3 Ways to Look at Stocks

by 20 Jul, 2020

3 Ways to Look at Stocks

A disclaimer, I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand.

In this article I will go over the three ways I analyze companies before investing in them. Many newer investors ask me how I pick companies and often feel overwhelmed. I hope to give these newer investors some ideas. The methods of that I use to invest range from a quick overview, to a basic financial analysis. 

The first method I use to determine if I want to buy a company is the most simple, and does suffer from a few major flaws. The benefit is that it is easy enough for anyone to do. When I use this method, it is often when I am low on time. The factors I look at are momentum and outlook for the product or service. Momentum can be broken down into a few categories: news, daily momentum, and short term historical performance. To determine momentum, I look at the news for anything that could benefit a stock. Perhaps its a potential merger, or a strong earnings report, or a new “buy” rating, any positive new for a company will usually, almost immediately move the stock price. I also look at daily performance, if there is strong momentum, you can ride it to potentially make a profit. The risk is that the momentum turns around, and if you do not understand why a stock is going up, this could happen to you. Similar to daily momentum, looking at monthly and yearly charts can be helpful as well. If a stock has been having a great year, maybe look up why, and see if you think it can continue. Combining news and price momentum can be a very powerful and quick way to look at a company. The downside is that trend-following has historically worked, but barely. This means that on average, it is right just slightly more than it is wrong, which means you can go through long periods of losing money. Next, is outlook. Thinking about where the company is headed is what investing is all about, but it does not need to be some crazy analysis. It can be as simple as this: you think the virus will make a strong second resurgence, so you think the outlook on Zoom video conferencing is strong, you buy zoom. Conversely, lets say you think: virus fears are overblown, people will go on cruises quicker than expected, so you buy Carnival Cruises. Researching and developing an outlook is a very powerful tool. If you expect more sales, and or more profit in the future, the stock will be worth more. Creating an outlook, validating it with news, and or using momentum can be a great first place to start. The weaknesses of this method are obvious, there is only surface level information, which can leave out a lot.

The next method I use is technical indicators. Three easy technical indicators to use are the RSI, Macd, and Bollinger Bands. To learn more about any of these click to read an article I wrote on each. In short, RSI will graph 0-100, an RSI of 30 or under indicates a stock is “oversold”, an RSI of 70 or above indicates a stock is “overbought”. The RSI can help you to “buy low and sell high”. The Macd measures momentum, a bullish signal is when the Macd is increasing and it is above zero. When the Macd is below zero and decreasing, that is bearish. Combining the RSI with Macd is one of my favorite combinations. I use the RSI to determine buying or selling levels, and I use the Macd to tell me exactly when to enter a position. Finally Bollinger bands can help to identify abnormally high or low levels for a stock (to read more about them click here). Again the weakness this method is that price information leaves out all fundamental information. There may be a reason that prices go down that technical indicators cannot tell you.

The method I personally enjoy the most is a comparable analysis. A comparable analysis is when you use financial ratios of comparable companies to establish a relative valuation. That sounds complicated, and while it is more advanced that the two previous methods, I really believe anyone can do it. There a many financial ratios, and you could spend all day looking at them (sometimes I have), but I will list what I think are the most important financial ratios. If I had to narrow it down to 4 ratios I would use the following: Enterprise value/EBITDA(EV/EBITDA), P/E, P/CF, and EBITDA margin. 

There are a lot of acronyms but I will break down why I chose each ratio and how to use it. If there are any questions having to do with vocabulary check out the vocab section in the bottom. EV/EBITDA measures how many times earnings or EBITDA the enterprise value is equal to. Put simply this ratio says how many times earnings the total value of the company is equal to. The price to earnings ratio is a measure of how expensive a stock is relative to how much the company earns, or how much you are paying for a dollar of earnings. You would pay more for a dollar of earnings if there is higher earnings growth. Price to cash flow is similar to p/e, the only difference is that cash flow does not include non-cash expenses like “earnings” in p/e does. For example cash flow does not take into account depreciation.  And finally EBITDA margin is similar to a profit margin, but I use EBITDA for an easier apples to apples comparison. This may seem complex, but my 4 favorite ratios are all available on websites like macrotrends.com or ycharts.com.  

You use these ratios by finding at least 3 but ideally up to around 6 comparable companies. Comparable companies are usually in the same or a similar industry, usually have a high stock price correlation, are affected by similar market forces, and are ideally a similar size. For example, lets take Pepsi, obviously Coke is a good comparable, but some others could be beer or spirit companies like AB InBev. I like to look at 2-3 years of these ratios in order to get a good idea of the company looks and has looked on paper. 

The 4 ratios break down into two categories, price ratios and quality ratios. EBITDA margin is a quality ratio, that measures profitability. EV/EBITDA, P/E, and P/CF are all price ratios. They measure how expensive a company is relative to earnings or cash flow. If you see low price ratios you should expect to see low quality ratios and vice versa. If this is not the case, then you should try to figure out why. If after researching why this stock may be undervalued you cannot find anything, you may have an opportunity on your hands. By using comparable companies, you can look for discrepancies and attempt to profit off them. For example, if a company has similar price ratios to another, but has a higher EBITDA margin, and a positive outlook, this could be an opportunity. There are many other financial ratios that can be used in this manner, and while I think the 4 are the most critical, a few others I like are debt/EV, earnings per share, free cash flow margin, operating cash flow margin, and fixed-asset turnover. A high debt/EV specifically can explain lower price ratios and higher quality ratios (if one company has a lot of debt it is seen as risky and thus would be less valuable than a similar company with less debt). This is just another example that financial ratios can give a lot of information about a business, but should not be used in isolation. 

Another thing to note, “the market can stay irrational longer than you can stay solvent”. This means the market could be wrong, and could take longer to correct itself than you can or will want to wait. A great example is the 2008 financial crisis, a few hedge fund managers thought the housing market should have crashed in 2006, they had to hold their positions for about two years. The same can happen with an undervalued company, so be aware of this. Additionally, sometimes you may hold for a while and later find out you are wrong. Always try to prove your thesis wrong, if you cannot and it passes a “stress test” it is more likely than before that you are right.

Combining financial ratios and the two methods above is an excellent way to begin investing. From these three methods there is a ton of information at your fingertips, all of which are quite straightforward to acquire. By learning about these three methods you can become more informed and hopefully make some great investment decisions. One thing to keep in mind is that the methods explained above are not considered a complete analysis. All the methods could easily leave you scratching your head as to why an investment did not work out. This is not meant to be a how to guide, just a place to start and hopefully a place to build off from into a complete analysis. If you have any questions send me an email at Roberto@marketspringpad.com. Also follow me on Invstr @robbieb for market updates.

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