How to Technically Analyze a Stock?

Deciding how to invest is a lot like shopping for a car, but the consequences are much more significant. Start by understanding your own needs and preferences. Then, explore various investment options, comparing them based on price and potential returns. Analyzing investment decisions requires a more thorough approach. It may not come as naturally as browsing cars at a dealership, especially if you’re new to it. However, by grasping the fundamentals, you’ll be able to identify what to seek and what to steer clear of.

Whether you’re purchasing a single stock or putting together a diverse portfolio, making smart choices can greatly impact how well your investments perform. But how can you spot a good investment from a bad one? While there are no guarantees, there are some methods you can use to increase your chances of making a successful investment that aligns with your goals. Here are four steps to consider when analyzing a potential stock investment:

1. Go in with a plan

Just like how you choose a car that suits your lifestyle, your investments should align with your goals. Your plans will determine how long you want to hold onto an investment and how much risk you’re comfortable taking. Some investment goals may require you to avoid more volatile assets. For example, if you need money in the short-term to pay off credit cards or tuition fees, investing in volatile assets could expose your money to too much risk. Stock prices can drop rapidly, jeopardizing your financial plans. However, it’s worth noting that stocks have historically provided good opportunities for long-term growth (although past performance is not a guarantee). Holding stocks for extended periods, like 10-plus years, generally reduces the risk of loss, making them beneficial for long-term goals such as buying a home, funding a child’s education, taking care of parents, or planning for retirement. To successfully implement this strategy, you must be able to weather market downturns, which can be challenging at times.

When determining your risk tolerance, it’s important to think about the balance of your investments. In other words, how much of your portfolio is allocated to different types of investments? Remember, as the potential for return increases, so does the risk. That’s why many investors include lower-return investments like bonds in their portfolios to balance out the higher-risk, higher-return investments like stocks.

2. Know the different makes and models

Just as there are various types of vehicles available at a dealership, stocks also come in a wide range of options. They differ in size, function, and obviously price. Whether you’re interested in a family-friendly SUV or a high-performance sports car, the decision is yours to make. When evaluating a stock, factors such as market capitalization, industry classification, and how it fits into your investment strategy. Additionally, it’s essential to determine what makes the stock attractive – does it offer dividends? Is it positioned for growth?

Here are some essential filters to help categorize stocks and evaluate their growth potential:

Size

When shopping for a car, you may consider choosing between an SUV or a sedan. Similarly, when it comes to investing, many investors consider the size of a company. One way to measure a company’s size is through its market capitalization, also known as “market cap.” This is calculated by multiplying the total number of outstanding shares by the current share price. For example, if an electronic company has 30 shares and the market price is $4, the company’s market cap would be $120 (30 shares x $4 per share = $120 market cap).

Small-cap companies are typically valued between $250 million and $2 billion, while mid-caps fall within the range of $2 billion to $10 billion. Large-cap companies, on the other hand, are valued at $10 billion or more. Market cap can sometimes be influenced more by perception rather than a company’s actual fundamentals. This is because some investors focus on a stock’s intrinsic value, while others consider its popularity or market sentiment. Despite these variations, companies often exhibit similar characteristics at different stages of growth. Small-cap companies often lack a proven track record – Many exhibit potential or could be targets for acquisition, but they also face challenges. Can they expand their customer base beyond their current one? Are they under pressure from established players or regulatory measures? Small-cap companies have the potential to grow into mid-cap or large-cap companies, but they also run the risk of failure. It’s also entirely possible for a small-cap company to remain as such. On the other hand, large-cap companies tend to be more stable, benefiting from experienced management and financial resources – both of which aid in overcoming competition and maintaining performance. Generally speaking, larger companies are more likely to pay dividends (more information on that below). You can find a wide range of these large-cap stocks in the S&P 500 Index, which includes some of the largest publicly-traded companies in the US.

Sector

If you divide businesses based on their industry, you’ll find different sectors. For example, internet companies are part of information technology or communication services, banks are categorized under the financial sector, diaper-makers are considered consumer staples, drug makers fall into the healthcare sector, and so on. The stock market is typically divided into 11 sectors based on the Global Industry Classification Standard. This standard is commonly used in the financial industry. When assessing a potential stock investment, it’s beneficial to compare it to others in the same sector. Diversifying your portfolio across various sectors can help mitigate the impact of underperformance in one sector by leveraging strong performance in another sector.

Style

Are you interested in purchasing a trendy, brand-new vehicle? Or do you prefer searching for a hidden gem? Style isn’t just about the brand, but also about how an investor classifies their investment. “Growth investors” tend to seek out companies that are rapidly growing. These are often companies that receive a lot of media attention and are seen as disruptors. On the other hand, “value investors” may search for companies they believe are undervalued. Each investment style has its own advantages and risks, which is why many investors have a combination of value and growth stocks.

Dividend (or not)

As a stockholder, there are two ways your investment can bring returns. Firstly, the company’s stock price may increase, allowing you to sell your investment for a higher price than what you paid. Secondly, you may receive dividends, which are a portion of the company’s profits that it distributes to its shareholders. It’s worth noting that not all companies pay dividends, but those that do typically do so periodically, often on a quarterly basis (around every three months). Although dividends are not guaranteed and can be changed unexpectedly, they can serve as an additional source of income for investors.

If you’ve ever heard the term “dividend yield,” it refers to the dividends a company paid in its last fiscal year divided by its share price. This measure helps investors understand where a company stands in terms of growth. Usually, young companies focus on building their business and creating new products, so they may not pay dividends to investors. On the other hand, established companies are more likely to offer a higher dividend yield. Companies that provide essential products or services, like consumer packaged goods businesses, often have high dividend yields.

As an investor, you’ll have to consider what to do with the dividends you receive. Some investors choose to reinvest their dividends by purchasing additional stock or fractional shares of the company through a Dividend Reinvestment Plan (DRIP). These plans are often available through brokerage firms or directly from the company.

Individual issue or fund

If the pressure of selecting a single stock is getting to you, there’s a solution. Instead, consider buying a bunch of stocks all at once through an exchange traded fund (ETF) or mutual fund. This way, you can own multiple stocks and minimize the risk of relying on just one. Plus, ETFs and mutual funds offer options tailored to specific sectors or risk levels.

If you’re looking to invest in stocks or funds, a stock screener can be a useful tool to narrow down your options based on various criteria like size, sector, and price. Alternatively, some investors prefer to start by examining companies they are familiar with and comparing them to others in the same category.

3. Check under the hood

When you purchase a stock, you’re essentially becoming a partial owner of the company. As a buyer, you’ll want to find a well-managed and profitable company at a fair price. To get this information, check out the company’s financials. Publicly traded companies are obligated to disclose their financial data to the Securities and Exchange Commission (SEC) and the public. You can find this information on the SEC’s EDGAR site or the company’s investor relations page. This data, such as annual 10-K filings, quarterly earnings reports, and other regulatory filings, can usually be accessed on the SEC’s EDGAR site or the companies’ investor relations pages. This information is typically available on the SEC’s EDGAR site and the company’s website (usually on an “investor relations” page). It can also be found in stock profiles on brokerage platforms. Here are a couple of ways to interpret the content.

1. Is the company growing?

Check its revenue.

Revenue is the overall amount of money that a company generates from the sales of its goods and services. If this amount goes up from one year to the next, it usually indicates growth. However, an even better indication is when the net income rises. Net income is the company’s total income after subtracting its expenses.

2. How much is the company earning?

Measure the EPS (earnings per share).

EPS, or earnings per share, is calculated by dividing a company’s earnings by the total number of shares it has on the market. If the EPS is high or on an upward trend, it can be a positive sign for investors, indicating a healthy stock with potential. However, it’s important to exercise caution as EPS can also rise due to less favorable circumstances, such as reverse stock splits.

3. Is the stock ‘fairly priced’? 

Examine its P/E ratio and the P/S ratio.

If you’re analyzing two stocks, the P/E ratio (price-to-earnings ratio) gives you an idea of what investors are paying for the stock in relation to the company’s earnings. It’s like showing you how much you’re investing for each dollar of earnings as an investor. Meanwhile, the P/S ratio ( price-to-sales ratio) compares a company’s stock price to its sales.

The P/E ratio calculates the stock’s current price by dividing it with earnings per share. So, if the P/E ratio is between 20 to 25, investors will pay $20 to $25 for every $1 of earnings. When the P/E ratio is high, it typically suggests that investors anticipate higher earnings. However, it could also indicate that the stock is overpriced. On the other hand, a low P/E ratio may suggest that the stock is undervalued or accurately represents a company with limited growth potential.

Investors often calculate the P/E ratio by dividing it with a company’s projected growth rate for the next year. This gives them the PEG ratio (price/earnings-to-growth ratio), which is useful in assessing whether a stock is overpriced or undervalued. A PEG ratio of one is considered fair value, while a ratio greater than one may indicate an expensive stock, and a ratio less than one could suggest a good deal.

Meanwhile, if you want to find the price-to-sales (P/S) ratio, also referred to as the “revenue multiple” or “sales multiple,” you can divide the company’s market capitalization by its revenue or total sales over a specific period, like a year. Another method is dividing the company’s share price by its sales per share. Comparing P/S ratios among companies in the same industry can give you insights into which ones might be undervalued or overvalued.

Let’s take a scenario where we are comparing three major tech companies. The first company has a P/S ratio of 6, while the other two have P/S ratios of 4 and 2. In this case, the company with the lowest P/S ratio might be undervalued because its sales are relatively high compared to its share price. It’s worth noting that sometimes you might come across a P/S ratio based on projected sales for the current year, which is referred to as a “forward ratio.”

4. What about red flags?

Watch the D/E ratio (debt-to-equity ratio).

While it’s normal for companies to have a certain level of debt, if a company is burdened with excessive debt, it could be a red flag. To compare stocks, you can use the debt-to-equity (D/E) ratio. This ratio is calculated by dividing a company’s total liabilities or debt by its shareholder value. Generally, a D/E ratio of one or lower indicates that a company can manage its debts even during tough times. On the other hand, a high D/E ratio might indicate that the company is facing significant financial challenges. While ratios and metrics are valuable tools, it’s crucial not to solely depend on one metric for analysis or investment decisions. Companies may excel temporarily based on certain metrics, but that success may not be long-lasting. Investments can seem more attractive than they truly are over brief time periods.

5. How volatile is the stock?

Before you invest in a stock, it’s important to understand its volatility so you have a better understanding of what you’re getting into. This can be done by looking at its beta, a numerical rating that compares the stock’s price fluctuations to the overall market. A higher beta suggests a more volatile stock, while a lower beta indicates less volatility. While lower beta stocks are generally seen as less risky, they may also offer fewer opportunities for potential gains.

6. Is it a good deal?

Return on Equity can help

Everyone wants to know if they’re getting a good deal or being ripped off. Return on equity (ROE) can help you determine that. It’s a tool for investors to measure the return they’re getting on their investment. The ROE ratio is calculated by dividing the company’s net income by shareholders’ equity. It tells you how much profit a company generates for each dollar invested by shareholders. When evaluating a company’s ROE, it’s crucial to compare it to other companies in the same industry and of similar size. It’s also useful to compare the company’s current ROE with its past ROE to see if profitability is improving or declining.

For instance, imagine a bank achieved a 10% return on equity in the previous year, resulting in 10 cents of profit for every dollar of shareholders’ ownership. To gauge its performance, you can analyze its ROE against other major banks and its own ROE from previous years.

7. How does it compare to the competition?

Explore analyst research.

Analyst reports are a valuable resource that can enhance your research by providing both quantitative and qualitative information. They can help you evaluate a company’s competitive advantages and disadvantages, new products, and significant consumer trends. Additionally, analysts often analyze management factors like stability, track record, and operational costs.

If you’re putting your money into an ETF or mutual fund, it’s a good idea to dig into the fund’s top investments, also known as holdings. You can even compare the fund to a stock index that has similar holdings, called a benchmark. For instance, the S&P 500 Index is a benchmark for large-cap stocks. If you’re going for an actively managed mutual fund, it’s worth considering the fund manager’s long-term performance and track record to assess the fund’s success over time. Don’t forget to keep an eye on the fees associated with investing in a fund. The expense ratio is one way to measure the costs, including payments to the fund manager, transaction fees, taxes, and other administrative costs, which are deducted from your overall investment returns as a percentage.

4. Take a test drive

Before investing in a stock, it’s beneficial to observe and follow its movements for a while. Looking at its past performance can give you some insight, but experiencing it as a shareholder can give you a more realistic view of what to expect. Even with thorough research and planning, there’s always a risk of facing investment losses. Keep in mind that diversification, asset allocation, and research are not guarantees against financial setbacks.