How to Analyze a Stock

Buying stocks can feel like gambling if you don't understand how to analyze a company and assess its growth potential. Fortunately, you can use several reliable ways to predict investment potential more accurately. If you're new to investing, you might hear other investors debating the relative merits of technical or fundamental analysis.  

By using various analysis methods, you can find stock trading opportunities and position your portfolio for future growth. Read on for how to analyze a stock.

What is Stock Analysis?

Stock analysis involves either technical or fundamental analysis. Generally, technical analysis focuses on short-term price fluctuations and is used by day traders trying to beat the market. Technical analysis aims to forecast the direction of prices by studying past market data, primarily price and volume. 

Fundamental analysis is intended to find long-term investment opportunities. Fundamental analysis examines the underlying company, its products, management, debt and cash flow. Focusing on great businesses trading at fair prices, fundamental analysis can help you select long-term growth opportunities.  

How Does Stock Analysis Work?

Stock analysis helps assess a company's financial health and market potential. Analysts start by reviewing financial statements, which include the balance sheet, income statement, and cash flow statement. This data indicates profitability, liquidity, and growth potential. Analysts also look at performance metrics like earnings per share (EPS) and return on equity (ROE). They compare a company to its competitors to identify strengths and weaknesses. Qualitative factors are also important. These include management effectiveness, industry trends, and competitive positioning. Talking to management can provide insights into the company’s strategy and future outlook. While professional analysts spend a lot of time on stock analysis, retail investors may not have the same resources. This difference underscores the need for focus and prioritization for individual investors aiming to make informed decisions.

Best Ways to Analyze Stocks

While fundamental analysis offers the best options for long-term investment analysis, it's worth understanding all your options. Here are the four most common methods of analyzing stocks. 

Technical Analysis

To evaluate investments and identify trading opportunities, technical analysis looks at statistical trends gathered from trading activity, such as price movement and volume. The idea behind technical analysis is that stock charts present all the information needed to analyze history and trends. Technical analysis requires in-depth market understanding and the ability to read trading charts. 

Technical analysis may look at:

• Historical movement and price trends
• Price movement trends
• Market patterns
• Price movement
• Open
• Close

What doesn't technical analysis include? It doesn't evaluate a company's intrinsic value. That means that if a company shows a strong possibility of growth based on historical trends, even if its products are obsolete or its management is weak, it might be a good pick from the perspective of technical analysis. 

Technical analysis attempts to predict whether stocks will go up or down with trend tools. Common trend tools include linear regression, parabolic SAR, MACD and moving averages. Technical analysis also looks at leading indicators and lagging indicators. 

But even with excellent tools, technical analysis can produce false signals. It also requires greater tools and extensive market understanding to use effectively.  

Qualitative Analysis

Qualitative analysis looks at the quality or strengths of the company. Common qualitative considerations are the company's leadership, product and industry. In many ways, qualitative analysis is the opposite of technical analysis. You're assessing whether it's a good business, a good product and a growing industry. 

Qualitative metrics to consider include:

Business Offerings

Does the company's business model address the needs of its target market? Are its products, services and brand identity in tune with current market demands, and is it showing innovation for future growth? Who are the company's target customers?

Industry Placement

Does the company have a competitive edge or existing market share that can drive further success? Does it have a patented process or product that protects it from competition?

Company Leadership

What credentials and past experience do the top executives and leadership bring to the team? Do they have a proven track record of success in similar environments?

Future Growth

Is the company's industry recession-proof? Is it a new or growing industry? Does the industry have strong long-term demand and growth?

Quantitative Analysis

Quantitative analysis is similar to technical analysis in that it uses data and numbers to predict future price movements. With quantitative analysis, investors focus on the company's revenues, price-to-earnings ratio and earnings-per-share ratio. Institutional investors may also use statistical modeling and mathematical techniques to predict a stock’s value.

Quantitative analysis offers an objective starting point for stock analysis. While it can help to identify patterns or risks, it requires expertise to shift through data and understand patterns. However, combined with qualitative and fundamental analysis, it can offer a comprehensive look at a stock's potential. 

Fundamental Analysis

Fundamental analysis is the most popular method for investors focused on long-term growth opportunities. With fundamental analysis, you'll use valuation metrics and other information to determine whether a stock is competitively priced. Fundamental analysis is built on the idea that a stock price doesn't necessarily reflect the intrinsic value of the underlying business. 

By using fundamental analysis tools such as earnings per share or debt to EBITDA, you'll get a sense of the company's long-term earning potential and more effectively locate investment opportunities. In reality, qualitative and quantitative analysis are elements of fundamental analysis. Here's an overview of the metrics to consider in fundamental analysis. 

Earnings Per Share (EPS)

Earnings per share (EPS) gives an indication of how profitable a company is by correlating the company's profit to each share of stock. Companies generally report EPS quarterly. EPS is calculated by dividing the company's net income minus dividends by the number of outstanding shares. 

A high EPS is a good sign; an EPS trending upward over time shows a company that is growing. A negative EPS over time can indicate a stock is a poor choice. Companies can inflate EPS by cutting expenses or selling an asset, so looking at trends over time is important. 

Price-to-Earnings (P/E) Ratio

A stock's P/E ratio compares its current price to its earnings per share. A lower P/E is a good sign of financial strength. With the P/E ratio, you can compare different stocks with each other or with a benchmark like the S&P 500 Index to understand the company's performance relative to the overall market. P/E doesn't factor in growth, so it should be used with other metrics. 

Price-Earnings-Growth (PEG) Ratio

A PEG ratio is used to predict a company's future performance. Investors can look at PEG for different historical periods to make an informed guess about future trends. 

To calculate PEG, divide a stock’s P/E by its projected 12-month forward revenue growth rate. Investors usually look for a PEG lower than 1. A PEG higher than 2 indicates a stock that may be overpriced.

Price-to-Sales Ratio (P/S)

A P/S ratio compares stock price to a company's revenue. To calculate P/S, you'll divide the stock price by company revenues. You can use the P/S ratio to compare competing companies. A low P/S ratio indicates a potentially advantageous stock opportunity. 

Price-to-Book Ratio (P/B)

The price-to-book ratio (P/B) compares a company’s book value to its current stock market value. You can use the P/B to identify companies that are undervalued. Generally, these companies have significant growth, but their stock prices remain low compared to that growth. 

To calculate the P/B ratio, you'll divide the market price of a stock by the company’s book value of equity. To get the company's book value, subtract its total liabilities from its assets.

Debt-to-Equity Ratio

A company's debt-to-equity ratio gives a picture of its debt and its ability to repay it. It's not a good sign if a company goes into more and more debt to continue growing and cannot pay it back.

Divide a company’s total liabilities (debt) by its shareholder equity to calculate the debt-to-equity ratio. A debt-to-equity ratio under 0.1 is considered good, while a ratio higher than 0.5 can be a bad sign about the company's debt management and future potential. 

Debt-to-EBITDA

A company's debt-to-EBITDA is a simple way to access a stock's potential. EBITDA stands for earnings before interest, taxes, depreciation and amortization. You can find it on a company's income statement. 

Divide the company's total debt by EBITDA to get a ratio. A high debt-to-EBITDA ratio could signify a higher-risk investment. This is especially true during recessions and other volatile financial times.

Revenue

A company's revenue indicates the financial viability of a company. A company with strong or increasing revenue indicates that the company is growing and expanding. Tracking changes in revenue over time can help identify companies with consistent growth.

Certain large companies, especially tech companies, may show growing revenue with a negative EPS because they are reinvesting profits into the company. In that case, they can still be a strong stock choice despite showing low profits. 

Dividend Yield

Dividend yield, or the amount a company pays in dividends, can indicate a company's financial strength. This assessment factor doesn't work for all stocks, as many companies don't pay dividends. However, large established companies sometimes pay their shareholders a portion of their earnings rather than reinvesting into their business. 

You can earn small, consistent returns with quarterly or annual dividend payments. You can calculate dividend yield by dividing the company's annual dividend payment by its share price. The average dividend yield for S&P 500 companies is around 2%, but some real estate investment trusts (REITs) or exchange-traded funds (ETFs) may pay 5% or more. Keep in mind that companies can change their dividend payments at any time, so dividend yield is not guaranteed. 

Company Reports and Projections

Companies release quarterly or annual reports. These reports can give investors a sense of the company's management. The reports often include projections for upcoming revenue and EPS, as well as the company's earnings report and balance sheet. Watch the effect of these reports on stock prices, as other shareholders and investors may buy or sell stock based on the news in the report.

Stock Analysis: Advantages and Limitations

There are pros and cons to any stock analysis. However, without a consistent, proven strategy, analyzing stocks can be difficult. And nothing is guaranteed in the stock market. Here are some of the pros and cons of stock analysis. 

Stock Analysis: Advantages

Stock analysis allows you to create a reasonable assessment of a company's potential and a particular stock's investment opportunity. You may be able to identify and purchase under-valued stocks from exceptional companies and benefit from faster portfolio growth. 

Stock Analysis: Limitations

While stock analysis is essential, it is far from a precise science. Even a company with excellent leadership and a solid product may struggle. 

For that reason, diversifying your portfolio across many stocks, bonds, ETFs, index funds, REITs and other investment classes can protect investors from the poor performance of an individual stock.   

Building Financial Growth

As with anything else, practicing the strategies to analyze a stock can build proficiency over time. You'll gain confidence in the various metrics of fundamental analysis and the skills to recognize companies with investment potential. It's worth practicing because creating a strong, diversified investment portfolio can create long-term financial growth. Learn more about how to build a stock portfolio here. 

Frequently Asked Questions