Last Updated: November 17, 2021
Do you plan to invest in stocks? Achieving success in the stock market takes a lot of effort. The first step toward such an endeavor is learning how to research stocks. This article discusses what stocks are, analyzes them, and what practical tips you can use to find the best ones.
What Is a Stock
Stocks or equity represents ownership of a fraction of a company and gives the owner a portion of the company’s assets or shares. When investing in the stock market, knowing how to value a stock is an essential skill.
Investors focus on finding a stock’s intrinsic value, which may not always be the same as its market price. If the intrinsic value is higher than the current market price, investors tend to go long or buy the stock. Otherwise, they tend to stay put or sell the stock to pursue other investment opportunities.
While trading stocks on the stock exchange seems straightforward—buying at low prices and selling at high prices—knowing when and how a stock is valued takes dedication, practice, and precision.
|NOTE: While owning stocks doesn’t make you an actual owner of the company—instead, an owner of its shares—it does give you voting rights and income in the form of dividends.|
How to Research Stocks
To find out a stock’s valuation, you need first to know what type of investor you are. Then, familiarize yourself with the most common stock analytical methods and stock metrics.
An Active or Passive Investor
Investors are generally categorized into two distinct types: active and passive. The primary difference between the two is their understanding of how a stock’s price reflects its true or intrinsic value.
They perform stock research to recognize that the current market price does or doesn’t reflect a stock’s true value. They develop and execute strategies based on this assumption—the goal: to outperform the broader market.
An active investor considers a stock as either undervalued or overvalued. Undervalued stocks are typically a buy; their current market prices are lower than their intrinsic value, and investors go long with hopes of selling when their prices go up. Conversely, overvalued stocks are those whose market prices are higher than their true value, and investors tend to sell them to avoid further losses.
Passive investors regard stock value as reflected on its current market price. They follow the efficient market hypothesis (EMH), which maintains that stock prices are always accurate and all available information is reflected upon such prices. As a result, trying to outperform the market isn’t a viable strategy.
Instead, passive investors prefer to invest in index funds or exchange-traded funds, which track the market’s movements and make investments that mimic them. Followers of the EMH invest in low-cost passive portfolios to generate stable long-term returns.
Know the Stock Analyses
To learn how to analyze stocks, investors must be familiar with the two main types of stock analysis: fundamental and technical.
This type of analysis evaluates stocks based on their intrinsic value. Additionally, fundamental investors measure stock performance in the context of macro factors, such as economic growth and company balance sheets. Active investors use fundamental analysis to evaluate the strength of a stock’s specific industry as part of their effort to find its intrinsic value.
When researching stock, fundamental analysts look at a company’s revenue, earnings, future growth, and return on equity. They then try to determine a company’s underlying value by studying the data. Next, they attempt to find stocks that have excellent growth potential. Ultimately, they either buy more of such stocks or hold them for a long time as it continues to grow, a technique that is known as ‘buy-and-hold’.
Technical analysis focuses on trends rather than underlying value. Analysts who subscribe to this technique use stock research tools that make identifying patterns easier. The goal is to use a stock’s past trading activity and price changes to predict future price movements.
Generally, technical analysis is used by traders who take advantage of volatility, trading volume, and price movements to generate significant, quick, long-term returns. They use trend stock charts and other tools, such as great robo advisors, to help them generate trading signals or points to make a trade.
Learn the Stock Metrics
Learning how to evaluate a stock also means that you must know about stock metrics. While these are the most common stock value metrics used by investors, you don’t have to use all of them all the time; you have to know which metrics matter.
Price-to-Earnings (P/E) Ratio
The P/E ratio compares the company’s current price to its earnings per share (EPS). This ratio may be helpful to one investor but not to another, depending on their investing approach. Value investors, who focus on underappreciated stocks, prefer low P/E ratios because it means the market’s stock valuation is lower than its intrinsic value. Growth investors, who focus on stock appreciation, prefer high P/E ratios when valuing a stock because they indicate superior earnings over other companies.
Price-to-Growth (P/G) Ratio
This is the P/E ratio divided by the company’s earnings for a specific period, essentially determining the stock’s value while considering its expected earnings growth. Investors use this metric to have a more holistic view of a stock’s value.
Price-to-Book (P/B) Ratio
The P/B ratio compares the company’s market capitalization to its book value (the value of its assets according to its balance sheet). When used to determine stock values, this ratio provides another way of pinpointing undervalued stocks. As such, value investors use it in conjunction with other metrics like a company’s return on equity (ROE).
The Debt/EBITDA (earnings before interest, tax, depreciation, and amortization) measures a company’s ability to pay its debts. Investors use this metric to have a more precise representation of a company’s actual cash flow.
Price-to-Sales (P/S) Ratio
This ratio gauges how much the broader market values each dollar in a company’s sales. In general, lower P/S ratios are more attractive to investors who research stocks undervalued but have a high potential for quick recovery and growth.
A dividend yield shows how much a company pays out in dividends relative to its market price. High dividend yields are generally a good sign of stability in mature companies. But it may also be a sign that a company’s growth has plateaued and isn’t reinvesting in its growth. As such, most investors don’t use dividend yields as a metric on their own.
Value traps are essentially fake buying opportunities in the form of cheaply priced stocks with low valuation metrics. When conducting investing research, it’s essential to avoid value traps. They can be misleading, especially to value investors who are used to seeing a certain valuation of a company’s stock.
|Stocks represent ownership of a company’s shares, and they carry investment growth with them.|
|To research stocks effectively, you must know whether you’re a passive or active investor.|
|You can research stocks using two approaches: technical analysis, and fundamental analysis.|
|Stock metrics help investors find the right stocks to invest in by serving as great investment tools.|
|You don’t need to use all stock metrics all the time; use ones that make sense for your situation and goals.|
Other Relevant Factors
Apart from your investment style, analysis approach, and preferred metrics, other relevant factors come into play when using stock valuation techniques.
Stocks represent companies, and companies operate in industries with competitors. One cannot ignore the competition factor (or ‘economic float’) when evaluating stocks.
According to Warren Buffett, an economic moat is a distinct advantage by a company that competitors cannot easily copy. A brand, technology, or patent should be difficult to duplicate. Companies with economic moats can effectively protect their market share, market returns, and profitability since other firms cannot imitate what they have.
When conducting investing research, try to find companies with broad economic moats, as they benefit from the following:
- Secure company bottom line
- More significant and sustainable competitive advantage
- Well-known brand name
- Pricing power
- Cost advantages
- Long-term returns
- Economies of scale
Moreover, companies with wide economic moats benefit from network effects, where many people or users improve the value of a service or product. For instance, as more users use social networks and online messaging apps, more features become available, and the overall performance of the product and service improves. With such improvements, companies can secure their competitive advantage and raise their stock worth.
When researching companies and stocks, internal factors—such as management structure and experience—should also be considered. For example, ask who manages the company and whether they have the appropriate expertise and reputation for leading the business to success.
An excellent management structure can drive up share prices. When investors trust a new CEO, it reflects on stock prices. Stock prices, however, aren’t always an indication of good management. So be wary of high stock prices that may plummet once management decisions fail to make sense—the stock market keeps a watchful eye on company heads.
When studying how to research stocks, you might’ve come across the word ‘trends’, which is used when dabbling in other markets, such as when investing in cryptocurrency or forex. In this context, trends refer to a company’s future price behavior and prospects.
Is the company growing? Are there any indications of poor performance? When it comes to determining stock value, focusing on long-term growth generally is the way to go, especially if you’re a buy-and-hold type of investor. But if you’re a novice, a good stockbroker for beginners can let you in on which companies have excellent long-term growth prospects.
Your research and preferences will also point you to companies focusing on value and stability rather than growth. These companies are generally undervalued but stable, meaning their stocks’ worth doesn’t move a lot but doesn’t suffer from economic downtrends either.
|NOTE: You can invest in stocks using some good IRA accounts; in fact, almost any type of investment is permissible, whether they’re bonds, mutual funds, or annuities.|
Tips for Quick Research
Finding the best stocks to invest in can be overwhelming. But practical tips can make your search easier and more efficient.
Financial News Sites
Websites, such as Investing.com, provide real-time financial market news. These are an invaluable resource if you want to keep up with market trends and events. Websites, such as Investopedia and BabyPips.com, focus on investor education—they’re great when you want to learn how to value a stock quickly.
Online Financial Tools
Online financial tools provide an added layer of accuracy and thoroughness to your evaluations. Crunching numbers and comparing the stock performance of companies are tremendous endeavors, but using online financial tools, such as Robo-advisors, streamlines the process and saves time.
|NOTE: While robo-advisors were initially made for rebalancing assets within target-date funds, their capabilities have expeditiously evolved into investment selection and retirement planning.|
Learning how to know what stocks to buy takes effort, time, and resources. It’s best to know what type of investor you are, what analysis approach suits you, and which metrics to monitor. Analyzing stocks means also studying the businesses behind them, including their long-term prospects and competition—using financial news sites and online tools is excellent for this purpose.
Whether a stock price is good or bad depends on your approach relative to its intrinsic value. If you’re looking for high growth, search for low-priced stocks that have high underlying values. On the flip side, stocks with the lowest prices (penny stocks) are risky investments.
To evaluate stocks before buying, take a holistic approach and determine your overall preference and strategy. For example, consider the stocks’ performance and know which ones will likely give you the best benefits for your overall strategy. And check numerical metrics, such as P/E, P/B, and P/G ratios.
Stocks have value because they give you ownership rights to a company’s shares. They represent a percentage of a company’s market capitalization. Any movement in their prices can affect a company’s value—the main reason why investors are eager to learn how to research stocks.