvantages of the business, the management experience, and the strategy of the company.
Likewise, before you invest your hard earned dollars in a stock, it is important to understand the company’s operations and prospects within the industry.
When purchasing a stock you are investing a personal stake in the business so you want to make sure the company’s prospects are good in the industry and that you understand the business operations.
Here are some characteristics of the business to understand:
Is management experienced and are they good stewards of the business? – What is the experience level of the management team? How diverse is the company’s board? Are there independent thinkers on the board? Investigate the management teams thinking and views by reading the annual reports and listening in or reviewing the company manuscripts to understand the strategy and how management speaks about the company prospects and/or challenges.
What could potentially go wrong? What fundamental changes could affect the business’s ability to grow over many years? Look for potential red flags by doing what if scenarios. Possible red flags could be a new leader is taking the business into a new uncharted territory, lawsuits pending against the company, issues with the core business or products, new technology that could obsolete the company’s products or services.
Does the company have a competitive advantage? Does the business have a unique position within the industry? Is the business difficult to compete against – huge start up costs, etc.
Competitive advantages include – business model, patent ownership, operational excellence, high switching costs, power in the industry, distribution channels, brand recognition.
What is the business model or how does the company make money? Invest in companies you truly understand. Understand how the business makes money. Is it clear how the company makes money and what their business model is? Is the business model something you understand?
4. Determine the Best Investment Opportunity
To pick the best investment opportunity for you it is important to make a decision based on the most complete picture you can. That is why it is important to review and understand all the information you have gathered in steps 1, 2, and 3.
Putting together a well-informed profile of the company including the advantages and disadvantages, how it compares in the industry, and any unique characteristics of the business will allow you to determine the best investment opportunity.
It is important to take a look at historical data for the company.
- Does the company have a trend of rising revenue and profitability?
- How does the company perform during tough economic periods?
- How resilient is the company’s balance sheet?
It is important to look for companies with a track record of delivering shareholder value over time and that have a history of improving performance and profitability.
Likewise, it is important to compare how the company performs against industry benchmarks and how it compares to the same or similar businesses.
Once you have completed all four steps and you have as complete a picture as you can get on the company, it is time to decide if this company is a good investment. If not, continue to analyze other potential stocks using these four (4) steps to determine the best potential stock for your investment portfolio.
