This is one of the most fundamental questions any novice investor will have. The basic idea of equities investing is to be able to identify which stocks are presently undervalued, purchase those equities, and have those equities appreciate in price. Hopefully, this blog will give you some ideas on what to look for. The purpose of this post is to help with the fundamental analysis of equities, that is, analyzing the financial condition and value of a share of stock. While it is also helpful to have at least a cursory knowledge of technical analysis as well, it is not as important to have such an understanding when performing long-term investing.
1) What is the purpose of the investment? Are you building your portfolio or diversifying? If you're building your portfolio, you need to pick equities in a wide range of industries to mitigate risk. If you're diversifying, pick an industry, or industries, which you do not currently own.
2) Stock screens are the easiest way to weed through data, do yourself a favor and learn to use one.
3) Analyze a company's price to cash-flow (most important), price-to-sales (less important), and price to earnings ratios. When you buy a stock, you are buying a stock based on the expected future earnings of that equity. Not all earnings are created equal. Ideally, you want companies that have lower price to cash-flow ratios. The cash flow statement is almost impossible to pad, and this ratio will tell you exactly how much cash the company is generating from it's primary business activity. If you're a true beginner, I recommend "Financial Statements for Dummies" to learn more about how to read financial statements.
4) Does the company pay a dividend? The higher the dividend yield, the better the indication the stock is undervalued. Given a constant dividend, a higher price results in a lower yield, and vice versa. However, be advised that not all dividends are sustainable. Analyze the company's financials and dividend history in order to gain a better sense of whether or not the company will maintain or grow the dividend. Quarterly conference calls are a good place to get this kind of information.
5) Look at multi-year earnings growth. This is a fairly common metric that can be found on most websites. Look at the earnings growth of at least 5-10 companies within the industry that the company in question operates. What kind of price to sales multiple are companies with similar earnings growth generating? As another form of analysis, use a stock screen to sort for 100 stocks with price to sales multiples near that of the organization under analysis. Setup the screen so that it returns those companies, their multi-year earnings growth rates, and their price to sales ratios. Then, take an average price to sales multiple for those stocks. IF the company in question has a lower multiple than the average, the price of the stock is undervalued.
The above-mentioned steps are all criteria to value a stock. Here are some things to look at to try to put the rest of the picture together:
6) Read the annual reports, and listen to at least the most recent conference call. This will give you a lot of insight into where the business has been, and where management thinks it is going.
7) Formulate an opinion of the business. I remember the first time I walked into an Apple store. I was absolutely amazed. Try to get a feel for the product the company sells, and whether or not the business plan makes sense to you.
8) Read all the latest news articles, and continue to read the news as it comes available.
In conclusion, if after you have performed a fundamental analysis of the company using some or all of the metrics above, as well as performed a "smell test" of the business the organization operates in and everything checks out, odds are it is a good investment. Investing in undervalued equities that have a good "story" behind them are as close to a sure thing as you will most likely get. However, identifying those stocks is the trick. Good luck in your analysis, and happy investing!
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