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If you’ve ever bought individual stocks based on research, you’ve already performed stock analysis. In fact, when you buy pretty much anything, you perform a kind of analysis. When buying a house for instance, you want to evaluate the current market and the price per square foot. You also analyze how much work the house needs, the neighborhood and location, the school district, and so on.
Doing this kind of work before buying a stock is known as fundamental analysis. (There’s another type of analysis—we’ll get into that below.) It involves reviewing the fundamentals about a company such as financials, competition, leadership, and industry sector to determine if it’s a sound investment.Wealthsimple Invest is an automated way to grow your money like the worlds most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.
What is stock analysis?
Stock analysis is the process of researching and evaluating a stock to forecast its long-term performance. People analyze stocks to predict how the value of a stock may increase or decrease. By looking at past and current data, investors try to gain an edge and make an informed decision when buying stocks.
While some people trust the professionals to do the stock analysis and build a balanced diversified portfolio, others like to do it themselves. If you prefer relying on your own judgment, you could learn the basics of evaluating stocks. (Though keep in mind that the best analysis won’t provide any certainty about how the stock will perform in the future.)
If you’re averse to risk, stock analysis may not be a good option. If you have a low risk tolerance, consider a high-interest savings account that will allow you to grow your money with less volatility.
Types of stock analysis
Mastering stock analysis takes time and research. Whether you’re looking for an investment that will grow over time or one that will immediately add value to your portfolio, you need to develop the right mindset.
You might decide to focus on a single sector or an industry and learn as much as you can about it. Once you have a good understanding of how it’s performing, select a few companies to focus your analysis.
The two basic types of stock analysis are technical analysis and fundamental analysis. Let’s look at each one in more detail.
Technical analysis looks at the way market factors affect a stock’s price. It evaluates historical market data, including volume and price. The idea is to use past performance to try and predict how a stock will behave in the future.
Investors looking for potential trading opportunities rely on tools and charts to determine the best time to buy or sell. Technical analysis accounts for the gap between how much a stock should be worth and the value the market is placing on it.
Traders use a combination of tools such as moving averages and chart formations to analyze the market and determine the best time for a trade. Technical analysis holds that history repeats itself, and that looking at past trends can help predict future stock behavior.
There are different strategies and tools that can help investors perform a technical analysis of a particular stock or a sector. For example, one such strategy is to track two moving averages on a stock and look for the crossover point.
This requires monitoring the 50-day and 200-day averages of an individual stock. If the short-term average goes higher than the 200-day average, this means it’s time to buy since the price is going up. If the averages move in the opposite direction, it shows it’s time to sell.
Technical analysis is often used by short-term traders who try to forecast future pricing and volume trends by looking at patterns within stock charts. Investors who use it believe it will predict how the stock will behave based on historical data and use the information to make stock buying and selling decisions.
Fundamental analysis looks at a company’s financial statements, balance sheets, cash flow, income, economic reports, market share, and so on. It requires reviewing a company’s 10-K report filed with the Securities and Exchange Commission (SEC).
Much of this information can be found on a company’s website in the “Investor” section or in the SEC filing database EDGAR. For Canadian companies, check out the Canadian Securities Administration database SEDAR.
Investors also look at quarterly earnings reports to review profits, revenues, and expenses. Other factors include the company’s efficiency, competition, sector performance, liquidity, and growth projections.
Traders who evaluate stocks based on fundamental analysis rely on ratios to indicate if the company is in good financial health or if it may go into default. Others may look at sector performance and compare a company to others in the same line of business.
The idea is to find companies that are fundamentally healthy but undervalued by the market. Looking at a company’s financials such as income, balance sheet, and cash flow can help an investor determine the overall health of the business.
While the numbers tell part of the story, fundamental analysis requires looking beyond the data. Information from management in the company’s annual report, press releases, and other public documents can reveal a company’s current performance and plans for the future.
Investors looking for long-term investments use fundamental analysis to find companies with a strong foundation that may not be trading at their full market potential.
If you want to do your own stock analysis, you could learn some of these basic concepts commonly used to evaluate stocks:
P/E Ratio: The price-to-earnings ratio, or P/E ratio, compares the company’s profits per share to the price per share. To calculate it, divide the company’s stock price by the earnings per share. This helps investors weed out stocks that are overvalued and focus on those that are a good investment.
Earnings per Share (EPS): This key metric tells investors how much profit a company is generating for each outstanding share of stock. The higher the EPS, the better the company is at investing in the business or distributing dividends. As the earnings per share rise, this usually drives up the stock price. Falling earnings per share can cause the price to drop.
PEG Ratio: The PEG ratio is short for the price-to-earnings-growth ratio of a company. To calculate it, divide the P/E ratio by the expected earnings growth rate of the company. A PEG ratio of less than 1 could indicate a stock that is undervalued while ratios higher than 1 are considered unfavorable.
Book Value: The book value of a company represents the total value of all assets minus any outstanding liabilities. You can find the total asset value and depreciation in the company’s balance sheet. To calculate the book value on a per-share basis, divide the total shareholder equity by the number of outstanding stock shares.
Return on Equity (ROE): The Return on Equity (ROE) measures how efficient a company is at generating earnings from assets. To calculate ROE, divide the company’s net income by the shareholders’ equity. You will need to compare a company’s ROE to other companies in the same sector to gauge whether it’s good or bad.
The Bottom Line
Even the best analysis can’t guarantee that a stock will go up or down. While the fundamentals may be sound or the technical information correct, market conditions may push the stock in a different direction.
The type of analysis you use depends on your trading strategy. In general, short-term traders focus on technical analysis while investors in it for the long-haul emphasize fundamental analysis.
Each form of analysis is important so focusing on both may be your best approach. If you ignore one, you may miss out on valuable information that could change the direction of a company’s share price.
Don’t put money into individual stocks if you can’t afford to lose it. Stock analysis takes time and experience to learn. Sometimes you will make money and sometimes you’ll take a loss.Wealthsimple Invest is an automated way to grow your money like the worlds most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.