Undoubtedly the most difficult part about investing in stocks is deciding which company you want to buy stock in. It’s easy to think about stock investing as a big guessing game, but the truth is that successful stock investors do a hefty amount of stock research before they invest in a company. Stock research can help you determine whether or not to buy stock in a business.
This guide will teach you how to research stocks so that you can make more educated investment decisions.
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How to Analyze Stocks
Most investors buy stocks in the hope that a company will grow more profitable over time. If the company becomes more profitable, then the stock value and dividends will probably increase.
The problem is that it’s nearly impossible to predict whether or not a company is going to grow more profitable—unless you own a time machine. So doing stock research can help you gauge whether or not a company’s profits are likely to grow.
Stock research is not an exact science. Consider it a “tool for educated guessing.”
Even if you have a high risk tolerance, it’s best to maintain stocks as only a minor portion of your investment portfolio. The following investments provide far more reliable returns than stocks do:
- Exchange traded funds (ETFs)
- Index funds
- Mutual funds
- Real estate
- Corporate or government bonds
- IRAs and 401(k)s
Most stocks are probably going to lose value or provide insubstantial returns, so you shouldn’t bank on them. Stocks should only make up the very tip of your investment pyramid.
If you heed this advice, then if your investment loses money, you’ll have other profitable investments to pick up the slack. In a best-case scenario, your stock outperforms the market and you generate a great return, in addition to the money generated by your other investments.
Don’t risk it all and pour all your capital into a company you believe is going to be the “next Amazon” or “next Google.” Because there’s a good chance it won’t.
Fundamental Analysis vs. Technical Analysis
There are two different methods on how to analyze stocks: fundamental analysis and technical analysis.
Fundamental analysis is an approach that’s based on the assumption that a company’s stock price does not reflect the intrinsic value of the company. What that means is that the current stock price is not an indicator of the company’s current or future success.
Technical analysis is the opposite approach: that stock price reflects all of the available information about a company and is an accurate measure of profitability.
The problem with technical analysis is that it’s only useful for short-term investors—those investors who are seeking immediate profit through day trading or short selling.
But stocks are a high-risk investment. The safest way to invest in them is to plan on holding them for a longer period so they can weather a potential drop in value. Smart investors consider stocks as money that won’t be needed for 5 years or more.
This stock research guide will teach you how to do fundamental analysis, because fundamental analysis is more helpful for long-term investors.
How to Research Stocks in 5 Steps
Stock research has 5 main steps:
- Start with Company Financials
- Focus on Key Information
- Understand the Company Basics
- Conduct Qualitative Research
- Decide if the Company is Right for You
1. Start With Company Financials
The first thing you’ll need to do is read the company financials. This is also known as “quantitative research.”
Every company that issues stocks is required to file certain financial documents with the U.S. Securities and Exchange Commission. These documents can shed light on the financial prospects of a company.
Two major documents you’ll want to check out are the company’s Form 10-K and Form 10-Q.
Form 10-K is an annual report that includes the company’s financial statements, which have been independently audited. The statements include the company’s balance sheet, revenues, expenses, and other sources of income.
Form 10-Q is a quarterly report that details the company’s operational expenses and revenue for that quarter.
These two documents can help you compare the financial results of one company against another. Most of the time, you can find the statements through a simple internet search, or your broker.
The documents are often very lengthy—as corporate financial statements tend to be—so you might feel a little overwhelmed by the sheer amount of numbers. You can avoid feeling overwhelmed by focusing on a few pieces of key information that the documents provide.
Pro Tip: Sometimes, a major financial news website will post highlights from a company’s financial statements. Your online brokerage firm may also have tools to help you interpret them.
2. Focus on Key Information
Corporate financial statements can be massive, but you’re only looking for a few important line items. Here are the key pieces of information to look for.
Revenue is the amount of money that a company generated during a specific period (annual or quarterly). Revenue is also referred to as the “top line” because it’s the first number listed on an income statement.
The statement might make a distinction between “operating revenue” and “nonoperating revenue.” Operating revenue is the money that’s generated by the company’s core business. Nonoperating revenue is money that comes from one-time business moves—for instance, if the company sells one of its properties or assets.
Net income is the total amount of money that the company generated, once operating expenses, taxes, and depreciation are accounted for. It’s also referred to as the “bottom line” because it’s listed at the end of the income statement.
If you were to make a comparison to your personal finances, revenue would be the equivalent of your wages, while your net income would be what’s left of your wages after you paid your living expenses—like rent, utilities, and food.
Earnings Per Share (EPS)
When you divide the company’s total earnings by the number of shares that it’s issued, then you get the earnings per share (EPS). The EPS shows you how profitable the company is on a per-share basis. It’s an important number to look at when you’re comparing multiple companies.
However, the EPS is still an imperfect financial measurement because it doesn’t tell you how efficiently the company spends its capital. Some companies, for instance, reinvest their earnings rather than paying them out to investors (not an appealing notion for some investors, but remember that smart reinvestment could significantly increase a company’s stock value in the future).
Return on Equity (ROE)
Return on equity (ROE) is a percentage that shows how much profit a company generates with each dollar invested by shareholders.
This percentage can help you understand how efficient a company is at generating profit from the money you invest. You are, after all, investing with the hope and expectation that your stock value and dividends will increase as the company grows more profitable.
If the company is experiencing a rough patch or going through an economic recession, this percentage becomes more important because it can measure the overall resilience of the company (maybe all they need is a little capital from investors to right the ship).
But the ROE and ROA are not perfect measurements. A company can artificially boost these percentages by buying back shares from investors, or by taking on more debt to increase their assets (debt is not always a good thing—especially during a recession).
This ratio measures the company debt by comparing the total company debt against the company earnings before interest, taxes, depreciation, and amortization (EBITDA).
Ideally, a company has low debt and high earnings. High debt and low earnings could mean trouble, especially during a recession. A “high” ratio is considered anything over 4.0.
When you’re looking for key information from a company’s financial documents, remember that your brokerage firm may have a variety of tools you can use to locate the key pieces of information listed above.
3. Understand the Company Basics
Investors sometimes make the mistake of buying stock in a company solely based on the numbers—but they don’t fully understand how the company works.
Before you invest in a company, you need to have a solid understanding of how the company generates profit. What product or service generates revenue from the company? Does the company make a profit by sales or through franchising? Is the company well-established, or is it a startup that’s going to be fighting for a place at the table?
It’s always best to invest in a company that you understand well, and that you’d personally want to be an owner of. It’s advice that’s been offered by many successful investors—Warren Buffet, included. When you understand the product or industry of a prospective investment, you’ll have a better understanding of whether or not it’s well-positioned to succeed.
How would you know whether or not a software company has a good product unless you know a thing or two about software? It helps to invest in businesses that you truly understand, at a core-product level.
4. Conduct Qualitative Research
Once you understand how a company generates profit, you should ask yourself some practical questions about the company’s prospects. This is called “qualitative research.”
Qualitative research is difficult for some people because there’s no right or wrong answer. These questions are highly subjective. You must try and look past any personal biases you may have and come up with answers that are honest and objectively reasoned.
What Are the Company’s Advantages?
Does the company have a competitive advantage that’ll make it profitable? Just what about the business makes it difficult to imitate? Does it have a great brand or business model? Does it innovate? Does it own any patents? Does it have a great distribution model? Has it achieved operational excellence?
How is the Company Leadership?
Every successful company has good leadership at the helm. Some of the key leaders in the corporate world include the CEO, CFO, and COO.
The internet has made it easier than ever to research a company’s leaders. They will be featured on the company website, and you can also do internet research to learn about their backgrounds. You should also seek out videos/speeches/conferences featuring the corporate leader so you can gain insight into their leadership style. The big question you want to answer is, “Do they have a good plan for success?”
You should also research the company’s board of directors, a group of leaders who represent the shareholders (as a shareholder, you may get to vote for members of the board). Some boards may be composed of company insiders, which may not be a good thing—it’s best to have a board of directors that’s removed from operations so they can make objective decisions.
What Are the Risks?
What could go wrong for the company? Could there be new technology that makes the company’s product obsolete? Will the company’s patent expire? Is there a new competitor in the market? Are company leaders taking the business in a direction that you’re uncertain about?
Remember: stocks are a high-risk investment. Never put all your eggs into one basket.
What Are the Industry Trends?
How are things looking for the sector? Is the general product or service growing in popularity, or declining? Are there impending regulations that could limit the industry’s profitability? And how is the industry responding to these trends?
5. Decide if the Company is Right for You
Once you’ve concluded your qualitative research, it’s time to decide whether or not a prospective company is the right investment for you.
Using both your quantitative and your qualitative research, try and get the big picture of the company:
- Where did they start?
- Where are they trying to go?
- What are they doing to get there?
Remember that you’re investing for the long-term.
You may also want to consider whether or not the company aligns with your values. For instance, if you’re passionate about the environment then you’ll probably want to invest in a company that practices sustainability. Figure out whether or not a company stands for what you believe in.
Example of How To Research Stocks
Let’s put into practice what we learned.
For this blog, let’s say that you’re a big fan of coffee and you’re interested in purchasing stock in a coffee company.
Starbucks is one of the most recognizable coffee brands, but maybe you’re interested in Dunkin’ Donuts.
Here are some of the company’s key financials for the previous 12 months (ttm). You can find all of this data through simple online searches.
- Revenue: $1,374,280,000
- Net Income: $241,814,000
- EPS: $0.93 (estimated fourth quarter 2020)
- ROE: -37.53%
- Debt-to-EBITDA: 6.06
Here are the key financials for Starbucks, for comparison:
- Revenue: $23,518,000,000
- Net Income: $928,300,000
- EPS: $0.35 (for third quarter 2020)
- ROE: -12.10%
- Debt-to-EBITDA: 6.67
Both Dunkin’ Donuts and Starbucks are struggling to provide a substantial return on equity, most likely due to the COVID-19 pandemic. Starbucks is generating far more revenue than Dunkin’ Donuts. However, Dunkin’ Donuts is generating more revenue per dollar invested (EPS).
Unfortunately, there’s not a lot of information here to help you make a distinction between the two companies.
You might be thinking, “what’s the stock price for each, and how much in dividends do they say out?”
But remember that you’re using fundamental analysis for long-term investing—the current stock price and dividends are not relevant to us. You’re thinking about the future.
Now might be a good time to look at historical figures. Dunkin’ Donuts has revenues that have been steadily increasing for most of the last several years. It’s also apparent that the company suffered a drop-off in 2018. Impressively, the company was able to maintain growth following the drop-off, which may be indicative of good leadership—and might suggest the company can successfully rebound from the COVID-19 recession.
Does Dunkin’ Donuts have any competitive advantages? Through online searches, it’s apparent that the company employs a strategy in which they offer a same-quality product at a better price:
- First, the company facilitates the lower price by producing a larger amount of overall products and then spreading out the costs.
- Second, the company offers less product and service customization than its competitors, which saves money.
- Third, the company is going to increase its number of stores across the United States—an expansion that will surely be funded, in part, by investors.
It appears as if Dunkin’ Donuts has a good business plan, with reliable growth and numbers to back it up. Now it’s time to start qualitative research.
Nothing about the leadership team, industry trends, or risk factors are worrisome. But maybe you’re just not interested in the product.
The lack of product customization is a good business strategy, but you really like the experimental flavors and seasonal blends that Starbucks produces—you’re a big fan of coffee drinks, after all. Furthermore, you’re not comfortable with the franchising model employed by Dunkin’ Donuts—there’s nothing inherently wrong with franchising, but it’s not a realm you’re familiar with, and you’re unsure whether it will benefit the company or handicap it.
And maybe you like how Starbucks is reducing its reliance on plastic straws—you’re all about eco-friendliness. The company seems to align with your values.
Now, you use the very same stock research method for Starbucks, after which you decide to buy stock and become a Starbucks shareholder.
FortuneBuilders does not advocate that you buy Starbucks stock over Dunkin’ Donuts stock—that was just a short demonstration on how to do stock research!
Remember that there’s no one right way to do stock research and that different investors may come to different conclusions about their quantitative and qualitative data. Just remember to think long-term!
You’ll never be able to predict with complete accuracy whether a stock investment will succeed, but learning how to research stocks will give you better clarity about your investment risk. There are 5 steps to doing fundamental analysis on stocks: start with the company financials, find the key information, understand how the company works, do qualitative research, and decide whether or not the company is right for you.
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