How to research stocks

Analysing 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.

1. Understand the two main types of stock analysis

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

Fundamental analysis

This analysis is based on the assumption that a stock price doesn't necessarily reflect the intrinsic value of the underlying business. 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. Fundamental analysis is designed for investors looking for excellent long-term returns.

Technical analysis

Technical analysis assumes that a stock's price reflects all available information and that prices generally move according to trends. In other words, by analysing a stock's price history, you may be able to predict its future behaviour. 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 Australia generally advocates fundamental analysis to seek the best long-term investment opportunities and not the best trades. By focusing on great businesses trading at fair prices, fundamental analysts believe investors can beat the market over time.

2. 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, or EPS for short. 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 useful for comparing companies in the same industry with similar growth prospects.
• Price-to-earnings-growth (PEG) ratio: Different companies grow at different rates. The PEG ratio takes a stock's P/E ratio and divides it by the expected annualised 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. This can be a great metric to use in cases where a stock's P/E ratio seems excessively high.
• 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 and sold everything it owned. The price-to-book, or P/B, ratio is a comparison of a company's stock price and its book value. This is best used in conjunction with other metrics to compare businesses in the same industry.
• Debt-to-EBITDA ratio: One good way to gauge financial health is by looking at a company's debt. There are several debt metrics, but 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 you'll find its EBITDA (earnings before interest, taxes, depreciation, and amortisation) on its income statement. Then, turn the two numbers into a ratio. A high debt-to-EBITDA ratio could be a sign of a higher-risk investment, especially during recessions and other tough times.

3. Look beyond the numbers to analyse 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.

As the legendary investor Warren Buffett once said:

It is far more important to invest in a good business than a cheap stock.

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 analysing potential stocks. This can come in several forms. For example, a trusted brand name can give a company pricing power. Patents can protect it from competitors. A large distribution network can give it a higher net margin than competitors.
• 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 key decisions. Ideally, the CEO and other main executives of a company 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 that have favourable long-term growth prospects. For example, over the past decade or so, the percentage of retail sales that take place online has grown from less than 6% to almost 15% today, according to data from the US Census Bureau. In the Australian retail market, the online share is 14.9% and is expected to increase by an average of 8.1% to 20.3% by 2027.¹ So e-commerce is an example of an industry with a favourable growth trend. Cloud computing, payments technology, and healthcare are among other industries that are likely to grow significantly in the years ahead.

A basic example of stock analysis

Let's 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 the larger, well-established Company A and its smaller rival, Company B.

First, I'd take a look at some numbers. Here's how these two companies stack up in terms of some of the metrics we've discussed:

Here's the key takeaway from these figures. Company A appears to be the cheaper buy on just a P/E basis. However, Company B has a higher projected growth rate, so its PEG ratio shows it might actually be the "cheaper" stock. On the other hand, Company B has a higher debt-to-EBITDA multiple, so this could indicate it isn't quite as financially strong.

I wouldn't say that either company has a major competitive advantage over the other. Company A has a better brand name and distribution network. However, its advantages aren't so significant that they would sway my investment decision, especially when Company B looks more attractive when considering its expected growth. I'm a fan of both management teams, and the home improvement industry is one that should always be busy. Plus, both are relatively recession-resistant businesses.

If you think I'm picking a few metrics to focus on and basing my opinions on them, you're right. And that's the point: There's no one perfect way to research stocks, which is why different investors choose different stocks.

Solid analysis can help you make smart decisions

There's no one correct way to analyse stocks. The goal of stock analysis is to find companies that 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 help prevent you from making bad investments and losing money.