How to analyse stocks like the pros

Stock analysis

If you're ready to buy your first stock, but don't know how to identify the best opportunities, the below article will get you on the right track.

When you buy a company's shares, you're looking to pay less than the real value of the company.

Unfortunately, this is easier said than done. After all, if you had a crystal ball to predict the future income and profits of every publicly traded company, getting rich would be easy!

That's why we use stock market analysis to invest in the stock market.

Stock analysis helps investors identify the best investment opportunities at any given time. Using analytical methods, we can try to find stocks that are trading below their actual value, and therefore will be in an excellent position to outperform the market in the future.

Fundamental analysis vs. technical analysis

When it comes to analysing stocks, professionals use two basic methods: fundamental analysis and technical analysis.

  • Fundamental analysis is based on the assumption that a stock's price doesn't necessarily reflect the true intrinsic value of the underlying company. Fundamental analysts use valuation metrics and other information about a company's activities to determine if a stock's price is attractive. Fundamental analysis is designed for investors looking for excellent long-term returns.
  • Technical analysis generally assumes that the price of a stock reflects all available information and that prices generally move according to trends. In other words, technical analysts believe that you can predict the stock's future behaviour by analysing its price history. If you've ever seen someone try to identify trends in stock charts or discuss moving averages, this is a form of technical analysis.

An important distinction is that fundamental analysis is generally aimed at finding long-term investment opportunities, while technical analysis is often geared towards profiting from short-term price movements.

We generally believe in fundamental analysis for stocks and believe that by focusing on large companies that trade at fair prices, investors can beat the stock market over time.

4 ways to measure valuation for stock analysis

With that in mind, let's take a look at 4 of the most important and easy-to-understand metrics you should have in your analytical toolkit:

  1. Price-to-Earnings Ratio (P/E): Companies report their profits to shareholders in the form of earnings per share (EPS for short). P/E is a company's share price divided by its earnings per share, usually on an annual basis. For example, if a stock is trading at £60 and the company's profits have been £4 per share in the past year, we would say the P/E ratio is 15, which is 15 times the earnings. It is the most common valuation measure used in fundamental analysis, and it is very useful for comparing companies in the same industry with similar growth prospects.
  2. Price-to-earnings-growth ratio (PEG): different companies grow at different rates. The PEG ratio takes the price/earnings ratio of a stock and divides it by the annualised earnings growth rate expected for the next few years. For example, a stock with a P/E ratio of 30 and expected earnings growth of 15% over the next five years would have a PEG ratio of 2. The idea is that a fast-growing company can be "cheaper" than a slower growing company, even if its P/E ratio makes it seem more expensive.
  3. Price-to-book ratio (P/B): the book value of a company is the net value of its assets. Book value is the amount of money a business would theoretically have if it went out of business and sold everything it owned. The price-to-book ratio is a comparison between a company's stock price and its book value. Like the P/E ratio, it is very useful for comparing companies in the same industry that have similar growth characteristics. You should use it in combination with other stock measurements.
  4. Debt-to-EBITDA ratio: A good way to assess the financial health of a company is to look at its debt. There are several ways to measure debt, but the debt to EBITDA ratio is a good learning tool for beginners. You can find a company's total debt on its balance sheet, and you can find its EBITDA (earnings before interest, taxes, depreciation and amortisation) on its income statement. If a company's debt-to-EBITDA ratio is significantly higher than that of its peers, it may be a sign of a riskier investment, especially in times of recession.

Looking beyond the numbers to analyse a stock

While everyone loves a good deal, there is more to analysing a stock than just valuation metrics. It is much more important to invest in a good company than a cheap stock. With that in mind, here are three other key stock analysis items that you should watch out for:

  • Sustainable competitive advantages: As long-term investors, we want to know that a company will be able to maintain (and hopefully increase) its market share over time. It is therefore important to try to identify a sustainable competitive advantage in the business model. This advantage can take several forms. To name a few possibilities, a well-known brand can give a company pricing power, patents can protect it from competitors, and a large distribution network can give it a cost advantage over its peers.
  • Good management: It doesn't matter how good a company's product is or how an industry grows if the wrong people are making the key decisions. Ideally, the CEO and other key executives of a company will have successful and extensive industry experience and have interests that align with those of the shareholders.
  • Industry trends: Long-term investors should focus on industries that have favorable long-term growth prospects. For example, there is a clear trend in the market towards online retail sales. Over recent years, the percentage of online retail sales has grown from less than 4% to over 13% today. Electronic commerce is therefore an example of a sector showing a favorable growth trend. Cloud computing, payment technologies and healthcare are just a few other examples of sectors that are likely to experience significant growth in the years to come. Trends can help you determine which areas to focus on (and avoid) in your analysis.

A basic example of stock analysis

Let's take a quick look at a hypothetical scenario. Imagine that I'm trying to choose between two companies in the pharmaceutical industry.

First, let's take a look at some numbers. Here's how these two companies rank side-by-side based on some of the metrics we've talked about:

Valuation measurementCompany ACompany B
P/E ratio (over 12 months)24.5 22.3
Projected earnings growth rate 4.5% 19.1%
PEG 5.44 1.17
Debt-to-EBITDA ratio1.71 2.26

Here are the main lessons to be drawn from these figures. Company B actually appears to be the cheapest purchase, both on a P/E ratio and PEG basis. It has a higher debt-to-EBITDA ratio, which could indicate that it is the riskier of the two companies.

I wouldn't say that either company has a major competitive advantage over the other. Company A arguably has the best brand and distribution network, but not so much that it influences my investment decision, especially when Company B looks more attractive. I'm a fan of both management teams, and the pharmaceutical industry is always going to be in high demand.

If you think I'm picking a few metrics to focus on and am basically giving my opinion on the company, you're right. And this is the problem: There is no perfect way to value stocks, which is why different investors pick different stocks to invest in.

A solid analysis can help you make smart decisions

As we mentioned above, there is no one correct way to analyse stocks. The goal of stock analysis is to find companies that you think are good stocks and companies that are worth investing in for the long term. Not only does this help you find stocks that are likely to deliver good long-term returns, but using analytical methods like the ones described here can prevent you from making bad investments and losing money in the stock market.

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