Learning how to properly perform a stock analysis is essential to anyone looking to invest in the stock market. If you don’t know how to analyze and evaluate the market you will not be able to make informed decisions and your investments will be based on guesses. Even though no analytic work can guarantee a profit, the correct understanding of the factors that affect a stock price and the health of a company will take you a long way.
There are two types of stock analysis and we recommend that you learn them both. Whether or not you use both analytic methods for your actual investments is up to you – some investors use both while others focus on one or the other depending on their strategy.
You can either perform a fundamental analysis of stocks or a technical analysis of stocks. Don’t be fooled by the name, the fundamental analysis is not necessarily easier than the technical analysis, they just focus on different aspects of the securities that you’re evaluating.
The goal of both fundamental stock analysis and technical stock analysis is to find value in the market and evaluate if certain stocks are good investments based on some predetermined criteria.
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Fundamental Stock Analysis
The objective of a fundamental analysis is to evaluate the health of a company compared to a technical analysis which only focuses on the stock price and how the market is acting. The idea behind a fundamental analysis is that you use certain ratios and numbers to calculate how much the company is worth on paper compared to what the market would pay for the company. You also check the company’s cash flow and evaluate their ability to pay back debt and your investment. One of the main tasks is also to figure out if the stock is undervalued and a possible good investment or if the stock is overvalued and therefore a bad investment.
We’ll try to walk you through the process of a fundamental stock analysis by first explaining the data you need to get your hands on and listing a series of questions that you need to answer. After that, we provide some examples of the most important ratios and what to use them for.
Information needed to conduct a fundamental analysis
To conduct a fundamental analysis you need access to a lot of financial data from the company. Luckily, there are rules and regulations that force publicly traded companies to be transparent which makes all the necessary data readily available to you. Generally speaking, you’re looking to find a company’s balance sheet, income statement, and cash flow statement. At first, this step can be confusing, especially if you’ve never studied this kind of financial data before. However, we urge you to learn how to read all this information and encourage you to find certain entry points and metrics to focus on.
The next step is to use the data from the financial statements to answer the following questions.
How is the company’s financials?
You wouldn’t want to invest in a company that is running on an empty tank since that would jeopardize your invested money. You need to make sure that the company has a steady cash flow and that they are planning to expand their business to create even more of an income. Acknowledge that this is one of the most important steps in an investment analysis.
Is revenue increasing and is the company making any profit?
If a company isn’t constantly increasing their revenue and profits you might end up with a stock that grows very slowly, or not at all. You see, a stock price is always mirroring the company’s health and as long as the company isn’t growing, neither will the stock. Also, if a company’s revenue is decreasing there is a high chance that the company is overvalued which is something you would want to avoid investing in.
Can the company pay back debt and loans?
If the company has debt you need to make sure that they can pay that back and you have to calculate how fast it would take them to pay it back. One of the main goals of a fundamental analysis of stocks is figuring out how much of a company’s cash flow is available to the company and if they use that money to further grow their business. If they can’t pay back the money they owe other companies, then how do you expect them to pay you back for your investment?
Does the company have potential to lead the industry and compete with the biggest?
What are the company’s plans for the future? Are they still developing innovative products and services that can take them to the next level? If the company has no ability to compete with their competitors you can’t expect much from the stock. Your goal is to find a company that works hard to be industry leading and is ready to step out of the box to continually grow.
Fundamental Ratios of a Fundamental Analysis
We’ve already mentioned that a fundamental stock analysis is based on certain ratios calculated from a company’s financial records. We’ve also walked you through why you need this data and the ratios. Now we’ll further explain some of the most important ratios that you need to calculate, how you calculate them, and what you use the information for.
P/E ratio – The price-earnings ratio (P/E ratio) is considered the most fundamental part of a fundamental analysis of stocks. It’s used to value a company and to calculate how much an investor or the market has to pay for $1 of the company’s earnings. This information will then be used to evaluate how the company is performing and whether or not the stock price is overvalued or undervalued.
To calculate the P/E ratio you need access to two numbers. You need the price per stock which is readily available from any basic stock chart and you need the earnings per share (EPS), which you get by dividing the profit with outstanding stocks. By dividing the price per stock with the EPS you get the P/E ratio.
There are two ways of calculating a P/E ratio. You can either use the company’s financial data from the last four quarters (past 12 months) to get the current P/E (trailing). Otherwise, you can use analytic estimates of how the company will perform to calculate an estimated P/E (future). Generally speaking, the first calculation is more accurate since estimates can be wrong.
Note that P/E ratios are so widely used that most modern stock charts provide them for your convenience.
PEG ratio – Price/earnings to growth (PEG ratio) is used for similar purposes as the P/E ratio, however, the numbers are slightly more accurate and it paints a more comprehensive picture. A PEG ratio is calculated by using the P/E ratio (see above) and dividing that by the earnings growth rate.
PEG ratios are used to determine a stock’s value based on its ability to grow over a specific amount of time. Most people consider a PEG below 1 as good and the lower the number is the better since it indicates that the stock is undervalued. On any given day the S&P 500 has at least a handful of stocks that have PEG 0.01 which is considered a very good investment if you only look at PEG. However, there are, of course, other factors to consider as well.
Technical Stock Analysis
The technical analysis of a stock might sound like it’s more complicated than a fundamental analysis, but that’s not really true. We would say that they are both fairly easy to understand at the core but that it takes a lifetime to actually master how to use them, especially if they’re used together.
Unlike the fundamental analysis that is based on the company’s financial records, a technical analysis only focuses on the stock price and market trends; price and volume are the two most important factors. The basic idea is that you evaluate the market and how it has performed in the past before you compare that with how the market is performing right now. You then use that information to calculate how the market will continue to develop in the future. You could call it a stock market analysis or even a stock chart analysis.
Before we get started we need to clarify something. A technical analysis of stock trends is based on one simple factor that we all already know, supply and demand. However, the technical analysis also revolves around three assumptions:
- The market discounts everything
- Prices move in trends
- History tends to repeat itself
We want you to keep this in mind as we continue to explain the technical analysis of stocks as it will make the process more comprehensible.
Technical Analysis: Supply and Demand
As is the case with all prices in our society, stock prices are affected by supply and demand. That means that a stock price will increase if there is a high demand and a smaller supply of a stock, and as soon as that changes the price drops. That is, for example, why market crashes usually start by major sell-offs. You see if several investors decide to sell their stock in the same company at once the supply will increase which will push the price down. As the price drops, people will not want to invest in the stock which means the demand will become less and all of a sudden the price will plummet. That is an extreme example, but it outlines the idea of supply and demand.
When you conduct a technical analysis of the stock market you have to assume that supply and demand are what affects the stock price. The only issue with that is that there are other factors that can affect a stock price such as dividend announcements, mergers, CEOs getting fired, scandals, and new policies.
Technical Analysis: Price Trends
As mentioned, a technical analysis is also based on three very specific assumptions. In short, those three assumptions explain the following:
The market discounts for everything, meaning that the market price already includes and reflects everything that is affecting a company.
Prices move in trends, meaning that the market price is more likely to continue an ongoing trend than to act randomly. Technical analysis looks at short, medium and long trends.
History repeats itself, meaning market price movements tend to be repetitive and that the repetitive nature is based on investor psychology.
Using Stock Charts for Technical Analysis
Since all technical analysis is based on price movements and stock prices, they are all based on stock charts. Because of this, learning how to read stock charts is of the utmost importance to all stock traders. There are several stock charts to use and they offer different features and information depending on what strategy you’re looking to apply.
The most common stock chart is called a basic stock chart and it only provides the stock market price with the possibility to check how that price has developed over time. Because of the limited amount of data a basic stock chart offers, they are not commonly used for the technical analysis of stocks. A more popular option is to use a candlestick chart that provides daily information about a stock price opening, closing, highest, and lowest prices. This type of chart is much more effective to use when conducting a technical analysis of the financial markets.
Moreover, there are several other stock charts that can be used for different sets of data and information. If you would like to know more about stock charts we suggest you check the stock chart guide that we’ve written. The guide also explains how to apply the chart data in your analytic work. We also provide information about stock analysis websites and stock analysis tools.
Which Analysis is Better?
There is no way of deciding whether a fundamental stock analysis is better than a technical stock analysis or vice versa. In fact, there is nothing called the best stock analysis, it’s more of a personal choice.
The two stock market analysis we describe provide different information and are based on different fundamental ideas. Because of this, the two analysis are best used together so that you can get a comprehensive idea of how the company you want to invest in operates and how the stock price has developed and will develop.
Some traders choose to only rely on one of the analysis and in the end, the choice is up to you. As long as you’re able to make well-informed decisions that lead to profit from the majority of your investments, you are free to analyze the market in whichever way you see fit.
How Economic Health Affects Stock Market Analysis
As a last side note, we want to mention one aspect that both of these analytic procedures fails to evaluate. The economic condition of the region or country where the company is listed and also the region where the company operates is highly important to how the stock performs. Political leaders and parties can affect the market and industries in ways that neither a fundamental stock analysis or a technical analysis or stock trends can predict.
Due to this, we urge our readers to also study the economic stability in the region where the company you invest in is operated and where the stock exchange is located.
Stock Market Analysis Summary
There are two types of stock analysis that one can perform before investing in a stock. The first one is called a fundamental stock analysis and it focuses on the company performance. How much money is the company making? How are they projected to perform in the coming months, year, etc.?
The second analysis is called a stock market technical analysis, it focuses on the market price and how supply and demand, as well as price trends, affect the stock price. A technical analysis of stock trends also called a stock trend analysis requires a good understanding of how stock charts work since that is where you get all the information.
Neither of these two options are considered the “better option,” instead they can be used on their own or as a combination in order to make well-informed decisions about your investments. We suggest that all our readers dedicate the needed time to learn how to analyze the market and different stocks since it will heavily influence your success as a stock trader. And don’t forget that mastering stock analysis is a lifelong commitment that you’re never really done with and can always improve.
All of our recommended stockbrokers offer impressive sets of stock charts, technical analysis charts, stock market analysis tools, and much more for your convenience. They also provide educational material in the form of e-books, webinars, videos, conferences, and even P2P training sessions where you can learn more about stock trading, how to analyze a stock, etc.