How To Analyse A Stock, With Six Simple Questions

• The first steps in assessing any stock are qualitative: understanding what the firm does and how exactly it makes its money, and then analyzing its industry and competitive landscape.

• Next, you’ll want to examine the firm’s sales growth, profit margin, return on invested capital, and cash flows to see whether it has strong fundamentals. Following that, you’ll want to compare the stock’s forward price-to-earnings ratio to its peers and the broader market.

• Finally, it’s important to assess what others (investors, professional analysts, and the firm’s own management team) think about the stock and what its biggest risk factors are.

Every now and again, a company’s shares will pique your interest – maybe because of something you’ve read or heard from a friend (hopefully, one with a solid investing record). And that’s an exciting moment, but what you do next is what really matters. Do nothing, and an opportunity could pass you by. Do a quick evaluation, and you could discover an investment that’s worthy of your hard-earned money. So here are six essential questions that can help you analyze a stock.

1. What does the company do?

When you buy stocks, you become a part owner of the company, no matter how many (or how few) shares you hold. So treat each stock purchase as if you’re actually buying the whole company. And that means making sure you understand what the firm does and how it makes its money.

That might sound obvious, but you’d be surprised how many people overlook this basic question. Thousands of investors bought Enron’s stock without any understanding of how the energy firm claimed to earn its profits, only to face huge losses after it was revealed that much of those profits were, in fact, fictitious.

“Never invest in an idea you can’t illustrate with a crayon.” Peter Lynch.

Those investors could’ve avoided getting burned had they listened to Lynch’s sage advice.

So, before you invest in a stock, take a minute to consult a company’s annual reports (particularly the business overview section), financial statements, website, mission and vision statements, and investor presentations. All that stuff is widely available and can typically be found on the company’s investor relations webpage. You even ask ChatGPT to summarize the firm’s exact business model. Then, to take your understanding a step further, you can do on-the-ground research – testing out the firm’s products, talking to current (or former) employees, and visiting its stores.

2. What’s the industry and competition like?

Companies don’t operate in a vacuum: they’re part of a wider industry with suppliers, competitors, key customers, and so on. And there are three important things to analyze when looking at the industry and competition.

First, pinpoint where the industry is in its life cycle, which is composed of five main phases. This is important because what makes a company successful may change, depending on which stage of the cycle its industry is in.

The five phases of the industry life cycle and what makes a company successful in each one. Source: Finimize.

Second, assess whether the industry is cyclical or non-cyclical. Cyclical industries fluctuate with economic cycles, experiencing high growth in boom times and sharp declines in downturns, whereas non-cyclical industries remain stable, showing consistent demand regardless of economic conditions. This should affect your view on the stock and whether it’s the right time to invest. To state the obvious: buying cyclical shares right before a recession is probably not a wise move.

Third, analyze the industry’s competitive landscape. Porter’s Five Forces (below) is a good framework for this. A hypothetical example of a perfect industry to invest in is one with no threats of new entrants or substitute products, very little bargaining power for suppliers and customers, and very low rivalry among existing competitors. By the way: you can also ask ChatGPT to conduct a Porter’s Five Forces analysis on a particular company – its results can often be a good starting point.

An overview of Porter’s Five Forces framework. Source: CFA.

3. Does the company have strong fundamentals?

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett.

Some folks have a knack for spotting distressed companies on the verge of a turnaround, but for most of us, investing in high-quality companies with solid fundamentals is a better bet. There are a lot of ways to determine whether a firm is high-quality, but I’d suggest starting with the three key metrics below.

Three key metrics to analyze a company’s fundamentals. Source: Finimize.

Sales growth and profit margins are easy enough to understand. Return on invested capital (ROIC) is a measure of profitability that gauges how effectively a company has used investors’ money. A higher return is better and – at a minimum – companies should (eventually) deliver returns that are higher than their cost of capital. That’s typically measured as a weighted average cost of capital (WACC), which accounts for the proportion of financing from debt and equity and the cost associated with each. For context, the WACC of the average publicly traded firm is around 7%, with some variations depending on its riskiness and industry. Here’s a great reference tool you can use that’s frequently updated.

In addition to those three metrics, you’ll want to analyze a company’s cash flow. While reported profit on the income statement can be manipulated through accounting shenanigans, the cash flow statement tracks actual money coming in and going out. And, consequently, it’s very hard to fudge – in this regard, cash really is king.

To assess a company’s performance on a cash basis, you can look at how much free cash flow (FCF) the company generates – and what it does with it. FCF represents the amount of cash generated after all necessary reinvestments back into the business. It’s calculated as cash flow from operations – the amount of money generated from core business activities like making and selling products – minus capital expenditures. Ideally, you want to see positive and growing FCF – and proof that the company is using that money to pay down debt, grow its cash pile (for future investments), and reward shareholders through dividends and share buybacks.

Analyzing a company’s free cash flow (FCF). Source: Finimize.

4. Is the stock cheap or expensive?

“Price is what you pay. Value is what you get.” – Warren Buffett.

If you overpay for a stock, you risk losing money on it – even if it’s a share in a high-quality company. That’s why it’s extremely important to assess a stock’s valuation before you invest. A widely used metric to do so is the forward price-to-earnings (P/E) ratio, which compares a company’s current share price relative to its estimated future earnings per share over the next 12 months. The ratio basically tells you how much you’d pay for one dollar’s worth of a company’s future earnings, allowing you to easily compare the valuations of different stocks, regardless of their size.

While you can look at the P/E ratio in isolation, it becomes a lot more meaningful when you compare it to the stock’s own history, its industry peers, and the broader market. Generally, a lower P/E ratio suggests a cheaper stock, while a higher ratio indicates a more expensive one. Just keep in mind that a higher P/E ratio on its own doesn’t necessarily mean a stock is overvalued: there are plenty of things that can justify a higher P/E ratio for a stock, including:

• Faster earnings growth

• Higher-quality earnings (e.g. comes from predictable and recurring revenue)

• Bigger profit margins

• Higher ROIC

• Lower company risk

• Superior management team

• Better environmental, social, and governance (ESG) credentials

• Stronger competitive advantages (because those protect profits)

• Lower cost of capital

Having said that, the reality is that investor sentiment often has a huge impact on stock valuations, driving P/E ratios far above (or below) what’s justifiable. And a stock that has a lower P/E ratio than justified might be a good buying opportunity, while a stock with a higher P/E ratio than justified might be one to avoid. That, then, leads us to question five.

5. What do others think about the stock?

It’s always worth assessing what others think about the stock before making any investment decision. By others, I’m referring to three groups of people: investors, professional analysts, and the firm’s own management team.

A quick way to assess overall investor sentiment toward a stock is to examine its price chart to see whether it’s in an uptrend or downtrend. Or you can do this more scientifically by looking at how much higher or lower a stock’s price is than its 50-day moving average. A price above the average indicates an uptrend (potentially a good time to invest), while below suggests a downtrend (perhaps better to avoid the stock). But take this rule with a grain of salt and apply your common sense. If a stock’s gone parabolic in a short period, that could suggest investor sentiment has become too extreme, potentially leading to trouble if attitudes shift.

You can easily see what professional analysts think about a particular stock by looking at the ratings they’ve assigned to it (you can find these on sites like WSJ or Yahoo Finance). These ratings indicate the analyst’s view on whether institutional investors – think: asset managers, hedge funds, and the like – should buy into or avoid a particular company’s shares. Ratings can be positive (expressed as “buy”, “outperform”, or “overweight”), negative (“sell”, “underperform”, or “underweight”), or neutral (“hold”, “market perform”, “equal-weight”).

You can use analyst ratings as a sense check for your own view on a stock (just note that recommendations tend to be skewed toward the positive end of the scale), or as an opportunity to be a contrarian investor – that is, going against the consensus recommendation. Similarly, tracking any rating changes over recent months can help you pick up on shifts in sentiment that might hint at a stock’s potential to rise or fall.

Finally, to gauge what a firm’s management team thinks of their stock, look no further than net insider buying (or selling). This shows the net amount of shares bought (or sold) by insiders – that is, executives and directors – over the past, say, 90 days. Company insiders arguably have the most knowledge about the firm’s prospects. So if a lot of them are buying shares, that suggests they’re feeling good about the company’s outlook and/or see its shares as undervalued. That’s a good sign from your point of view. Of course, the opposite is also true.

6. How risky is the stock?

Risk management is key to long-term success in investing. It’s one thing to weigh up a stock’s potential upside, but if you don’t consider the potential downside, you could stand to lose a lot of money when things go wrong. Fortunately, it’s pretty simple to see what key risks a business is facing because virtually every publicly listed company discloses them in their annual reports (usually under a section called “risk factors”). To quantitatively assess how precarious a stock might be, you can look at its beta and the company’s net debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio.

Stock beta measures a stock’s sensitivity to the broader market. A beta above 1 indicates that the stock price is likely to move more than the broader stock market – while a beta below 1 indicates that it might move less. For example, a stock with a beta of 1.5 would be expected to rise 15% when the broader stock market rises 10%, but fall 15% when the market falls 10%. The higher the beta, the more volatile the stock and, therefore, the riskier it is as an investment.

The net debt-to-EBITDA ratio shows the company’s net debt (total debt minus cash) relative to its operating profit before factoring in the impacts of various financing and accounting decisions. Investors use the ratio to assess a firm’s debt burden, and companies that have huge debt piles relative to their earnings are considered more risky. The number itself hints at how many years a company would need to keep performing as it is to pay off all its debt. Certain industries rely more heavily on debt and might carry higher ratios as a result. But generally, anything above five (regardless of industry) should be viewed as a red flag.

Take JCPenney as a case study: the department store chain’s net debt-to-EBITDA ratio at the end of 2019 stood at 5.5x. A few months later, when the pandemic struck and forced it to close its physical stores, the firm became unable to manage its debts and was forced to file for bankruptcy. Oh, and you’ll never guess what the company cited in its 2019 annual report as a big risk factor: “As of 1-Feb-2020, we have $3.7 billion in total indebtedness and we are highly leveraged”. Snap.