How to analyze actions? If you are ready to buy your first stock, but are not sure how to find the best opportunities, we offer coverage.
When investing in a stock, your goal should be to pay a price lower than the value of the company’s future profits.
Unfortunately, it’s easier said than done to predict the future profits of any company and future growth accurately. After all, if we had a crystal ball to predict the future revenue and earnings of all publicly traded companies, getting rich would be easy!
So, we use the next best thing when investing in the stock market: how to analyze stocks.
Stock analysis helps investors to find the best investment opportunities at a given time. Using analytical methods, we can try to find stocks by trading at a discount on their intrinsic value and therefore we will be in a great position to capture better market returns in the future.
How to analyze stocks
Fundamental and technical analysis
When it comes to analyzing actions, there are two basic ways in which you can follow: fundamental analysis and technical analysis.
Fundamental analysis is based on the assumption that stock prices do not necessarily reflect the true intrinsic value of the underlying business. Fundamental analysts use valuation metrics and other information about a company’s business to determine whether a stock is attractively priced. Fundamental analysis is the best option for investors seeking excellent long-term returns.
Technical analysis generally assumes that a stock’s price reflects all available information and that prices generally move in line with trends. In other words, by analyzing a stock’s price history, technical analysts believe that they can predict its future price behavior. If you have seen someone trying to identify patterns in stock charts or discussing moving averages, for example, it is a form of technical analysis.
Technical analysis is often used by short-term traders in search of quick profits, but is generally not suitable for long-term investors. Trading stocks based on technical analysis involves a lot of risk.
An important distinction is that fundamental analysis is typically aimed at finding long-term investment opportunities, while technical analysis is usually focused on profit from short-term price fluctuations.
In general, we should be defenders of fundamental analysis and we believe that, focusing on big companies trading at fair prices, it is entirely possible to win the stock market along the time. Technical analysis certainly has its place, but we firmly believe that fundamental analysis is the best way to find great investment opportunities in the long term.
5 metrics to use in your stock analysis
With this in mind, let’s look at five of the most important and easy to understand metrics you should have in your analytical toolkit:
Price to earnings (P/E) ratio – publicly traded companies report their profits to shareholders as earnings per share, or EPS. If a company earned $10 million and had 10 million shares outstanding, its earnings per share would be $1.00 in that period. The P/E is the current price of a company’s shares divided by its earnings per share, usually annually. For example, if a stock is traded for $ 30.00 and the company’s earnings are $ 2.00 per share last year, we would say it was traded for a P/L ratio of 15 or «15 times profit». This is the most used valuation metric in the fundamental analysis and is most useful when comparing companies of the same sector with similar growth perspectives.
Price-to-earnings growth ratio (PEG) – This metric takes the P/E rate one step further.
Different companies grow at different rates, so it is important to take this into account. Therefore, the PEG ratio takes the P/E ratio of a stock and divides it by the expected annual growth rate of profits in the coming years. For example, a stock with a P/E ratio of 20 and 10% expected profit growth over the next five years would have a PEG ratio of 2. The idea here is that fast-growing companies can be «cheaper» than slower growing companies, even if their P/E ratio makes them look more expensive.
Price-to-book (B/B) ratio – The book value of a company is the sum of the value of its assets. Think of the book value as the amount of money that a company would have, theoretically, if it closed its business and sold everything it owned – tangible properties, as well as things like patents, brand names, etc. The price-to-book, or B/B, is a comparison of a company’s stock price with its book value. Like the P/E ratio, this is more useful for comparing companies in the same industry that have similar growth characteristics and should be used in combination with other valuation metrics.
Return on equity (ROE) – One of the most commonly used profitability metrics, return on capital or ROE, is calculated by dividing a firm’s net income by net capital (assets minus liabilities). In short, ROE tells us how efficiently a company is using its invested capital to make a profit and, like most metrics, is useful for comparing companies in the same industry. In other words, you can consider a company with an ROE of 20% as more efficient in generating profit than a company with an ROE of 10%.
Debt to EBITDA – The financial health of a company should also be taken into account when analyzing its actions, and a good way to evaluate the financial health is by observing the debts of the company. There are several debt metrics you can use, and the debt-to-EBITDA ratio is good for beginners to learn. You can find a company’s total debts on its balance sheet and its EBITDA (earnings before interest, taxes, depreciation and amortization) in its income statement. There is no set rule regarding the amount of debt in excess, but if a company’s debt with EBITDA is significantly higher than its peers, this can be a sign of a higher risk investment.