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Analyzing investments: Fundamental analysis, technical analysis, and more

At a glance:

  • How securities are analyzed

  • What is fundamental analysis?

  • How to look at company value

  • Fundamental analysis of company books

  • Fundamental analysis of corporate data

  • What is technical analysis?

  • How is technical analysis used for picking stocks?

  • Summary of analyzing investments

  • Practical ideas you can start with today

Are you one of the many Americans who did not invest a small amount in a big-name stock back when it was small and unknown?

Do you grit your teeth, knowing that you could have retired on it by now? The road to wealth is seldom a matter of dumb luck.

To choose securities that will make good investments, you will need to know the basics of investment analysis. It is not as daunting as it sounds: just think of it as shopping for bargains.

How securities are analyzed

Before investing in a major purchase such as a car or a stereo, most people do some extensive research to make sure they are getting the best bang for their buck. Investing in securities such as stocks and bonds is no different.

What securities analysts do

Security analysis is the process of researching and evaluating the factors that may influence a security's value.

A person who makes a living researching securities and recommending investments based on their research is called a securities analyst. Securities analysts often have professional designations, such as the Chartered Financial Analyst (CFA) credential. Securities analysts usually work for brokerages or other financial institutions.

There are many different ways to analyze a security's value. Most security analysis techniques look at a company's earnings, revenues, cash flow, equity, and dividends to determine the value of a security.

How do you use security analysis?

The main goal of security analysis is to calculate a security's real value from analytical data. Just because a company's stock is rising or seems to be a great bargain, doesn't make it so. Analysts go behind the scenes to see how good a company really is relative to other companies.

The techniques of security analysis can be used by all investors to determine the kinds of securities that will help them meet their investment objectives, and they can also be used to evaluate those securities' future potential.

Investors can use security analysis to determine whether a security's market price is over or under its actual value. Investors buy undervalued securities at low prices and hold onto them in the hopes that someday the market will realize the company's value and increase the security's prices.

What does security analysis look for?

Securities analysts determine a company's profitability by looking at its returns. A return is the amount an investment earns as a percentage of the price paid to own it. It is the sum of income an investment makes over time, plus its capital gains. Analysts not only look at the security's historical market returns, they also look at a company's return on investment (income divided by stock and debt), return on assets (income divided by total assets), and return on equity (additional earnings made from reinvesting profits).

The importance of dividends

The amount of dividends a security returns is also an important measure of its worth. The percentage of a company's stock price paid to shareholders in dividends is known as the security's dividend yield. Dividend yield is calculated by dividing the sum of a company's annual dividends by its current share price.

Important ratios used

Analysts evaluate a security's price behavior in many different ways. The most common measurement is the price-to-earnings (P/E) ratio. The P/E ratio tells you how many years it will take at the current rate of earnings for you to make all of your investment back. Other common price indicators include the price-to-sales (P/S) ratio, earnings per share (EPS), and earnings before interest and taxes (EBIT).

Identifying future price trends

Security analysis is also used to identify a security's future price trends. Knowledge of expected returns and true company value gives analysts a sound basis upon which to make their predictions.

What is fundamental analysis?

Fundamental analysis determines the value of a security by analyzing the financial strength of its issuing company. All the information fundamental analysts need to analyze a stock can be found in a company's financial statements.

What is intrinsic value?

Fundamental analysts use this company information to determine a security's intrinsic value. Intrinsic value is the value of a security independent of its market price. Fundamental analysis is based on the belief that a security's market price moves toward its intrinsic value. When the stock's intrinsic value is higher than its market price, the fundamental analyst buys it; when it is below, the analyst sells it.

Using fundamental analysis to determine whether to buy or sell a security is a complex process. The analyst first looks at the overall health of the economy and trends in interest rates. Next, the analyst examines a company's entire industry before moving on to evaluating the company itself.

How to look at company value

There are many aspects of a company's financial record that a fundamental analyst must study to get a full picture of a stock's intrinsic value.

  • Capitalization. Capitalization is the total market value of a company's available shares. Analysts also look at how a company manages its securities, including its turnover rates and credit debts.

  • Current and past earnings. A company's current and past earnings are also examined. Earnings include not only money made from sales, but also a company's investment income. Sales refers to money received as compensation for the company's products and services.

  • Growth. A company's growth is also important. An analyst will look to see whether the company has stable or erratic growth over time. If a company's earnings per share jump around a lot, the fundamental analyst might want to look for another stock.

  • Assets and liabilities. The analyst will compare a company's assets and liabilities. Assets are valuable items held or owned by the company. These include items such as cash, accounts receivable (money owed to the company), investments, property, and equipment. Liabilities are money that the company owes to others. They include accounts payable, dividends, retirement costs, and income taxes.

Fundamental analysis of company books

The primary source of financial information used by fundamental analysts comes from a company balance sheet.

  • The role of the balance sheet. A balance sheet is a snapshot of a company's financials at a given point in time. One side of the sheet contains the company's assets, and the other lists its liabilities. A business' total asset value must equal its total liabilities and owners' equity. This is because all assets are purchased with funds from two sources: debt (someone else's cash) and/or equity (the company's cash). Thus, when added up at any given time, these assets must equal the sources from which they were derived. To find a company's revenues and expenses, the analyst looks at the company's income statement, which lists sales and investment revenue as well as costs, taxes, and other expenses.

  • The cash flow statement. A cash flow statement is another important tool for the fundamental analyst. Cash flow is the difference between a company's total cash received and total cash used. The cash flow statement measures the amount of cash a company has at the beginning and end of a set period.

Fundamental analysis of corporate data

Fundamental analysis uses information from a corporation's financial statements to determine the company's intrinsic value. It takes all this company information and interprets it using a wide array of measurements.

Important ratios and other figures

  • Liquidity ratios measure the degree to which a company's assets can be converted to cash without a loss of income.

  • The current liabilities of a company, such as accounts payable, get paid with its current assets, such as accounts receivable.

  • A current ratio divides a company's assets by its liabilities. The higher the ratio, the better the company scores.

  • The difference between what a company has on hand (ready assets) and what it owes (liabilities) is called net working capital.

  • To find out how quickly a company's customers pay their bills, analysts look at accounts receivable turnover. This is the ratio of a company's net credit sales and its average accounts receivable.

  • Inventory turnover is the ratio of a company's yearly sales to its inventory. High turnover is a good sign, indicating strong sales.

  • Dividing a company's long-term debt by its net worth gives analysts the debt-to-equity ratio. A high ratio means a company is a risk because it needs its investment interest to pay off its debts.

  • To look at a company's profits, analysts use net profit margin, which is simply a company's net income divided by gross revenue. Net profit margin shows the percentage of each company dollar that made a profit.

Many factors go into the fundamental analysis of a security. You can evaluate securities by looking at company stock, dividend-paying ability, or growth potential. Either way, you will be well armed to invest with confidence.

What is technical analysis?

Technical analysts use security pricing and trading history to identify the strength and direction of market trends. The familiar charts and graphs we see in the financial news are examples of the tools technical analysis provides for active security traders to predict future trading patterns.

Assumption: market movements reveal all

Technical analysts do not use any fundamental company information, such as balance sheets or income statements, to make their predictions.

Technical analysis is based on the assumption that every aspect of the market is revealed through market movement. Prices move in trends, and history repeats itself. A trend in motion is more likely to continue than to reverse. This gives the technical analyst the ability to make trades on the basis of predicted market trends.

What technical analysts use

Technical analysts use chart indicators to measure past prices, volume, number of issues traded in a day, and price movement trends. Market price is believed to reflect all known information and investor opinions about a security.

Technical Analysis Looks for Trends in the Market

Charts are the foundation of technical analysis.

Consolidation patterns

A consolidation pattern indicates that a trend similar to the previous trend is likely to occur. It can also indicate investor indecision. If security prices rise above a consolidation line, it could indicate a rise in future prices.

Reversal patterns

A reversal pattern is the opposite of consolidation. A reversal indicates that the next trend to occur will be the opposite of the previous trend. If there was an upward trend, prices could now fall, and vice versa.

Support and resistance

Technical analysts also look at something called support and resistance. Security prices are decided by the negotiation between buyer and seller to reach an agreeable price. A buyer wants to buy low and a seller wants to sell high. Support and resistance measures the degree to which buyers or sellers are winning the price wars.

Support level

The support level is the lowest price at which sellers are willing to sell a security. A support level can indicate the price at which a downtrend may reverse itself. The resistance level is the level above which it is difficult for a price to rise. Upward trends may reverse themselves when prices reach the resistance price level.

Technical analysts look for these trends in stock indexes and market indicators, and use them as their basis for making decisions about buying, holding, or selling securities.

How is technical analysis used for picking stocks?

Technical analysts use three different types of charts to track stock prices. Line charts track the daily movements of closing prices. Bar charts show the highs and lows of stock prices over time. A point chart lists a price only when it changes by a predetermined amount, such as one point. Point charts are used to determine a stock's momentum.

Trend lines

Investors use trend lines from these charts to try to predict the next stock price. After establishing a stock's trend, the investor compares the current price of the stock to its historical trading range. Most stocks trade within a set range. The bottom of the range is the stock's support level, and the top is its resistance level. The price of the stock usually continues in the same direction until it reaches one of these two unsustainable levels. When it hits the support level, its price turns around and starts to climb, making it time to consider selling. When it hits the resistance level, it starts to drop and it's time to consider buying.

Price indicators

Investors also combine price indicators to determine when to buy and sell. When a stock's price line falls below the market moving average, an investor might advocate selling. If the price line is above the moving average, it might be a good time to buy.

Market indicators

Analysts can also predict the trend of the overall market through market indicators. A sentiment indicator focuses on investor expectations. The market will generally move in the opposite direction of investor expectations. Momentum indicators also give analysts the information they need to attempt to predict market trends. These usually consist of price/volume indicators applied to market indices.

Investors can use an indicator called relative strength to pick out successful stocks. Relative strength divides the price of a stock by its market price index. A resulting upward sloping line means the stock is outperforming the market and vice versa. Relative strength can also be used to pick out entire industry sectors.

Summary of analyzing investments

Investment analysis is an important tool to help identify trends in the future behavior of securities. You can use it to evaluate your own stocks and to determine when to consider buying or selling. Investing in securities is a major purchase and should be treated as such. Taking the time to do your research upfront can mean a world of difference later. As an educated investor, you need the basics of security analysis and to know how it can be used to help make your investments successful ones.

Practical ideas you can start with today

  • Select some companies I am interested in, and read their dividend, price/earnings, and other information in the financial pages or online.

  • Choose a few companies that are attractive to me. Find their annual reports on their Websites, and read the financial statements (balance sheets and cash flow statements, etc.) in them.

  • Choose a few companies that are attractive to me. Find their stock information on their Websites, and read through the various charts presented.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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