Your first task in analyzing a stock is to understand the company behind it. What are its main products or services? Who are its customers? What advantage does the company have over its competitors? The better you understand a company, the better you’ll be able to make sound investment decisions and stick through normal market corrections.
To a fundamentalist, the market price of a stock tends to move towards its intrinsic value. If the intrinsic value of a stock is above the current market price, the investor would purchase the stock, and if the intrinsic value of a stock was below the market price, the investor would sell the stock.
To start a fundamentalist makes an examination of the current and future overall health of the economy as a whole. In this step you should attempt to determine the direction and level of interest rates.
After you analyzed the overall economy then analyze firms individually. You should analyze factors that give the firm a competitive advantage in its sector such as management experience, history of performance, growth potential, low cost producer, and etc.
Some common expressions:
- EPS – Earnings per share: Comparing a price of two stock is meaningless as there are many different factors, similarly comparing earnings of two companies really does not make sense.For example, companies A and B both earn $100, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which companys stock do you want to own?It makes more sense to look at earnings per share (EPS) for use as a comparison tool. You calculate earnings per share by taking the net earnings and divide by the outstanding shares.
>EPS = Net Earnings / Outstanding Shares Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and 50 shares outstanding, which equals an EPS of 2 ($100 / 50 = 2).
- P/E or Price to Earning Ratio: You calculate the P/E by taking the share price and dividing it by the company’s EPS.The P/E gives you an idea of what the market is willing to pay for the company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings.Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.
- Dividend Yield: You calculate the Dividend Yield by taking the annual dividend per share and divide by the stocks price. Dividend Yield = annual dividend per share / stock’s price per share
- BV or Book Value: Book Value = Assets – Liabilitiesif you wanted to close the doors, how much would be left after you settled all the outstanding obligations and sold off all the assets.
- Return on Equity (ROE): Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. You calculate ROE by dividing Net Income by Book Value. A healthy company may produce an ROE in the 13% to 15% range. Like all metrics, compare companies in the same industry to get a better picture.
- Debt To Equity Ratio: This ratio indicates what proportion of finances company received from debt (like loans or bonds) and equity.
Three earnings-related parameters to use to analyze stocks:
- Earnings per share in the latest quarter should show a major percentage increase versus the same quarter a year ago. At least 18% or 20% and preferably much more.
- Earnings growth should be accelerating in recent quarters compared with earlier rates of change. This means that the rate of year-over-year earnings growth in recent quarters will exceed that of previous quarters. The acceleration doesn’t have to occur in the latest period. It could have started up to six or eight quarters ago.
- Annual earnings for the last three years should be increasing at a rate of 25% per year or even more. If you are looking at a younger company that recently had its IPO, you might accept the last five or six quarters being up a significant amount.
In addition to earnings growth, you’ll want to see an accompanying increase in sales. A company can cut costs only so much to increase earnings. Big profit gains must eventually be accompanied by sales growth. Use the following sales-related parameter during your analysis:
- Sales should be up 25% or more in one or more recent quarters, or at least accelerating in their percentage change for the last three quarters.
Finally, you should analyze how efficient the company is at generating returns given the amount of capital it employs. Return on equity(ROE) measures how much net income (earnings) a company generates in relation to the amount of shareholder equity it has. The very best companies will generate consistently high ROEs. Keep the following parameter in mind:
Return on equity should be 17% or higher.
Common Stock analysis mistakes:
- Investing in Companies You Don’t Understand
- Forgetting About Sales: Earnings growth is the lifeblood of almost all major stock advances. Without increasing profits, there is little reason for most stocks to go higher. As a result, it’s important to look for sales growth to accompany that earnings growth. Companies can only grow earnings by cost-cutting so much. Eventually, to keep expanding earnings, the company must also expand sales.
- Looking for Bases without a Prior Uptrend: All bases should be preceded by a strong prior uptrend of 30% or more. This uptrend should be accompanied by improving relative strength and a very substantial increase in volume at some points. This action confirms that the stock has a lot of demand behind it. The subsequent base is usually caused by a general market action, which causes the stock to correct before moving higher.