The names like Mr. Rakesh Jhunjhunwala, Mr. Radhakishan Damani, Mr. Vijay Kedia, etc. are big names in the stock markets and have built huge empires from their trading and investing in stock markets. But this was not done overnight and was a lifetime in making. Starting from grassroots levels to creating a name for themselves in the industry, the basis of this success has to be in carefully picking their investments and nurturing them. So did they have any key to identifying the right stocks or did they just get lucky? While luck does play some role in it, the ability to analyze a stock and select them as per their tailored preferences is what makes a difference between a successful portfolio and a struggling one.
Given below is the meaning of stock analysis and the key factors that have to be considered for the same.
What is stock analysis?
Stock analysis is a very detailed study of the stocks of the company with respect to two broad parameters namely, fundamental analysis and technical analysis. This detailed study helps in understanding the right time to enter and exit the markets as well as the correct holding period for the stocks. This analysis is not limited to the individual stocks but also the economy and the industry as a whole to determine if it is on an upward trend or an adverse one.
Read more: Best strategies for taking profits from stocks
What are the factors to understand for stock selection and analysis?
As mentioned above, the stock analysis and selection are based on the broad parameters of fundamental and technical analysis. The details of the same and their relevance are mentioned hereunder.
Using Fundamental Analysis for stock selection and analysis
Fundamental analysis is the study of the core principles of the company and the industry to understand the intrinsic value of its stocks. The decision to buy or sell the stock of the company is ideally based on the intrinsic value so derived. If the market value of the stock is higher than its intrinsic value, it triggers a sell decision whereas if the intrinsic value is higher than its market value, it would trigger a buying decision for such stock. Investors and traders can have the top-down approach or the bottom-up approach for stock analysis. The key factors to be analyzed under fundamental analysis are detailed below.
- Understanding the business and the industry of the company
The study of fundamental analysis begins with a basic understanding of the industry that the company belongs to and the company itself as a whole. The organization’s ethics and the core principles of functioning give a brief overview of its objectives and growth trajectory.
This will further help the analysts understand the relative position of the consumer in the industry in terms of its market dominance or being a mid-level player. If the company is a market-dominant in the said industry, its shares would command a higher price due to the obvious demand for the same.
- Reviewing the financial statements of the company
The analysis of the financials of a company is essentially reviewing its bones. For the potential investors and creditors of a company, this is the first point of review and helps them understand the financial health of the organization. A company having a consistent increase in its revenues and profit margins is viewed as a sign of a healthy organization.
Furthermore, analysts should also review the expenses like COGS (cost of goods sold), operating costs, and liabilities, and if there is an above-industry standard increase and on the same, it can be considered a red flag. Financial statements should be reviewed on a standalone basis but should be compared for at least 5 years as well as with that of their peers to analyze them in a true sense.
- Analyzing the key ratios
The study of the key ratios of a business is the basis for the fundamental analysis of a company. These key ratios include analyzing the EPS, PE ratio, PB ratio, Return on Capital Employed (ROCE), Return on Equity (ROE), debt-equity ratio, etc. These ratios are then compared to industry standards and also the closest competition to have a clear picture of the company’s position.
- Analyzing the competition in the industry
Healthy competition in an industry helps in keeping stock prices in check. It stops a company from being monopolistic which is ultimately adverse for the interest of the ultimate consumers. Under fundamental analysis, it is important to review the competition as well as their key ratios, and their strengths and weaknesses. This will help the analysts understand if the company has an edge over its competition or where it is going wrong.
- Analyzing the future prospects
An important factor in picking stocks is selecting one that has virtually no decrease in its demand. This ensures that there is effectively no adverse impact on the stock prices which can result in a reduction in the investor’s portfolio. The ultimate goal of any investor is to have a successful portfolio in the long run. Therefore, picking stocks that have a good growth trajectory or a company belonging to a sunrise sector should be preferred for investment. There is no point in investing in stocks of a company that has a virtually obsolete product or a company that may not be in existence in say the next 10 years.
- Management competence and expertise
One of the most important aspects of fundamental analysis that is often overlooked or not given much importance is management experience and competence. The management of a company is responsible for driving it in the right direction, therefore, if the management is not competent enough or lacks experience they can take a good product or a healthy company and botch up its future. Therefore, it is important to also review the company’s management in terms of their qualifications, ethics, experience, and their knowledge of the industry as well core product of the company.
Using technical analysis for stock selection and analysis
Technical analysis is the other side of studying stocks for their effective analysis. While fundamental analysis focuses on the overall health of the company and the intrinsic value of its stock, technical analysis simply focuses on the price and volume movement of the stocks. It is essentially used by traders to understand the market trends and the optimum entry and exit points for security in the short-term or medium-term horizon.
There are various tools of technical analysis that can be used by traders like charts, candlestick patterns, oscillators, moving averages, etc. to effectively analyze a stock and its movements throughout the trading day or over a period of time.
Stock selection and its analysis is a very time-consuming task that cannot and should not be rushed. Any rash decisions without the backing of correct analysis can result in a negative impact on the overall portfolio of an investor. Therefore, a basic understanding of the stocks and their possible trends allows the investors and traders to create a healthy and profitable portfolio that can potentially sustain the adverse market trends too.
The key factors of a company that can be reviewed to ascertain its profitability include,
-Consistent growth in the revenue of the company and its profit margin.
-Dividend payouts over the years
-The debt-equity ratio of the company should not be over 100% and the current ratio should be at least 1.5.
-The ROE of the company should be around approximately 15%
EPS refers to the earnings per share that are available to the ultimate shareholders. The mathematical formula to calculate the same is
EPS = Net income – preference dividends/ number of outstanding common shares
The three core principles of technical analysis are,
-The market price knows it all
-History is always repeated
-Price moves in trends
The financial statements that should be reviewed by investors and traders for fundamental analysis of stocks are the balance sheet of the company, the profit and loss statement, the cash flow statement, and the audit report.