Introduction
Learning how to analyze stocks is an essential part of making better investment decisions. One day a stock can soar, another it can tank, which can seem confusing. The key takeaway to this is to not base your stock picks and stock analysis on opinions, recommendations, and popularity. The latest news is important but is one of many elements to finding a stock that you can hold long-term.
In this guide, I will cut through the fluff of stock analysis, and focus on the core things you need to understand that I personally use for deciding on a stock.
To make it a bit more accessible, I will use a common stock TSCO (Tesco PLC), the UK’s retail giant with a break down of how it could be analyzed as an investor.
1. Fundamental and Technical Analysis
A stock analysis is broadly divided into two methodologies called Fundamental Analysis and Technical Analysis. Both of these methods of analysis are important but serve different purposes.
Fundamental Analysis
A fundamental analysis involves the evaluation of a companies financial health and growth prospects, to determine their intrinsic value (the true worth of a stock to shareholders) based on performance metrics.
“Is this company built to last, or is it just coasting on a hype train?”
However, although a fundamental analysis is important, it is usually used in combination with financial statements, earnings reports, and an understanding of the market conditions to assess the company’s performance.
Key elements of a Fundamental Analysis:
- Revenue and earnings growth – Is the business building more revenue?
- Profit margins – Are they profitable or at least working towards it?
- Debt levels – Do they produce more than they own?
- Management team and leadership – Strong leadership represented by a quality management team with a vision for the company.
- Competitive positioning – Does it have a “moat” or strong edge in the market?
Technical Analysis
We use this metric to look at historical market data patters, such as price movements and trading volumes. A technical analysis is great for predicting future trends through the use of charts, indicators, and patterns, such as moving averages (the general direction) or relative strength indices (often shortened to RSI). All of these within a technical analysis will help you to identify trading opportunities.
For long-term investors, a fundamental analysis is normally the most recommended and the go to method for most. A technical analysis is better suited for short-term traders who are looking for volatility and market fluctuations.
So Should You Use a Fundamental Analysis or Technical Analysis?
- Short-term traders often rely on technical analysis to navigate volatility
- Long-term investors typically use fundamental analysis
2. Key Metrics for Stock Analysis
I will focus on the most important metrics and ratios for a fundamental analysis using several evaluation metric frameworks.
Earnings Per Share (EPS)
Earnings Per Share (also commonly referred to as EPS) is one of the most important and well known ways of understanding how profitable a company is.
EPS tells you how much profit the company is generating per share of the stock. In this case, the more the better as it would indicate that they’re not just burning cash but actually making use of that money efficiently.
A higher EPS typically indicates better financial health.
General rules to look for:
- Consistent growth in EPS year on year.
- Comparative with industry peers for relative comparison.
How it works: Take the company’s total profit and divide it by the number of shares floating around. Say they made £50 million and have 1 million shares outstanding, that’s an EPS of £50. Simple, right?
Price-to-Earnings (P/E) Ratio
The Price-to-Earnings ratio (often referred to as P/E for short) is used to understand the price based on its earnings. It can help to tell you whether a stock is undervalued or overvalued based on their earnings. A P/E can tell us whether a stock is overvalued. However, that over-evaluation can sometimes be justified which is why a P/E ratio should not be the sole evaluation metric for understanding a business.
A high P/E ratio tells you that a stock is overvalued, while a low P/E ratio could indicate it’s undervalued.
General rules to look for:
| P/E Range | What it Could Mean |
|---|---|
| Under 15 | Potentially undervalued or underperforming |
| 15 to 25 | Often seen as reasonable/average |
| Over 25 | High optimism or market overhype |
How it works: Divide the stock price by the EPS. If the stock price is £20 and the EPS is £2, you’ve got a P/E of 10. A lower P/E can be a hint you’re getting a deal, but don’t bet the farm on it alone.
Price-to-Book (P/B) Ratio
The Price to Book or P/B ratio takes the company’s market value and compares it to its book value (net assets). A P/B ratio below 1 could suggest that the stock is undervalued, but it’s not a one size fits all, there are other important factors one should also assess.
General rules to look for:
| P/B Range | What it Could Mean |
|---|---|
| Under 1 | Possibly undervalued or company is facing issues |
| 1 to 3 | Reasonable for most established businesses |
| Over 3 | High growth expectations or potential overvaluation |
How it works: Stock price divided by book value per share. A £10 stock with a £12 book value per share has a P/B of 0.83. Sounds cheap, but you’ve still got to ask why this is the case.
Return on Equity (ROE)
Return on Equity (often shortened to ROE) is a metric for measuring how well a company is utilising shareholder equity to generate profits. A high ROE would usually mean a company is effectively using the capital it has acquired through the sale of shares to grow the business. The opposite would mean they’re failing to use shareholder financing efficiently.
| ROE Range | What it Could Mean |
|---|---|
| Under 10% | Would mean the business is very inefficient or has weak profitability. |
| Between 10% to 20% | This is a healthy range and means the business is stable. |
| Over 20% | Can reflect strong performance or possibly high debt |
How it works:
Divide the net income by shareholders’ equity. For example, if a company earns £5 million in net income and has £25 million in equity, the ROE is 20%. A higher ROE means more profit per pound/dollar of equity, but watch out for signs of excessive debt that could be boosting the number.
3. Understanding Financial Statements
Financial statements are one of the most important aspects of understanding a company’s performance. They are a perfect snapshot of the current financial situation of the business.
Income Statement
This shows the company’s revenues, expenses, and profits over a specific period to see how they are performing.
Key metrics include:
- Revenue – this is the company’s total income generated from sales.
- Gross Profit Margin – how much of each Dollar (or Pound/Euro) of sales is profit after deducting the cost of goods or services sold.
Example:
If a company earns £500,000 in revenue and has £300,000 in cost of goods sold, the gross profit is £200,000, resulting in a Gross Profit Margin of 40%.
Balance Sheet
The balance sheet outlines the company’s assets, liabilities, and equity. It helps you understand how much debt the company has and how financially stable it is.
Key metrics include:
- A key ratio to look at here is the debt-to-equity ratio, which compares the company’s total debt to its equity (the value of its shares). A higher ratio can signal a riskier financial position.
Example:
If a company has £2 million in total liabilities and £1 million in shareholder equity, the Debt-to-Equity Ratio is 2:1, which may indicate higher financial risk.
Cash Flow Statement
A company cash flow statement shows how cash is entering and leaving the business. It is your go to manual for fully understanding the business.
Free cash flow (FCF) is an important figure here. FCF represents the cash left over after the company covers its required capital expenditures and operating costs. A company with a healthy free cash flow is better positioned to weather tough times and invest in growth.
It also means they have more flexibility in terms of rewarding shareholders with buybacks, dividend increases, or research and acquisitions to expand and grow.
Key metrics include:
- Free Cash Flow (FCF) – the cash left after covering operating expenses and capital expenditures.
Example:
Let’s say a company generates £150,000 in operating cash flow and spends £50,000 on capital investments. With some simple math £150,000 – £50,000 = £100,000 in Free Cash Flow. This suggests the company has funds available for dividends, debt repayment, or reinvestment (or however the company decides to utilise this capital)
4. Assessing Growth Potential
While analysing past performance is essential, you also need to evaluate the company’s future prospects to see whether their prospects can improve, maintain, or discourage investments.
Sometimes you might need to look above and beyond metrics, does the company have a moat or opportunity for growth in a sector that has increasing demand?.
Some growth factors to consider include:
- Industry Trends: Is the company operating in a growing sector? For example, tech companies tend to grow the fastest. Meanwhile, satellite-TV companies are a a dying industry with streaming replacing it.
- Competitive Advantage: Is there a “moat” (or an edge) that sets the company apart from competitors?. A strong brand, innovative product, or low-cost production can contribute to providing a competitive advantage over competitors.
- Management Quality: Poor management can destroy a company. To the contrary, a strong management team can lead a company to long-term success. Look at their track record if they’ve worked in other companies and whether they have a clear strategic vision for guiding the company.
5. Valuation Methods:
How to Determine If a Stock is Over or Undervalued
Once you’ve evaluated the company’s financial health and future potential, you need to determine if the stock is fairly priced relative to its value. I would recommend using a tool once you’ve gathered the required data.
Here are two common methods:
Discounted Cash Flow (DCF)
A DCF model is useful for estimating the present value of a company’s future cash flow. An easier way to understand this is if the current stock price is lower than the present value, then the stock could be a good buy.
Compare It to the Competition
You can also compare the company’s key ratios Price-to-earnings or Price-to-book (P/E or P/B) to other companies in the same industry. This helps you determine if the stock is priced reasonably relative to its peers.
6. Debt Levels – Is the Company Overloaded?
Debt isn’t always a bad thing. Debt can be a strategic decision to fuel growth, invest in expansion, or if you are a REIT, be required in order to invest back into the business.
However… too much debt is an issue, especially if it starts to limit the company’s financial flexibility. a higher D/E indicates that a company is using more debt to finance its assets (which therefore means higher risk). The threshold average is considered to be 2.0 but this can vary by industry.
It is calculated by dividing a company’s total liabilities by its shareholders’ equity.
Key metrics:
- Debt-to-Equity Ratio: This represents a company’s ability to leverage finance. A financial metric used to evaluate a company’s financial leverage. A ratio under 1 is generally considered healthy.
- Interest Coverage Ratio: This tells you whether the company can comfortably cover its interest payments using its operating profits. A ratio below 1.5 could indicate potential trouble.
- Debt Payback Period: This estimates how many years it would take the company to pay off its total debt using its free cash flow.
You’ll find most of these figures in the balance sheet and cash flow statement of the company’s financial reports.
Example:
Company A with £500 in debt generates a free cash flow of £100 per year. Using a Free Cash Flow Payback period calculator, we would know that it would take exactly 5 years to repay its debt (under the assumption that all cash goes towards debt repayment which is not possible, but you get the idea).
Although a reasonable free cash flow period will vary by sector (some sectors incur more operational debt than others). Here is a rough guide:
Free Cash Flow Payback Period
- Under 1 year: This is typically viewed as an excellent payback period, indicating a very low risk investment.
- 1 to 3 years: This is generally considered a good payback period, striking a balance between reasonable risk and return.
- 3 to 5 years: This could be acceptable for investments that have significant upside potential but come with increased risk.
- Over 5 years: This is usually viewed as a less attractive payback period unless the investment genuinely offers substantial long-term returns.
7. An Example: Analyzing Tesco (TSCO)
Okay, enough theory, let’s put this to work with Tesco, the UK’s supermarket kingpin.
- Earnings Per Share (EPS)
Tesco’s pulling in about £0.31 per share. That’s 31p of profit for every share, which ain’t half bad for a grocery chain. - Price-to-Earnings (P/E) Ratio
Fitting within the undervalued range, with a P/E of 14, Tesco’s is currently pretty well valued and not over overpriced. - Price-to-Book (P/B) Ratio
Tesco’s P/B is about 1.2, so it’s trading a smidge above its book value. Not a fire sale, but not crazy either. - Return on Equity (ROE)
At 10.5%, Tesco’s doing a solid job squeezing profits out of shareholders’ money. It’s not setting the world on fire, but it’s steady. - Financial Health
Tesco’s debt-to-equity ratio isn’t scary, so they’re not borrowing like there’s no tomorrow. Plus, their free cash flow is positive, meaning they’ve got cash to keep things running and maybe open a few more stores. - Growth Potential
Supermarkets aren’t exactly the next big thing, but Tesco’s is a solid business. Their Clubcard keeps shoppers hooked (who doesn’t love a discount?), and they’ve been expanding it with online grocery delivery. That’s a big deal when everyone’s ordering everything online these days.
Helpful Resources for Stock Analysis
Ready to dive deeper into stock analysis? Here are a few resources that can help:
- Investopedia – Stock Analysis: A solid guide on how to analyze stocks with easy-to-understand articles.
Read more on Investopedia - Yahoo Finance – Financials: Find detailed financial data and key metrics for any company you’re interested in. It also offers a useful follow for stocks you are interested in.
Explore Yahoo Finance - Morningstar – Stock Analysis: Offers in-depth analysis and ratings on a variety of stocks, ETFs, and mutual funds.
Visit Morningstar
My Personal Tools
- Tools Archives – Chasing Cheddar – A collection of calculators and investing tools
- Freebies
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Conclusion
Being a smarter investor means using all the tools at your disposal to make better choices in the stocks you buy, keep, or sell. Don’t buy stocks based on FOMO, trends, or comments. Remember that if you would rather take the safer route, there is always the option of buying a diversified managed ETF like the S&P 500 if you are not confident picking stocks.
Disclaimer: This is not financial advice, please speak to a financial advisor when making important investment decisions with your money.
Awesome article and essential reading for any investor.
Thanks for reading!, i’m glad it was useful 🙂