Nobody asks you to become your own doctor or your own lawyer, so why should anybody ask you to become your own stock analyst? Some people like to take up cooking simply because they enjoy doing it. Similarly, there are people like Warren Buffett who enjoy the process of making investments.
Therefore, if you are an investor who likes to be self-reliant, then you should consider becoming your own stock analyst. With a big question mark hanging over some analysts about their credibility, it is always better to learn the ropes yourself. Read on to find out how you too can think like an analyst, even while sitting at home.
- Wall Street often relies on analysts' estimates based on corporate financial data to recommend stocks and determine their target prices.
- Individual investors, too, can utilize the same type of fundamental analysis to identify potential undervalued stocks and set price targets.
- Here, we go over some of the basics for researching stocks and starting to conduct your own analysis.
Stock Analysis Is a Process
It doesn't matter whether you are an investor looking for growth or value, the first step in thinking like an analyst is to develop a probing mind. You need to find out what to buy or sell at what price. Analysts usually focus on one particular industry or sector. Within that particular sector, they focus on select companies. An analyst's aim is to deeply probe the affairs of the companies on their list. They do this by analyzing the financial statements and all other available information about the company. To cross-check the facts, analysts also probe the affairs of a company's suppliers, customers, and competitors. Some analysts also visit the company and interact with its management in order to gain a first-hand understanding of the workings of the company. Gradually, professional analysts connect all the dots to get the full picture.
Before making any investment, you should do your own research. It is always better to research several stocks in the same industry, so you have a comparative analysis. Access to information isn't usually an issue. The biggest constraint in becoming your own stock analyst is time. Retail investors who have many other things to do may not be able to devote as much time as professional security analysts. However, you can surely take up just one or two firms, in the beginning, to test how well you can analyze them. That would help you in understanding the process. With more experience and time, you can think of putting more stocks under your lens.
(For more, see: 12 Things You Need to Know About Financial Statements)
Best to Start Where You Are
Looking over analyst reports is the best way to start your own analysis. That way, you save a lot of time by cutting short preliminary work. You don't have to blindly follow sell or buy recommendations that analysts make, but you can read their research reports to get a quick overview of the company, including its strengths and weaknesses, main competitors, industry outlook and future prospects. Analysts' reports are loaded with information, and reading reports by different analysts simultaneously would help you in identifying the common thread. Opinions may differ, but basic facts in all reports are common.
Furthermore, you can take a closer look at the earnings forecasts of different analysts, which ultimately determine their buy or sell recommendations. Different analysts may set different target prices for the same stock. Always look for the reasons while reading analysts' reports. What would have been your opinion about the present stock given the same information? No clue? Then move on to the next step. (See also: Earnings Forecasts: A Primer)
What to Analyze
To arrive at your own reliable conclusion about a stock, you need to understand the various steps involved in stock analysis. Some analysts follow a top-down strategy, starting with an industry and then locating a winning company, while others follow a bottom-up approach, starting with a particular company and then learning about the outlook of the industry. You can make your own order, but the entire process must flow smoothly. Any process of analyzing a stock would involve the following steps.
There are publicly available sources of information for almost any industry. Often, the annual report of a company itself gives a good enough overview of the industry, along with its future growth outlook. Annual reports also tell us about the major and minor competitors in a particular industry. Simultaneously reading the annual reports of two or three companies should give a clearer picture. You can also subscribe to trade magazines and websites that cater to a particular industry for monitoring the latest industry happenings.
Business Model Analysis
You should focus on a company's strength and weaknesses. There can be a strong company in a weak industry and a weak company in a strong industry. The strengths of a company are often reflected in things such as its unique brand identity, products, customers, and suppliers. You can learn about a company's business model from its annual report, trade magazines, and websites.
Whether you like it or not, understanding the financial strength of a company is the most crucial step in analyzing a stock. Without understanding financials, you cannot actually think like an analyst. You should be able to understand a company's balance sheet, income statement, and cash flow statements. Often, numbers lying in the financial statements speak louder than the glossy words of an annual report. If you're not comfortable with numbers, and you want to analyze stocks, there's no time like the present to begin learning and getting comfortable with them.
Management quality is also a critical factor for a stock analyst. It is often said that there are no good or bad companies, only good or bad managers. Key executives are responsible for the future of the company. You can assess company management and board quality by doing some research on the Internet. There is a plethora of information is out there about every public company.
Stock prices follow earnings, so in order to know whether a stock price would be moving up or down in the future, you need to know where future earnings are heading. Unfortunately, there is no quick formula that can tell you what to expect for future earnings. Analysts make their own estimates by analyzing past figures of sales growth and profit margins, along with profitability trends in that particular industry. It's basically connecting what has happened in the past to what's expected to happen in the future. Making accurate enough earnings forecasts is the ultimate test of your stock analysis capabilities because it's a good indication of how well you understand those industries and companies.
Once you understand future earnings, the next step is to know about the worth of a company. What should be the worth of your company's stock? Analysts need to find out how much the current market price of the stock is justified in comparison to the company's value. There is no "correct value," and different analysts use different parameters. Value investors look at intrinsic worth whereas growth investors look at earning potential. A company selling at a higher P/E ratio must grow at a higher price to justify its current price for growth investors.
(For related reading, see: 6 Basic Financial Ratios and What They Reveal)
The final step is to set a target price. Once you know about future earnings, you can calculate a high and low target price by multiplying estimated earnings per share (EPS) with the estimated high and low P/E Ratio. The high and low target price is the price band within which the future stock price is likely to move in response to the expected future earnings. Once you know the target price, you can very well use it to reach your destination.
The Bottom Line
The ultimate goal of every investor is to make a profit, however, not every investor or analyst is good at it. Never blindly accept what stock analysts have to say and always do your own research. Not everybody can be an investing expert, but you can always improve your analytical skills when it comes to stocks.