Stock Analysis

By James Chen

Updated Aug 5, 2018

What Is Stock Analysis?

Stock analysis is the evaluation of a particular trading instrument, an investment sector, or the
market as a whole. Stock analysts attempt to determine the future activity of an instrument, sector,
or market.

What Are Stocks?

Understanding Stock Analysis

Stock analysis is a method for investors and traders to make buying and selling decisions. By studying
and evaluating past and current data, investors and traders attempt to gain an edge in the markets
by making informed decisions.

Fundamental Analysis

There are two basic types of stock analysis: fundamental analysis and technical analysis.
Fundamental analysis concentrates on data from sources, including financial records, economic
reports, company assets, and market share. To conduct fundamental analysis on a public company
or sector, investors and analysts typically analyze the metrics on a company’s financial statements –
balance sheet, income statement, cash flow statement, and footnotes. These statements are
released to the public in the form of a 10-Q or 10-K report through the database system, EDGAR,
which is administered by the US Securities and Exchange Commission (SEC). Also, the earnings report
released by a company during its quarterly earnings press release is analyzed by investors who look
to ascertain how much revenues, expenses, and profits a company made.

When running stock analysis on a company’s financial statements, an analyst will usually be checking
for the measure of a company’s profitability, liquidity, solvency, efficiency, growth trajectory, and
leverage. Different ratios can be used to determine how healthy a company is. For example, the
current ratio and quick ratio are used to estimate whether a company will be able to pay its short-
term liabilities with its available current assets. The formula for current ratio is calculated by dividing
current assets by current liabilities, figures that can be gotten from the balance sheet. Although,
there is no such thing as an ideal current ratio, a ratio less than 1 could indicate to the stock analyst
that the company is in poor financial health and may not be able to cover its short-term debt
obligations when they come due.

Looking at the balance sheet still, a stock analyst may want to know the current debt levels taken on
by a company. In this case, a stock analyst may use the debt ratio, which is calculated by dividing
total liabilities by total assets. A debt ratio above 1 typically means that a company has more debt
than assets. In this case, if the company has a high degree of leverage, a stock analyst may conclude
that a rise in interest rates may increase the company’s probability of going into default.

Stock analysis involves comparing a company’s current financial statement to its financial statements
in previous years to give an investor a sense of whether the company is growing, stable, or
deteriorating. The financial statement of a company can also be compared to that of one or more
other companies within the same industry. A stock analyst may be looking to compare the operating
profit margin of two competing companies, by looking at their income statements. The operating
profit margin is a metric that shows how much revenue is left after operating expenses have been
paid and what proportion of revenue is left to cover non-operating costs and is calculated as
operating income divided by revenue. A company with an operating margin of 0.30 will be looked on
more favorably than one with a margin of 0.03. A 0.30 operating margin means that for every dollar
of revenue, a company has 30 cents left after operating costs have been covered. In other words, the
company uses 70 cents out of every dollar in net sales to pay for it's variable or operating costs.

Technical Analysis

The second method of stock analysis is technical analysis. Technical analysis focuses on the study of
past market action to predict future price movement. Technical analysts analyze the financial market
as a whole and are primarily concerned with price and volume, as well as the demand and supply
factors that move the market. Charts are a key tool for technical analysts as they show a graphical
illustration of a stock’s trend within a stated time period. For example, using a chart, a technical
analyst may mark certain areas as a support or resistance level. The support levels are marked by
previous lows below the current trading price, and the resistance markers are placed at previous
highs above the current market price of the stock. A break below the support level would indicate a
bearish trend to the stock analyst, while a break above the resistance level would take on a bullish
outlook.

Technical stock analysis is effective only when supply and demand forces influence the price trend
analyzed. When outside factors are involved in a price movement, analyzing stocks using technical
analysis may not be successful. Examples of factors, other than supply and demand, that can affect a
stock price include stock splits, mergers, dividend announcements, a class action lawsuit, death of a
company’s CEO, a terrorist attack, accounting scandals, change of management, monetary policy
changes, etc.

Both fundamental and technical analysis can be done independently or together. Some analysts use
both methods of analysis, while others stick to one. Either way, using stock analysis to vet stocks,
sectors, and the market is an important method of creating the best investment strategy for one’s
portfolio.

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Technical Analysis
What is Technical Analysis?
Technical analysis is the interpretation of the price action of a company’s underlying
stock (or any tradable financial instrument). It utilizes various charts and statistical
indicators to determine price support/resistance, range and trends. It identifies
historically relevant price patterns and behaviors to help forecast potential direction
of the stock. This methodology focuses only on the price of the shares, not the
operations of the company.
How Does Technical Analysis Work?
By using historical price data, technical analysis attempts to interpret the supply and
demand that moves share prices. Dinosaurs can’t walk in the sand without leaving
footprints. The dinosaurs are the institutions, mutual and hedge funds. They are the
participants that move stock prices. Technical analysis visually tracks the activity of
the dinosaurs using various charts and indicators to pinpoint price areas of strong
interest both in terms of buying and selling. History tends to repeat itself as
evidenced by price patterns.
Who is Technical Analysis For?
Anyone who trades or invests in the stock market or any other tradable financial
instrument should consider learning at least a basic level of technical analysis. It
your money is invested into a position that has price movement, then technical
analysis will help you make better-informed decisions as to how much risk to employ
for how much potential reward.
Stocks represent the underlying company’s business and operations. However, the
perception and future valuation of the company and its performance is reflected into
its stock price. There is often a divergence between the two. Technical analysis also
helped to determine where the divergence lies and how much opportunity may exist.

Basics of Technical Analysis

 Technical Analysis can be applied to all different chart types.

Technical analysis involves and utilizes various tools and indicators. The right mix of
the tools can be used to generate converging signals that improve the probability of
a direction price move.

Stock Charts
Technical analysis seeks to interpret the story of a stock’s price action. Charts act as
the canvas where the story is painted. The common types of charts are candlestick,
bar and line charts. Charts plot the prices where trades have been executed. The
time interval of the chart can be specified through the settings. Time intervals
segment the price action of the stock. For a 5-minute candlestick chart, each candle
represents a five-minute segment of trading that record the starting price (open), the
highest price (high), lowest price (low) and last price (close) trade during the period.
As the five minute window ends, it will display a candlestick that details the four data
points (open, high, low, close) and a fifth data point that encapsulates the opening
and closing price (body) and colors the body red if the last trade (close) is lower than
the first trade (open), or green if the last trade (close) has a higher price than the first
trade (open). Bar charts include the same information without painting the body. Line
charts simply connect the closing price only for each time period.
Support/Resistance
By visually marking the charts, users can see certain price levels that tend to prevent
prices from falling any further before rising back up again. These are known as price
support levels. Users will also spot price levels that continue to provide a ceiling, that
eventually causing prices to fall back down again after testing. These are known as
price resistance levels.
Stock Volume
Volume measures the total number of shares traded for a specified period of time. It
is used as a measure of interest that can manifest into significant price action. High
volume indicates significant trading activity that triggers a breakout or a breakdown
accompanied by a sustaining trend in prices. Breakouts result in higher trending
prices and breakdowns result in lower trending prices. When volume is light, stocks
tend to chop around in a range known as consolidation.
Trends
Trends indicate the current direction of share prices. When stock prices continue to
rise higher, it is considered to be in an uptrend and vice versa for a downtrend.
Uptrends indicate increasing demand for shares, as buyers are willing to pay higher
prices as supply diminishes. Downtrends represent an oversupply of shares with
waning buying interest resulting in falling prices. By connecting the various high and
low points on a chart, you can manually generate trendlines that pinpoint
support/resistance and direction of stock prices. When compared to historical
templates of similar trendlines, you may be able to forecast the future direction,
turning/inflection points and targets.
 Trend lines can be used to summarize the general sentiment surrounding a stock, whether it is bullish, bearish,
or neutral.

neutral.
Technical Indicators
Having the data points plotted on a chart helps to eyeball the direction of stock
prices, but deeper analysis requires more data crunching. What may have taken
hours by hand in the old days can be processed in seconds thanks to the multitude
of technical indicators on today’s charting and trading platforms. Trends can be
visually tracked with indicators like moving averages, which are dynamic lines that
connect each period’s closing (last) price. Charting/trading platforms enable users to
manually draw in their own trendlines directly onto their charts. Different traders may
have different trendlines based on the time frame of the chart as well as the starting
point.
 Technical indicators can be used to organize, summarize, and analyze price and volume data for improved
decision making.
Price indicators
Indicators that output price-based information like trends, support and resistance are
price indicators. They are usually displayed and tracked on the price portion of a
chart, usually the upper chart. Moving averages, candlesticks/bars/lines, Ichimoku
clouds, point and figure, pivot points, three line break and Renko bars are all popular
price indicators. Trendlines and trend channels are either manually or automatically
drawn are strong price indicators as well.
Momentum indicators
Indicators that measure the momentum of a stock including overbought and oversold
conditions are momentum indicators. Basic momentum indicators come pre-
programmed in most charting/trading platforms. These indicators help traders to
better time their entries and exits. When properly used, traders are able to avoid
chasing prices when momentum indicators show overbought conditions like a
stochastics peaking and falling back under the 80-band. While price is important,
understanding how the price level is achieved can be just as significant. Stochastic,
Relative Strength Index (RSI) and Commodity Channel Index (CCI) are three widely
used momentum indicators.
Using a combination of price and momentum indicators can help generate effective
entry and exit signals. The science of successful trading utilizes the right mix of
technical indicators to generate high probability set-ups and triggers married with
prudent disciplined trade management. Technical indicators optimize the process of
price analysis.

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Fundamental Analysis
What is Fundamental Analysis?
While technical analysis evaluates the share price action of a stock, fundamental
analysis evaluates the actual business operations to determine the financial health of
the company, project future growth prospects and determine current and future
valuation. Fundamental analysis can be performed quickly with various widely
available financial tools or be extensive depending on how much time and effort the
investor wants to commit.
How Does Fundamental Analysis Work?
Fundamental analysis uses publicly available information usually disclosed by the
company through SEC filings to build an accurate assessment of the business. It is
believed that a company’s fundamentals are the key long-term driver for share
prices. While short-term market fluctuations impact immediate stock prices, the
market will eventually price a stock correctly in the future. Fundamental analysis
attempts to extract a fair valuation for the company to determine if the markets have
overvalued or undervalued the shares. Based on this thesis, investors can decide if
the shares are an attractive investment now or wait for a better valuation later.
Components of Fundamental Analysis
This various components of research include analysis of the earnings reports,
company business model/strategy, catalysts, and financials including
assets/liabilities, financing/debt obligations, credit facilities, rumors and press release
documents. Additional research on the company’s sector/industry and peers can
also be performed. It also involves staying current on any executive changes with the
management and board of directors. Intensive fundamental analysis can be tedious
and time consuming for an individual investor.
Research Departments
To attract and maintain clients, full service brokerage firms assign the heavy legwork
to in-house financial analysts that specialize in specific sectors, industries and
companies. Many online discount brokers have also beefed up their research
departments to retain customers. The most widely followed analysts run intricate
fundamental analysis through various qualitative and quantitative models to forecast
future earnings results known as consensus analyst estimates. Meeting, beating or
missing these estimates have an immediate and material impact on share prices.
Who is Fundamental Analysis For?
Long-term investors benefit the most with fundamental analysis, since valuations
and stock prices ultimately reach parity in the longer run. Swing traders benefit
depending on their holding period and premises for holding (IE: undervalued assets
or buy the rumor, sell the news into a scheduled event). Intra-day traders are
mostly affected when news, events or rumors trigger price volatility and spur
momentum on heavy volume, often resulting in price gaps up or down in the pre and
post-market. Earnings report releases generate the heaviest volume and price
action, which is why traders look forward to each earnings season. For
biotechnology companies, clinical trial data and FDA decisions tend to generate the
most volatility.
Basics of Fundamental Analysis
Fundamental analysis requires information provided by the company to develop a
thesis about the business. These are some of the factors that should be included in
the thesis.
Understand a Company’s Real Value
Perception is reality in the financial markets. Different investors and analysts will
have differing valuations for a company. Where one analyst sees a dying legacy
pipeline, another may see an undervalued asset. For example, when retail big box
stores suffered declining sales, private equity focused on the undervalued valuations
of their real estate assets. This sparked a rally in the sector based on a new
perception. However, the continued declining sales forecasts caused the sector to
plummet, when the earnings reports revealed even larger revenue declines, as
perception shifted negative again.
Sentiment Influences Perception
The markets are the ultimate judge and jury as to which valuation pricing prevails
and when. Sentiment influences perception, which is why stocks tend to overshoot
their valuations in strong bullish markets and undershoots during weak bearish
markets, as the adage of a “rising tide lifts all boats” rings true. Astute fundamental
analysts will work to develop their own valuation models using specialized metrics to
calibrate them to any catalysts or events. Companies can be valued based on
financial metrics as well as assets that may not be efficiently priced in. The “parts are
worth more than the whole” is a common justification for under valuation, which
assumes that the company may spin-off or sell certain assets to improve shareholder
equity.
Reading Financial Statements
Publicly traded companies are required to file financial statements with the United
Stated Securities and Exchange Commission (SEC). Investors can access this
information directly from the SEC website through the EDGAR database. The three
key documents every self-directed investor should be familiar with are the 10-K
quarterly report; most recent annual report and recent 8-K filings of material events.
Quarterly earnings are initially disclosed in a press release and filed as a 10-K
document afterwards. Companies will usually pair the earnings release with a
conference call an hour afterwards or the next morning. The conference call can be
very revealing, especially the question and answer session with analysts. Often
times the company may disclose a bombshell item in the conference call including
future earnings guidance estimates which may be increased or decrease from
consensus analyst estimates, regulatory issues, impending lawsuits and major
contract wins or losses, which can result in significant share price volatility
Understanding Industry Trends
Stocks are segmented by sector and industry. To ascertain the true performance of a
stock, it should be evaluated amongst its competitors within the industry. When a
particular sector or industry is very strong, it tends to lift most of the companies
within. The leaders in the particular industry usually establish the industry trends.
Therefore, it is prudent to stay abreast of the industry trends for your particular
stocks. An effective way to pursue this is by identifying the top three leaders in the
sector or industry. The performance of the industry leaders sets the sentiment with
the group. For example, when a leading stock in the heavy machinery industry
slashes its earnings guidance, it generates a top-down ripple effect for the peer
stocks as well. It is guilt by association until proven otherwise as share prices sell-off.
Accounting for Company Growth
There are two types of accounting that is used with earnings reports. The official
numbers are reported under Generally Accepted Accounting Principles (GAAP),
which take into account all expense items including non-cash compensation like
restricted stock and options. Companies like to also provide non-GAAP numbers,
which excludes non-cash items. The purpose is to allow shareholders to better
gauge the growth of the core business without being sidetracked by factors that don’t
affect cash flow. However, critics argue that non-GAAP accounting is deceptive. Any
and all compensation must be accounted for especially when existing shareholders
face further dilution in shareholder equity.

Using Financial Ratios

There are a number of widely used financial ratios that can be used to help investors
gauge valuation and assess how a company stacks up against its peers. These
ratios are standard on broker platforms as well as most popular search engines. Just
as with technical analysis, financial analysis should be performed using multiple
financial ratios to help paint a clearer picture of the operations.
Price-Earnings (P/E) is perhaps the most commonly used financial ratio. It
measures the profitability of the company relative to the share price. All sectors have
an average P/E, which can be found quickly by looking up the heaviest traded
exchange-traded-funds (ETF) which track the specific index. This ratio can be used
to compare a specific company with the industry, peers and or benchmark indices.
For example, if the consumer discretionary sector has a P/E of 20 and your stock
has a P/E of 55, it may be overvalued. Some sectors traditionally have higher P/Es
than others, like technology compared to utilities. The S&P 500 has a historical P/E
ratio of 21. Keep in mind that a company needs to generate profits in order to have a
P/E. There are more ratios that can be used in the absence of profits.
Price-Sales (P/S) and Price-Book (P/B) are comparative valuation ratios that
indicate if a stock is trading at a premium or discount compared to its peers and
sector/industry. If a stock is trading at a very deep discount like .3 P/S compared to
industry average of 2.5 P/S, then there could be an inherent structural problem with
the business or could be overlooked by Wall Street and presents an undervalued
investment situation and warrants further investigation.
Cash-Per-Share (CPS) and Book Value (BV) are two valuation ratios that can help
determine if the stock has been overly punished by investors. When a company
trades under the CPS or BV, it has virtually valued the business operations at zero
presenting either a very undervalued situation or potential bankruptcy. The cash burn
rate and debt should also be investigated. Biotech stocks are notorious for these
situations. These ratios don’t apply well to financials like banks and insurance
companies that tend to trade at or below CPS and BV, due to federal banking
regulations and off balance sheet entities.
Keep in mind that every sector and industry has an average financial ratio, which can
be used as a measuring stick. However, just because a stock has an aggressively
high financial ratio doesn’t necessarily mean it is overpriced. Momentum stocks are
notorious for exorbitant ratios.
Accounting Ratios
These are the popular quick metrics that traders can pull up immediately through a
trading platform or numerous Internet sites. The ratios allow for any trader or investor
to quickly do a peer or market benchmark comparison to determine how the
valuation stands in the markets, and whether a trading opportunity is present based
on over or under-valuation. The most widely used accounting ratios are:
Price/Earnings Ratio
Price-Earnings ratio is arguably the most used ratio. It is derived from taking the
price of the stock and dividing it by the latest earnings per share (EPS), thus P/E.
The company needs to have profits in order to correctly calculate the P/E. The P/E
can then be compared to peers within the sector or industry and general market to
determine if the stock is under or overvalued. The same applies with comparing the
other accounting ratios.
Price/Book Ratio
Price-Book ratio is used to analyze the value of the company in relation to its
intrinsic value. This is a useful ratio for companies that don’t generate a profit thus
have no P/E ratio. The price is divided by book value to generate the P/B ratio. The
P/B can be compared against sector and industry peers as well as the overall
markets through a benchmark like the SPY exchange traded fund (ETF).
Price/Sales Ratio
Price-Sales ratio is used like the P/B making it especially useful for companies that
don’t generate profits. The price of the stock divided by sales generates the P/S
ratio. This can be compared to sector and industry peers to gauge if the valuation if
particularly over or under-valued.
Cash-Per-Share Ratio
Cash-Per-Share ratio is used to evaluate how much premium the market value the
underlying business. It is derived from dividing the total cash by the outstanding
shares. Value investors like to scan for companies trading under the CPS for
potential cheap investments. However, it is important to be aware that very few
companies trade under the CPS without some very ugly fundamentals.

Stock Structure
Importance of Understanding a Stock’s Structure
One of the facets of trading that is often overlooked when performing fundamental
and technical analysis is a company’s stock structure. A stock’s structure pertains to
how the shares of a public corporation are set up. This can have implications on both
a fundamental and technical level. Fundamentally, stock structures can affect
earnings-per-share, voting rights, financing, dilution, valuation and short interest.
From a technical analysis perspective, the stock structure can affect stock price
behavior, the rigidity of price movement, spreads, volume, liquidity and momentum.
Outstanding Shares
The outstanding shares represent the total number of authorized shares that are in
the hands of shareholders, financiers, investors and insiders, which include free
trading and restricted stock. The outstanding shares represents all authorized shares
that are not held by the company, which are called treasury stock. Outstanding
shares values tend to expand and contract based on actions by the company. Stock
based compensation and private placements increase the outstanding shares, which
can further dilute the shareholder value. Stock buyback programs will shrink
outstanding shares, which technically increases the earnings-per-share (EPS) values
without actually increasing the actual earnings amount.
This little trick is called financial engineering. For example, if a company has 10
million outstanding shares with $10 million in earnings, the EPS is $1 per share. If
the company buys back 2 million shares leaving 8 million shares outstanding, the
same $10 million earnings equates to $1.25 EPS and increase of 25% due solely to
share buybacks, not an actual increase in profits.

Float
The float is the total number of free trading shares that are in the hands of investors.
These shares have no restrictions and can be traded any time. Shares held by
insiders require reporting protocol and aren’t counted as part of the float until
disposition, which also includes restricted shares, which cannot be traded until they
meet certain time and vesting conditions. The float is usually much smaller than the
total outstanding shares. Smaller floats equate to thinner liquidity since there are less
free trading shares in the market. Smaller floats are also subject to more volatile
price action and less daily trading volume. In many cases, smaller floats can lead to
short squeezes.

Authorized Shares
When a company is incorporated, it is required to state the total number of
authorized shares it can issue. The total authorized shares states the maximum
shares that can be issues by the company. From that amount, the outstanding
shares are derived from the shares it actually issues including the initial public
offering, secondary offerings, private placements and stock-based compensation
and incentives. Companies may authorize more shares, but it will further dilute the
shareholder equity when they are issued.

Common Shares
Common stock is also known as free trading shares. These shares are offered to the
public through an initial public offering (IPO) when a company decides to go public
and trade on a stock exchange. Common shares carry voting rights but are the last
in line to receive dividend payouts and have almost no claim on assets if the
company has to liquidate assets in bankruptcy proceedings. Shareholders of
common stock are invited to annual shareholder meetings where the company
presents the annual report, which includes the audited financial statements, and
reviews the company’s performance and strategy moving forward. Shareholders are
also presented with various items for vote including executive compensation,
dividend payments, auditors, pending mergers or acquisitions and board member
changes.
Periodically, the company will release more shares into the market through equity
offerings including secondary offerings, shelf offerings and private placements.
Newly listed public companies also have lock-up expiration periods starting six
months after the IPO, which allow insiders and restricted stockholders to sell their
shares in the open markets. This tends to further dilute the float but improves
liquidity. Shares tend to sell-off weeks before a lock-up expiration in anticipation of
more shares flooding the market. Further lock-up expirations are scheduled by the
company to incrementally increase the float. Successful lock-up expirations result in
liquidity improvement, stock price stabilization and daily trading volume improvement
as the market successfully absorbs the shares.

Preferred Shares
Preferred shares have priority on dividend payouts above common shares and have
a claim on the company’s assets in the event of liquidation or insolvency. Preferred
shares tend to receive higher dividend payments consistently since it act more like a
bond and shares virtually the same rights as bondholders. Unlike common shares,
preferred shares usually don’t provide voting rights. Many preferred shares have the
ability to convert to common shares, also known as convertible debentures or
preferred shares. Companies use preferred shares as a method of financing that
doesn’t incur heavy debt.

Restricted Shares
Restricted stocks are non-trading company shares that cannot be transferred or sold
until certain conditions are met. Restricted shares are commonly issued/granted to
company employees and insiders as part of their compensation/incentive packages.
Companies have their own rules regarding vesting of employee stock and time
requirements before restrictions can be lifted on shares. Restricted shares are also
used to raise funds for the company through private placements, secondary offerings
and convertible debt offerings. Restricted stock requires the company to lift the
restricted status before the shares are available for free trading.