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Before venturing into stock market investments, a careful evaluation of crucial factors is imperative for making informed decisions. This involves assessing a company’s financial health, understanding market trends, and considering broader economic conditions. In this discussion on what to check about stocks before investing, we delve into the key considerations that empower investors to navigate the complexities of the stock market with confidence.
Defining a Stock
A stock, also known as a share or equity, represents ownership in a company. When an individual owns a stock, they become a shareholder, entitling them to a portion of the company’s assets and earnings.
- Stocks are typically bought and sold on stock exchanges, and their value can fluctuate based on various factors such as company performance, market conditions, and investor sentiment.
- Investing in stocks offers the potential for capital appreciation and may also provide dividends as a share of the company’s profits.
- Overall, stocks play a fundamental role in the financial markets, serving as a key vehicle for investors to participate in the ownership and potential growth of publicly traded companies.
Types of Stock Analysis
When delving into stock analysis, there are two primary approaches to consider: fundamental analysis and technical analysis.
Fundamental Analysis
Fundamental analysis is based on the assumption that a stock price doesn’t necessarily reflect the true intrinsic value of the underlying business. Fundamental analysts use valuation metrics and other information to determine whether a stock is attractively priced. Fundamental analysis is designed for investors looking for excellent long term returns.
Technical Analysis
Technical analysis operates on the assumption that a stock’s price incorporates all available information, and price movements tend to follow trends. In essence, scrutinising a stock’s price history allows for potential predictions of its future price behaviour. When you observe individuals identifying short-term patterns in stock charts or discussing moving averages, they are engaging in a form of technical analysis.
One important distinction is that fundamental analysis is intended to find long term investment opportunities, while technical analysis typically focuses on relative short-term price fluctuations.
Key Considerations Before Investing in Stocks
Identify Companies
There are various strategies you can implement to find the companies with the right stocks for you. For instance, you can track exchange-traded funds, or ETFs, that closely follow the composition and performance of prominent indices. Alternatively, you can start by filtering out stocks on the basis of your preference of industry and sector.
Monitor Financial News
Another recommendation on how to pick stocks is to closely follow the latest financial and market-related news. Financial, well-researched opinions in the form of interviews, blogs and articles can be informative and help you narrow down your choices. This form of news can sometimes also be speculative, so make sure to conduct your own research as confirmation.
Follow Public Interests and Events
Sometimes, certain trends in culture and lifestyle can lead to a renewed interest in specific products or services. This can eventually lead to an increase in demand and therefore considerable price movements for certain stocks. You can capitalise on such opportunities by following such trends as they emerge and making investments in the appropriate stocks.
Important Investing Metrics
Let’s take a look at four of the most important and easily understood metrics any investor should have in their analytical toolkit to understand a company’s financials:
- Price to Earnings (P/E) Ratio: Companies report their profits to shareholders as earnings per share, or EPS for short. The price to earnings ratio, or P/E ratio, is a company’s share price divided by its annual per-share earnings. It is the most common valuation metric in fundamental analysis and is useful for comparing companies in the same industry with similar growth prospects.
- Price to Earnings Growth (PEG) Ratio: Different companies grow at different rates. The PEG ratio takes a stock’s P/E ratio and divides it by the expected annualised earnings growth rate over the next few years to level the playing field. The idea is that a fast-growing company can be ‘cheaper’ than a slower-growing one.
- Price to Book (P/B) Ratio: A company’s book value is the net value of all of its assets. Book value is the amount of money a company would theoretically have if it shut down its business and sold everything it owned. The price to book, or P/B, ratio is a comparison of a company’s stock price and its book value.
- Debt to EBITDA Ratio: One good way to gauge financial health is by looking at a company’s debt. There are several debt metrics, but the debt to EBITDA ratio is a good one for beginners to learn. You can find a company’s total debts on its balance sheet, and you’ll find its EBITDA (earnings before interest, taxes, depreciation, and amortisation) on its income statement. A high debt to EBITDA ratio could be a sign of a higher-risk investment, especially during recessions and other tough economic times.
Look Beyond Numbers
This is perhaps the most important step in the analytical process. There’s more to stock research and analysis than just looking at valuation metrics. It is far more important to invest in a good business than a cheap stock. With that in mind, here are three other essential components of stock analysis that you should watch:
- Durable competitive advantages: As long term investors, we should be aware of whether the company will be able to sustain or grow its market share over time. This can come in several forms. A trusted brand name can give a company pricing power, patents can protect it from competitors, and a large distribution network can give it a cost advantage over peers, just to name a few.
- Great management: It doesn’t matter how good a company’s product is or how much growth is taking place in an industry if the wrong people are making key decisions. Ideally, the CEO and other main executives of a company will have successful and extensive industry experience and financial interests that align with shareholders.
- Industry trends: Investors should focus on industries that have favourable long term growth prospects. For example, e-commerce is an example of an industry with a favourable growth trend. Cloud computing, payments technology, and healthcare are a few other examples of industries that are likely to grow significantly in the years ahead.
Conclusion
The goal of stock analysis is to find companies that you believe are good values and great long term businesses. Not only does this help you find stocks likely to deliver strong returns, but using analytical methods like those described here can help prevent you from making bad investments and losing money. Now that you’re armed with knowledge on how to take the first steps in identifying good stocks in your portfolio, consider making your first (or next) investment in Share India’s next-gen trading apps that come with a plethora of analytics and smart tools.