When investing in a stock, your goal should be to pay a price that's less than the value of the company's future profits.
Unfortunately, predicting any company's future profits and future growth with accuracy is easier said than done. After all, if we had a crystal ball to predict the future revenue and earnings of every publicly traded company, getting rich would be easy!
So, we use the next best thing when investing in the stock market: analyzing stocks.
Stock analysis helps investors find the best investment opportunities at a given time. By using analytical methods, we can attempt to find stocks trading for a discount to their intrinsic value, and therefore will be in a great position to capture market-beating returns in the future.
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Fundamental vs. technical analysis
When it comes to analyzing stocks, there are two basic ways you can go: fundamental analysis and technical analysis.
- Fundamental analysis is based on the assumption that stock prices don't necessarily reflect the true intrinsic value of the underlying business. Fundamental analysts use valuation metrics and other information about a company's business in order to determine whether a stock is attractively priced. Fundamental analysis is the best choice for investors looking for excellent long-term returns.
- 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, technical analysts believe you can predict its future price behavior. If you've ever seen someone trying to identify patterns in stock charts or discussing moving averages, for example, that's a form of technical analysis. Technical analysis is often used by short-term traders in search of quick profits, but is generally not well suited for long-term investors. Trading stocks based on technical analysis involves a great deal of risk.
One important distinction is that fundamental analysis is typically intended to find long-term investment opportunities, while technical analysis is often geared toward profiting from short-term price fluctuations.
We generally are advocates of fundamental analysis and believe that by focusing on great businesses trading at fair prices, it's entirely possible to beat the stock market over time. Technical analysis certainly has its place, but we strongly believe that fundamental analysis is the best way to find great long-term investment opportunities.
5 metrics to use in your stock analysis
With that in mind, let's take a look at five of the most important and easy-to-understand metrics you should have in your analytical toolkit:
- Price to earnings (P/E) ratio -- Publicly traded companies report their profits to shareholders as earnings per share, or EPS for short. If a company earned $10 million and has 10 million outstanding shares, its EPS would be $1.00 for that time period. The price-to-earnings ratio, or P/E ratio, is a company's current share price divided by its per-share earnings, typically on an annual basis. For example, if a stock trades for $30.00 and the company's earnings were $2.00 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 commonly used valuation metric in fundamental analysis, and is most useful when comparing companies in the same industry with similar growth prospects.
- Price-to-earnings growth (PEG) ratio -- This metric takes the P/E ratio a step further. Different companies grow at different rates, so it's important to take this into consideration. So, the PEG ratio takes a stock's P/E ratio and divides by the expected annualized earnings growth rate over the next few years. 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 here is that fast-growing companies can be "cheaper" than slower-growing companies, even if their P/E ratio makes them look more expensive.
- Price-to-book (P/B) ratio -- A company's book value is the sum of the value of its assets. Think of book value as the amount of money a company would theoretically have if it shut down its business and sold everything it owned – tangible property as well as things like patents, brand names, etc. The price-to-book, or P/B ratio, is a comparison of a company's stock price to its book value. Like the P/E ratio, this is most useful for comparing companies in the same industry that have similar growth characteristics and should be used in combination with other valuation metrics.
- Return on equity (ROE) -- One of the most commonly used profitability metrics, return on equity or ROE is calculated by dividing a company's net income by its shareholders equity (assets minus liabilities). In a nutshell, ROE tells us how efficiently a company is using its invested capital to earn a profit, and like most metrics, is useful for comparing companies in the same industry. In other words, you could consider a company with a 20% ROE to be more efficient at generating a profit than one with a 10% ROE.
- Debt to EBITDA -- A company's financial health should also be taken into consideration when analyzing its stock, and one good way to gauge financial health is by looking at the company's debts. There are several debt metrics you can use, and the debt-to-EBITDA ratio is a good one for beginners to learn. You can find a company's total debts on its balance sheet and its EBITDA (earnings before interest, taxes, depreciation, and amortization) on its income statement. There's no set rule in regards to how much debt is too much, but if a company's debt to EBITDA is significantly higher than its peers, it could be a sign of a higher-risk investment.
Looking beyond the numbers to analyze stocks
It's also important to understand that there's more to analyzing a stock than just looking at valuation metrics. After all, it's far more important to invest in a good business than a cheap stock. With that in mind, here are three other essential components to stock analysis that you shouldn't overlook:
- Durable competitive advantages -- As long-term investors, we want to know that a company will be able to sustain (and hopefully grow) its market share over time. So, it's important to try and 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. Just to name a few possibilities, a well-known brand name can give a company pricing power, patents can protect it from would-be competitors, or a large distribution network can give it a cost advantage over peers.
- Great management -- It's tough to overstate the importance of great management. It doesn't matter how good a company's product is or how much growth is taking place in an industry if the wrong people are making the key decisions. Ideally, the CEO and other main executives of a company will have successful and extensive industry experience and will have their interest aligned with shareholders through equity-based compensation and/or large positions in company stock.
- Industry trends -- Long-term investors should focus on industries that have favorable long-term growth prospects. For example, there's a clear trend toward online retail sales. Over the past decade or so, the percentage of retail sales that have taken place online have grown from less than 5% to more than 11% today. So, e-commerce is an example of an industry with a favorable growth trend. Cloud computing, payments technology, and healthcare are just a few other examples of industries that are likely to grow significantly in the years ahead. This can be helpful in determining which industries you should focus on (and avoid) in your analysis.
A basic example of stock analysis
Let's quickly look at a hypothetical scenario. We'll say that I want to add a home-improvement stock to my portfolio and that I'm trying to decide between Home Depot (NYSE: HD) and Lowe's (NYSE: LOW).
First, let's take a look at some numbers. Here's how these two companies stack up side by side in some of the metrics we've discussed:
Data sources: CNBC, Ycharts, Yahoo Finance. Figures as of Dec. 4, 2019.
Here's the key takeaway from these figures. Even though Home Depot appears cheaper on a P/E basis, when we incorporate earnings growth, Lowe's actually appears to be the better buy on a PEG basis. Lowe's does have a higher debt-to-EBITDA multiple, so this could indicate that Lowe's could be the riskier of the two.
I wouldn't say that either company has a major competitive advantage over the other. Home Depot arguably has the better brand name and distribution network, but not so much that it would sway my investment decision. I'm a fan of both management teams, and the home improvement industry is a business that will always be in demand.
If this sounds like I'm picking a few metrics to focus on and essentially giving my opinions on the company, you're right. And that's kind of the point. There's no perfect way to evaluate stocks, which is why different investors choose different stocks to invest in.
Solid analysis can help you make smart decisions
As I just mentioned (and it's worth reiterating), there's no one correct way to analyze stocks. The point of stock analysis is to find companies that you believe are good values and great long-term businesses to invest in. Not only does this help you find stocks that are likely to deliver strong returns over the long run but using analytical methods like those described here can help prevent you from making bad investments and losing money in the stock market.
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Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool recommends Home Depot and Lowe's and recommends the following options: long January 2021 $120 calls on Home Depot and short February 2020 $205 calls on Home Depot. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
