Researching a stock is a lot like shopping for a car. You can base a decision solely on technical specs, but it’s also important to consider how the ride feels on the road, the manufacturer’s reputation and whether the color of the interior will camouflage dog hair.
Investors have a name for that type of stock research: fundamental analysis.
What that means: Looking at a range of factors — such as the company’s financials, leadership team and competition — to evaluate a stock and decide whether it deserves a parking spot in your portfolio.
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Stock research: 4 key steps to evaluate any stock
One note before we dive in: Stocks are considered long-term investments because they carry quite a bit of risk; you need time to weather any ups and downs and benefit from long-term gains. That means investing in stocks is best for money you won't need in at least the next five years. (Elsewhere we outline better options for short-term savings.)
1. Gather your stock research materials
Start by reviewing the company's financials. This is called quantitative research, and it begins with pulling together a few documents that companies are required to file with the U.S. Securities and Exchange Commission:
Form 10-K: An annual report that includes key financial statements that have been independently audited. Here you can review a company’s balance sheet, its sources of income and how it handles its cash, and its revenues and expenses.
Form 10-Q: A quarterly update on operations and financial results.
Short on time? You’ll find highlights from the above filings and important financial ratios on your brokerage firm’s website or on major financial news websites. (If you don't have a brokerage account, here's how to open one.) This information will help you compare a company’s performance against other candidates for your investment dollars.
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2. Narrow your focus
These financial reports contain a ton of numbers and it's easy to get bogged down. Zero in on the following line items to become familiar with the measurable inner workings of a company:
Revenue: This is the amount of money a company brought in during the specified period. It’s the first thing you’ll see on the income statement, which is why it’s often referred to as the “top line.” Sometimes revenue is broken down into “operating revenue” and “nonoperating revenue.” Operating revenue is most telling because it’s generated from the company’s core business. Nonoperating revenue often comes from one-time business activities, such as selling an asset.
Net income: This “bottom line” figure — so called because it’s listed at the end of the income statement — is the total amount of money a company has made after operating expenses, taxes and depreciation are subtracted from revenue. Revenue is the equivalent of your gross salary, and net income is comparable to what’s left over after you’ve paid taxes and living expenses.
Earnings and earnings per share (EPS). When you divide earnings by the number of shares available to trade, you get earnings per share. This number shows a company’s profitability on a per-share basis, which makes it easier to compare with other companies. When you see earnings per share followed by “(ttm)” that refers to the “trailing twelve months.”
Earnings is far from a perfect financial measurement because it doesn’t tell you how — or how efficiently — the company uses its capital. Some companies take those earnings and reinvest them in the business. Others pay them out to shareholders in the form of dividends.
Price-earnings ratio (P/E): Dividing a company’s current stock price by its earnings per share — usually over the last 12 months — gives you a company’s trailing P/E ratio. Dividing the stock price by forecasted earnings from Wall Street analysts gives you the forward P/E. This measure of a stock’s value tells you how much investors are willing to pay to receive $1 of the company’s current earnings.
Keep in mind that the P/E ratio is derived from the potentially flawed earnings per share calculation, and analyst estimates are notoriously focused on the short term. Therefore it’s not a reliable stand-alone metric.
Return on equity (ROE) and return on assets (ROA): Return on equity reveals, in percentage terms, how much profit a company generates with each dollar shareholders have invested. The equity is shareholder equity. Return on assets shows what percentage of its profits the company generates with each dollar of its assets. Each is derived from dividing a company’s annual net income by one of those measures. These percentages also tell you something about how efficient the company is at generating profits.
Here again, beware of the gotchas. A company can artificially boost return on equity by buying back shares to reduce the shareholder equity denominator. Similarly, taking on more debt — say, loans to increase inventory or finance property — increases the amount in assets used to calculate return on assets.
» Want to make sense of stock charts? Learn how to read stock charts and interpret data
3. Turn to qualitative research
If quantitative research reveals the black-and-white financials of a company’s story, qualitative research provides the technicolor details that give you a truer picture of its operations and prospects.
Warren Buffett famously said: “Buy into a company because you want to own it, not because you want the stock to go up.” That’s because when you buy stocks, you purchase a personal stake in a business.
“If quantitative research reveals the black-and-white financials of a company’s story, qualitative research provides the technicolor details.”
Here are some questions to help you screen your potential business partners:
How does the company make money? Sometimes it’s obvious, such as a clothing retailer whose main business is selling clothes. Sometimes it’s not, such as a fast-food company that derives most of its revenue from selling franchises or an electronics firm that relies on providing consumer financing for growth. A good rule of thumb that’s served Buffett well: Invest in common-sense companies that you truly understand.
Does this company have a competitive advantage? Look for something about the business that makes it difficult to imitate, equal or eclipse. This could be its brand, business model, ability to innovate, research capabilities, patent ownership, operational excellence or superior distribution capabilities, to name a few. The harder it is for competitors to breach the company’s moat, the stronger the competitive advantage.
How good is the management team? A company is only as good as its leaders’ ability to plot a course and steer the enterprise. You can find out a lot about management by reading their words in the transcripts of company conference calls and annual reports. Also research the company’s board of directors, the people representing shareholders in the boardroom. Be wary of boards comprised mainly of company insiders. You want to see a healthy number of independent thinkers who can objectively assess management’s actions.
What could go wrong? We’re not talking about developments that might affect the company’s stock price in the short-term, but fundamental changes that affect a business’s ability to grow over many years. Identify potential red flags using “what if” scenarios: An important patent expires; the CEO’s successor starts taking the business in a different direction; a viable competitor emerges; new technology usurps the company’s product or service.
4. Put your research into context
As you can see, there are endless metrics and ratios investors can use to assess a company’s general financial health and calculate the intrinsic value of its stock. But looking solely at a company's revenue or income from a single year or the management team's most recent decisions paints an incomplete picture.
Before you buy any stock, you want to build a well-informed narrative about the company and what factors make it worthy of a long-term partnership. And to do that, context is key.
For long-term context, pull back the lens of your research to look at historical data. This will give you insight into the company's resilience during tough times, reactions to challenges, and ability to improve its performance and deliver shareholder value over time.
Then look at how the company fits into the big picture by comparing the numbers and key ratios above to industry averages and other companies in the same or similar business. The easiest way to make these comparisons is by using the research tools provided on your broker's website, such as a stock screener. (Learn how to use a stock screener.)
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