In this article, we’ll explore how to evaluate a stock, including:
- The basics of what a stock is
- What makes an investment riskier or less risky?
- How to evaluate a stock using technical analysis, fundamental analysis, and investment analysis techniques
- How to identify investments that are worth your time and money?
- Which sites can help you evaluate stocks
What is a Stock?
A stock (aka share) is a unit of ownership in a company. It’s a financial security that gives you ownership of part of a company.
From the company’s standpoint, a stock/share is a financial instrument that helps them raise capital (money).
If you own shares in Apple Inc., you’re a stockholder.
Each stockholder/shareholder typically gets one vote in the company’s key decisions for each share that she or he owns.
In addition to ownership rights and voting rights, being a stockholder can entitle you to dividends (a share of the company’s profits).
Dividends are your financial reward for investing in the company.
Note that companies don’t have to pay your dividends.
It’s not a legal requirement nor a legal obligation. But many companies do pay dividends, and they do so fairly consistently.
What makes an investment riskier or less risky?
There are many definitions and measures of risk. But the general consensus is that riskier investments are those that have a higher chance of losing your capital.
Less risky investments, on the other hand, are those that have lower chances of losing capital.
Investments that are less risky today won’t necessarily always remain less risky. And equally, investments that are risky today won’t necessarily always remain risky.
The riskiness of securities/investments can (and do) vary with time.
There are many factors that determine how risky a stock is. For the most part, though, we tend to think of the risk of stocks in 2 broad ways:
- market risk (aka systematic risk), and
- firm-specific risk (aka unsystematic risk)
Firms with higher market risk have greater exposure to the market risk. They’re more likely to be hit badly in a recession, for example.
Stocks with higher firm-specific risk are those that have a greater “unique risk”.
For instance, this might be the risk of bankruptcy. Or the risk of the company “cooking the books” (faking its accounts). It could also be the risk of the company being run by poor management.
Broadly speaking then, market risk is the stock’s exposure to the overall market. This risk cannot be eliminated or diversified away. It always exists, regardless of which type of investment you buy or hold.
Firm-specific risk, on the other hand, is unique to a given firm. The risk of Mark Zuckerberg leaving Facebook, for example, is not something that would affect Apple Inc.
That’s because Mark leaving Facebook is a risk that applies to Facebook exclusively.
Since firm-specific risk is unique to individual firms, it can be eliminated by diversification.
This Article features a concept that is covered extensively in our course on Investment Analysis & Portfolio Management (with Excel®).
If you’re interested in learning how to quantify risk for stocks and portfolios, working with real world data, then you should definitely check out the course.
How to Evaluate a Stock
Alright, now that you know the basics of what a stock is and what makes one investment riskier vis-a-vis another, we can now explore how to evaluate a stock.
As with most things in Finance/Investments, there’s no single “correct” answer.
There’s dime a dozen different ways of evaluating a stock. We’ll focus on the 3 main approaches typically used, including:
- technical analysis
- fundamental analysis, and
- investment analysis techniques
How to evaluate a stock using technical analysis
Technical analysis is a method of stock trading that uses historic price information and alleged “trends” to try and predict stock prices.
Proponents of technical analysis tend to “analyse” charts of historical price movements and plot out supposed “trend lines” to identify the potential direction of the price based on its current trajectory.
Time and time again, the research and data consistently show that technical analysis simply does not work.
The weak form of the Efficient Market Hypothesis shows that one cannot consistently earn abnormal returns by relying on historic price information. “Abnormal returns” refers to returns over and above what “the market” offers.
Moreover, intuitively, random “patterns” in stock price data have no impact on a business and its performance.
For instance, if Tesla’s stock price displays a “head and shoulder pattern” (one of the many ‘favourites’ of technical analysts), it says nothing about Tesla’s:
- production capabilities
- current and future demand
- operational challenges
- competitive advantages/rivalries
- regulatory or compliance issues
- innovation and continuous development
It’s these things and a whole host of others that ultimately drive Tesla’s (the company’s) performance.
And it’s the (expected) future performance of Tesla that ultimately drives/impacts its current stock price.
Nevertheless, many people use technical analysis because it is often a faster way of doing research on the market compared to fundamental analysis. And perhaps because it “looks cool”.
By its very nature, fundamental analysis requires a lot more information. And much of the information can be seen as “boring” (accounting information, for example).
We hope it’s clear that:
- we’re really not fans of technical analysis, and
- the research and data consistently show that technical analysis does not work
How to evaluate a stock using fundamental analysis
Fundamental analysis is in some sense the exact opposite of technical analysis.
It studies the economic and business factors that influence a company’s performance and earnings, rather than using random charts or historical patterns of price movement to forecast what direction a stock will likely be in the future.
It uses company financial reports / financial statements to evaluate a firm’s performance and reveal information about the future prospects of a business.
Some fundamental analysts focus on just a specific financial statement (e.g., just the They do so because they’re predominantly interested in a
Others focus on all financial statements (income statement, balance sheet, cash flow statement at the very least).
They critically evaluate the company’s financial performance and position.
This approach is naturally better than one where one focuses on a single number.
Because, when it comes to company fundamentals, there’s no “single number” which tells you the whole story.
Fundamental analysis is often used for large-cap companies since they have more publicly available data that can be used to assess their financial health vis-a-vis smaller companies. This is partly because larger companies tend to, on average, have more reporting and regulatory compliance requirements vis-a-vis smaller companies.
One of the most popular forms of fundamental analysis is value investing, which essentially aims to aid investors in identifying “bargain”/”cheap” stocks.
Broadly speaking, value investing involves estimating the “intrinsic value” of a stock before comparing it to the current market price.
A stock is considered worthwhile if the stock price is considerably lower than the intrinsic value since it’s an undervalued stock.
Want to go beyond evaluating a stock?
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Stock valuation – getting to the intrinsic value
There are broadly 3 main ways of getting to the “intrinsic value”, including:
- Discounted Cash Flow (DCF) valuation,
- Multiples / Relative valuation, and
- Options / Contingency based valuation
Discounted cash flow valuation
Discounted cash flow (DCF) valuation includes free cash flow valuation (“FCF”), free cash flow to equity valuation (“FCFE”), dividend discount model (“DDM”) for example.
Regardless of which model you use, the key idea is to:
- estimate future cash flows,
- discount them back to the present using an appropriate discount rate
The Present Value (PV) of the future cash flows is seen as the stock’s “intrinsic value”.
In a Multiples / Relative valuation approach, the key idea is to find a comparable company and look at its value.
Here, the underlying assumption/theory is the Law of One Price, which says that if you have 2 identical assets which have exactly the same risk and payoffs, then they must have exactly the same price.
Options based valuation
Options or contingency valuation is a method of valuing a contingent item (or an item that has a fixed value in the short run) and is subject to random variations in the long run.
Contingent items are valued by determining what would be the value of the item if it were certain, as an event. The value will be higher the more valuable is the outcome to which it is attached.
Another way of looking at it is to use the fact that options, as in the financial securities, are priced based on an underlying security (e.g., a stock).
If we know the value of an option (which is based on an underlying asset), then we can “reverse engineer” the price/value of the underlying asset.
The “True” Intrinsic Value
Now, of course, getting to the “correct” intrinsic value is not easy. We’d even argue it’s impossible. There’s no such thing as a “true”, or “correct” value.
Each investor has different goals in mind when performing fundamental analysis. But they all generally want to own assets that are as cheap and as safe as possible.
As a result of their different expectations and different goals, however, they’ll end up with different estimates for the “intrinsic value”.
Thus, while fundamental analysis is relatively more scientific than technical analysis, it’s still important to note that there are plenty of arbitrary assumptions and variables at play.
It’s not quite a full-fledged “science” as some strong proponents of fundamental analysis might argue.
Nevertheless, if you are interested in reading more about stock valuation, we encourage you to take a look at our sister articles, our Stock Valuation using Multiples course, or Aswath Damodaran’s Little Book of Valuation.
How to evaluate a stock using investment analysis (data-driven) techniques
Investment analysis techniques largely comprise of modern portfolio techniques originally developed by Harry Markowitz.
These techniques are based on the principle of maximizing the expected return for any given level of risk (volatility).
Quite revolutionary for his time, Markowitz found that by combining 2 or more assets, it’s possible to earn a higher return for the same level of risk or the same return for a lower level of risk.
Today these investment analysis techniques are referred to by a variety of different names, including:
- Modern Portfolio Theory (MPT)
- Mean-variance efficient portfolios
- Portfolio optimization
Regardless of what you call it, it’s fair to say these are largely data-driven techniques for stock evaluation and analysis.
Importantly, while you can use these techniques to evaluate individual stocks, they’re mainly intended to be used to evaluate and analyse portfolios.
How to identify investments that are worth your time and money?
Acting on a recommendation from a professional can be a good idea if you have the time and the money to make it pay off.
But note that even “professionals” don’t necessarily know what they claim to know. It’s sad but true.
A lot of people are drawn to invest in stocks based on the opinions of their friends and relatives. Or perhaps worse, online forums which oftentimes have little knowledge in finance.
Buying something just for speculative reasons is certainly not the right way to go about making your investment decisions.
For most people, the best investments are almost certainly low-cost index funds that track the overall market portfolio.
These aren’t glamorous, but they do tend to deliver results. And for the most part, they tend to outperform the vast majority of “professionals” funds.
Having said that, for those who have the time, will, and money to rigorously research and analyse stocks…
Identifying good investment opportunities involves building a ‘system’. One that is aligned with your investment preferences.
Regardless of which approach you decide to choose once you learn how to evaluate a stock, you should always ask yourself two things:
- will this investment earn me more than the overall market portfolio (usually approximately 8% per year)
- is it less risky than the market portfolio?
If you can answer both questions affirmatively (as in, “yes”), then consider evaluating the investment in more detail.
If you can’t say yes to both questions, seriously ask yourself whether the time and effort in analysing it is really worthwhile.
Which websites can help you evaluate stocks
There are a lot of websites that can help you evaluate stocks. Some of them will analyse the financial status of a company and give you some basic information and others will provide in-depth analysis of the company’s performance and current valuation.
Then there are websites that tell you whether a stock is a “good buy” or not.
These sites will often give you a list of stocks that might be good investments and then it’s up for you to make your own decisions from there.
Remember that a lot of these reviews are more opinion than anything. And that’s despite how “scientific” and “accurate” they may claim their “recommendations” as.
It’s always a good idea to think about the incentive of the recommender. What’s in it for them to recommend buying a given stock? Or even selling it for that matter?
Full disclosure – our incentive is educational (we’re here to empower individuals to master complex concepts in Finance, Accounting, and Investing). We never provide explicit investment advice nor “buy”/”sell”/”hold” recommendations.
Now, while there are a whole host of different financial and investing information websites, the most popular ones are probably:
- Yahoo! Finance
- Financial Times (FT)
Alright, that’s it for this post. Hopefully, you now know how to evaluate a stock well. If you’re serious about investing and about evaluating stocks rigorously, do check out the course below.
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