*Disclaimer: This blog post is not a financial advice, nor connected with a recommendation to buy or sell shares, but an educational article for those who are interested to know about investing in the stock market, written by DisiCouture.com contributor and finance advisor.
How to analyse if a stock is a good buy?
You are new to investing and want to buy stocks. Where to start? You’re thinking of buying Apple, Microsoft, Amazon – all the big names who have proved to be stable assets. In 1982, The New York Times cautioned against investing in hyped-up tech companies. One of them was Apple. Less they knew that Apple stocks would go through the roof.
No matter which stocks you buy, it is important to do your research first. Therefore, this article deals with fundamental analysis (no technical analysis) and is aimed to give beginners an idea how they can research a company.
There is basically a 3-step process to decide if a stock is worth investing in or not. These steps contain both the qualitative and quantitative analysis on three levels. When you as an investor are completely unfamiliar with a share, you often collect both quantitative and qualitative information in phases.
The qualitative analysis: which consists of a substantive piece of research that is not measurable.
The quantitative analysis: which consists of hard figures that are measurable, such as turnover and profit.
Step 1:
Qualitatively:
During this phase you want to get a picture of the company and some basic indications whether it is worth buying the shares of a company.
To get a picture of the company, it is first of all important to find out what the core activities of the company are with which they at least make an attempt to earn money (profit). The starting point for any investor in a survey is a stock’s “Investor Relations” page. This one can be found simply by googling the company name with investor relations pasted behind it. You always want to be the first to look at the annual report.
An annual report will traditionally start with an overview of the company and its core activities.
Pay attention to things like:
• What do they offer (product/services)
• Where are they active
• Size of customer base
• Type of customers
Answering the above questions will give you a reference point at a later stage.
Quantitative:
Step 1 also includes a quantitative part; quantitative figures can always be found in the annual report or quarterly updates (both available on the investor relations page). They can also be found on pages like Yahoo finance. Make sure that the data on Yahoo finance is accurate and also pay attention to which currency is used.
During this initial scan, you’ll want to look for:
• Revenue
• Profit per share)
• Price Sales Ratio (PS)
• Price Earnings Ratio (PE)
• Market Cap
Answers to the above questions basically give an idea of how “expensive” or “cheap” a company is. Revenue and profit are the input you need to calculate both the PS and PE ratio. Please note: both the PS and PE ratio are not decisive ratios; it is already in the name they only give an indication.
For explanation and formula PE ratio, click here
For explanation and formula PS ratio, click here
Rule of thumb for both ratios:
Lower = cheaper
Higher = more expensive
If a stock has a very high PE and PS ratio, it is also necessary in the second phase to investigate why this is the case. Even if it is very low, don’t make the mistake of making a decision based solely on these ratios. Perhaps a company is on the brink and that is why it is so “cheap”. On the other hand, a company does not immediately have to be a bubble with a high ratio.
Market cap can also say something about potential growth of the share, you may not be interested at all in Apple because you are looking for smaller companies that still have exponential growth (not that it’s not possible with Apple but its very unlikely).
During this first phase you have taken a snapshot, you have not yet looked at the past or the future, you have now only found out in roughly 15 minutes whether the company might be interesting to delve into in more detail.
Step 2:
Qualitatively:
During this phase, there will already be a partial answer to the question “Do I want to buy this stock, yes or no?” During this phase we take a closer look at what the company does and how it is built as well as a deeper dive into the financial health of the company.
Also, during this phase, we will divide it into a qualitative and quantitative part for the sake of dexterity.
We’ll start again with the Annual Report of the investor relations page, but now we’re going to look a bit further than the core activities.
You will often find a report from the executive board at the front. Investors are often no nonsense and want to have all the core results up front. Results of the past year are compared with the results of the previous year, which immediately gives you an idea of whether a company has done better or worse, I will not go into this right now, by the way, we will save that for the quantitative piece.
Questions you want answers to now:
• Who is the board of directors?
• What is the relevant management plan for the company?
• What are the risks that the company foresees itself?
To find out who is on the board and what their experience is, you can look up the people behind the individual positions, such as a CEO, CFO, CCO.
Use Google and LinkedIn to learn more about these people, questions you want to answer are:
1. What kind of work did they do before (experience)?
2. Past statements have been fulfilled?
3. How long have they been with the company?
What does the relevant management plan for the company?
To find out the plans of the management, you can first read the segment of an annual report, although it is often called differently: “Corporate governance”, “Business review”, “Mission”, etc.
Watch out for things like:
1. How do they deal with stakeholders?
2. What is the intended strategy?
3. Implementation of intended strategy?
What are the risks that the company foresees?
To find out what the risks are for a company, you can go to the risk assessment in an annual report. Reading through the risks and how the company tries to minimize these risks is a very important part of your research, because you first have to have confidence in the approach, but it also gives you some handles to do further research on how large a risk. There will also be risks over which the company has little or no influence. If you subsequently see developments in the world that relate to such a risk, this may be an indication that you should stay far away from the share.
There is often talk of external risks where the company itself can only do damage limitation internally instead of solving it completely, this is often because the company is dependent on external partners, macro-economic factors or competitors.
An excellent model for mapping these factors is Porter’s five forces model.Five forces model, read here
ATTENTION: This is an essential part of your analysis, you also include the competitors of the intended company on the qualitative part, which may lead to you stopping the analysis of the current share and continuing with the competitor! (This may stem from the threat of substitutes).
Quantitative:
For the quantitative analysis for step 2 you need three things:
• Income statement
• Balance
• Cash Flow statement
These three documents give you a complete picture of the financial health of a company. For convenience you can use Yahoo because then you also have a picture of the past.
Whether a company is financially healthy can mainly be found on the balance sheet. By means of ratio analysis you can process the data of a balance sheet to get a picture of a company, below are some liquidity indicators.
The liquidity of a company indicates the extent to which they can meet payment obligations.
• Current ratio, click here
• Quick ratio, click here
• Debt Ratio, click here
Again, the outcome of the ratio is no guarantee, try to find out the reason why a ratio may be lower or higher than “normal”. You will also have to look at the other statements such as cash flow statement and income statement, it is possible that a company has higher long-term debts, but this may be counterbalanced by high free cash flow which indicates that the company can easily pay off the debt. if they want. (Also find out why they don’t do it then).
In addition to financial health on the basis of a balance sheet, it is also always good to look at how things are developing on an income statement. Answer questions such as:
• Is turnover (total revenue) increasing?
• Is profit increasing? (Net income)
• Are there significant cost reductions? (Cost of revenue/operating expense)
Are there things that strike you, such as a large decrease or significant increase, try to find out what causes this.
The last part you look at is the Cash Flow statement. Three things can be distinguished from this:
• Operating Cash Flow
Operating Cashflow says something about the cash flows associated with the core activities of a company. Negative cash flow simply means that more money is being spent than is coming in, this does not necessarily mean that a company earns too little, it can also be related to poor payment agreements between the company and customers/partners.
• Investing Cash Flow
Investing Cashflow says something about the income and expenditure related to investments, in this part you will get a picture of the investments that a company makes, an increase does not have to be negative at all because it can be investments in factories / buildings or machines. Companies that are growing fast or have just started will burn a lot of cash. It is then especially important to look at the progress and try to find out where the money is going.
• Financing Cash Flow`
Financing cash flow says something about, on the one hand, payments made by a company to, for example, shareholders and, on the other hand, the income from investments of, for example, a bank or investors.
Step 3:
Step 3 also be the last piece in the analysis, here we will also discuss the fact that you can do research in many more different ways.
Qualitatively:
When we have gone through all the previous steps, you already have a good idea whether you want to buy the share or not. In this phase you will mainly check that there are no strings attached. You may also have come across something interesting that weighs heavily in your final decision on what you want to know more about.
This can be done in different ways and you can make it as broad as you want, you can simply type the name of the company on Google News and read at your leisure what is written about the company.
The important thing is that you compare the information with what you found during step 1 and step 2.
Quantitative:
The quantitative part at this level is an essential part of any research and that is setting a price target for the stock. The purpose of this is first of all to determine whether a stock is relatively “expensive” or “cheap”, not how much the stock costs in absolute dollars or euros, but how much the stock costs relative to the financial performance of the company. There are many different ways to do this, each with its shortcomings and strengths. Determining a price target is also one of the most difficult things when it comes to investing.
Because this article is aimed at starters, you should be aware of the current price of a share, in order to judge from there whether it is worth buying at all or whether it is already too expensive.
– Look at how much the company is worth (market cap) and how much profit/turnover it actually makes.
– Look at revenue and profit growth (or decline) that is in the pipeline, what are they going to sell in one year, what are they going to sell in five years.
– Use figures from similar companies or even competitors to estimate the current valuation.
– Realize that things that you see as positive during a survey are often already priced in, so check how much growth there is still in the stock when you buy it.
And most importantly, realize that you can often not use hard numbers for this step in the analysis, you can use analysts’ predictions, but realize that it is almost always partly guesswork.
Edisa Shahini wears: NEHERA cardigan and NEHERA pants.
Photography (c) Ksenia Kogler
*This post is 100% NOT sponsored.
*Disclaimer: This blog post is not a financial advice, nor connected with a recommendation to buy or sell shares, but an educational article for those who are interested to know about investing in the stock market, written by DisiCouture.com contributor and finance advisor.
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