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How to analyze a stock
Learn how to research stocks and find the right investment opportunities in 4 steps.
Figuring out how to research stocks can seem intimidating. With the right analysis, investors can decide whether a company is undervalued or overvalued, and they can find a good price for buying stocks. Luckily, anyone can learn how to analyze a stock. Here’s how it works.
Step 1: Understand different types of analysis
There are 3 types of analysis that differ based on the information you use about a company: Fundamental, technical and quantitative.
Despite each having its perks and flaws, successful investors and companies use a combination of two or all three of these techniques.
Fundamental
Fundamental analysis aims to determine a company’s fair value. This is a more common type of analysis because it uses freely-available information like price-to-earnings ratio, cash flow, earnings per share, etc.
Typically, fundamental analysis is used by growth investors and value investors who are looking to get a great company at a fair price.
Pros
- Easy to learn
- Provides valuable company information
- Helps you find excellent companies at a discount
Cons
- May take a lot of time to find the right company
- Could take months or years for the investment to pay off
- Not foolproof — economic factors may change and negatively affect the company in multiple ways
Dive deeper 5 must-have fundamental analysis tools
Technical
Technical analysis uses charts with historical price movements of company shares to predict future price movements. Day traders and swing traders often use this type of analysis to help them find a good entry and exit price.
Pros
- Helps you identify support and resistance levels, i.e. which price point is likely to be a good buy or sell
- Highly customizable for your trading goals and strategies
Cons
- All technical indicators are lagging behind the price
- Can often give false signals
- Doesn’t care about the company fundamentals; only focuses on the share price.
Quantitative
Quantitative analysis uses mathematical and statistical data to determine the value of a company’s stock and predict future moves. Typically, quantitative analysts (or “quants”) don’t concern themselves with the company’s fundamentals. Instead, their trades are based on computer models.
Quantitative analysis is often used by high-frequency traders and hedge funds and rarely by long-term investors.
Pros
- Eliminates emotional and personally biased stock trading
- Quant strategies can be automated, further removing human interaction
Cons
- Can’t predict macroeconomic changes
- A computer algorithm doesn’t understand news and events like a human does, which can impact stock prices
Step 2: Interpret key company metrics to analyze a stock
We’ll start off with some of the most popular metrics used in fundamental analysis.
Market capitalization
Market capitalization — often called “market cap” — is the total dollar market value of a company’s stocks. Market cap is used to determine the company’s size. Typically, the bigger the market cap, the safer the company and the investment.
On the other hand, smaller cap companies are riskier but can have a bigger upside. Also, chances are higher that small-cap companies could be acquired by larger companies, which could quickly drive up the stock price.
Based on market cap, companies can be:
- Micro-cap (less than $30 million)
- Small-cap ($300 million to $2 billion)
- Mid-cap ($2 billion to $10 billion)
- Large-cap ($10 billion or more)
Companies with a market cap of over $200 billion are often referred to as mega-cap. Blue chip companies, like Apple and Amazon, are mega-cap.
How it’s calculated: Current market price x the total number of stocks.
Price-to-earnings (P/E) ratio
The price-to-earnings ratio compares the share price to its earnings per share (EPS). This is a metric used to determine the value of the company stock.
A high P/E ratio often means the company’s shares are overvalued or that investors expect increased growth. If the company has no earnings or is losing money, then the P/E ratio can be negative.
How it’s calculated: Current stock market price / Company’s EPS.
PEG ratio
PEG ratio — price/earnings-to-growth — is used to determine a company’s value by factoring in the earnings growth. This is supposed to provide more detailed information than simply using the P/E ratio.
Many investors use the PEG ratio to show the stock’s true value. The idea behind this is that investors are looking for companies with low PEG ratios, meaning the company is undervalued.
How it’s calculated: Price/EPS / EPS growth.
EBITDA
Earnings before interest, taxes, depreciation and amortization (EBITDA) is a measure of profitability. A negative EBITDA shows that a business has problems with profitability, while a positive EBITDA typically shows the company generates cash.
How it’s calculated: Net income + interest + taxes + depreciation + amortization.
Step 3: Learn the difference between a “good” stock and a “bad stock”
In addition to the most widely used valuation metrics, there are other factors you should consider when researching stocks like profitability, competitive moat and leadership.
Profitability
Cost of goods sold (COGS), also known as gross profit margin, is another metric that measures company profitability. This is the difference between revenue and the costs of production. Typically, the higher the number, the more profitable the company.
However, some sectors are affected by seasonality where the profitability number varies throughout the year. Note, startups and growth companies may not be profitable for months or years while they are reinvesting in growth or expanding their operations.
Competitive moat
Also known as an economic moat, a competitive moat is an advantage the company has over its competitors. This could be either access to cheaper raw materials, a patent or technology that no one else has.
Good companies typically have a stronger competitive moat, which makes them a good candidate to invest in. Bad companies often don’t have any advantage over their competitors, which makes the competition hard to beat.
Leadership
Having strong leadership with a proven track record is another indication of a good company. Some of the criteria you should look for are:
- How much of the leadership team has their net worth tied up in the company stock.
- Whether their vision is clearly communicated to their employees, customers and shareholders.
- Their success in attracting and retaining talent.
- Their track record. This is the most important.
Market trends
Keep an eye out for market trends when deciding on which company to invest in. Market trends change often based on macroeconomic and geopolitical events. For example, during the pandemic, companies that made vaccines did great.
With the rise in cryptocurrency prices in 2021, crypto mining that used computer hardware boomed. Combined with the work-from-home practice and the need for new computers and devices caused massive demand for computer hardware. This benefited chip companies like Nvidia and AMD.
Step 4: Find the data to research stocks
Now that you know how to analyze a stock with data, you need to know where to find data in the first place. Company financial reports are available on the SEDAR website (Canadian stocks) or Securities and Exchange Commission (SEC) website (US stocks). All you have to do is type the company name in the search tab, and go through its public filings.
Another alternative is to research stocks using your brokerage’s tools. Large brokerage companies like Interactive Brokers and Scotia iTRADE offers tons of useful information. It can be easier to find stock data this way than wading through a company’s securities filings.
Decide on your investment strategy
Once you’re done researching potential investment candidates, you must decide on your strategy. This includes factors such as how long you’re willing to wait for your investment to become profitable, your risk tolerance and when to cash out.
- Type of stocks. When you’re looking for long-term investments, value and growth stocks are typically the way to go. To ride out high-inflation periods or prolonged bear market, dividend stocks are often a good option. But if you’re not keen on choosing the stocks yourself, you can always invest in exchange-traded funds (ETFs), which are basically a basket of stocks in a particular sector, industry or theme.
- Risk tolerance. Those who are nearing retirement are often investing in low-risk companies. That’s because there’s not much time to correct a mistake if you’re wrong. Investors who have a long time to go to retirement can go for riskier investments in growth stocks.
- Minimum holding period. Similar to risk tolerance, this typically depends on how long you plan to hold onto your stock. Value stocks may need years to be profitable, while growth stocks and speculative stocks can become profitable in days or months. However, they can lose value quickly if something goes wrong either with the company or the broader economy.
- Amount willing to invest. This depends on your investment and diversification goals. General consensus among experts is that you should invest between 10% and 20% of your monthly income. Of course, this is flexible and mostly depends on your financial situation.
Dive deeper Value investing
Create your watchlist
Watchlists are useful if you have multiple companies on sight and are waiting for a good price to enter. Most watchlists, whether they be from your brokerage or dedicated apps and platforms, let you set alerts when specific criteria are met.
Most brokerage platforms let you create a watchlist of stocks, but if your brokerage doesn’t offer this feature, you can create a watchlist for free on platforms such as Yahoo Finance, MarketWatch, StockCharts.com and Finviz.
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Bottom line
- 3 types of analysis can help you find the right stock to invest in: Fundamental, technical and quantitative.
- Fundamental analysis is most common and uses company financial data that’s freely available online.
- If you need help with your stock research, use investing newsletters like Ticker Nerd that do the work for you.
Related Stock trading
Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades.
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