Introductory Guide to Analyzing Stocks Part 1 — Objective Research
Know what you own, and know why you own it.”
Whether you are contemplating adding a new stock to your portfolio, or are pitching a stock recommendation, with any long-term investment, it's imperative to always take a look at a company's fundamentals. Understanding how a company operates help gives us as investors deeper insights into how macroeconomic situations and future developments will affect the values of companies. Especially with shorter-term swing trades, while technical analysis can be useful, keeping an eye out for recent news catalysts, such as earnings or operation developments can help even technical traders get an edge in their investment decisions. Knowing, for example, key financial metrics, can help investors gauge whether a company is a worthwhile growth pick or a cash-burning dumpster fire.
For those who are in high school or college, these tips can be used to start writing equity and stock pitch reports for competitions, coursework, and more. For those simply starting their journey in investing, I hope to shed some light on key areas to look out for and how to get started on crafting a basic investment rationale for a company.
To begin a stock analysis, we must always begin with the question of
“What exactly does this company even do?”
1. Company Overview
The best place to find a general overview of a company is through the company's annual filings, also known as the 10-K. The best website to find these public SEC filings is EDGAR, where you can view annual and quarterly earnings. The 10-K report is an extremely comprehensive guide detailing the business's financial and operational conditions. When looking to understand what a company does, the 10-K is the best place to start. For example, after scrolling a bit down in the 10-K, we are greeted by a brief business model written by the company itself.
While doing a company overview, it’s good to first lay out basic information. The full company name, ticker (abbreviation on the stock exchange), current price, 52-week range, and market cap are all good places to start. This data can help you get an understanding of how expensive the company is right now, how established it is, and a general history of the price action of the company (which will help later during the valuation portion).
After getting a general gist of the background and history of the company, you should then look for its main revenue segments: how does this company make money? Many companies have multiple revenue sources, and separating them out to analyze them separately is important. Take Apple, for example. Its revenue is broken into both products and services. Whenever I analyze a company, I always like to look into how the revenue for these segments is broken down and how much they are growing. A pie chart is very useful for giving visuals on how revenue is broken down, and bar graphs can show year-over-year revenue growth.
A good way to show revenue growth is through the compound annual growth rate, also known as CAGR. This can easily be calculated and gives investors a more accurate representation of how a company has grown over a period of time.
2. Industry Overview + Competitive Positioning
While investing in stock requires lots of analysis, understanding the industry the stock competes in, as well as its competitive positioning is also very important. It just might be that there is another company very similar to the one you are analyzing but is at a much more attractive price point and positioned for more future growth. Additionally, if there is news coming out about a given sector, it's good to always keep monitoring the specific industry the company works in. Questions to ask about the industry include: How are interest rates affecting the stock? What are potentially new innovations that might help this industry? Is there any synergy or sympathy growth from another industry?
The Global Industry Classification Standard (GICS) breaks the world's companies into 11 sectors, 25 industry groups, and many smaller subdivisions. After learning which sector or industry the stock you are analyzing is in, it's recommended to first look at how that sector is growing, and what macro trends may be affecting it. Seekingalpha for instance has many tools to help you with industry comparison (on top of having lots of in-depth stock analyses).
After I figure out a company's industry, I always first look at its CAGR. A website I recommend is Grand View Research, which goes into industry/sector growth rate, market cap, and further insights into geographical developments and potential future growth drivers. Here is an example of their market analysis for Software as a Service (SaaS) companies.
After doing a dive into the industry, you should next pivot to see how your stock is faring in that said industry. The 2 beginner ways to do this are either through a SWOT analysis or Porter's 5 forces analysis. A SWOT analysis details the strengths, weaknesses, opportunities, and threats, the company faces, specifically in regard to the macroeconomic climate and its competitors. SWOT analysis tends to be better when you want to focus specifically on the company's internal and external factors for growth. Porter's 5 forces on the other hand detail out risks from suppliers, buyers competitors, new entries, and substitutes. This gives a broader understanding of the industry dynamics. There are many other ways you can detail the competitive landscape such as PESTLE analysis, so I suggest experimenting to find out one that works the best. To build out these analysis models, you can either skim to 10-K to build your own or read articles and other premade models to craft basic ones.
A key thing to look out for in regard to competitive positioning is economic moats. Economic moats are basically common ways a company can differentiate itself from another. The main 5 are brand identity, high switching costs, network effects, intangible assets, and cost efficiency/ economies of scale. While I won’t go too much into these in this article, these 5 moats are examples of how a company can set itself apart as an industry leader. An example would be Apple's strong brand identity and network effect. While Apple does also boast strong intangible assets from its patents, and economies of scale to lessen its operating costs, no other moat is more well-known than its brand identity, and its unique network effect. Apple software such as I-messages, Facetime, Airdropping, and Apple store is only accessible to those who also have Apple products, leading many people to continue using Apple to make use of their extensive network. Economic moats such as these can be used in your SWOT/Porter's analysis and add a unique competitive edge to a company.
After doing a bit of this analysis, you can then transition to looking at key competitors. In a company’s 10-K filing, many of them list their key competitors. If you can’t find it there, sites such as Market Watch and Yahoo Finance also offer compare tabs to see the top competitors. Taking a look at the industry leaders and comparable companies such as yours can help you understand how well it's doing relative to its peers. Even if it has stellar performance, if the other industries in its sectors are doing just as well, you should dive a bit deeper to understand why, and if there is another stock that may be worth your attention.
For more experienced investors, detailing a comparables table valuation can also be very useful. As this is just an introductory article, I won’t go into the specifics but there are many videos such as this and these are simple introductory links that can help if you’re interested.
3. Financial Analysis
To wrap up the objective quantitative research, we have to take a look at the company's financials. Looking at its financial statements, key metrics, and year-over-year performance is the last puzzle piece we need before creating our investment rationales.
Before starting our financial analysis, we must first briefly understand the 3 financial statements. You can easily find them in the 10-K and are easily identified in the table of contents. The 3 statements are the balance sheet, income statement, and cash flow statement. Without going too in-depth, the income statement shows how much the company has made and spent over a period of time (profit/losses). The balance sheet shows what a company owns and owes at a specific moment in time. And the Cash Flow Statement starts taking the net income from the income statement and adjusts it for other noncash items and debt (among other things) to arrive at the company's final cash balance.
Key things to look for when doing financial analysis:
Revenue: Top-line revenue is a great indicator of company growth and expansion of assets. Looking at YOY change is especially important in determining the growth prospects of the company. Growth between 10–20% is standard for most companies, but for smaller growth phase companies, we would like to see higher numbers before considering a potential investment. If looking through a 10-K filing is too difficult, there are many other websites that can simplify financial metrics. Tikr Terminal, Seekingalpha, and Yahoo Finance (free and best for beginners) are all good examples of places that neatly organize company financials.
Profit Margins and Net Income: Looking at gross, operating, and net margins can tell you if a company's operations are sustainable. If you don’t understand these terms, Investopedia is a great way to learn financial vocabulary. In short, these profit margins help you understand how profitable the business is to make sure it can sustain investments, acquisitions, and future developments for growth. When looking at net income, we use earnings per share, or EPS as a standardized measure of a company’s profitability on a per-share basis. We tend to want higher positive EPS to signal health and profitability for a company.
Liquidity Ratios: Looking at the current ratio and quick ratio can help gauge the company’s short-term ability to meet debt and other financial obligations. This can be important to look at when there are new announcements for facilities being made, or new products/services, and is overall something to always consider.
Other: Other financial metrics or numbers such as share buybacks, efficiency ratios, and cash flow to name a few can vary in significance depending on the company. For introductions, however, the main ones I have detailed should be enough.
After performing these first 3 steps of the company, you will have a pretty good idea of the facts and data of the company. I like to call this the objective part of the research, because no matter who is doing it, they should come up with similar data points. In part 2 of this article, I will dive into the subjective part of the analysis. This includes developing the actual investment rationale, detailing both potential ways the company may grow, key considerations and risks, as well as a final valuation that all depend on the investor’s beliefs.
Disclaimer: I am not a financial analyst or adviser of any sort, and my articles are strictly for educational purposes. Stock trading is inherently risky and by reading this, you assume complete and full responsibility for the outcomes of all trading decisions, including but not limited to loss of capital. I hope to share my strategies and experience, and no individual should blindly follow without their own due diligence. Remember, if you fail to plan, plan to fail.
