The key to success in the commodities market is meaningfully investing in and analyzing stocks. While some have found financial stability with a passive approach, the potential for wealth is much greater with a more hands-on plan.
Stock analysis involves the careful review and measurement of a handful of data points. It includes surveying market trends, financial statements, risk management, and other metrics.
The process may seem daunting, reserved for financial professionals with deep resources. However, investing in and analyzing stocks doesn’t require a deep background in financial management. The modern retail investor has access to a wealth of tools to work with.
In this guide, Gorilla Trades takes you through some of the basic steps of stock analysis that almost anyone can use.
The Basics of Stock Valuation
The stock valuation process is making an educated estimation of a given company’s value. It offers a reasonable indication of how the stock should perform on the market. Stock valuation is a snapshot of a company’s overall financial health.
Stock valuation can be divided into two metrics: intrinsic and extrinsic value. Intrinsic value is a measurement of how much a commodity is worth as a business. This value is independent of the company’s stock price. Instead, it’s calculated with objective considerations of earnings, cash flow, technical indicators, historical trends, and other hard data.
Extrinsic value takes a stock’s market value into account. It involves an analysis of how much time the stock has to grow in value along with expected market volatility. It’s how much extra capital investors are willing to pay to buy shares of a certain company over its competitors.
Stock valuation helps you make smart investment decisions. It can provide guidance on whether a stock is undervalued, overvalued, or appropriately priced. The valuation process can reveal growth opportunities, identify risks, and hopefully generate the best return on investments.
The Role of Financial Analysis
Financial analysis is the path for evaluating a company’s basic financial profile and health. Much of the information investors need to perform this analysis is publicly available. Companies are required to post regular financial statements by the Securities and Exchange Commission (SEC) so they’re easily accessible.
The most commonly used financial analysis statements include the following.
Income Statements
Income is a straightforward report detailing a company’s revenue, net profits, and operating expenses. Analyzing income gives a clear view of a company’s relative financial health and profitability over time.
Balance Sheet
The balance sheet measures a company’s assets against its liabilities and calculates shareholder equity. Investors can see how financially stable the company is and how easily it settles its debts.
Cash Flow Statement
The cash flow statement charts a company’s incoming and outgoing cash over time. It gives a fair assessment of a company’s liquidity, along with its capacity to operate and grow independently of outside financing.
Additional Data
Other sources of information that can be helpful when investing in and analyzing stocks include:
- Shareholders’ equity statements
- Quarterly and annual earnings reports
- Performance breakdowns by divisions and regions
- Proxy statements outlining executive decisions and leadership
The lion’s share of the material you need to conduct financial analysis should be easily obtainable. If the company doesn’t make it freely accessible, your brokerage should have most of the basic metrics at hand.
Trend Analysis
The evaluation of market and stock price trends reflects an attempt to project future price movements. The data points investors use to analyze trends include historical price fluctuations, trading volume, earnings reports, stock ratios, and other reliable economic indicators.
Trend evaluation breaks down into technical and fundamental analysis. Technical analysis is the consideration of a stock’s performance across different models and frameworks. Investors look at charts to recognize patterns and movements. They also review moving averages and the Relative Strength Index (RSI) to gauge investor sentiment and establish buying and selling points.
Fundamental analysis considers financial statements, earnings reports, executive reviews, and industry metrics to establish intrinsic value. The intention of fundamental analysis is to get a sense of how much the company is worth based solely on its financial health, overall market, and potential for growth — regardless of its stock price movements.
The difference between technical and fundamental analysis can be summarized fairly simply. Technical analysis describes what the overall market is doing. Fundamental analysis focuses strictly on what the company is worth. Both help investors evaluate trends, identify opportunities for growth, and recognize possible risks.
Stock Ratios
The investment industry has a few standard measurements for investing in and analyzing stocks. These metrics take the form of ratios and are readily visible on the company’s financial statements.
Stock ratios inform investor decisions by revealing a company’s financial status from multiple angles. The ratios investment analysts use the most include the following.
Price-to-Earnings (P/E) Ratio
The P/E ratio is a computation of a company’s share prices against the price of each share. It compares the company’s current value to its historical performance and other companies in its market or sector. There’s no consistent definition of a “good” P/E ratio — there may be underlying factors that are more important — but in general, the lower the better.
Price-to-Book (P/B) Ratio
The P/B ratio compares a company’s market capitalization — the stock’s overall worth — to its book value, or its assets minus its liabilities. Investors use the P/B ratio to determine whether a stock is overpriced, undervalued, or appropriately priced. A P/B ratio less than 1.0 reflects a strong investment opportunity.
Debt-to-Equity (D/E) Ratio
The D/E ratio is calculated by dividing a company’s total liabilities by its shareholders’ equity, which is the amount the company would have left if it settled all its debts. It’s a snapshot of how much leverage the company has in the marketplace. In general, investors look for D/E ratios of 2.0 or lower for investments.
Return on Equity (ROE)
ROE is a straight-up measure of a company’s overall profitability. It’s calculated by dividing its net income by its shareholders’ equity. Most investors consider an ROE of at least 20% to be “good,” but an ROE of 15% may be acceptable in some circumstances.
Make sure to evaluate ratios in the context of each industry and sector — there may be different benchmarks for success between them.
Evaluating and Managing Risk
Risk management is at the heart of stock investment decisions. In this context, risk is defined as the possibility that a stock’s gains will be different than what was projected. Risk is evaluated using the company’s performance history and outcomes.
Some of the metrics investors use to evaluate a given stock’s risk are its volatility, market sentiment, fundamentals like supply and demand, and influencing factors like inflation and currency movement. Risky investments may represent chances for greater profits if the investor has the stomach for them. Low-risk stocks can be valuable but might also indicate stagnant performance.
With a clear picture of a stock’s risks, investors can use strategies like stop-loss limits, asset allocation, hedging, and rebalancing to maximize their positions. Having a diverse portfolio with assets in several different sectors and types is a traditional way to mitigate investment risks.
Investing in and Analyzing Stocks: An Important Approach
Taking the initiative to analyze stock performances can be the difference in a successful investment portfolio. Although every piece of data can be of value, everyday investors can still get an accurate perspective of a company’s status with some basic, common calculations professionals rely on.
With regular, ongoing analysis of your current investments and potential opportunities, you can become a seasoned, informed, and successful investor.
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