Contents
Stock Investing Basics
Types of Stock
Stock Indices
How to Determine Your Level of Risk Tolerance
How to Plan Your Stock Portfolio
How to Research Stocks
How to Buy and Sell Stocks
How to Manage Your Stock Portfolio
Stock Investing and Taxes
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How to Research Stocks
After you’ve decided which types of stocks to buy for your portfolio, you can start to research specific stocks within each type to choose which ones to buy. Researching stocks, also known as due diligence, involves looking into the details of a stock, and the company behind that stock, to determine whether it is a sound investment.
Researching stocks takes time, patience, and attention to detail, but it is a crucial component of stock investing. Failing to do the proper research—or buying a stock on the basis of hype or fleeting news—can significantly amplify the inherent risks of stock investing. The two main approaches investors take to researching stocks are fundamental analysis and technical analysis.
Fundamental Analysis
Fundamental analysis is the process of analyzing a company’s financial results to determine its prospects for the future and to assess whether its stock is fairly valued. The goal of fundamental analysis is to find bargain stocks, or stocks whose share prices are below where the market should be pricing them. When investors refer to a company’s fundamentals, they mean the company’s financial well-being, as determined by three main factors:
- Profits (earnings): The total amount of money the company actually earns after expenses
- Debt: The company’s outstanding financial obligations to suppliers, banks, and so on
- Assets: The company’s valuable property, including cash, inventory, real estate, and so on
Data about a company’s fundamentals is easy to find, as every publicly traded company is required to report it quarterly to the SEC. One good place to start is online, at a site such as Yahoo! Finance (finance.yahoo.com).
Once you have this data, you can use a variety of simple statistics and ratios to assess a company’s fundamentals and determine whether the company’s stock is worth buying. The most commonly used ratios and statistics are:
- Earnings per share (EPS)
- Price-to-earnings (P/E) ratio
- Price-to-earnings-growth (PEG) ratio
- Debt-to-asset ratio
- Price-to-book (P/B) ratio
- Beta
Fundamental Analysis Example
The best way to understand how to calculate and use these ratios and statistics is through an example. The fictitious company in the example below, Tommy’s Texas Roasters Inc. (stock symbol “BIRD”), has financials as follows:
- Assets: $120,000
- Debts: $20,000
- Publicly traded shares: 1,000
- Share price: $100 per share
- Profits (prior year): $10,000
- Stock dividend payments (prior year): $4 per share
- Projected earnings growth rate (next year): 5%
- Beta (explained below): 0.8
To analyze BIRD’s fundamentals and the value of its stock:
Earnings Per Share (EPS)
- Definition: The portion of a company’s earnings (profits) that each share of the company’s stock contains.
- How to calculate: Divide a company’s earnings by the number of publicly traded shares.
- BIRD example: $10,000 in earnings / 1,000 publicly traded shares = $10.
- How to evaluate: If all other factors are equal, given two stocks with the same profits, investors tend to favor the stock with fewer publicly traded shares and therefore higher EPS.
Price-to-Earnings (P/E) Ratio
- Definition: A way to assess the value of a company’s shares relative to its industry peers by comparing its current share price to its current EPS.
- How to calculate: Divide the company’s share price by the company’s EPS over a specified period of time.
- BIRD example: $100 (share price) / $10 (EPS) = 10 (P/E)
- How to evaluate: Investors favor stocks with low P/E ratios relative to other stocks in the same industry. Given two companies in the same industry with the same profits, investors tend to buy the shares of the company with the lower priced stock—in effect, paying a lower price for the same amount of profits.
Price-to-Earnings-Growth (PEG) Ratio
- Definition: A comparison of a company’s share price to its earnings growth rate. Some investors consider this ratio more useful than the P/E ratio because it factors in future earnings, not just past earnings.
- How to calculate: Divide a company’s P/E ratio by its projected earnings growth rate (in percentage form).
- BIRD example: 10 (P/E) / 5% (earnings growth) = 2
- How to evaluate: If all other factors are equal, given two stocks with the same P/E ratio, investors tend to favor the stock with the lower PEG ratio, since it predicts higher future earnings growth. Investors generally consider stocks with a PEG below 1 to present a good value, though this can vary from industry to industry.
Debt-to-Asset Ratio
- Definition: A measure of the amount of a company’s assets that have been secured through debt as opposed to equity (assets minus debts).
- How to calculate: Divide the company’s debts by the company’s assets.
- BIRD example: $20,000 (debts) / $120,000 (assets) = 0.16
- How to evaluate: A debt-to-asset ratio greater than 1 means that the company’s assets have been financed primarily by debt. Investors favor stocks with debt to asset ratios less than 1, since these companies have fewer liabilities and therefore present less risk.
Price-to-Book (P/B) Ratio
- Definition: A stock’s book value (equal to its equity) gives an indication of what the company is actually worth “on the books” after all debts have been subtracted from assets. A company’s book value is equal to its assets minus its debts. The price-to-book ratio helps investors get a sense of the discrepancy between how the market values a stock and what the stock is actually worth.
- How to calculate: Divide current share price by book value per share (book value divided by number of shares).
- BIRD example: BIRD’s book value per share = ($120,000 in assets – $20,000 in debts) / 1,000 shares = $100. BIRD’s Price to book ratio = $100 (current share price) / $100 (book value per share) = 1.
- How to evaluate: Stocks with P/B ratios equal to 1, such as BIRD, show a strong correlation between the company’s underlying value and the value that the market currently places on the stock. A P/B ratio of less than 1 suggests that the market has either overlooked some value in the stock or doubts the value of the company’s underlying assets. Stocks with P/B ratios greater than 1 command a premium from the market. Investors tend to buy these stocks only if they believe that the premium is justified based on actual earnings expectations, as opposed to speculation.
Beta
- Definition: A measure of a stock’s historical volatility relative to the broader market’s volatility, which is represented by a beta of 1.
- How to calculate: Calculating a stock’s beta requires advanced math and considerable amounts of data, so consult websites such as Yahoo! Finance to find the latest beta information for stocks you’re researching.
- BIRD example: Beta = 0.8
- How to evaluate: Stocks with betas greater than 1 are more volatile than the broader market—they tend to move up and down in price more often and in greater extremes than the market. Stocks with betas of less than 1, such as BIRD, tend to be less volatile than the general market. If the market drops by 1%, BIRD should drop by 0.8%; however, if the market rises by 1%, BIRD should rise by just 0.8%. High beta stocks offer more potential profits to investors but also more risk.You can calculate the average beta of your portfolio stocks to try to keep your holdings in line with your risk tolerance and financial goals. For instance, a portfolio designed to beat the market should have an average beta of greater than 1.
Technical Analysis
Technical analysis is a method that short-term investors and stock traders use to evaluate stocks without considering fundamentals such as earnings, assets, and so on. Investors who use technical analysis buy stocks based exclusively on the recent performance of a stock’s share price. Though technical analysis has many devotees, it is controversial. Many academics believe that relying exclusively on technical analysis does not lead to higher returns and that it in fact wastes money, as frequent stock trades mean higher transaction costs. Generally, long-term investors tend to pay more attention to fundamental analysis.
Trends
To evaluate a stock’s recent performance, investors look closely at its stock chart, which graphically depicts the past performance of the stock’s share price. The example below shows the performance of Google shares over a three-month period in 2006.
Technical analysts examine these charts to discern patterns, which they use to try to predict when upward movements in share price might begin and when these trends might start to break down. They then use this information to decide when to buy or sell.
All stocks experience uptrends (periods in which the share price and/or share volume increase) and downtrends (periods in which share price and/or share volume decrease). Investors who use technical analysis aim to find stocks with simultaneous uptrends in share price and share volume. This combination suggests that a stock is attracting more and more investors at higher and higher prices. The Google chart above shows a strong upward trend in share price but a relatively flat volume trend, which may indicate that the strong upward movement in price could be limited by the lack of new investors buying into the stock.
How to Use Technical Analysis to Evaluate Stocks
Technical analysis can be used to evaluate stocks over the long term (months or years) or the short term (days or weeks). To evaluate a particular stock, follow these steps:
- Generate a chart for your stock over a specific period of time. You can generate free stock charts at Yahoo! Finance by entering the stock symbol of the company you’re researching in the “Get Quotes” search box and then selecting “Charts” from the menu on the left. Select the timeframe of the chart you’d like to generate.
- Pinpoint the lowest and highest share prices on your chart. Print the chart and draw a line between these two points.
- Technical analysis would dictate that you favor stocks whose lines:
- Move consistently from the bottom left toward the upper right of the chart.
- Veer only slightly above and below the line during their overall uptrend.
For more detailed information on technical analysis, see the Quamut guide to Stock Trading, available in Barnes & Noble bookstores and online at www.quamut.com.
How to Use Fundamental and Technical Analysis Together
Some investors like to combine fundamental analysis with technical analysis. This approach attempts to identify stocks with strong fundamentals that have also trended upward in price consistently over time. For example, to determine whether you should buy the stock for the investment bank Bear Stearns (stock symbol: BSC) shown in the following chart:
- Gather the data you need to evaluate BSC’s fundamentals over the time period you wish to examine (1 year, for instance). Then generate BSC’s chart for the past year.
- Calculate BSC’s P/E ratio, PEG, and other fundamentals over the past year and compare them to the P/E’s of stocks within the same industry (for Bear Stearns, you might look at Lehman Brothers, Morgan Stanley, Goldman Sachs, and so on).
- Draw a line from the lowest share price on BSC’s one-year chart to the current price and evaluate the trend.
- If BSC’s fundamentals compare favorably with its competitors and its stock chart suggests a continued uptrend, you might feel comfortable buying the stock.
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