Whether it’s because people think they can make some money on the rebound of the coronavirus stock market bust or because Robinhood has made investing a whole lot easier for anyone with an iPhone, a lot of people these days are getting into the stock market at some level. Unfortunately, a lot of those people don’t really have any idea what they’re doing and they end up losing a bunch of money on a stock that they basically picked at random, or because they read some guy’s post on Reddit saying that a stock was going to the moon.
That sort of blind-dart-throwing approach is a pretty good way to lose a lot of money if you aren’t careful. So, if you want to know how to pick stocks like a pro, I’m about to teach you the basic fundamentals of researching and picking the best companies for your investments. To be clear, I’ll only be talking about long-term stock investments in this article.
So, if you’re only into day trading or you’re just trying to hop on the crypto wave, this isn’t the article for you. But, if you want to learn how to choose stocks that are going to make you money for years and years to come, listen up. This is how to pick stocks for beginners. Let’s go.
Technical vs. Fundamental Analysis – The Two Schools of Thought
The first thing I want to cover before we go any further is the difference between the two main approaches to stock research: technical and fundamental analysis. And, while this article will focus more heavily on one than the other, both are important tools for picking a stock that’s going to make you big money.
Alright, so technical analysis is basically the art of looking at the way a stock chart is moving and trying to predict which direction it’s going to go based on its past movements. It’s not just meditating and, like, being one with the stock… Technical analysts focus on price, volume, and volatility, basically looking at the supply and demand movements for a stock, more often than not using super-complex computer models that tell them about a stock’s past movements.
So, if you want to beat the market using technical analysis, you’d better take some coding classes and learn how to model. And I’m not going to go into that in this article; that takes hours and hours and hours. Luckily, there’s another effective method of analysis that stock traders have been using for years, and most stock traders still use it today. And that’s fundamental analysis.
Fundamental analysis basically involves diving into a company’s financial statements and looking at their performance, combined with poring through news articles about that company, the company’s industry, and the economy as a whole. And that’s what we’re going to focus on in this article.
Now, to be clear, if you really want to be a stock-picking wizard, it’s best to combine both kinds of analysis. That’s going to give you the clearest picture of what a stock’s future is. And, of course, regardless of how much research you do using either technical or fundamental analysis, there’s still no guarantee that a stock’s price is going to move the way you want it to. No one can predict the future. Even the best minds in the world couldn’t predict the 2008 stock market crash, and a whole lot of people lost a whole lot of money.
But, using these techniques that I’m about to tell you, you can give yourself the best chance of making long-term money on your investments. So, what’s the first step in your journey into fundamental analysis and stock market success? Hop on SEC.gov and start digging through those financials!
Open Up Those Financial Statements – The Materials
A company’s financial statements are like a doctor’s report. They’ll tell you what parts of the company are healthy, which ones are at risk of going bad, and which ones are damn-near dead. So, the first thing you should do when you start researching a company is pull up its financial statements. You can find all the financial statements for every publicly traded company in the United States on SEC.gov. All you have to do is search the name of the company or their stock ticker and their past financial statements will come up.
For our purposes, you probably want to open up their 10-K, their yearly report. To save yourself some time of going through a million different companies’ financials, you should narrow your focus down to just a few companies first, And they should be companies that you’re familiar with and that you believe in at face value. You’re going to save yourself a ton of time by looking into companies that you already know something about rather than looking through the financials of all 2,800 companies listed on the NYSE.
Once you’ve identified a couple of companies that you want to research, really start sinking your teeth into those 10-Ks. These reports are going to give you all the information you need to learn about the company’s balance sheet (which essentially tells you where their assets, liabilities, and equities are held), their income statement (which tells you their sources of revenue and expenses from normal business operations), and their cash flow statement (which tells you how that company handles their cash).
Now, I know that may sound like a lot. And when you go into those statements, you’re going to see a ton of numbers that may seem very confusing. But let me make it easier for you and let you in on the key metrics you should be looking at.
The Key Metrics – Performance Stats
You can think of financial metrics like an athlete’s stats. Each one tells you about a different aspect of that athlete’s game. Are they pulling in a ton of rebounds? Are they terrible on the free-throw line? You get the point. The first financial metric you want to look at is revenue. That’s going to be the top line on the income statement, and it tells you exactly how much money a company is pulling in from its business operations.
Sometimes it’s divided into “operating revenue” and “non-operating revenue,” in which case you want to focus on “operating revenue” because that’s going to tell you more about the core business. Does the company sell cars? Well, operating revenue is how much they pulled in from car sales.
Next, you want to check out net income, which is the amount of revenue that’s left over after you subtract out all their expenses. For that company that sells cars, the expenses would be how much it costs to manufacture those cars, how much it costs to keep their factories open, how much it costs to get those stupid commercials on the air, and a ton of other things.
If the revenue is high but the net income isn’t very much or even negative, maybe that company isn’t managing its expenses well enough, and that’s something to consider. However, that’s not the whole picture. Tesla was posting negative net incomes for many years because, although their revenues were good, they were investing so much in research and development of new vehicles that their expenses were super high. Yet, their stock price was still going up because people believed that their revenues would eventually outgrow their expenses.
But, net income tells you how much a company is generating, not how much it’s generating for each of its investors, which is why we have to turn to earnings per share now. To get earnings per share or EPS, you divide the net income by the number of shares that a company has, which you can find on any site like Yahoo Finance or Google Finance. Since every company has a different number of shares out there, it’s important to know how much of the net income corresponds to one share, which will help you understand the actual value of the stock. Generally, high EPS is good and low EPS is bad.
Now, let’s take that even a step further and look at the price-to-earnings ratio. To get this, you divided the stock’s price by the EPS. And that number is basically going to tell you how much investors are willing to pay for $1 of a company’s earnings. And you might be saying, “Well, why would you pay any more than $1 for $1 of a company’s earnings?” And there are a lot of reasons.
Think about Tesla. Their earnings aren’t the only thing they have going for them. They have Supercharger stations all over the country. They have patents on top-of-the-line technology. There’s all the hype around Elon Musk and Tesla being the future. There’s the value of the brand itself. And there’s the belief that Tesla’s earnings are going to continue to increase in the future. Those are just some of the reasons why Tesla’s price-to-earnings ratio is up at like 685, which is absurdly high. That ratio is going to give you a lot of insight into how investors feel about the future of the company. If they see a bright future, it will probably be high. If they think it’s going to tank, it will probably be low.
Finally, you want to look at ROE and ROA, which are “return on equity” and “return on assets.” To get these numbers, you just go to the balance sheet, get the total number for shareholder equity or assets, and then divide the net income by that. ROE is going to tell you how much profit a company makes with each dollar of stock that’s invested in them. ROA tells you how much money they generate with each dollar of assets they have.
Both of these are generally just ways to find out how effective a company is at turning a profit. For all of these metrics. First of all, you can probably find them online without actually going to the financial statements. However, looking at the financial statement might make you notice something about the company that may be skewing one of these numbers that you wouldn’t notice otherwise. For instance, the Tesla example from before. You might not notice that they were spending tons of money on research and development, which is going to bring down net income and other metrics, if you didn’t look at the financial statements.
Also, with these metrics, it’s important to compare them with other companies in the same industry sector as the company you’re researching, which brings me to my next point.
Add in Qualitative Research – Add Some Color
Up until now, we’ve been doing quantitative research, looking at the company’s metrics. and that will tell you a lot. But, there are plenty of other factors that need to be considered when trying to predict a company’s future. That’s where qualitative research comes in. You want to look at the industry as a whole. It’s like adding color to the picture, and a lot of it has to do with the fact that these companies aren’t just robots or computers, they’re run by human beings.
You want to look at what the company does to make money. Is there still going to be a demand for that in 20 years? Does that company have an advantage over other companies selling the same thing? What would stop another company from coming in and stealing all that company’s business? Do they have their technology patented? Are they able to do business at such a low cost that they can drive other competitors out of the market by lowering their prices?
Look at how much Amazon has grown. Why? Because they deliver things in such a convenient way that no one else can possibly compete with them. That’s what is meant by a competitive advantage. With Coca-Cola, their brand is their competitive advantage. Is Coca-Cola all that much better than Pepsi or RC Cola or any other no-name cola out there? I don’t know… probably not. Oh boy, I know I’m gonna get some angry comments for that one. But the point is that these companies have an x-factor that allows them to dominate their markets, which is something you should look for in the companies you choose to invest in.
Then you need to consider what could go wrong. Does their patent expire in the next few years, leaving the door open for a new competitor? Is the CEO a Jordan Belfort-esque playboy who might cause the company to bomb with their insane antics? Might the government pull out the antitrust laws and stunt the growth of the company (like they’ve been talking about doing with Amazon…)? These are all things you should be considering when you’re researching a stock.
And, before you put any money in, make sure you’ve done all that quantitative and qualitative research, and make sure the overall picture looks promising. But, no company exists in a vacuum, and so there’s one more thing we need to look at before we’re done here, and that’s the industry and economy as a whole.
Put Things Into Context – The Total Picture
There is so much that goes into a stock’s performance that it’s impossible to know it all. But giving yourself an idea of what’s going on in the economy overall will help you decide if it’s a good idea to invest in a company or not. You see, the economy, like the Earth itself, is all interconnected. Yeah, I guess gave you a free spirituality lesson in the middle of an article about stocks. But it’s true. Pretty much everything that happens in the economy affects everything else in some sort of remote and indirect way.
Let’s say the banks raise rates, and so some fishing company isn’t able to get a loan to repair their fishing boats, and they have to close down. Suddenly, the chain of sushi restaurants that they were supplying has nowhere to get their tuna, and their business starts hurting. So, they close down a bunch of restaurants. Next thing you know, the chopstick supplier is hurting, and so the wood supplier to the chopstick factory is hurting, and the guy who sells chainsaws to the wood company is hurting, and you get the point.
Everything exists in a larger context, so it’s important that you pay attention to the overall news. Things like inflation, what the Federal Reserve chooses to do with the federal funds rate, presidential elections, natural disasters, and a million other factors can have a serious impact on the economy as a whole, as well as what individual stocks do.
No one can know everything, and there are always going to be missing pieces of the puzzle but, by keeping yourself as informed as possible, you give yourself the best chance of accurately predicting a company’s future.