How to research stocks: 7 Steps to follow
Stock research can appear intimidating with complex charts and a hefty annual report for each company. There's more than one way to determine a stock's value and establish an outlook for the future of a company's performance. The process can help make your own investment strategy and personal finance goals clear.
- Research is key to better trading judgements.
- Know your own investment goals.
- Fundamental and technical analysis are the most common forms of research.
Researching stocks means making more informed and better decisions. It can aid your search for growth stocks suited to a specific risk tolerance and investment timeframe.
How to research stocks in 7 steps
- Understand your risk tolerance and the amount you're willing to invest
- Gather stock research reports and earnings statements
- Focus on important investing metrics
- Conduct qualitative stock research
- Analyse the research holistically and look at historical data
- Conduct technical analysis on the stock
- Assess the research and whether the stock fits in your investing goals
Continue reading to get a thorough breakdown of these steps on how to research stocks.
Why should you learn how to research stocks?
Knowing how to research stocks is an important step to assess whether a trade fits within your portfolio. It's something to think about to keep your investments aligned with longer-term personal finance goals. This additional knowledge about a share could be a competitive advantage, and a useful tool to test a company's financials against its potential returns.
Researching stocks: Follow these steps to evaluate any stock
1. Understand your risk tolerance and the amount you're willing to invest
There are many reasons to invest, but there are no guaranteed returns. Establishing a specific goal for an investment matters, it can shape the time period and the amount you want to invest. These are major factors in how much risk is suitable.
Generally, shorter stretches mean lower volatility is best. With stock prices constantly changing, you should be able to wait for higher returns before needing the funds. One particular stock won't necessarily be best for investing some spare cash to grow wealth, hoping to boost a future house deposit and saving for retirement.
Some types of investments and sectors are known for greater volatility, such as earlier-stage businesses and energy shares. Although it's not easy for everyone starting out, constructing a diversified investment portfolio with multiple stocks can lead to more stable growth. Only choosing a single company to invest in leaves you highly exposed to their financial health.
Growth investing is about improving life, not adding stress. How much risk you personally feel comfortable with is different for everyone and will also impact your actions.
2. Gather stock research reports and earnings statements
Finding the intrinsic value of a stock involves analysing information related to the company's economic and financial situation. This process aims to figure out whether the stock price is over or undervalued by other investors (value investing is a great strategy to become acquainted with).
As publicly traded companies are required to regularly publish reports, most of this data is readily available online. Individual companies usually have an investor section on their website and exchanges such as the ASX also have all the relevant announcements.
The quarterly reports describe recent business activities and figures. The annual reports tend to have more extensive information about all aspects of the company and future growth strategies. The balance sheet and income statement should provide financial details such as cash flow and debts.
Sometimes research reports and shorter articles on stocks from others might be accessible. They can provide an idea of the outcomes of an analysis and be useful for comparison.
These documents should contain the numerical information used in quantitative research and together with online sources provide enough for qualitative analysis. Check out Woolworths’ latest annual report as an example.
3. Focus on important investing metrics
Analysing financial ratios can help determine the financial health of a business. To get a more complete picture of the company's story it’s best to consider several valuation metrics together, rather than focusing on a specific metric. Conducting fundamental analysis should demonstrate whether the stock is trading above or below its fair value and can be compared to those of the company's competitors. They can be forward-looking or historical. The averages for metrics also vary across industries and should not be used in isolation. Let's look at some of the most important metrics to analyse.
Earnings per share (EPS) expresses the amount of net profit for each share that's issued by the firm. A higher EPS means greater profitability and income to support future growth. It's important to consider how the firm earns money and its strategy outlook, as the EPS can also be negative for periods when losing money. This metric is published in many reports and used in other measures.
Price-Earnings-Ratio (P/E ratio) gives a view of the market value of a stock compared to the business' earnings. A high P/E ratio usually means that a share is expensive in relation to its earnings and the lower ratios could indicate the current stock price is cheap. It's calculated by dividing the share price by earnings per share, although also often already available online.
Price-to-Book Ratio (P/B ratio) compares the company's share price to its book value. This is how much it’s worth according to its financial statements, taking away liabilities from assets. The share price is divided by the book value per share. Lower P/B ratios tend to indicate undervalued opportunities.
Quick Ratio reveals how easily a business could cover its short-term debts with existing liquid assets or cash on its balance sheet. Also known as the acid test, it subtracts current inventory from current assets and divides this number by liabilities. Outcomes of below one signal that companies could not cover current liabilities with liquid assets, but very high ratios might indicate unproductive idle cash. Keep in mind that some business models naturally have higher levels of inventory.
Return on Equity (ROE) measures profitability by taking net income divided by shareholder equity. It's considered to give the return on net assets as the equity equals assets minus debts. A higher ROE shows the management team is more efficient at generating income and growth from equity financing.
Debt-to-Equity Ratio (D/E ratio) explains the extent to which the company is funding its operations using borrowed funds. By dividing total liabilities by shareholder equity the lower result generally indicates a less risky investment. High loans often mean increased fixed charges and reduced free cash flow available for dividends for a particular stock.
4. Conduct qualitative stock research
A qualitative analysis examines the 'soft metrics' of a business, which are intangible and not easily measured by exact numbers. Companies are ultimately run by people, who shape the present and future of their operations. Everyone dealing with a company is impacted by factors such as its management quality, stakeholder satisfaction, ethics and brand value.
The simplest way to start is to consider the business model and if its source or multiple channels of income represent a solid foundation. This helps place the company's product or services in the industry landscape, suggesting whether it has or could create a competitive advantage. Exploring the wider industry also points out which trends they need to consider. For example, many industries are currently prioritising ESG initiatives and those ignoring movement could be left behind.
The company's annual report should provide details about areas such as the management team, and employee and customer satisfaction surveys. Quarterly reports and announcements have more regular updates about business activities, dividends, relationships with suppliers and the involvement of institutional investors. When hunting for undervalued share prices, positive qualitative factors could indicate growth stocks.
5. Analyse the research holistically and look at historical data
Whilst we know that past performance is famously no guarantee of future results, it shouldn't be ignored. Historical data can be another useful tool for value investors. It shows which companies have been able to remain competitive and respond to industry trends over the years. One reason recently listed companies tend to be associated with more risk is due to this lack of information.
Various figures and company strategies should be available in their annual reports or online. Going over periods of hard times can provide insights into the levels of resilience and the potential for outperformance in good times for a business. Just knowing these methods could also give rise to an opinion about future returns when researching other stocks.
6. Conduct technical analysis on the stock
Technical analysis aims to predict equity prices by examining historical trends, mostly price and volume data. It involves measuring the movements of a stock, usually on charts, to find signals about potential future shifts. Technical analysts assume that the stock market is efficient at assessing available information and that the company's current stock price reflects the true value.
Longer-term traders often focus on individual stocks with a bottom-up approach. They look for specific entry and exit points on stocks with interesting price movements. Traders could also take the top-down approach to first regard the general economy, sectors and then companies when focusing on short-term profits.
Many investors use both methods of stock analysis, as some factors in the fundamental analysis aren't reflected in the market price. Some investors use fundamental analysis to see whether to invest in a market and then try to pinpoint a good, cheap entry price through technical investigation.
7. Assess the research and whether the stock fits in your investing goals
Your investment strategy should come with a general timeframe and level of returns wanted. The stock research should determine the likelihood of an investment performing to this hurdle over this period. There's no complete safeguard for future performance, but these actions should reveal which options are more appropriate.
Consider whether you prefer more stable growth and dividend income or will be ready to sell quickly at a high share price. Setting a limit for a financial ratio or looking for certain operations strategies could also be buy or sell indicators. These patterns can be seen through historical data and analysis. Your research process will become more refined through practice and make it easier to identify growth stocks.
Example of stock analysis
Australia’s grocery giants Woolworths and Coles are often compared and contrasted. They compete directly for the bulk of their operations in fresh food but maintain some differences. Woolworths still owns its New Zealand counterpart (Countdown) and discount store Big W, while Coles has maintained its liquor division.
Woolworths Group ($WOW)
Coles Group ($COL)
Figures at 5/12/2022.
There are multiple reasons why over the past five years Coles’ share performance was 43.3% and WOW only 26.76%. For a basic overview, it would be useful to investigate some of the following areas.
- The level of control over supply chains, which is significant in the fresh food sector.
- Need to adapt to the general market trend to offer an efficient online sales experience.
- Promotions could quickly eat into profit margins in the current inflationary environment.
- Loyalty schemes will be important to keeping cost-conscious customers.
- How past dividend payouts have diverged.
- Some stock charts could provide more technical insights.
What are the best websites to research stocks?
There's a lot of options, all with varying amounts of detail and approaches to researching stocks. Here's a few to start the journey:
Which is better: Technical analysis or fundamental analysis?
There's no clear winner, it depends on your investing purpose and timeframe. Some fundamental factors might not strongly influence the stock in the short-term. Technical analysis could only provide a limited understanding of a sector as a whole and not learning about competitors sometimes means missing out.
The ideal situation is to be as informed as possible. How frequently you trade can influence which processes are best suited. Perhaps start with the fundamentals of the market or industry and then hone in on your top picks with technical analysis before making the final decision.