What is inventory analysis? Financial experts explain their favorite strategies
Choosing stocks is like playing the claw machine – it’s really hard to win, but you still have hope every time you come home with a plush giant Jigglypuff.
Financial market experts agree that identifying which stocks will beat the global market is difficult. That’s why investors often invest their money in index funds, an easy way to build a diversified portfolio while ensuring that you at least match market returns.
Yet many of us, having built a diversified portfolio, still want to invest in companies that we believe are going to make big. The question is how to spot these stocks before their values ââskyrocket, like Amazon. On the last day of 2005, just a few months after Amazon Prime launched, the stock was trading at around $ 47; now it is trading above $ 3,000, up over 6,000%.
A word of warning
If you are determined to uncover an undervalued stock that few others have already found, it probably won’t happen. Emma Rasiel, professor of economics at Duke University, told us directly without a hunter.
âThere are thousands of professional stock analysts doing this all day,â she said. âIt’s incredibly unlikely that someone who spends a few minutes a day looking at it is going to find or see something that someone else hasn’t already spotted, and therefore isn’t already in the price. “
Brutal, but true. And it’s also not as if the Bloomberg Terminal stock analysts are right: MorningStar Analysis found that in 2020, only 42% of actively managed U.S. equity funds outperformed comparable passively managed funds.
Every pundit we’ve spoken to has said one version of the same: don’t pick stocks because you think it’s your way to summer in the Hamptons. Research, analyze, and invest in individual stocks because you enjoy studying the financial markets, have money you can afford to lose, and want to have fun.
Now that you know the risks, here’s how the pros approach stock analysis.
Choose your (analysis) fighter
Investors take a fundamental, technical or mixed approach to stock analysis. Which method you use depends on your goals, said Phil Huber, CIO of SavantWealth.
Fundamental analysis is to determine the company intrinsic value from bottom to top, from reviewing historical financial statements to imagining the company’s future. You then compare your estimate to its current market price and decide if it’s a good buy.
who is opposed to technical analysis, which takes a more “unbiased” approach, Huber said. It’s more about finding trends in stock prices that investors can exploit. They care less about the intrinsic value of the company and more about how the stock price will move in the future.
In general, fundamental analysts look for long-term investments, where technical analysts want to generate quick profits. A mixed analysis gives you the most holistic understanding of a stock.
Review the numbers
Regardless of your approach, it’s a good idea to review the company’s financial data before investing. Investment analysts have already analyzed the numbers, so you can put your TI-83 away. We’ll walk you through some of the numbers you’ll find on Twitter Finance.
Publicly traded companies are required to publish their financial results quarterly, when investors compare their expectations with the actual performance of the company and decide to buy, hold or sell. This is why you often see a higher volume of transactions around the income reports.
You can find the financial data of the company through the SEC EDGAR portal. Here, for example, is Berkshire Hathaway’s EDGAR page. You won’t find any analysis there, so go to a site like Yahoo Finance to see what investors are thinking.
First, take the pulse of a business by examining its liquidity and profitability ratios. These ratios only have value when compared to a benchmark, whether they are direct competitors of a company or a industry average, so make sure you have them on hand.
- Quick report: Current assets, excluding inventories, divided by current liabilities. It determines whether a business has enough cash and short-term investments to cover future debts. Typically you want a quick ratio greater than 1.
- The net profit margin: Net income divided by turnover. An important metric in mature businesses, net profit margin shows you how much money a business actually makes for every dollar in sales. You want to see that number increase – or at least not decrease – over time.
- Return on Assets (ROA): Net income divided by total assets. It is a sign of efficiency and of how much the company earns in relation to its resources. Like all ratios, the industry and direct competitors will dictate what constitutes a strong ROA.
Next, move on to valuation ratios, which compare a company’s financial results to its market price. Analysts at major financial institutions release their forecasts ahead of corporate earnings announcements, and a company’s goal is for those metrics to meet or exceed analysts’ expectations.
- Earnings per share (EPS): Profit divided by the weighted average number of shares in circulation. If a company has $ 1 million in profits and 1 million shares outstanding, its EPS is $ 1. It is useful to watch BPA when trying to choose between a few stocks; the one with the highest BPA theoretically offers the highest value.
- Price / earnings ratio (PE): Share price divided by annual earnings per share (EPS). If the same company is trading at $ 20 per share, the PE ratio is 20. If someone says a company’s stock price is “20 times earnings,” they are talking about the PE ratio.
- Price / sales ratio (PSR): Market capitalization divided by annual sales. If the company’s market cap – or total market value – is $ 50 million and sales have been $ 5 million in the past 12 months, the PSR is 10. That is a good ratio for “growth stocks” or companies that have not yet made a profit.
- Multiple company: Enterprise value divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), where enterprise value is the company’s market capitalization plus debt minus cash. Saira Malik, Global Equities CIO at Nuveen, said this ratio is large enough to be relevant for any business, as it can adjust to “different capital structures and variety of accounting policies.”
These are by no means the only metrics you should consider when valuing a stock, and they aren’t always relevant in every analysis. Analysts often associate sectors with specific ratios that best describe a company’s financial data.
Do your own research
At first, financial statements may appear to be written in Klingon. It’s okay if you feel that way, because a stock’s price isn’t just about numbers. Find out what analysts, and even your friends, are saying about the future of the business in qualitative terms.
Much of what is built into a company’s stock price is investor expectations for the future, from new product lines to changing market conditions. The valuations of some companies, like Tesla’s, are largely based on feelings and expectations.
âTesla’s market valuation is hard to justify on the numbers alone, but who’s going to bet against Tesla,â Rasiel said.
Vincent Glode, professor of finance at the Wharton School at the University of Pennsylvania, said looking beyond the numbers can help you feel more confident in the action.
âIf you are unfamiliar or uncomfortable with the numbers, you must think the future of the business is brighter than the price,â he said.
Here are some signs of a business with a flourishing future:
- Sustainable advantage in the market: You want to invest in a company that has a certain competitive advantage in its sector. Maybe it has proprietary technology, or it can do the same as a competitor, but at half the price.
- Growth prospects: Your parents may have told you to look at the future trajectory of your dream job before you locked yourself in your major in college. It’s the same with stock picking: you want to invest in companies that are part of a growing industry.
- No threatening lawsuits: Watch out for pending lawsuits that could affect the future of the business. Large companies are constantly involved in lawsuits, but you’ll want to study the ones that make the headlines to see how management and financial analysts react.
- Impressive management: Good businesses can suffer from terrible management (looking at you, Enron). Take a look at who’s at the helm, including the executive suite and the board. Research their track record to see what they’ve accomplished, and listen to investor calls each quarter to see what they’re planning for the future.
- Positive consumer sentiment: The markets also have feelings. Take stock – pun intended – on what your friends are saying and thinking about the businesses you are considering. âA big part of the investing market is psychology,â Rasiel said. âPsychological visions of companies can last a very long time. ”
Put it all together
This is where investment analysts do their research, create a financial model, and forecast the company’s future financial results before making a business decision. Unless discounted cash flow analysis gives you a thrill, this is probably where your analysis ends.
One final reminder: you are probably not going to get stupid rich by investing in individual stocks. You will pick a bunch of losers, but you might also find a few winners. Talk to a financial advisor about the most responsible way to integrate stock trading into your portfolio.