Introductory Guide to Analyzing Stocks: Part 2- Subjective Analysis
“In investing, as in life, there is usually more than one way to look at things”
In my previous article, I went over some key things to look for when objectively researching a company for new investors. Our analysis of quantifiable financial metrics and company data is useful for getting a clear understanding of the company's business model. However, to truly understand whether to buy a stock or largely based on subjective analysis and our own interpretation. All investments have their risks, and knowing how to weigh the pros and cons through analysis is crucial to detailing a clear investment rationale before investing in a stock.
Catalysts
After we finished our objective analysis (company overview, industry, financial analysis), we can first look at catalysts, AKA growth/revenue drivers. Catalysts include anything that may drive a stock’s growth. This includes expansion through acquisitions/mergers, international growth, and new products to name a few. They may help develop the company's competitive edge or simply push revenue streams. Catalysts can best be found in publically available conference calls or earnings reports, which often contain details for future guidance and expectations. The job of investors is to analyze and determine how these potential developments will help/hurt the company, and to what extent.
The steps in writing about the catalysts include:
1. Identify the catalyst.
2. Explain briefly what part of operations this catalyst will help. Is it advancing a certain revenue stream? Is it expected to help with profitability? Which part of the business is directly affected by this catalyst?
3. Citing numbers. Are there macroeconomic trends that can be used to quantify the effects of this development? How do you personally believe this development will help the company? If you can’t cite numbers, that's fine, but being able to add a quantitative element will no doubt help you.
Example on Adobe (Taken from one of my stock pitch reports)
This is one of the many possible catalysts you can do, which is a discussion of a potential expansion of market share. This can often be done through mergers and acquisitions, new product developments, or partnerships between companies to combine operations. In this case, I identify Adobe’s recent expansion into the field of AI through Adobe Firefly AI and other generative AI developments as a potential catalyst for growth. This report was done in March of 2023 and in the past couple of months, Adobe’s stock has nearly gone up by 50% due to the developments of AI alongside sympathy momentum with Nvidia. While this type of growth was not expected, the main point was that AI was in fact a catalyst, and taking a look into future developments for other companies may also yield these results. However, my analysis does not go without its flaws. While I did cite the AI industry's impressive CAGR alongside adobes large investment into research and development, I should have looked more specifically to see how Adobe’s AI products would increase revenues/help other products through either analyst estimates or further research.
Capital Developments
In one of my more recent articles, I cited a catalyst to be potential developments to help the profitability of a company that has historically struggled with burning more money than they earn— Plug Power. In their most recent earnings call, they estimated that with internal hydrogen production, they would be able to reduce a large part of their revenue costs by over 70%. I then created a quick sheet to see the effects of this potential estimate to back up this catalyst. My final conclusion was that given they followed through with the estimates, they could finally reach breakeven margins and begin to operate profitably. I also cite a larger macroeconomic event, the recent Inflation Reduction Act, that would help green hydrogen-producing companies such as Plug Power subsidize their hydrogen through tax credits, further strengthening this catalyst. I believe this is one of the better-written catalysts, with key numbers to cite my expectations (even if wrong) as well as citing larger macro trends that connect to this trend. Remember, your catalyst and investment rationale can be wrong, you just have to create your belief based on what your numbers are telling you. If this thesis was a mistake, you should take it as a learning opportunity by seeing what went wrong.
Valuation
I would say that this is largely the hardest part of stock analysis is valuing a company. The reason why we value a company is to see if the stock is at a price point that is at a discount compared to an investor's believed true (intrinsic value). Essentially, value investors believe the stock will go up if it is undervalued, and will invest in it in order to make profits.
There are many ways to value a company, but the most common ones are the discounted cash flow model (DCF) and comparables table. For this article, I will not dive into how to model/craft these valuation models, as it is out of the scope of what I intend to cover.
For beginners, an introductory way to understand if a stock is overvalued or undervalued is simply by comparing a company's valuation ratios to its historic mean and its competitors. Valuation ratios are financial metrics that analysts use to assess the relative value of a company’s stock or its financial performance. The most common ones are the P/E ratio and the P/S ratio, which are the price-to-earnings and price-to-sales ratios (respectively). A higher relative P/E ratio may reflect a company's overvaluedness as it means that investors would pay a higher price for each unit of the company's earnings (performance). Further discussion clarification of P/E ratios can be found here. It's important to note that for growth companies, a higher P/E ratio may not be a bad thing, and may signal sentiment that investors believe the stock price will rise higher. In order to see if the P/E ratio is an undervalued number or not, you can compare it against its sector median and its historical performance. Yahoo Finance and Seekingalpha are examples of places that offer these numbers, but there are many others that also provide analysts insights into these ratios. The P/S ratio is similar but uses revenue/sales instead of earnings. This can be more reflective of growth-type companies, which may be increasing their revenue quickly but be unprofitable due to frequent reinvesting for research and development.
There are many other valuation ratios, which you can find here. All valuation ratios do have their limitations, however, and just because a company's P/E ratio is high or low is not fully indicative of the stock's intrinsic value. Many things can affect these ratios to differ, so it's best to always have a relative price point to compare it to.
I would like to cut this article short as the examples I have listed are quite long. In the next continuation article on subjective analysis, we will finish our analysis of a company by looking at its key risks and concluding our investment rationale.
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.
