Nobody comes born with the innate ability to know what will happen to stock prices.
To be successful at buying and selling stocks, you need to learn how to research before investing.
Investing in stocks can be a great way to generate income and build wealth. But it’s important to do your research before you buy anything.
This guide will walk readers through the steps necessary to research a stock, including understanding how fundamental analysis and technical analysis work, analyzing financial metrics, gathering information on qualitative research and news developments, and how to place everything into context.
Combined, these will allow investors to make an informed decision about whether or not they want to invest in the stock they’re researching.
How to Research a Stock Before Investing
It’s essential to research a stock thoroughly before you invest in it. If you invest in the wrong stocks, you’ll see your funds go down rather than up.
Investment approaches often break into two schools of thought: fundamental and technical analysis.
Fundamental analysts focus on determining what they believe to be the intrinsic value of stocks. Many valuation metrics go into this analysis.
This includes items like price-to-earnings ratios, price-to-sales ratios, price-to-free cash flow, return on invested capital, the net present value of discounted cash flows, and much, much more.
Once fundamental investors come up with a number for the intrinsic value, they compare it to the current stock price to see if it is undervalued and should be bought or overvalued and should be sold.
Fundamental analysis is meant to be used to find long-term investments that appreciate value.
The other popular investment approach is technical analysis. Technical analysis involves looking at simple moving averages, momentum indicators, trendlines, and more.
This strategy typically assumes a stock’s price already reflects all available information, and the prices move based on trends.
Technical analysis is used for short-term investments, like the trading done by day traders and swing traders.
Financial Information to Gather When Researching Stocks
You’ll need to gather the necessary materials to research a stock before you buy. This means documents like SEC filings, the company’s most recent annual report, quarterly earnings reports, press releases, company presentations, reports, and financial statements.
A description of each item is below:
- SEC filings. These documents will provide you with the necessary information to analyze how effective management is at running the company and what competitors are doing in the market, among other details that may be important for your investment decision. Look for important details in the Management’s Discussion & Analysis (MD&A) section.
- Annual reports. Gather these if possible because they detail exactly how profitable or unprofitable the company has been since its inception.
- Quarterly reports. These can also be useful, but they will not cover as much ground. You can access this financial info quickly and easily with a service like Stock Rover. The service is a powerful investment research and analysis tool that dives deeper than traditional equity research sites.
- Press releases. The company may announce major acquisitions, a new product launch, or other key events in the news. It’s important to read these because they can affect how you should view the stock.
- Company presentations and reports. These are often found on corporate websites, but not all companies have them available online. They typically document presentations given by executives or offer an overview of the company.
- Financial statements. These are your most important research material. They show how the company is doing financially in terms of what they’re earning, spending, and investing quarterly.
- Industry research publications. You’ll have many good opportunities to find information about publicly traded companies online through their website or the SEC. You’ll also want to use good research and stock advisor services to find potential companies to buy.
Generally speaking, the more information you have on a publicly available stock through various channels, the better informed your decision would be when investing in those shares.
Focus on the Financial Metrics that Matter
After gathering these company materials, you’ll want to focus on the most important financial metrics.
Look at the following data points as the most important for understanding performance, trends, and the overall financial picture.
- Revenue – How much money a company earns during a specified period. This appears as the first line item on an income statement and is why people call this metric the “top line.” You might see a detailed breakdown of revenue into categories like “operating income,” which is the most important metric because it is money earned from a core business operation.
- Net Income – This represents the amount of money a company earns during a period after accounting for all expenses related to running, financing, and paying taxes on the business. This is the most important number for most investors because it shows a business can convert sales into actual profits for investors.
- Earnings per Share (EPS) – Companies have ownership represented by shares of stock. One share of stock is worth one vote in determining how a company will be run and entitles you to one share’s worth of earnings, or earnings per share. Formally, EPS reflects the total earnings available to each shareholder, per share on average.
- Book Value per Share – This is the value of your share based on what the financial statements show. If the company shuts down tomorrow and sells off all its assets on their cost basis, this will be the book value per share. In effect, book value is the net value of a firm’s assets found on a balance sheet, net of depreciation, and amortization.
- Market Capitalization (Cap) – This metric demonstrates how big this business would be on the stock market if it were publicly traded today, calculated by multiplying current number of shares outstanding by the price per share. Depending on the market cap size, companies can be organized into different categories like micro, small, mid, large, and mega-cap stocks.
- P/E Ratio – Calculates how expensive a stock is compared to past earnings or future projections using one simple ratio: divide Price by Earnings Per Share (the P stands for “Price” and E stands for “Earnings”).
- Return on Equity (ROE) – This shows how efficiently the company uses its money to generate profit for shareholders. It’s calculated by dividing Net Income (the bottom line) by Shareholder Equity, Common and Preferred Stock. Higher ROEs mean a company earns more on its invested equity and has a higher level of profitability. This measure can be changed by selling products or services for a higher profit margin, controlling your overhead costs, or taking on more debt to finance your company.
- Dividends – Dividends are earnings that a corporation pays out in cash or stock to investors. They represent one component of a return on investment of stocks held over time. The most recent dividend will be reflected in the stock price. Not all stocks pay dividends that make them cash-flowing investments.
How to Analyze a Stock with Fundamental Analysis
Fundamental analysts usually focus on long-term investments rather than intraday trading.
They seek to determine a stock’s intrinsic or “fair market” value. It’s recommended to buy undervalued stocks.
One way to determine if a stock is undervalued is to compare its value to its industry peers. This is called a relative valuation model.
For example, you might look at what Nike stock is currently priced versus how much Adidas stock costs. Or, you might compare budget airlines.
Alternatively, investors can use an absolute value model. This model bases a stock’s value on its estimated future free cash flows discounted to the present value.
Investors also look at a company’s price-to-earnings (P/E) ratio. You determine the P/E ratio by dividing a stock price by earnings per share (EPS).
A business with a low P/E ratio trading at a lower price per dollar of EPS could be a good buy, though you need to understand why it trades at a discount compared to its peers.
This stock might trade lower due to fundamental differences in their business, opportunities to grow, different profit margins, brand premiums, or more.
This can also signal that a stock is undervalued relative to the going P/E ratio for peers in the industry.
If it’s trading at a higher price per dollar of earnings than its competitors, it could be considered overvalued and might be avoided.
Though, again, this could mean the company is fundamentally a better investment than its peers. This means investors are willing to pay a premium to own its shares because they believe it will outperform.
The key message in either circumstance is the context for how the stock trades about its peers.
Market Assumptions to Know When Researching Stocks
→ Markets Discount Everything
Keep in mind that markets discount everything. Unfortunately, this isn’t using the word “discounts” to mean “on sale.” This means markets price all publicly available information into stock and trade efficiently based on it.
This relies on the efficient market hypothesis, stating markets reflect all available information. By extension, this also means beating the market isn’t possible.
→ Everything Is Priced In
Or is it? According to technical analysts, every available factor is reflected in the price of a stock.
Technical analysts believe your focus should be on analyzing price movements, which change based on supply and demand for the stock. All other factors involved too much guesswork.
→ Prices Move in Trends
Technical analysts also work on the market assumption that prices move in trends. This is a good thing. The trend is your friend.
The stock market is more likely to continue a past trend than to move randomly. A trend is expected to continue until it shows signs of a reversal.
It works like Newton’s first law of motion. A stock trend continues on its course until an external force changes its direction.
Analyzing candlestick charts with a stock analysis app is a popular way to look for signals that a reversal is coming.
This is in line with the Dow Theory, which looks at the relationship between industrials and transportation.
When one of the markets climbs to a new high, investors expect the other to do the same fairly quickly. If it doesn’t, there will likely be a reversal.
→ History Tends to Repeat
According to technical analysts, history tends to repeat itself.
The repetitiveness of price movements is frequently attributed to market psychology, which is often very predictable based on human emotions with stocks.
By using chart patterns to analyze emotions and how they affect market movements, one is said to understand trends better.
However, this aspect of technical analysis is often criticized, and many other investors ignore price patterns.
Technical traders using the same information may all choose to short a stock around the same time. This causes the stock price to go down, and when others see it declining, they sell as well.
The trend may be more of a self-fulling prophecy than based on logic and may have no bearing on where the stock’s price will be in the future.
Buying for the Long-Term
After conducting this research with gathered sources, assessing and measuring financial metrics, reviewing qualitative considerations, and putting it all in context, you’ll need to decide to invest or pass.
You’ll also need to choose how long you think the company will serve as a good investment. That means buying and holding or trading for the short-term due to temporary valuation discrepancies.
When buying for the long-term, you’ll want to have a long-term perspective of how the company will fare in the next several years.
That means maintaining an important position as part of your portfolio with money you’re prepared to lose and not relying on daily updates or market fluctuations.
You’ll hold the stock in your investment account and watch the company perform over longer periods of time.
You’ll want to choose investments that earn a great return and consider what you expect your returns will be with this company.
Intraday Stock Buying (and Selling)
Intraday stock buying and selling also referred to as day trading, is when traders attempt to profit from price changes within a single day.
Day trading is risky but can be profitable for those who are familiar with the techniques.
Day traders focus on very liquid stocks, meaning shares can be quickly bought and sold because of the high volume. Stocks with mid to high volatility work best.
You can focus on stocks that move a lot in terms of dollars or percentages. The more it moves up and down, the more opportunity for profit.
The tricky part is that you can never know precisely what point a rising stock will go back down.
Don’t get greedy and hold on too long or the trend will reverse, and you’ll lose money rather than gain it. People who hold a stock too long are often called “bagholders.”
Many in the crypto community continue this practice as a financial mantra to survive the extreme bouts of volatility seen in virtual currencies.
In other investments, it’s essential to have entry and exit strategies. Stick to the guidelines you set for yourself when buying and selling, so emotions don’t get in the way and leave you holding the bag.
Let yourself take regular profits. Setting trailing stops can help with this.
Many people lose money in stock trading because they are basing their decisions on “hot tips.” Trade based on facts, not rumors. Trading on rumors is gambling.
Instead, try to pick stocks for day trading by isolating the current market trends and capitalizing on them. Ignore “inside information” others try to push to you.
Remember that intraday trading profits are taxed as short-term gains, which, for most tax brackets, means you’re being taxed higher than long-term profits.
You can subscribe to investment newsletters or stock advisor services to source your ideas, making sure you research the recommendations fully.
How to Research a Stock Before You Buy
There are no guarantees in the stock market, especially for short-term trading.
For this reason, it’s crucial to thoroughly research stocks before purchasing them. Look at a stock’s fundamentals, business prospects, competitive advantages, and leadership performance.
From there, you’ll likely want to look toward a stock’s technicals like trendlines, liquidity, simple moving averages, and more.
This information can assist with developing a full picture not only of the investment justification for the company and the timing for buying the stock.
If you need help finding stocks to research, consider using a trusted investment research website, such as the Motley Fool. You may think you can’t afford an investment service, but choosing the wrong stocks ends up being much more expensive.
The more you know about a stock’s value, the more you can make informed decisions that make your money grow.
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