Stock analysis is the evaluation of a particular trading instrument, an investment sector, or the market as a whole. Stock analysts attempt to determine the future activity of an instrument, sector, or market.
What Are Stocks?
Breaking Down Stock Analysis
Stock analysis is a method for investors and traders to make buying and selling decisions. By studying and evaluating past and current data, investors and traders attempt to gain an edge in the markets by making informed decisions.
There are two basic types of stock analysis: fundamental analysis and technical analysis. Fundamental analysis concentrates on data from sources, including financial records, economic reports, company assets, and market share. To conduct fundamental analysis on a public company or sector, investors and analysts typically analyze the metrics on a company’s financial statements – balance sheet, income statement, cash flow statement, and footnotes. These statements are released to the public in the form of a 10-Q or 10-K report through the database system, EDGAR, which is administered by the US Securities and Exchange Commission (SEC). Also, the earnings report released by a company during its quarterly earnings press release is analyzed by investors who look to ascertain how much revenues, expenses, and profits a company made.
When running stock analysis on a company’s financial statements, an analyst will usually be checking for the measure of a company’s profitability, liquidity, solvency, efficiency, growth trajectory, and leverage. Different ratios can be used to determine how healthy a company is. For example, the current ratio and quick ratio are used to estimate whether a company will be able to pay its short-term liabilities with its available current assets. The formula for current ratio is calculated by dividing current assets by current liabilities, figures that can be gotten from the balance sheet. Although, there is no such thing as an ideal current ratio, a ratio less than 1 could indicate to the stock analyst that the company is in poor financial health and may not be able to cover its short-term debt obligations when they come due.
Looking at the balance sheet still, a stock analyst may want to know the current debt levels taken on by a company. In this case, a stock analyst may use the debt ratio, which is calculated by dividing total liabilities by total assets. A debt ratio above 1 typically means that a company has more debt than assets. In this case, if the company has a high degree of leverage, a stock analyst may conclude that a rise in interest rates may increase the company’s probability of going into default.
Stock analysis involves comparing a company’s current financial statement to its financial statements in previous years to give an investor a sense of whether the company is growing, stable, or deteriorating. The financial statement of a company can also be compared to that of one or more other companies within the same industry. A stock analyst may be looking to compare the operating profit margin of two competing companies, by looking at their income statements. The operating profit margin is a metric that shows how much revenue is left after operating expenses have been paid and what proportion of revenue is left to cover non-operating costs and is calculated as operating income divided by revenue. A company with an operating margin of 0.30 will be looked on more favorably than one with a margin of 0.03. A 0.30 operating margin means that for every dollar of revenue, a company has 30 cents left after operating costs have been covered. In other words, the company uses 70 cents out of every dollar in net sales to pay for its variable or operating costs.
The second method of stock analysis is technical analysis. Technical analysis focuses on the study of past market action to predict future price movement. Technical analysts analyze the financial market as a whole and are primarily concerned with price and volume, as well as the demand and supply factors that move the market. Charts are a key tool for technical analysts as they show a graphical illustration of a stock’s trend within a stated time period. For example, using a chart, a technical analyst may mark certain areas as a support or resistance level. The support levels are marked by previous lows below the current trading price, and the resistance markers are placed at previous highs above the current market price of the stock. A break below the support level would indicate a bearish trend to the stock analyst, while a break above the resistance level would take on bullish outlook.
Technical stock analysis is effective only when supply and demand forces influence the price trend analyzed. When outside factors are involved in a price movement, analyzing stocks using technical analysis may not be successful. Examples of factors, other than supply and demand, that can affect a stock price includes stock splits, mergers, dividend announcements, a class action lawsuit, death of a company’s CEO, a terrorist attack, accounting scandals, change of management, monetary policy changes, etc.
Both fundamental and technical analysis can be done independently or together. Some analysts use both methods of analyses, while others stick to one. Either way, using stock analysis to vet stocks, sectors, and the market is an important method of creating the best investment strategy for one’s portfolio.