Now that we are making our way to the end of the investment essentials series, we can now get into the best part - picking stocks to purchase. One of the best ways to do so is by using a process that is referred to as fundamental analysis. It is probably one of the most widely accepted ways of evaluating a stock.
Fundamental analysis involves looking at the underlying data of a company to see whether or not the metrics and fundamentals suggest a strong buy or a strong sell/avoid. There are multiple areas that are included in fundamental analysis and not all investors use each of the metrics. Some use only a few. I myself like to rely mainly on the P/E ratio, the PEG ratio, the EPS, yield, and 10-K (review of the business as released by the business itself).
The first and most important item to look at when you first pull up a company to review by fundamental analysis is the business itself. None of the numbers matter much if you don't understand what the business actually is in my opinion. If you have never used Tupperware (TUP) you might not have much of an idea what it actually is or what the business it is created on is run on. This is step one: understand what makes the business a business. This is most easily achieved by reading the company's 10-K which is posted on almost all finance websites such as: finance.yahoo.com, tdameritrade.com, and google finance. To test it out, pull up your favorite company's 10-K which should be under the area that states SEC filings or Key Filings. It is a good rule to never invest in any business that after reading the 10-K you can't understand.
Secondly, look at the company's sheets. This includes their balance sheet, income statement, and cash flow. All three of these should generally be higher and higher each year if the company is doing what it should be doing to make money. This can also tell you how much debt the company has. If a company is overloaded in debt, you might want to think twice about investing in it. There are few companies that have little to no debt that turn over when times get bad.
Third, more on to the listed statistics that should be listed readily on any stock ticker review on the finance websites or on your trading platform. These are the items that should be looked at: price, 52 week high/low, EPS, yield, PEG, P/E ratio, and ROE.
Price: is the price a price that you would be willing and able to buy into?
52 Week High/Low: if you can, find stocks that you're getting a discount on. If the price is sitting close to their 52 week low, you may have found a bargain. Keep in mind however that you could also be finding one that is effectively dead.
EPS - Earnings per Share: this is where we find how profitable a company is in relation to their outstanding shares. The EPS is the amount of money that company has made in profit in relation to the amount of shares they have issued. Higher the better!
Yield: this is how much the company pays in dividends to their shareholders. Divide this number by the EPS to determine how much of the company's profits are paid in dividends. The lower percentage, the better because that means the company has that much more room to continue making dividend payments. If the percentage is too high (above 70 or 80%), if something were to impact profits, the company may have to cut their dividend payments. You want them to be able to continue paying and continue raising them.
P/E Ratio - Price to Earnings Ratio: this is calculated by dividing the stock price by the EPS but it should be listed already for you on most stock analysis websites. This ratio can be used to let you know just how much value the market puts on a particular stock. I like to try to aim for stocks that have a P/E of between 10-20. Typically stocks under 10 may be too undervalued and have trouble becoming a star in the market again while those over 20 may be far over valued. Technology stocks are notorious for being over valued.
PEG Ratio - Price to Earnings to Growth: This piggy backs onto the P/E ratio. The only difference is that the PEG takes into account future growth. However, since future growth is something that is essentially a guess, I don't put a ton of weight on this. I do however like to use it because it will likely influence other investors and it can give a good idea as to how the price of the stock may move. An undervalued stock may have a PEG of less than 0.5 and an over valued one can typically be over 2.
ROE - Return On Equity: this is one of the best measures that shows the health of a company. It is calculated by dividing the net income by net worth. The higher the number, the better the company is managing because it's making more with less (essentially...).
All of these factors put together can make for a great way to analyze a stock. This is fundamental analysis.