8 Simple Steps to Analyze a Stock
The best investors in the world analyze stocks with a simple process. We all can do it if we slow down and have the patience to go step by step and don’t get too far ahead of ourselves. For those who may lack the confidence to read financial statements, a great and easy read book is “The interpretation of financial statements” by Mary Buffet and David Clark (Amazon Link to Book). It’s great because of its simple explanations and easy-to-follow examples.
OK, before we jump in, we should understand the advantage of having a step-by-step process for analyzing a stock. Our goal is to keep learning about the company and see if we come across a reason to eliminate the company as an investment. If we find a reason the company could be a bad investment, we bail out of this process and start again with a new company. With that in the back of our minds, let’s jump in.
Step One: Understanding a Company’s Business – The best place for investors to learn about what a company does is in the annual report (aka 10k) – known as the business section. Generally, the business description section will be the first (or one of the first) section in each annual report. It’s where we can find a complete description of the business and the segments of the company. Ultimately, it explains what the business does and how they make money.
After reading the business section, we might decide, you know what, this company doesn’t do what I thought, and if that’s the case, we should stop and move onto the next company. An investor might research a dozen companies and only get through the eight steps to analyzing a stock once. So step one is to learn what the company does and determine if that business has long-term potential. If it does, let’s move on to step two.
Step Two: Management Discussion & Analysis – The Management Discussion and Analysis (MD&A) is found in both annual (10k) and quarterly (10q) filings. Ideally, we want to get our hands on the most recent filing (quarterly or annual) and start with that one.
The MD&A section is where investors can find the management team’s plan for the business. Many times we can see the trends of the industry and a recap of the financial performance of each sector of the company.
In the first step, we learned what the company does and how they look at their company. In this step, we’re looking at how the company performs, and how the management team looks at the business, and where they believe the opportunities and weaknesses are.
Step Three: Financial Statements – So this is where we get an opportunity to look at all the financial statements of a company. We want to look at the Income Statement, Balance Sheet, and Cash Flow Statement. We can also look at the footnotes in the quarterly and annual reports. The footnotes tell us what and why the management team is doing and how they classify many line items. Mary Buffet’s interpretation of financial statements should be right beside you as you go through the financials. It’s a great tool (buy on Amazon).
Step Four: Company Presentations and Earnings Calls – The investor relation section of a company’s website will generally list recent investor presentations and recent earnings calls. Many times these presentations are PowerPoint-type presentations and give us a high-level view of the company.
Since we’ve already read the annual report’s business section, the most recent MD&A section, and reviewed the financial statements, we’re now looking for anything we may have missed or perhaps some new development that is just now coming out.
Often we can find this data in the presentation or by listening to an earnings call. Many times, at the end of earnings calls, analysts will ask questions. Analyst questions can be a great place to find new ways to look at the company we’re analyzing for possible investment. What questions get asked? How does management handle those questions? Assuming we still like the company, let’s move on to Step 5.
Step Five: Getting to Know the Competitors – This step is where an investor can find competitive advantages. Ideally, we want to look at two to three competitors. By now, we know the company well and have identified its strengths and weaknesses. Now we want to make comparisons to similar companies. Often, larger companies are large and operate in many business lines. To make better comparisons, we may need to identify competitors for a specific segment to understand the industry better.
Now let’s assume we find a company that appears to have a stronger position in the industry. Well, we could switch our analysis over that new company if we want. Of course, we are starting with Step 1 of our How to Analyze a Stock process.
But this doesn’t mean we are starting from scratch. Since the company we just analyzed is in the same industry, it’s likely, our analysis of their competitor goes much faster – since we already know much of the jargon.
Step Six: Calculate the Fair Value of the Stock –OK. Since we’ve made it to this point in our analysis, the company is likely at least decent. Now we want to figure out what we think the company is worth today. IF POSSIBLE, try not to look at the current stock price or the market cap of the stock – I know it’s tricky to ignore that – but let’s try.
There are many popular methods for valuing stock, and depending on the type of business we’re analyzing, some stock valuation methods are better than others. We’ve done guided tutorials on many stock valuation methods. But here is a quick intro to some of them
Discounted Free Cash Flow – Great for large, well-established companies
Enterprise Value to EBITDA – Good for younger, faster-growing companies, as well as many unprofitable companies.
Price to Earnings – A simple way to value stocks and can be used for most profitable companies.
Price to Book Value – A good starting point for financial stocks like banks
If we have access to any analyst reports, this is where they come into play. What valuation methods are analysts utilizing? We can also look at how analysts value similar stocks in the industry. Often, looking at analyst reports gives us a good starting place for identifying a good valuation method.
Once we decide on the valuation method we’re going to use, we should try to pick unbiased calculations based on reasonable expectations, not numbers that favor us buying or selling the stock.
EXAMPLE, if we’re analyzing a stock and we see the average historical P/E multiple of our stock is 17x. The industry average P/E multiple is 18x. But there is one fast-growing company in the industry that has a P/E multiple of 25x. Well, it makes far more sense for us to use the industry average or even the company’s historical average. If our company is currently trading at 20x, well, it makes more sense to hold off until that stock price drops. But if we opted to go with the high-flying company, our stock would appear undervalued (lower is better with the P/E ratio), and we could end up paying too much for it. The potential for bias is why we want to avoid looking at the current value on the stock market until after we complete our calculation.
OK, now we know where we want to own our stock, now we move on to step 7.
Step Seven: Identify the Drivers of the Stock – The goal of this step is to understand better how the stock acts in different situations. So ideally, we want to pull down a long-term chart of the company and look for where the stock jumped quickly or fell quickly in the past few years. Then we want to go and find the news from that time period. What caused the rapid change in the stock price? Often its earnings, but it could be a lot of things. Identifying the stock price drivers can be an excellent way to understand better how the investing world looks at our stock. Knowing these drivers may offer a glimpse into the future if similar news comes out on the company.
Step Eight: Wait for a Buying Opportunity – This step is where we finally look to see where the stock is currently trading? How much of a margin of safety do you want? Let us assume we think a stock is worth $100 a share, but we believe there are reasons it might need a few things to go their way, so the $100 valuation holds up if things do go their way. Well, to account for the fact that the company may not perfectly achieve their goals, or perhaps it takes longer. Well, it may make sense to add a 10% or 20% margin of safety to our valuation calculation, which means if it hits $80 or $90 a share, that is where our best entry point could be. Our margin of safety depends on how confident we are in our analysis. If we think we nailed our stock analysis, we may be willing to buy with a smaller margin of safety; if we feel there is uncertainty, we can add a higher margin of safety on our entry point.
The key to finding great stocks to invest in is to research as many companies as we can. The more stocks we analyze, the faster and more efficient our research process will become. Often, the best stocks to start researching are the companies that interest us the most. Now, if you have any questions or ideas, please put them in the comments below, and we’ll get back to you as soon as we can.
