What Makes a Good Stock Research Report
How to analyze a stock
Unfortunately, predicting a company's future earnings and growth with accuracy is easier said than done. If we had a crystal ball to predict future sales and profits of public companies, getting rich would be easy!
So we use the next best method when we invest in the stock market: analyzing stocks.
Stock analysis helps investors find the best investment opportunities at any given time. By using analytical methods, we can try to find stocks that are trading at a discount to their intrinsic value and put ourselves in a good position to generate above-average returns in the future.
Fundamental or technical analysis
When it comes to analyzing stocks, there are two basic options: fundamental data analysis and technical analysis.
- The 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 valued. Fundamental data analysis is the best choice for investors seeking excellent long-term returns.
- Technical analysis generally assumes that the price of a stock reflects all available information and that prices generally move in line with trends. In other words, by analyzing a stock's price development, technical analysts believe they can predict its future price behavior. If you've ever seen someone trying to identify patterns on stock charts or, for example, talking about moving averages, this is some form of technical analysis. Technical analysis is often used by day traders looking for quick profits, but is usually not well suited for long-term investors. Stock trading based on technical analysis also carries a high level of risk.
One important difference is that fundamental analysis is usually aimed at finding long-term investment opportunities, while technical analysis is often aimed at capitalizing on short-term price fluctuations.
We are generally advocates of fundamental research and believe that great stocks that trade at fair prices can produce above-average returns. Technical analysis certainly has its place, but we strongly believe that fundamental data analysis is the best way to find good long-term investment opportunities.
5 key figures for stock analysis
With that in mind, let's take a look at five of the most important and easiest to understand metrics that you should understand:
- Price-earnings ratio (P / E) - Listed companies show their profits to shareholders as earnings per share, EPS for short. If a company made $ 10 million and had 10 million shares outstanding, its earnings per share for that period would be $ 1.00. The price-earnings ratio (P / E) is the current share price of a company divided by the earnings per share, usually on an annual basis. For example, if a stock is trading for $ 30.00 and last year earnings were $ 2.00 per share, we would say it was trading at 15 or 15 times earnings becomes. This is the most commonly used valuation metric in fundamentals analysis and is particularly useful when comparing companies in the same industry with similar growth prospects.
- Price to Earnings Growth Ratio (PEG) - This metric takes the Price to Earnings Ratio one step further. Different companies grow at different rates so it's important to keep that in mind. The PEG ratio is based on the P / E ratio of a stock and divides it by the expected average annual earnings growth rate over the next few years. For example, a stock with a P / E of 20 and 10% expected earnings growth over the next five years would have a PEG of 2, although fast growing companies may be “cheaper” than slower growing companies, even if their P / E makes them more expensive.
- Price-to-Book Value Ratio (P / B) - A company's book value is the sum of its assets. Think of book value as the amount of money a company would theoretically have if it went out of business and sold everything it owned - tangible property, things like patents, brand names, etc. The price-to-book ratio is a comparison of the A company's share price with its book value. Like P / E ratio, this value is most useful when comparing different companies in the same industry that have similar growth characteristics and should be used in conjunction with other valuation metrics.
- Return on Equity / Return on Equity (ROE) - One of the most widely used metrics of return, return on equity or ROE, is calculated by dividing a company's net income by its equity (assets minus liabilities). In short, ROE tells us how efficiently a company uses its invested capital to generate a profit and, like most metrics, is most useful for comparing companies in the same industry. In other words, a company with a 20% ROE can be seen as more efficient at generating its bottom line than a company with a 10% ROE.
- Debt to EBITDA - A company's financial health should also be considered when analyzing, and a great way to do this is by looking at debt. There are several debt metrics you can use, and the debt to EBITDA ratio is a good guide for beginners. In the balance sheet you can find the total debt of a company and in the income statement the EBITDA (earnings before interest, taxes, depreciation and amortization). There's no hard and fast rule of how much debt is too much, but if a company's debt to EBITDA is significantly higher than that of its competitors, it could be a sign of a riskier investment.
Look beyond the numbers
It's also important to understand that there is more to analyzing a stock than just looking at valuation metrics. After all, investing in good business is far more important than investing in cheap stock. With that in mind, here are three other key components of stock analysis that shouldn't be overlooked:
- Lasting Competitive Advantage - As long-term investors, we want to know that a company will be able to hold (and hopefully increase) its market share over time. Therefore, when analyzing potential stocks, it is important to try to identify a lasting competitive advantage in the business model. This can show up in a number of ways. To name just a few possibilities: A well-known brand name can give a company pricing power, patents can protect it from potential competitors, or a large sales network can give it a cost advantage over its competitors.
- Excellent Management - The importance of great management cannot be stressed enough. It doesn't matter how good a company's product is or how much growth there is in an industry if the wrong people make the most important decisions. Ideally, the CEO and other executives of a company have extensive industry experience and success, and their interests are congruent with those of the investors through share-based compensation and / or large blocks of shares.
- Industry Trends - Long-term investors should focus on industries that have favorable long-term growth prospects. For example, there is a clear trend towards online trading. Over the past decade, the percentage of retail sales that took place online has grown from less than 5% to more than 11% today. So e-commerce is an example of an industry with a favorable growth trend. Cloud computing, payment technology, and healthcare are just a few other examples of industries that are likely to grow significantly in the coming years. This consideration can be helpful in deciding which industries to focus on (and which to avoid) in your analysis.
A basic example of stock analysis
Let's take a quick look at a hypothetical scenario. Let's say I want to buy a home improvement business and I'm trying to choose between Home Depot and Lowe's.
First, let's take a look at some numbers. Here's how the two companies differ on some of the metrics we discussed:
|identification number||Home Depot||Lowe's|
|PER last 12 months||21,4||31,2|
|Expected earnings growth||8,3 %||14,9 %|
|Debt to EBITDA||1,55||2,73|
DATA SOURCES: CNBC, YCHARTS, YAHOO FINANCE. VALUES FROM DEC 4. 2019.
Even if Home Depot appears cheaper on a P / E basis, Lowe's is a better buy on a PEG basis, if we factor in earnings growth. Lowe's has a higher debt to EBITDA ratio, which suggests that Lowe's may be the riskier investment.
I wouldn't say that either company has a huge competitive advantage over the other. Home Depot arguably has the better brand name and distribution network, but not by far enough that it would affect my investment decision. I'm a fan of both management teams and the hardware store industry is a business that will always be in demand.
If that sounds like I'm picking a few metrics to focus on and, essentially, giving my opinion on the company, then you're right. That's exactly the point. There is no perfect way to value stocks.
Solid analysis helps make smart decisions
As I just mentioned (and worth repeating), there is no one right way to analyze stocks. The purpose of stock research is to find companies that you believe are good values and long-term successful companies to invest in. Not only will this help you find stocks that are likely to generate high returns over the long term, but using analytical methods like those described here can also help you avoid bad investments and losses in the stock market.
Is this the next Wirecard?
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Matthew Frankel has no position in any of the stocks mentioned. It has been translated so that our German readers can take part in the discussion.
The Motley Fool recommends Home Depot and Lowe's and recommends the following options: long January 2021 $ 120 calls on Home Depot and short February 2020 $ 205 calls on Home Depot.
Motley Fool Germany 2019
Photo: Getty Images
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