How do you analyze an investment
Updated: Sep 19, 2020
Each investment decision should start with a plan and personal goal for your portfolio
Break an investment down into risk and opportunity
Examining the fundamentals (earnings, sales, valuation) can help you assess a potential investment
Pay attention to the macroeconomic context
Volatility of the stock should be proportional to investor’s horizon
Evaluating an investment opportunity may seem similar to other shopping decisions you make, but it is a lot more introspective. Opinions and reviews don’t matter as much. Past experience with a stock isn’t a great guide to the future.
To begin, you should understand your personal needs and style. Investment decisions deserve a robust analysis. Imagine you were buying a car: before entering the lot you’d be well advised to arm yourself with the basics (fuel mileage, maintenance costs, warranty) and have at least a vague idea what you’d like to use the car for, and how much you can spend on it.
Whether you’re buying a single stock or building a diversified portfolio, smart shopping can have an impact on your portfolio’s performance. So how do you tell a reasonable investment from a total lemon? There are ways to increase your chances of making an investment that supports your goals.
Have a plan
Much like a car ought to fit your lifestyle, investments should support your goals. Your plans will inform how long you want to keep an investment, and how much risk you’re willing to take on. This may remove the more volatile investments from your consideration (triple leveraged volatility ETFs, for example.)
If you need this money next week (e.g., to pay rent or a credit card bill), volatile assets are unlikely the right choice. Stock prices can fall quickly, taking your plans for the money along with them. You could find yourself staring at a balance 50% lower than you started with in a matter of days.
In contrast, holding stocks for longer periods of time, 5-10 years, meaningfully reduces the risk of loss while increasing your expected return. These investments can support your long-term goals: a home purchase, education, or retirement. However, you need to be able to ride out market downturns, which is not always easy.
The right mix in your portfolio is crucial here: a combination of riskier investments and more predictable fixed income instruments can produce a risk profile that doesn’t cause a heart attack (more on risk parity portfolios here.)
Just like cars come in different sizes, colors and shapes, every stock is different. They vary in size, sector, price. You need to consider its market cap, the industry it’s in, and how it might fit into your portfolio. Does the company pay dividends? What are the business prospects for the industry?
As with cars, investors think about the company’s market cap. This is a good proxy for the size of the business, and is the number you get if you multiply the total number of outstanding shares by the company’s current share price. If the company has 100 shares and its current price is $5, its market cap is $500.
Companies come in a range of sizes. Small caps, as they are known, are generally valued between $250 million and $2 billion. Mid-caps are valued between $2 billion and $10 billion and large caps at $10 billion or above. (Sometimes you’ll hear Facebook, or Microsoft, even referred to as Mega caps.)
Size is important because businesses typically share certain similarities at different stages of growth. Small caps are often unproven: they have a lot of potential, but are also often the first to fail when the economic environment sours. They also face growing pains.
Large caps, on the other hand, are more stable: they have a devoted customer base and experienced management. Both can help weather the challenges that arise from competitors and sustain performance. They are also usually more likely to pay dividends.
Sector is a way to divide all companies into categories loosely related to the type of business they operate. Some are straightforward: banks are in the financial sector, drug makers in the healthcare sector. Others are less clear cut. Internet companies fall into the telecom sector or the technology sector.
There are 11 sectors in the stock market, referred to as the GICS classification. Companies within the same sector are called “peers” and can be used to evaluate a potential investment on a “like for like” basis. It’s never entirely like-for-like but better than comparing a drug maker to an internet stock. Furthermore, investing across different sectors can help diversify the industry risk.
This is less about the company and more about the investor: a “growth investor” looks for companies that are expanding rapidly. These are companies that are sometimes labeled as disruptors. A “value investor” (Warren Buffet types) look for companies they consider underpriced. There is no right or wrong here: both investment styles have their benefits and risks, and many investors use a blend of both.
There are two ways to earn money with stock investing. The more commonly touted one is stock price appreciation: you can sell an investment for more than you paid. A less appreciated way to get a return of your investment is collecting dividends, a portion of profits which a company might pay to its shareholders. Not all companies pay dividends, but those that do typically do so on a periodic basis, often quarterly (i.e., roughly once every three months). They’re not guaranteed and can be eliminated or reduced without notice. However, dividends can provide investors with a meaningful source of income.
A term you’ll often see in this regard is DIVIDEND YIELD, a ratio of the company’s most recent dividend divided by the share price. Early stage companies will typically have zero dividend yield while more mature companies - especially in sectors with reasonably stable earnings - can offer substantial yields.
Do the homework
If you’re buying a stock, you’re taking a stake in a real company. You’ll probably want one that is well-managed and profitable—and you want to pay a reasonable price. The usual starting point are company’s financials. Companies with publicly traded stocks make their financial information available to the public, and you can find on the SEC’s EDGAR site or companies’ investor relations pages. These pages will typically include annual 10-K filings, quarterly earnings reports, and other relevant material. It’s also often included in stock profiles on brokerage platforms or Yahoo Finance.
There are a few questions investors usually ask about companies they’re investigating.
Is the company growing?
Look at the REVENUE. Revenue is the total amount of money the company generates from sales of goods and services. If it increases from one year to the next, that’s generally a sign of growth. An even better sign can be increasing net income, which is a company’s total income minus its expenses.
Is the company profitable?
The go-to metric for experienced investors is the EARNINGS PER SHARE. Earnings per share (EPS) is the company’s total earnings divided by the total number of shares it has on the market. A high (or rising) EPS is often a sign that the company’s business is healthy and the stock a potential opportunity for investors. However, companies know investors watch this metric and occasionally try to raise it artificially: one such example is reverse stock splits.
Is the stock ‘overvalued’ or ‘undervalued?
The operating word you’ll have probably heard is the stock’s PRICE-TO-EARNINGS ratio. The P/E ratio is the stock’s current price divided by earnings per share. It tells you what investors are paying for each dollar of the company’s earnings. For example, a P/E ratio of 10 means investors will pay $10 for every $1 of earnings.
As a rule of thumb a high P/E ratio means investors expect higher earnings, but (to make things a bit confusing) it can also be a sign the stock is overpriced. Similarly, a low P/E may indicate that a stock is undervalued, or it might be an accurate reflection of a company with unexciting growth prospects.
An alternative is to look at the price-to-sales (P/S) ratio. In the lingo, this is known as the “sales multiple.” The ratio divides the company’s market capitalization by its revenue, or total sales, over (usually) a year. P/S ratios for companies in the same industry can help give you a sense of which ones might be undervalued or overvalued. Occasionally, you may also come across a “forward P/S ratio” based on forecasted - rather than actual - sales for the current year.
Is it a good deal?
Everyone loves a good deal. RETURN ON EQUITY (ROE), a measure of how well a company is turning equity into a profit, can help here. The return on equity ratio is net income divided by shareholders’ equity. It’s a way for an investor to measure the bang they’re getting for their buck: how much bottom-line profit a company earns per dollar of value that the shareholders have invested in the company?
As with other metrics, it’s essential to compare it to similar companies, that is, companies in the same industry and of comparable size. It can also be useful to compare a company’s most recent ROE to its ROE in previous years to see if profitability is improving or getting worse.
Analyst reports can help add quantitative, as well as qualitative, information to your research, such as assessing a company’s competitive strengths and weaknesses, new products, and important consumer trends. Analysts also regularly look at management, including stability, track record, and the costs of operating the business.
Watch out for warning signs
Companies often run into trouble when - due to mismanagement or the macroeconomic situation - their revenues fall substantially more than expected. If they borrowed money (to finance expansion, for example), they will be faced with debt payments from a shrinking amount of cash coming in the door.
Some debt is normal, of course, but a company levered to the hilt should be a warning sign. The DEBT-TO-EQUITY ratio can help you look out for over leveraged companies. The ratio takes the company’s total liabilities (i.e. debt) and divides it by shareholder value. A D/E ratio of one or lower generally suggests that a company can cover debts if it has a bad year. A high D/E ratio may be a sign the company is stretched too thin.
The ratios and metrics we discussed above are useful but relying on any single metric alone can lead to poor investment decisions.
And now we come to volatility
Volatility is often confused with risk. The two are not quite the same: a very important economic risk for an investor to avoid is that the investment goes to zero (the company fails, either because of internal or external reasons.) Volatility, on the other hand, is the turbulence of the stock price’s path. It is an important consideration but has more to do with liquidity preferences than the attractiveness of the opportunity. Some of the best investments will be quite volatile and some of the worst will exhibit little price movement until, one day, they’re worth zero.
You’ll often hear the word BETA when discussing volatility. Beta is a numerical rating of a stock’s volatility. It compares the fluctuations of a stock to the broader moves of the market, indicating how sensitive that stock is to market movement. The more volatile a stock or other traded investment is, the higher its beta tends to be. Conversely, the less volatile, the lower the beta tends to be.
The key question the investor must answer is: do i need the money i am investing to be available soon? If the answer is yes, less volatile investments are probably the right choice.
Try it out
It’s always a good idea to watch and follow a stock for a period of time before becoming an investor. Putting yourself in the investor seat can give you a good feel for how you might handle what could be a bumpy ride.
If you’re concerned by the pressure of picking a stock, you can purchase a collection of stocks through an exchange traded fund (ETF) or a mutual fund. These allow you to own many stocks at once and help reduce the risk of picking just one stock. With ETFs and mutual funds, you can also find funds focused on specific sectors or risk levels.
You may choose to do some of the same research as above on the fund’s biggest investments (fund “holdings”.) If you are investing in an actively managed mutual fund, the long-term performance and track record of the fund manager can help you evaluate the fund’s success over time.
An important aspect of fund investing is paying attention to the fees the fund charges every investor. An EXPENSE RATIO is a measurement of the costs associated with investing in a fund. These costs include payments to the fund manager, transaction fees, taxes, and other administrative costs, and are deducted from your returns in the fund as a percentage of your overall investment.