Welcome to part 4 in the intermediate guide to investing! Previously, we had learnt 10 key financial ratios and metrics to look out for when choosing a stock. We have also learnt the importance of annual reports and reading up on quarterly reports.
However, this is just one part in evaluating whether a stock is a good buy or not. In this part, we will explore some other things to look out for when analyzing a stock.
If you haven't yet read our beginner's guide to investing, where we introduce things like why you should invest, how to start investing, risks, rewards and strategies, do check it out first!
Chapters in this guide:
Part 1 - Why Read Financial Statements?
Part 2 - How To Read Financial Statements
Part 3 - 10 Key Financial Ratios & Metrics
Part 4 - How To Analyze A Stock
Part 5 - Portfolio Management & Asset Allocation
Part 6 - Portfolio Rebalancing & Market Conditions
Resource - Stock Analysis Checklist
Although financial metrics and ratios can help us get a snapshot of a company's health, it does not paint the complete picture of the company. How should we determine, based on our own ideals, whether a company is good value for investment or not?
In this part, we will explore a structured way to analyze a stock or any other investment product, and talk a bit about valuing stock prices.
Know what you invest in
In the previous parts, we have heavily emphasized the knowledge of a company's financial health. However, this is not enough.
The first step in analyzing a stock is in understanding the core tenets of the underlying business.
Knowing how a company makes money is extremely important for an investor. This allows you to have an outlook that is long term.
Above all, we are looking to see if a company is able to grow over the years. Does this company's business model make sense? How will this business grow over the next 5 years? What about 10 years, or more?
In this blog, we advocate for long term investments. This means that we are looking for stable and good growth for as long as possible, instead of being influenced and reacting to short term news, which is volatile and highly risky.
The reason we love long term growth is that that's how you can expect to make the most profits. If you buy a company that has stable growth of 10% every year, over 10 years, you would have more than doubled your original amount.
If you had bought the same company, but sold it after just a year of holding in fear of a dip, then you would have made only 10% on your original amount.
The best investment plan for the individual investor is to look for well valued, long term companies that grow well stably. Only through time can we reap the greatest profits.
This means that we have to analyze the company's industry risk and firm specific risks. There are three steps in analyzing an underlying business. Identifying the industry, identifying the target markets, and analyzing the product and problem.
Identify the industry
When trying to understand a business, start with the industry. Which industry is the business functioning in? Understanding the industry allows you to have a view of industry related risks.
For example, if you are investing in an oil stock, you have to be aware of the various risks that the oil industry is facing. In the US alone, renewable energy is now producing more energy than oil and gas.
Does this mean the oil industry is dying? Not really - crude oil is used for much more things than simply energy production, such as plastics production and aviation. Does this mean that the oil industry could weaken? Perhaps.
Other than industry risks, industry opportunities also arise. If the renewable energy industry is burgeoning, are there more opportunities there? Are there any businesses that are good in that industry?
Expanding your view and connecting the stock to various related industries give you a bird's eye view on the business situation and allows you to make more informed decisions as to whether this stock is good, or if there are better options.
Next, check the target market of the business. Is it youths, teenagers, adults? Does it target the middle class? Does it target certain cultures or countries?
A lot of businesses are multi-national these days, but this means different things. How is the business performing in different countries? What trends are it following?
If a business is concentrated in youths and young adults, such as those in fashion, how are the trends changing in those target markets?
Knowing if the business is meeting the needs of its target market is imperative in determining if the business will flourish or die off in the next 10 years or so.
Understanding the target market also allows us to determine if the market is growing or not. If a business is primarily centered around the US for example, then any new growth would need to face steep competition in an already saturated market.
If a business is considering expansion into Africa or India for example, then there is still a lot of untapped market. Can the target market they are aiming for meet expectations of growth in the future?
Analyzing the problem and product
This brings us to the third part - the problem and the product. To know if a company is able to sustain its growth, we must examine its product model and how it solves the problems faced by its target market.
This is the most important part of a business as its where their model for earning money comes from. No one will pay money for a product that they find useless.
First, identify the problems that the underlying business is trying to solve. Is this a significant problem for the target market? Is it something people would pay money to solve?
Next, look at the solution offered by the product of the company. In our previous part, we examined Microsoft, whose strong product in Microsoft Azure is bringing in large profits for the company.
Microsoft Azure is the product - a cloud server solution distributed globally. The target market is worldwide, and the target market is businesses and enterprises. Obviously, most businesses will not have products this impressive, but this is an example.
Firstly, we note that there indeed is a huge demand for scalability in applications for businesses, as well as an increasing need for customers and enterprises to access data globally for global businesses.
We will know this if we did the industry segment research - and find out that Microsoft targets the Software and Technology industry.
This industry is growing significantly as businesses worldwide are trying to digitize themselves to bring about scalability and automation. Cloud solutions solve this need perfectly.
Therefore, we can somewhat conclude that in the next 10 years, Microsoft Azure should theoretically be a very successful product as it perfectly solves the problems of its target market and industry.
Of course, the above is just a simplified example. You should look at all facets of a business and its products. A simple question you might ask yourself is: "If this business ceased to exist tomorrow, would anyone notice?"
This logic applies for other investment products as well, not just stocks. For REITs and ETFs, watch out for their underlying products (holdings, property, locations, rental rates etc).
In summary, we must first understand the business' operations and how they make money. As Warren Buffet said:
Invest in what you know... and nothing more.
Make sure you have experience in what the business is doing and what their products are trying to achieve. Don't trust the words of other people - be diligent and do the corresponding research yourself.
This way, you can avoid a lot of the risk down the road by making sure the business's products were solid from the start. This can give you the confidence that the business will succeed and grow in the long term.
Of course, there are many other factors that can impact a business, but doing your own homework to minimize these risks are a basic precaution.
A business is only as good as its leaders
Apart from understanding the underlying business of an investment product, watch out for its management as well. As the saying goes:
A team is only as strong as its weakest link.
Similarly, a business is only as strong as how well it's managed. A management that doesn't do well will only cause a good business to fall into ruin.
What should you look out for when examining the management of a business?
Reliability of managers
First, make sure that the management has experience. Of course, we aren't discounting the ability of new and upcoming stars. However, between someone in the industry for a year and someone in the industry for 10 years, who would you choose to trust?
Obviously, the person with more experience wins. Many new businesses actually have more experienced leaders coming over to coach them or take a hold of the reins in order to reliably grow the business from an infancy stage.
The level of experience you want to see with a business is honestly up to your own expectations. An experienced manager might not perform as well as a less experienced manager and vice versa.
However, a more experienced manager may have experienced more problems and know how to overcome them, so generally, we want to see a more experienced managerial board to hold the ship steady.
In addition, we need to make sure that as investors, we can trust the managerial team. Has the managerial team been caught up in any scandals or problematic situations? How did they resolve them?
We want to look for transparency in reporting the company's situation to shareholders. Look out for managers that work for and with the shareholders, not against them for their own gain. The business is the priority.
Alignment of interests
More importantly, the expectations of an investor should be that the managerial board should align the interests of the company with the interest of the shareholder.
Generally speaking, this could mean that shareholders want the business to progress in a direction that makes them the most money.
However, to be more specific, what shareholders are looking for is a business that evolves in the correct direction.
This means that the business should have a long term outlook, expanding and growing into the correct markets, and modifying their products to continuously evolve towards the needs of the target market of the product.
Of course, this depends on the type of investor you are as well. If you're a short term investor, you will want to look for a company that focuses on short term profits, and vice versa if you're a long term investor.
When we say that you should check that the managerial board aligns their direction with your direction, we mean that what the company is doing (and plans to do) should align with the direction you see the company going.
To this end, you should read the annual letter and quarterly reports to know more about where the company is headed.
There is no point investing in a business that you have no confidence or faith in. Invest in something you believe in.
Gather expert opinions but hold your own
The third step in analyzing a stock is to gather external opinions. Human beings suffer from something called the confirmation bias. Essentially, this is us looking out for evidence to support the things we believe in and ignoring the rest.
This is an unconscious thing - and can happen even if you're trying your hardest to be objective. If you firmly believe a stock is good, you will subconsciously only see things to support your stand, and tend to ignore or play down evidence otherwise.
This is an extremely dangerous thing for investors, since it could mislead us into making rash or uninformed decisions.
When investing, we should always take a second opinion. In fact, the more the better. This gives us a more well rounded view of the situation, and open up perspectives that we may not or did not want to consider.
Importantly, when we say to gather expert opinions, we must know who to trust as well. One cannot blindly believe other people's opinions. This is like hopping off a building because someone said it's a good thing to do.
Instead, we have to corroborate other people's opinions with our own, and cross-examine them to see the pros and cons of a stock.
To this end, we like to view expert analysis on the stock or investment product in question. A lot of brokerages offer this built into their investment platform, but in case yours doesn't, it's easy to find such articles on the internet these days.
Watch out for expert analysis from banks and other investment institutions. They usually have insider information or more information than you would expect out of some random guy on a forum boasting about how they made 400% profits in 1 day. Yes, I saw an absurd advertisement like that once.
Remember, don't trust expert analysis blindly. Regard them as an in depth research paper or a thesis about the stock that they are writing for graduation. Use their opinions as a basis to form your own, and check the underlying business yourself.
Money and profits are king
Of course, in the end, we are still heavily concerned about the company's profitability. After understanding the underlying business, gathering the management direction, and viewing expert opinions, step 4 is to look at the company's financials.
In the previous part, we examined 10 important financial ratios and metrics. As mentioned, these will provide a financial snapshot of the company's health. Be sure to look through each one to determine if a company is making money.
Profits and growth
The general idea here is to first focus on the revenue and profits of the company. Is revenue and net income increasing year over year? This could give a hint as to whether a company is growing or not.
The first warning signs of a company's financial instability is if net income is dwindling or even negative.
In addition, we need to look out for profit margins. The net income can't be too little. Objectively speaking, if a company is only barely making more than its spending, then it's profit margins aren't too good, hurting future growth and reducing our returns.
Next, we are concerned with the cash of the company. We want a long term stable growth for the company, which means that the company has to have enough money to pay off its liabilities to survive.
This means checking things like the current ratio, debt to equity ratio, net margin and the free cash flows of the company. We need to make sure these are in acceptable limits (depending on your risk profile).
If the company has dividends, we also want to keep a lookout for the payout ratio to see if the dividends are stable, or whether they are at risk of being cut or reduced.
This will help us check that the company has enough cash on hand to pay their liabilities and is funded by an acceptable amount of debt (or has a good reason to have a lot of debt from their reports).
It also allows us to check that the company has a healthy amount of cash remaining leftover to pay out dividends or simply to weather out unexpected situations like a COVID-19 lockdown. We want companies that are not over leveraged and have healthy cash positions.
Next, we have the returns. How much are we expecting to get out of investing in this stock? What should we expect to get in return?
Here, we can look at things like return on equity (ROE) and the dividend yield. These directly translate to the percentage growth we can expect to get on our original investment.
As investors, we want as high a profit as possible without taking on too much risk. However, an ROE or dividend yield that is abnormally high throws up warning signs as well.
We need to turn back and check the financial stability and future plans of the company to see if anything is wrong. Read the expert opinions again and corroborate on your suspicions!
Valuing a stock
Lastly, if at the end of this process, we decide to purchase the stock or investment product, we have some decisions left to make.
When should we purchase it, and at what price?
As long term investors, we like to say that the best time to enter the market is now, and the best time to exit is never. Basically, hold it for as long as you can. However, we do know that stocks can be extremely overvalued.
It doesn't make sense intrinsically to pay much more for something that is worth only so much. A sandwich could cost you 4 dollars. Maybe, you might even be willing to pay a premium up to 15 dollars. But would you buy a plain sandwich for 50 dollars?
It's the same with stocks or other investment products. We want good value on our investments. Paying too much from the get go means less returns on our original investment.
Some useful financial metrics to look at here include the price to book ratio and the price to earnings to growth ratio (PEG), which we have covered previously.
You can also look online to find analysts' price targets, as well as estimates of share price based on financial formulas such as discounted cash flows (DCF). We won't be going into those calculations here, but you are welcome to find a financial course online to learn them!
These can help you to determine if a company is overpriced right now, which may cause you to hold out for a while or find better investment opportunities.
Sure, getting money into the market as early as possible is a good thing for compounding growth, but no one said that you have to put it into this particular investment product.
If something doesn't look to be a good price right now, invest in something else! There are no lack of investment opportunities out there - it's only a matter of whether you can find them.
We have went through a series of steps that you can take in evaluating and analyzing a stock. As usual, this list is non exhaustive, and you should do your own due diligence in finding out more about what you are investing in.
Remember, only invest in what you know, not what you think you know. That is the safest way to avoid getting burnt.
In our beginner's guide to investing, we have also examined some investment strategies that investors like to take. When analyzing and picking stocks, be sure to choose those that align with your strategy, be it dividends and value, growth or the best of both worlds.
Ultimately, investment is a journey that is supposed to help you create and grow your wealth. The end goal that this blog advocates is to let your money work for you, so you can be free to do the things you really want to do.
If the above series of steps have left you reeling, you don't have to do all of that. You could simply put your money into something more simple like an index fund or a robo-advisor, and just forget about it.
These steps are for those who like to be a bit more personal about their investing, and are looking to pick investment products that could help them beat the market, or active investing.
You could totally choose a more passive route and be just fine. Now, we won't say which method is better, because there really is no right answer. It all depends on what you want to achieve.
As always, do your own research, and invest wisely. It never hurts to read more and learn more.
The list of things to do when picking stocks above is long, so we have condensed it into a helpful guide. Get this useful cheat sheet to analyze stocks below for free!
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Read on for part 5 of our intermediate guide to investing, where we will be exploring why and how to come up with a preliminary portfolio allocation while considering your risk tolerance!
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