In Part 1 we covered the first part on how to select stocks to invest in if it is right for you. You can click here for more information and download the SMART Stock Checklist! With more than 45,000 stocks listed in stock exchanges in the world and approximately 8,800 in the U.S., it can be hard to choose the right one! There are two main ways to analyze a stock: fundamental analysis and technical analysis. In this article we talk about fundamental analysis.
Fundamental analysis is one of the most common ways experts analyze a stock. This involves measuring the value of the company through its financial data, the state of the economy, its competitors and company management. The goal is to compare the intrinsic value of the company to its current stock price on the market. If it is trading lower, then it may be underpriced and it would be a good time to buy. If it is trading higher, than it may be over-priced and a good time to sell or short (betting that the stock will go down).
- Financial Statements. You will want to see the company’s balance sheet, income statement and profit and loss statement to forecast the company’s future. The focus is always on earnings, sales, growth and value in the market. Is the company making money? How much profit is it making? How much is it growing by? What are the assets, debts and liabilities?
- Key Ratios. The easiest way to determine the financial health of a company is to use key ratios such as earnings per share (EPS), Price to Earnings (P/E) and Price/Earnings to Growth (PEG). There are other ratios to choose from, but we will just focus on three of the most common. Visit artofthinkingsmart.com/go/glossary for more information.
- P/E Ratio. This is calculated by dividing the price of the stock by the earnings per share (net profit per outstanding share in the stock). A P/E ratio essentially tells you how much investors are willing to pay for the company’s earnings. A company that has a higher P/E ratio compared to its industry or its competitors could mean that you are paying more for every dollar of earnings. This could mean that the stock is expensive and overvalued. A lower P/E might mean that the stock is undervalued. Having a P/E less than 15 is a good rule of thumb for choosing a stock. It is important to note that each industry and company is different, so you will want to delve deeper into the data.
- PEG Ratio. This is a modified version of the P/E Ratio that takes into account the expected growth of its earnings. You divide the P/E Ratio by the annual EPS growth. A PEG Ratio of 1.0 or less is interpreted to mean that a company is undervalued relative to its future earnings, which are expected to be significantly higher than in the past.
- Free Cash Flow (FCF). Because of the unique accounting methods (GAAP) used in the U.S., even if a company reports huge profits its bank account could be empty! The FCF helps solve that problem by showing you how much cash a company actually has. Generally, you want to look for a company with a FCF yield of at 8 percent. This means a company can pursue other opportunities to grow and has the cash on hand to pay for any unexpected expenses.
It is important to note that each company and industry is different, and these tips are the starting point in selecting good stocks. In Part 3 we will talk about the technical analysis and how you can use it to choose stocks.