How to Research Stocks

Key Points

• Fundamental analysis identifies solid long-term investments trading for less than their true value.
• Key financial metrics, like P/E, PEG, and debt-to-EBITDA ratios, can help guide your investment choices.
• Considering competitive advantages and industry trends is crucial beyond just using numbers.

Analyzing stocks helps investors find the best investment opportunities. By using analytical methods when researching stocks, you can find stocks trading for a discount to their true value and be in a great position to capture future market-beating returns.

Understanding the two types of stock analysis

When it comes to analyzing stocks, there are two basic ways you can go: fundamental analysis and technical analysis.

1. Fundamental analysis

Fundamental analysis is based on the assumption that a stock price doesn’t necessarily reflect the true value of the underlying business in all cases. This is the central tool value investors use to find the best investment opportunities.

Fundamental analysts use valuation metrics and other information to determine whether a stock is attractively priced. This type of analysis is designed for investors looking for excellent long-term returns.

2. Technical analysis

Technical analysis generally assumes that a stock’s price reflects all available information and that prices generally move according to trends. In other words, by analyzing a stock’s price history, you may be able to predict its future behavior. If you’ve ever seen someone trying to identify patterns in stock charts or discussing moving averages, that’s a form of technical analysis.

One important distinction is that fundamental analysis is intended to find long-term investment opportunities. Technical analysis typically focuses on short-term price fluctuations.

The Motley Fool generally advocates fundamental analysis to seek the best long-term investment opportunities, not the best trades. Fundamental analysts believe investors can beat the market over time by focusing on great businesses trading at fair prices.

Learn some important investing metrics

With that in mind, let’s take a look at four of the most important and easily understood metrics every investor should have in their analytical toolkit to understand a company’s financial statements:

Price-to-earnings (P/E) ratio

Companies report their profits to shareholders as earnings per share (EPS). The price-to-earnings ratio, or P/E ratio, is a company’s share price divided by its annual per-share earnings.

For example, if a stock trades for $30 and the company’s earnings were $2 per share over the past year, we’d say it traded for a P/E ratio of 15, or “15 times earnings.” This is the most common valuation metric in fundamental analysis and is most useful for comparing companies in the same industry with similar growth prospects.

Price/earnings-to-growth (PEG) ratio

Different companies grow at different rates. The PEG ratio divides a stock’s P/E ratio by the expected annualized earnings growth rate over the next few years to level the playing field. For example, a stock with a P/E ratio of 20 and 10% expected earnings growth over the next five years would have a PEG ratio of 2. The idea is that a fast-growing company can be “cheaper” than a slower-growing one.

Price-to-book (P/B) ratio

A company’s book value is the net value of all of its assets. Think of book value as the amount of money a company would theoretically have if it shut down its business, sold everything it owned, and paid its debts. The price-to-book (P/B) ratio is a comparison of a company’s stock price and its book value.

Debt-to-EBITDA ratio

As with your personal finances, a good way to gauge financial health is to look at a company’s debt. The debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio is a good one for beginners to learn. You can find a company’s total debts on its balance sheet and its EBITDA on its income statement. A high debt-to-EBITDA ratio could be a sign of a higher-risk investment.

Look beyond the numbers to analyze stocks

This is perhaps the most important step in the analytical process. While everyone loves a good bargain, there’s more to stock research and analysis than just looking at valuation metrics.

With that in mind, here are three other essential components of stock analysis that you should watch:

Durable competitive advantages

As long-term investors, we want to know that a company will be able to sustain (and hopefully increase) its market share over time. So, it’s important to try to identify a durable competitive advantage — also known as an economic moat — in the company’s business model when analyzing potential stocks. This can come in several forms, including:

• A great brand name
• Intellectual property, such as patents
• Cost advantages
• Distribution advantages

Great management

A business is only as strong as the executives calling the shots. Ideally, a company’s CEO and other main executives will have successful and extensive industry experience and financial interests that align with shareholder interests. High insider ownership and a large proportion of stock-based incentive compensation are two things to consider.

Industry trends

Investors should focus on industries with favorable long-term growth prospects. Cloud computing, payments technology, e-commerce, and healthcare are examples of industries that are likely to grow significantly in the years ahead.

Solid analysis can help you make smart decisions

There’s no one correct way to analyze stocks. The goal of stock analysis is to find companies you believe are good values and great long-term businesses. Not only does this help you find stocks likely to deliver strong returns, but using analytical methods like those described here can also help prevent you from making bad investments and losing money.