Interested in playing the stock market? Here's how to research stocks.
Researching a stock is a lot like shopping for a car. You can base a decision solely on technical specs, such as torque, mpg and seating capacity. But it鈥檚 also important to consider how the ride feels on the road, the manufacturer鈥檚 reputation and whether the color of the interior will camouflage dog hair.
Investors have a name for that type of research: fundamental analysis.
Fundamental analysis involves looking at numbers and other measures in a company鈥檚 financials as well as assessing the less tangible aspects of a business. This holistic approach can help you decide whether a stock deserves a parking spot in your portfolio.
How to perform quantitative research
Quantitative research begins with financial information that companies are required to file with the U.S. Securities and Exchange Commission:
- Form 10-K is an annual report including key financial statements that have been independently audited. Here you can review a company鈥檚 assets and liabilities via the balance sheet, its sources of income and how it handles its cash via the cash flow statement, and its revenues and expenses via the income statement.
- Form 10-Q provides a quarterly update on operations and聽the already mentioned聽financial results.
- Annual reports include a company鈥檚 10-K and all quarterly updates. They also provide a business overview and often color commentary about the state of the company for prospective and existing shareholders.
You鈥檒l find highlights from these filings and important financial ratios on your brokerage鈥檚 website or on major financial news websites. This information will help you compare a company鈥檚 performance against聽other candidates for your investment dollars.
Don鈥檛 get too hung up on specific numbers. But starting with these line items will get you familiar with the measurable inner workings of a company:
REVENUE
This is the amount of money a company brought in during the specified period. It鈥檚 the first thing you鈥檒l see on the income statement, which is why it鈥檚 often referred to as the 鈥渢op line.鈥� Sometimes revenue is broken down into 鈥渙perating revenue鈥� and 鈥渘onoperating revenue.鈥� Operating revenue is most telling because it鈥檚 generated from the company鈥檚 core business. Nonoperating revenue often comes from one-time business activities, such as selling an asset.
NET INCOME
This 鈥渂ottom line鈥� figure 鈥斅爏o called because it鈥檚 listed at the end of the income statement 鈥斅爄s the total amount of money a company has made after operating expenses, taxes and depreciation are subtracted from revenue. Revenue is the equivalent of your gross salary, and net income is comparable to what鈥檚 left over after you鈥檝e paid taxes and living expenses.
EARNINGS AND EARNINGS PER SHARE (EPS)
When you divide earnings by the number of shares available to trade, you get earnings per share. This number聽shows a company鈥檚 profitability on a per-share basis, which makes it easier to compare with other companies. When you see earnings per share聽followed by 鈥�(ttm)鈥� that refers to the 鈥渢railing twelve聽months.鈥�
Earnings is far from a perfect financial measurement because it doesn鈥檛 tell you how 鈥� or how efficiently 鈥� the company uses its capital. Some companies take those earnings and reinvest them in the business. Others pay them out to shareholders in the form of dividends. It鈥檚 also easy for company management to manipulate the number by using 鈥渃reative鈥� accounting.
PRICE-EARNINGS RATIO (P/E)
Dividing a company鈥檚 current stock price by its earnings per share 鈥� usually over the last 12 months 鈥� gives you聽a company鈥檚 trailing P/E聽ratio. Dividing the stock price by forecasted earnings from Wall Street analysts gives you the forward P/E. This measure of a stock鈥檚 value tells you how much investors are willing to pay to receive $1 of the company鈥檚 current earnings.
Keep in mind that the P/E ratio is derived from the potentially flawed earnings per share calculation, and analyst estimates are notoriously focused on the short term. Therefore it鈥檚 not a reliable stand-alone metric.
RETURN ON EQUITY (ROE) AND RETURN ON ASSETS (ROA)
Return on equity reveals, in percentage terms, how much profit a company generates with each dollar shareholders have invested. The equity is聽shareholder equity. Return on assets聽shows what percentage of its profits the company generates with each dollar of its assets. Each is derived from dividing a company鈥檚 annual net income by one of those measures. These percentages聽also tell you something about how efficient the company is at generating profits.
Here again, beware of the gotchas. A company can artificially boost return on equity聽by buying back shares to reduce聽the shareholder equity denominator. Similarly, taking on more debt 鈥� say, loans to increase inventory or finance property 鈥� increases the amount in assets used to calculate return on assets.
There鈥檚 No Perfect Financial Ratio
There are endless metrics and ratios investors can use to assess a company鈥檚 general financial health and calculate the intrinsic value of its stock. But in all things, context is key.
Looking at a company鈥檚 revenue or income from a single year tells you nothing about the quality of the business. You have to look at its historical data to spot trends and a general business trajectory. You must also compare key ratios to individual businesses in the same industry and industry averages. Then dive into qualitative research.
If quantitative research reveals the black-and-white financials of a company鈥檚 story, qualitative research provides the technicolor details that give you a truer picture of its operations and prospects.
How to perform qualitative research
: 鈥淏uy into a company because you want to own it, not because you want the stock to go up.鈥� That鈥檚 because when you聽, you purchase a personal stake in a business.
Doing qualitative stock research with a business-buyer mindset helps investors focus on the qualities of a company that truly matter in long-term聽.
Here are some questions to help you screen your potential business partners:
HOW DOES THE COMPANY MAKE MONEY?
Sometimes it鈥檚 obvious, such as a clothing retailer whose main business is selling clothes. Sometimes it鈥檚 not, such as a fast-food company that derives most of its revenue from selling franchises or an electronics firm that relies on providing consumer financing for growth. A good rule of thumb that鈥檚 served Buffett well: Invest in common-sense companies that you truly understand.
DOES THIS COMPANY HAVE A COMPETITIVE ADVANTAGE?
Look for something about the business that makes it difficult to imitate, equal or eclipse. This could be its brand, business model, ability to innovate, research capabilities, patent ownership, operational excellence or superior distribution capabilities, to name a few. The harder it is for competitors to breach the company鈥檚 moat, the stronger the competitive advantage.
HOW GOOD IS THE MANAGEMENT TEAM?
A company is only as good as its leaders鈥� ability to plot a course and steer the enterprise. What is their industry experience? Tenure and career trajectory? How big a personal stake do the corner-office dwellers have in the company they run, and are portions of their salaries tied directly to company performance?
You can find out a lot about management by reading their words in the transcripts of company conference calls and annual reports, and how they respond to questions from the press. Also research the company鈥檚 board of directors, the people representing shareholders in the boardroom. Be wary of boards comprised mainly of company insiders. You want to see a healthy number of independent thinkers who can objectively assess management鈥檚 actions.
WILL THIS COMPANY BE AROUND IN 20 YEARS?
You want to buy a stake in a business so you can share in its long-term prosperity, right? So, bottom line, what could go wrong? We鈥檙e not talking about developments that might affect the company鈥檚 stock price in the short-term, but fundamental changes that affect a business鈥檚 ability to grow over many years. Identify potential red flags using 鈥渨hat if鈥� scenarios: An important patent expires; the CEO鈥檚 successor starts taking the business in a different direction; a viable competitor emerges; new technology usurps the company鈥檚 product or service.
Put it all together
Pick a company you鈥檙e interested in, and dig in. Read current and past annual reports and letters to shareholders. Gather the numbers and financial ratios and put them all into context by comparing the company鈥檚 performance history to the industry and its peers. Then put on your business-buyer hat and work through the list of qualitative questions.
A combination of quantitative and qualitative research helps you more deeply聽understand a company鈥檚 operations, its place in the industry, its competitors, its long-term potential and, ultimately, if it鈥檚 worth making room for in your portfolio for the long road trip ahead.
Dayana Yochim is a staff writer at NerdWallet, a personal finance website. Email:聽dyochim@nerdwallet.com. Twitter:聽.
This story originally appeared on .
