You already know you need great stocks if you’re going to invest in the market. But how do you know which ones are good and which are terrible?
When it comes to stock research, many will debate whether you should focus on fundamental analysis or technical analysis. Is one right and the other wrong? Can you do both or do you have to pick just one?
Yes and no. But before we go any further, let’s look at what fundamental and technical analysis really are.
Fundamental Analysis is based on looking at…well, the fundamentals of a company. So…what is that, you’re asking? Things like how much debt they have, their earnings, how they manage their assets and so on.
It’s as if the company went to the doctor to get a check up. All of their vitals are checked and measured.
The fundamentals are important because they tell you how the company is being managed. Are they using their assets wisely and most importantly, profitably? Have they borrowed too much money to build a bigger manufacturing plant?
I’ve mentioned before that much of the stock info that you see online comes from Zacks. But Zacks has a ton of info on their site. Figuring out where to start can make you forget trying to pick a stock in the first place.
Let’s look at a stock and see exactly what you can find out about any given company.
From the Zacks.com homepage, simply type any stock symbol in the search bar. For now we’ll take a look at Starbucks – SBUX.
Scroll down until you see the ‘Financials’ section on the left side. Then you’ll want to click on ‘Financial Overview’.
This will give you all of the fundamental details about the company. Here are Starbucks’ fundamentals below.
Excuse the red line. I had to splice to pics together as I couldn’t get a screen shot of the entire page.
Let’s go over each item so you’ll be able to easily spot a great stock.
This is known as the price to earnings ratio. It’s calculated by taking the current stock price and dividing it by the yearly earnings. Since the price changes frequently, the P/E ratio you see today may be slightly different than the next to time you view it.
An easy way to look at P/E is as a multiple of the stock’s earnings. A stock with a P/E of 18 is said to be trading at 18 times it’s earnings.
You’ll also notice there are three numbers listed under P/E. This is because a stock’s earnings can be calculated in different ways. Let’s look a little closer.
P/E (F1). This number is used when you look at the estimated earnings for the current fiscal year. Trailing 12 months P/E uses the actual earnings from the last 12 months.
The difference between fiscal (F1) and trailing 12 months P/E (ttm) comes down to earnings estimates v. actual earnings. This is why you’ll never have the exact same P/E ratio for these two calculations.
It’s worth noting since we’re on the subject of estimates, when determining P/E ratio, you should always use earnings for an entire year. I say this because when you look up a stock quote and it displays the current earnings, it’s usually only for the most recent or upcoming quarter.
If you’d like to see all the earnings for any stock, check out ‘Detailed Earnings’ on the left side of the page on Zacks.com.
Next up is the PEG ratio. To get the PEG ratio you divide the P/E by the growth rate. The growth rate can be found by again looking at the ‘Detailed Estimates’ link on Zacks.
What the PEG ratio tells you is how the stock’s value compares to it’s rate of growth. Ideally, a PEG ratio of 1 or less says that the stock is a bargain compared to it’s rate of growth. Although there are some who say the PEG ratio isn’t really necessary.
As you can see, they are all grouped under P/E because they are all telling a similar story of what the stock’s value is based on it’s price and it’s earnings.
If you don’t know already, EPS stands for Earnings Per Share. Basically you take a company’s yearly earnings and divide it by the number of outstanding shares. This will give you a stock’s EPS.
EPS Growth measures numbers from the previously reported quarter and previous year to see if earnings are moving higher or lower. If you want to make money, this is one of the ratios you need to look at. You pretty much want these numbers to be positive as some companies do have negative EPS growth.
This one is pretty straight forward. Here, the growth of the company’s sales is measured against the last quarter and last year. Again you want these numbers to be positive.
If the numbers are negative compared to last quarter but positive compared to last year, you may want to investigate what happened during the previous quarter. Checking the news is a great place to start.
Just like P/E, there are three numbers listed. Each number is derived from comparing the stock price to some other number.
Price/Book ratio. This is calculated by taking the current price of the stock and dividing it by it’s most recent book value. We’ll discuss book value in a second as it’s further along on the page.
There’s not a definite good or bad number. Most people use this number to see if the stock is undervalued or not. Generally a Price/Book ratio under three is said to be undervalued.
Price/Cash Flow. Take the current stock price and divide it by the cash flow per share. This gives you the Price/Cash Flow ratio. Again, there are no right or wrong numbers. A lower number could be a sign that the company is undervalued for it’s current stock price.
If you had two stocks that were trading at the same price and one had a lower Price/Cash Flow ratio, that would signal a better buy for your money. And as far as figuring out what the actual cash flow is, check ‘Cash Flow Estimates’ at Zacks.
I don’t want you to get overwhelmed here. Just be able to know what these numbers stand for.
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You don’t need to be able to explain electricity to turn on the lights. All you need to know is how the switch works. A great way to get more familiar is to compare similar companies and their ratios.
Price/Sales. The price to sales ratio compares the company’s yearly sales to it’s market cap. It can be calculated one of two ways. First, by dividing the market cap by the yearly sales (market cap/yr sales) or by dividing the earnings per share by the stock price (eps/stock price).
This number really can’t be evaluated on it’s own. It’s better to compare it to other stocks in the same industry. You can then find out the industry average and see if your stock is undervalued or overvalued. Starting to see a pattern here?
Better known as return on equity. This measures how efficient a company is at generating income on money from investors (all the people that have bought their shares of stock). You always want to see this number in positive territory as it means the company is creating income with invested money.
Higher numbers can indicate a company with a higher growth rate. I don’t want to over-complicate this for you. If you want to go into further detail check out this entry here and this article here. In short, make sure this is definitely not a negative number.
If you look at our example of Starbucks, you’ll see ROE is calculated every quarter.
In this instance SBUX is increasing it’s ROE every quarter, which is a good thing. Keep in mind that in many instances, a company may not be able to keep up the current pace.
Yep you guessed it. This stands for return on assets. Basically, this is a measure of how efficient a company is at generating income from it’s assets…whatever those may be. You get this number when you divide their net income by total assets (net income/total assets).
To get the details of all of a company’s assets, you’d have to do some serious digging into their financial statements. I don’t know about you, but I’d prefer just to look at the ratio than become an instant accountant. Unless you already are an accountant…in that case, do math and carry on.
A stock’s ROA should once again be a positive number. You also need to compare this percentage to other stocks in the same industry to better understand if this is under or above the average.
As you can see from our Zacks info on Starbucks, each quarter is slightly better than the last. Something you’d like to see in any stock you’re thinking about putting your money into.
In short, the current ratio give you a snapshot of a company’s ability to meet any present and/or long term financial obligations. You get this number by taking all assets divided by all liabilities (assets/liabilities).
If you’ve ever bought any piece of real estate before you’ve probably had to give your own ‘current ratio’ to your banker. How you can use all that you own and control to pay off any long or short term commitments, is what this tell you in a nutshell.
A guideline for the current ratio is that you’d like it to be over one. Current ratios under one indicate a company has more liabilities than assets and may have problems meeting it’s obligations.
I say they may have issues because depending on the company, there may be a pending deal or product launch that justifies the liabilities. You’d have to dig in and do a little more research on that stock to better understand the whole picture.
Starbucks’ current ratio for the three quarters listed is slightly over one. You’ll notice though, that each quarter the number is ever so slightly declining. Maybe they were opening new locations or launching a new product? At least now you understand what it means and how to apply it to your stock research.
This metric measures a company’s ability to meet it’s short term obligations with it’s liquid assets. In short, what assets could it liquidate to meet any short term debts or payments.
If you compare this to the Current Ratio, you’ll notice that the current ratio takes into account all assets and all liabilities. The quick ratio is only focused on the short term.
It measures the dollar amount of all liquid assets to the dollar amount of current liabilities. If a quick ratio is 1, then the company has $1 of liquid assets for every $1 of liabilities. (Just to be clear, liquid assets are things that can be quickly converted into cash. Company logos and trademarks are assets, but can’t be easily converted to cash)
Looking at Starbucks’ three quarters of quick ratios, we see they are all under 1. Each quarter showing a small decline over the last. This shows that their liquid assets are either declining or their liabilities are increasing. Either of those two things could cause the difference in the quick ratio.
This is similar to what I mentioned to you earlier about Sales Growth. When you see numbers that are not favorable, they tend to be telling a story. Checking out the news on a stock can often give you more pieces of the picture.
The ratio here measures what percentage of operating income is left after paying for the total cost to produce their goods. In other words, after they’ve made their sales, how much is left after the expenses are paid.
When you hear that a company made $15 million in sales, obviously that is not all profit. There are costs to produce the goods such as raw materials, any packaging and the cost of employees to produce the goods.
A basic way to think of the ratio is a percent of each dollar of sales. Starbucks’ quarter in the image above has an operating margin of 12.61%. This means they earn 12.61% of every dollar in sales, or just under $0.13. The higher the margin of course, the better the company is doing.
It tells the story of revenue after all expenses have been paid. Those include taxes, interest payments, preferred stock dividends, not to mention normal operational costs.
You should also note that net margin does not tell how much money a company earned, as other factors are included such as depreciation of assets and amortization.
The basics of net margin are to make sure the number is positive. If there is a trend where the net margin is continually declining, you may want to do some digging to see the company’s whole financial picture.
The percentage of a company’s earnings before tax, as compared to their revenue, is the pre-tax margin. If a company has $1 million in earnings before tax and $15 million in revenue, the pre-tax margin would be 6%. (1/15 = .06)
You can use Pre-Tax Margin to see exactly how profitable a company is, regardless of how much revenue they may have. It also helps you to compare companies who have different amounts of revenue.
More revenue doesn’t always mean a company is more profitable.
This accounting term just means the value derived after you subtract all a company’s liabilities from all of their assets. The numbers you see listed are actual book value per share.
According to financeformulas.net, book value per share is calculated by taking total common stockholder’s equity and diving it by the number of common shares. As you see from the figures on Zacks this number is calculated quarterly.
BVPS, or book value per share, is commonly compared to the current stock price. When you look at the two numbers you can see if the stock price reflects its value on paper. If it doesn’t, you can begin to analyze why a stock is trading above, below or at it’s book value.
This measures how quickly a company sells it’s entire inventory over a set period. You’ll either see a quarterly or yearly number. The figure is calculated by taking sales and dividing it by inventory (sales/inventory).
A higher inventory turnover number is usually better. It often indicates that a company is efficient at selling it’s products or goods quickly. If you see a low number, it’s time to dig once again to find out why they aren’t able to sell things quickly.
Debt to Equity
This measures how much debt, if any, a company has compared to it’s total stock value. It can also shed light on how a company pays for things. Dividing the total assets by total shareholder equity (total assets/total shareholder equity) gives you the ratio.
It’s often expressed as a percent. If you see a debt to equity ratio of 0.42, that would be 42%. When it comes to analyzing it, a 30 to 60% ratio is what most investors look for. Always keep in mind however, that you need to compare it to other companies in the same industry to get the full picture.
Debt to Capital
Here, it’s pretty much what is says. It’s a company’s debt divided by it’s total capital (debt / total capital). In our example of Starbucks, you’ll see it has a debt to capital ratio of 24.56.
Again, comparing this number to it’s peers in the industry tells you where they stack up. The higher the number, the more debt they have when compared to their capital.
Now that you have a basic understanding of how to interpret fundamental info for a stock, let’s talk about what to look for in technical analysis.
What is Technical Analysis?
It’s a way of investigating a stock by looking at the stock’s price history, number of shares traded and any patterns that may exist when viewing it on a chart.
An important note about technical analysis is that it only looks at the past. Since you can only see the current or past stock price, all decisions are based on things that have already happened.
This is one of the criticisms of technical analysis. That you are in essence, using the past to forecast the future. I hesitate to say ‘predict’ the future because no one can predict future stock movement.
Many people don’t invest in the stock market for that very reason. They think they have to perfectly predict the future in order to make any kind of money from stocks.
That couldn’t be further from the truth.
What you want to do, if you’re using technical analysis, is try to find a pattern within the price of the stock. What does that mean exactly?
I can show you better than I can tell you. Take a look at the chart below.
What’s the first thing that comes to mind when you look at this chart?
Do you notice at the beginning of the chart, it starts to go down? But if you look at the rest of the chart, it pretty much continues to go higher.
What stock is this you’re asking? It doesn’t matter.
I’m not trying to be harsh but it really doesn’t matter what chart you are looking at. If you can begin to spot the story the chart is telling you, you can literally apply it to any and every stock.
Time and Volume
Another basic, but important thing to look at, is how many shares of a company have been traded. You need to look at volume over a particular time frame to get a good understanding of it.
Let’s say a stock has 500,000 shares that were traded. Is this an actively traded company? You need to know the time frame in which the shares were traded to be sure.
Here’s a little secret (not really a secret though). When you look at any stock quote on sites like Yahoo Finance, Google Finance or Finviz.com, they’ll always show you the current volume of the stock that day.
These financial sites also show you the average daily volume for any stock. Comparing the current or daily volume to the average volume can alert you that something newsworthy has happen to the stock.
Often, checking recent news about the stock can shed even more light on why the stock volume may be higher or lower than normal.
Take a look at this quote from Google finance for AMD below.
In the circled area, you see the current volume (Vol) followed by the average volume. Google finance uses the last 30 days to get the average volume.
Advanced Micro Devices’ volume for this day was over 106 million shares. Compare that to its usual volume of 49 million and you’ll see more than twice as many shares were traded during this trading day.
Now that you see what the volume was, let’s figure out why the volume was twice the normal amount.
Above you’ll see the news for AMD on Finviz.com for December 8, 2016. Pretty much every entry is talking about the stock being upgraded by analysts.
For comparison, look at this chart for AMD. You can see the volume measured at the very bottom of the chart.
Each bar at the bottom measures the volume per day in millions. On the right side, you see to markers, 180 and 90. You can see there have been a few days that the volume for the stock has reached nearly 180 million shares traded.
Oftentimes you’ll only have one piece of info at first. Either you’ll notice the change in volume or hear the news about the upgrade. Each item of information you have about a stock is a puzzle piece that can help you see the bigger picture.
As you can see technical analysis mainly relies on monitoring changes in price.
With the upgrade, AMD closed over 8% higher than the day before. Would that be a time to buy? Should you sell some shares you already own?
It comes down to what type of an investor you are. There is no right or wrong answer. Knowing your risk tolerance and your investing style is something only you can figure out.
Here’s one more piece of info that falls into technical analysis.
When it comes to moving averages there are two basic kinds. A simple moving average and an exponential moving average.
Simple moving averages (SMA) calculate the average price of a stock over a set period of time. When you see a moving average it’s always associated with a number. For example, a 20 day moving average uses the last 20 closing prices.
Each day the average of the last 20 days is calculated and plotted on a chart. This continual averaging of the last 20 closing prices forms a line on the stock chart.
Here’s a chart of Microsoft with a 20 day moving average.
Notice how the price of the stock dances above and below the red line (the 20 day moving average). Some investing strategies involve buying or selling stocks when they cross above or below certain moving averages. The 20, 50 and 200 are the more common averages used.
A simple moving average can also help you to identify any long or short term trends in a stock.
The exponential moving average (EMA) is similar to the simple moving average. Its difference is that it doesn’t count every closing price equally. More weight is given to the most recent closing prices.
Take a look at the same Microsoft chart as above, only now it has a 20 day exponential moving average.
Can you tell the difference? Probably not. If you’re just starting out I recommend using only simple moving averages.
If you’d like a more detailed explanation of an exponential moving average and how it’s calculated, check out this article here by StockCharts.com.
In conclusion, whether you choose to be a technical or fundamental investor, always stick with what makes you comfortable. And remember, you don’t have to be just one.
Fundamental investors depend more on a company’s financial health. Technical investors rely more on what the charts and indicators are saying.
You can pick from both sides. As long as you stay consistent with your method of stock picking, you give yourself a great chance to profit.
Which will give you the better chance to make money? They both will. There are many individuals who only look at the fundamentals when choosing stocks.
Others swear only by the story the charts are telling.
I personally lean more towards technical analysis. Although I still check the fundamentals to see if the company is sound before I start to look at any chart.
So are you a Fundy or a Techy? What’s your investing style? Share your thoughts in the comments below.
Want a checklist of all the fundamentals criteria?
Click below to download the PDF now.