Learn how to do anything: How to Research a Stock

Researching a stock is an essential step before making an investment. If your investments are not informed by a solid research process, you could subject yourself to risks that would have otherwise been avoidable. A solid research process involves first learning the basics of the business, including what it does and how it makes money, as well as the economic environment it operates in. Then, it is a matter of delving into the finances of the business to determine its profitability, safety, and how it compare to its peers.

EditSteps

EditResearching the Industry

Look for basic industry information. Start by figuring out specifically what industry your chosen company is in. Industries are split up into categories by the North American Industry Classification System (NAICS). These are numbered categories and refer to a broad industry within the North American economy. NAIC's numbers can be found easily online.^[1] Then, do research to assess the size of the industry. Look for annual industry revenues and the number of companies in the industry. In addition, find figures on industry growth, including annual percentage growth and growth in the number of companies.
Find out which companies hold the largest market shares. In order to assess the company, you will need some basic information on its competitors. Start by obtaining a Standard & Poor's Industry Survey for the company's industry. This report contains financial information for the largest companies in the industry and ranks them by size. You can also get historical industry surveys going back to 1971. This information can be obtained on the S&P Global Market Intelligence website.
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Research regulatory issues. Look for any barriers, trade agreements, regulatory rulings, or other government decisions that might be affecting the industry either now or down the road. These regulatory rulings can be either positive or negative in their effects on an industry or specific companies. Look for regulatory news on market websites like the Wall Street Journal and Bloomberg.
Assess future trends in the industry. Look into industry growth, trends, and expectations for the future. For example, consider any new products or types of products that might transform the industry in the coming years. Or, perhaps the industry is shrinking as another slowly replaces it. Look for consolidation or expansion in the number of companies in the industry. How these factors affect your chosen company can vary dramatically, but it is important to understand what's going on in the industry.

EditUnderstanding the Company

Learn what the company does. The first step to researching any company is to find out precisely what the business produces, and how it makes money. For example, assume you have heard good things about a particular fertilizer, and you are interested in investing in the company that makes it. You would want to familiarize yourself with the types of fertilizer it produces, who the typical customers are, and if there are other other products or services the business provides.
- The best way to begin this process is by visiting the "Investor Relations" section of the business's website. Once there, most businesses have a "Corporate Profile" or "Company Snapshot" document that provides a general overview of the business.
- After you have read that, look for the "Investor Presentations" section on the Investor Relations page. Every quarter, as well as annually, many publicly-traded companies create a Powerpoint slideshow for investors. These slides not only provide an overview of the business, but also describe new developments, challenges, and results.
- These documents should give you a solid overview of the business. Expect that there will be parts of the documents you do not understand. When you encounter terms or concepts you don't understand, do a Google search to better familiarize yourself.
- Documents prepared by the company reflect facts and interpretations by management and are skewed to be positive. It is best to have a healthy skepticism of the information presented in these documents.
Read expert commentary on the business. There is never any shortage of expert commentary on businesses, and reading what analysts and other experts have to say can help you to understand some of the major risks and rewards of buying a particular business. Look for consensus among analysts: is there a general belief that the stock has a positive outlook?
- Stockchase.com is a useful resource, which lists a variety of analysts' opinion on a stock, along with their recommendation whether to buy, sell, or hold.
- However, you should also seek to understand the reasons behind the recommendations. Analysts often have an ulterior motive for their recommendations; few ever give a sell recommendation.
- Your online broker typically has a research section as well, which will provide you access to free analyst reports on the stock you are interested in.
- Yahoo Finance and Google Finance also offer plenty of articles highlighting recent news on stocks, as well as insights by analysts. You can search your particular stock of interest.
- Doing a Google search of the company can also yield plenty of articles and opinions.
Inform yourself on the macroeconomic outlook for the business. While "macroeconomic outlook" may sound complicated, it simply refers to the fact that the business you are interested in does not exist in a vacuum, and bigger economic forces could affect its performance.
- For example, you may be interested in buying a coal stock. However, coal prices have recently fallen dramatically due to the fact that the world's largest buyer of coal, China, is seeing a permanent decline in its economic growth.
- Being aware of the grim outlook for coal prices before you buy the stock is critical, since the business's profits are determined largely by how expensive coal prices are.
- Reading company reports, as well as news and analysis on the business, should let you know if there any major economic factors that are affecting and will continue to affect the company's performance.
- If you are investing in a commodity-based stock (a stock that sells things like oil, coal, copper, gold, zinc, natural gas, etc.), it is very important to look at what the price outlook for these products are.
Assess the company's competitive advantage. Competitive advantage refers to a quality of a company or its products that allows it to earn money more easily than its competitors. For example, if a company is able to produce a similar-quality product to its competitors' products at half the price, its low price is a competitive advantage. Competitive advantages can include many other attributes as well, such as good customer service, a patent, a unique product, or a better distribution network. Companies with sustainable competitive advantages are likely to continue to experience growth in their share price.^[3]
Judge the company's management. A company's management has a critical impact on stock price performance. Assess the current management of the company for experience in the industry and past successes. In addition, look at dividend policies. A company that pays dividends should do so regularly and at regular (or increasing) amounts. Finally, look for positive employee relations. A company that cannot retain employees likely has other internal management issues.
Decide whether the business is a potential investment. By reading company reports, analyst opinions, news articles, and learning any economic risks, you can likely come to a conclusion about whether it is worth moving on to the next stage of research.
- If the business is facing many challenges, there are major economic pressures, and analysts seem to agree the outlook is poor, it may be worth it to consider moving on to a new investment option.
- While it is often true that distressed companies or companies with a large amount of negative opinion from analysts can turn out to be great investments, these are often much higher risk options and are not suitable for new investors.
- If the company is in a stable industry, has been performing well, and does not have any major economic or operating risks, continuing to consider the company is a wise choice.

EditPerforming Fundamental Analysis on the Business

Understand fundamental analysis. Fundamental analysis refers to analyzing the financial information of a business to gain insight on what its future performance might be. Technical analysis, on the other hand, is stock price centered and uses past price movement data to predict future price movements. Technical analysis is used for short-term trading, while fundamental analysis is used when someone intends to become a long-term owner of the company. The ability to perform fundamental analysis is an essential skill to determine the merits of a particular investment.^[4]
- Understanding fundamental analysis means understanding what it is not. Fundamental analysis is not concerned with the company's stock chart, recent movements in price, or how the stock price has performed over a particular time period.
- Fundamental analysis is concerned with the business itself. That is to say, if revenue is growing, how profitable the company is, how much debt it has, and how able it is to compete with its peers.
- The analysis concerns the three past and present financial documents: income statement, balance statement, and cash flow statement.
Look at the company's revenues. A company's revenues are simply the total amount of money the company brings in before subtracting the company's expenses. Looking at revenues over several years can give you an idea if the business is growing, shrinking, or has remained stagnant.
- To locate a company's revenues, consider using morningstar.com. Simply visit the website, type in the stock you are interested in, navigate to "Financials," and then click "Income Statement." At the top, you will see the company's revenues going back 10 years.
- Ideally, you are looking for revenues that are stable and rising. Wild swings up and down year-to-year can indicate the business is in a very competitive industry.
Examine the company's gross profit margin. Gross profit is calculated by taking the company's revenues and subtracting the raw costs and labor used to make the goods that were sold. When you take this number and divide it by total revenues, you get the gross profit margin.^[5]
- For example, if revenue is $1 million, and gross profits are $500,000, $500,000 divided by $1 million is 50%. The gross profit margin would be 50%.
- You can examine gross profit margin on morningstar.com
- You should look for both high gross profit margins and stable gross profit margins. A good rule of thumb is that a consistent gross profit margin over 40% is considered very strong, whereas margins under 10% indicate the business may be in a highly competitive industry and lack the ability to set high prices, or has very high costs. Note that margins vary by industry, so you should always compare margins to competitor companies.
Look at the company's debt. High levels of debt is a bad sign. It means the company has high interest expenses, and that the company is unable or unwilling to fund its growth with its own money. However, some companies may obtain high amounts of growth by using a large amount of debt to finance their operations, rather than relying on investors. This is called using leverage and increases both potential profits and risk. ^[6]
- The debt-to-equity ratio is one way to determine how much debt a company has. This measure simply divides debt by the company's shareholder equity. This helps compare how of the business is owned by debt compared to by shareholders. The lower the number the better.
- A debt-to-equity ratio of two means that the the business has two times the amount of shareholder equity in debt.
- Leverage can be good or bad, but high leverage must be sustained by stable earnings. Utilities and insurance companies for example are usually highly leveraged.
Analyze return on equity (ROE). Return on equity simply determines what kind of profits a company is generating with its shareholders' money. It is calculated by dividing a company's profit by the company's shareholder equity (or how much of the overall business shareholders own as opposed to creditors). You can use morningstar.com to see return on equity.^[7].
- Equity is found on the Balance Sheet.
- Returns on equity above 10% are generally considered strong, but it is important to compare your company's return on equity with its peers. For example, if you are considering purchasing McDonald's shares you may find its ROE is 10%. Comparing that to Wendy's ROE of 5%, McDonald's has a relatively high ROE.
Examine the company's earnings growth. In investing, high levels of earnings growth means high levels of share price growth. It is for this reason that looking at past and future growth is important. Note that earnings are synonymous with profits.^[8]
- You can see past earnings growth over time on morningstar.com by looking at "Net Income," or "Earnings Per Share." Net income is the company's profit, and earnings per share is simply the net income per share. Check to see if earnings grow steadily over time, or if they are declining. Stable, growing earnings are ideal.
- Many analysts compare EBITA rather than net income since the latter can be affected by external factors and management's decisions. It is also important to be consistent when looking at past earnings of the same company or comparing earnings of divergent companies.
- Future growth is always an estimate, but you can find these estimates using Yahoo Finance. Is a company's future growth higher than its competitors? If so, it may be a good buy, especially if all the other areas check out.
Determine the company's price-to-earnings ratio (P/E ratio). The P/E ratio is a way to value a company. That is to say, it helps you determine how much you are paying for a dollar of the company's profits by dividing the share price by the earnings per share. If you are paying much more for a dollar of the company's profits than you are for a dollar of its competitors' profits, the stock is seen as being "expensive."
- For example, assume the company's share price is $100 per share, and its earnings are $5 per share. The P/E ratio would be 20. In other words, you are paying $20 for $1 of the company's profits.
- If all the company's peers have a P/E of 10, your company is considered expensive.
- Generally, you want to buy stocks with lower P/E ratios. This means you are getting a good deal for the stock, and may mean the stock is worth much more.
Compare a company with its peers. Once you have analyzed the stock fully and determined its P/E ratio, it is time to compare the company to its peers. Generally speaking, you are looking for companies that outperform their peers on the factors mentioned above, while having a lower P/E ratio.
- For example, assume company X has gross profits of 40%, a return on equity of 12%, and steady earnings growth for the past 10 years, while having a P/E of 15. If company Y has gross profits of 40%, a return on equity of 8%, volatile earnings, and a P/E of 16, you would want to buy company X. This is because you are getting a better business for a lower price with company X.
- You can locate a list of a company's competitors on morningstar.com or by doing a Google search.