“Never invest in a business you don’t understand.”
So you decided you want to invest in stocks, but you don’t know where to start? Think of researching stocks like buying anything, a car, dishwasher, home, or T.V. You can make your decision solely on the specs or listen to experts’ opinions, or you can dig in and do it yourself.
If you are a DIY-style investor like myself, then digging and learning all that you can about the business and its prospects are the fun part of deciding which is the best investment. We refer to that process as fundamental analysis. And it refers to the process of discovering how the business makes money, the status of its financials, and its place in the market.
We need to analyze many different factors from company financials, management, and competition to get a full picture of the company’s prospects and decide whether we want to own part of that business.
In today’s post, we will learn the step by step process to research stocks:
- Gather All of Your Materials
- Learn What the Company Does to Make Money
- Study the Industry and the Company’s Advantages
- Learn Some Basic Metrics
- Put It All Into Practice
Okay, let’s dive in and learn more about researching stocks for beginners.
Gather All of Your Materials
One thought before we dive in and learn about the materials necessary for preliminary study; owning stocks means owning a piece of the business. When we buy a stock, we are becoming a part business owner with other shareholders. It is important to understand that point because it does not own a ticker or symbol; it is a business. That business creates products and services that customers buy, which creates profits for the company’s owners or shareholders. As owners, we benefit from those profits either in dividends, buybacks, or share appreciation.
The first place to start gathering our materials is the company’s financial statements, typically the 10-k and 10-q. We can find these documents on the U.S. Security and Exchange Commission’s website or SEC.gov.
- Form 10-k: An annual report that each publicly traded company is required to file on an annual basis at the end of the company’s fiscal year. Note, these fiscal years don’t always line up with the end of the calendar year; for example, Apple’s fiscal year ends in September. The 10-k contains all of the financial information we need, along with descriptions of the business products, revenues, debts, and assets. Accountants audit the 10-k’s annually to verify all information is correct. To learn more about how to work through a 10-k, check out this link.
- Form 10-Q: Similar to the 10-k, these reports are filed quarterly or every three months. They are not as complete as the 10-k, they are also not audited, which means there could be discrepancies in the numbers, but that is rare. Reading through the 10-Q is a good resource because it gives you a snapshot of the performance during troubled times, like the recent pandemic or how different initiatives play out.
- Earnings Calls: Each quarter, the company’s executives, typically the CEO, CFO, and COO, present quarterly information to analysts, and in some cases, the public. In these remarks, the management lays out the company’s recent performances, plus how any initiatives are going. After the prepared remarks, they take calls from industry analysts, which gives you a great flavor of management: their speaking style, comprehension of the business, and temperament. You can find these valuable reports either in the Investor Relations section of the company’s website, or investment research sites such as Seeking Alpha, Gurufocus, or Bamsec, to name a few.
Other resources for materials are the websites mentioned above which provide analyst reports written by individuals unrelated to the investment industry. These reports or articles give you a good sense of how the general public feels about the company. For example, if you search for a company on Seeking Alpha, you can see if the mood is bullish (optimistic) or bearish (negative) by the flavor of the articles.
Other great material sources are the financial websites that electronically lay out the financial numbers to make reading the financials easier. They also compile long-term trends, ratios, and trends to help make analysis easier. Some of my favorites include:
**A Pro tip**
Many of these resources allow you to download excel spreadsheets of the financials, which allows you to manipulate the data in any way you wish. For example, if you want to study the company’s debt, you can use the excel spreadsheet to calculate different metrics for you by pulling all the information together. That makes analyzing the financials that much easier. Did I also mention that much of this is free!!
If you are short on time, using the websites mentioned above can give a good snapshot of the financial situation for any company.
Many online brokerages such as Schwab and Fidelity provide great snapshots of company’s such as certain financials like revenues, earnings, and other metrics that can give you a good snapshot.
But to fully understand the company, we need to read the financial reports, 10-K and 10-Q.
Learn What the Company Does to Make Money
An often overlooked but critical piece to the puzzle is the understanding of business operations. If we don’t understand how the company makes money or what kind of products or services they offer, we waste our time.
To truly understand the company, we need to understand what is going on under the hood. Many companies are transparent and easy to understand. Take Walmart or Target, for example; they sell merchandise ranging from home goods, clothing, and groceries. We have the option to buy online or in the store, so pretty simple.
But others such as Microsoft or Amazon are more complicated, but not impossible. In many cases, you can turn to someplace like Google or Youtube to get a breakdown of how a company operates. For example, recently, I did a deep dive into the lithium battery industry, and I turned to Youtube videos as a resource to help me better understand the making of batteries, how they mine lithium ore, and how the companies develop better batteries. These helped me better understand how a company like Albemarle makes money, which helps me interpret the financials.
Warren Buffett reads 500 pages a day, many of it financials, and he has stated many times that he puts plenty of companies in the “too hard” pile. If he doesn’t understand the business, he moves on; with over 7,000 public companies in the U.S. alone, there are plenty of fish in the sea.
It is far better to understand the business and analyze those businesses than step outside your circle of competence or comfort zone and buy a company you don’t understand. For example, I know nothing about the biotech world, so analyzing a company in that industry would be a waste of time because I would never truly understand how the company makes money and the risks involved in buying those companies.
Study the Industry and the Company Advantages
Learning the ins and outs of the industry is a good way to get a feeling for the company you are studying. We don’t need to become an industry expert, but instead familiarize ourselves with the industry and the trends in the industry.
The first place to start is reading your company’s annual reports and two or three other competitors in the same industry. Reading competitor’s reports will give you a clearer picture of what is happening in the industry. Other good sources of information are trade magazines or websites focusing on that particular industry. Another great resource is talking to others that work in that particular industry; taking a boots-on-the-ground approach is always helpful. Chatting with the Starbucks employees is a great way to get a feel for the company and the competition if you are researching Dunkin Donuts.
Another great resource for examining industries is listening to podcasts that focus on the different industries. With the increased popularity of podcasts, there are tons to help fill the gaps in our knowledge.
Moving beyond the industry, we should next focus on the company’s competitive advantage. Some great books and blogs focus on competitive advantages; for example, Michael Porter’s Five Forces and Competitive Strategy focus on the different advantages that your company may have or strive to acquire.
Items such as:
- Network effects
- Scale advantages
- Technological advantages
Those are just a few big ones; think of companies that dominate, such as Apple, Nike, Coke, Netflix, and Google. These are all companies with some sort of competitive advantage over their competition, and we need to figure out how our company may compete and win in their niche. The harder it is for a competitor to breach its competitive advantage or moat, the stronger the company.
Next, we need to study the management team. Again, much of this information is available in the financial reports, such as their tenure, how long they have worked for the company, experience, and age. It is also important to analyze their capital allocation skills; these are investing skills to grow the business or pay shareholders dividends.
A good resource for analyzing a company’s management and board members is the company’s proxy or DEF14 document, which you can find on SEC.gov or in the Investor Relations tab on the company website. The proxy will tell you how the management is compensated; incentives will tell you a lot about motivations. It will also inform you of the board of directors who sit on the board; you want a mix of insiders (management) and outsiders to assess management’s actions objectively.
The final resource for assessing company culture and management is to look at management ratings on Glassdoor, the employment website. Here you can find ratings of the company from insiders and, in many cases, reviews on management.
Finally, we need to consider what could go wrong with the company? What are the risks associated with investing in Apple, for example? Sometimes they are obvious answers, and other times it may be more industry or company-specific. For example, banks risk losing money on credit defaults in an economic downturn or when interest rates drop.
All of the above in this section are the soft skills or qualitative analysis of studying different companies. They are as important as studying the financials or fundamentals of the company, and it is important to consider all of the above when finding the right investment.
Learn Some Basic Metrics
Once we have a handle on what the company does, how they make money, and some soft skills, it is time to dive into its financial health.
The best way to do this is to study some ratios and learn how to read the story that the financials are telling us. There are many ways to go, but I will lay out some basic ones to get you started.
Revenue: The top line of the company, the money that the company brings in a specified period, such as quarterly or annually, and sits at the top of the income statement. Focus on the operating revenue because these monies come from the core operations of the business. Many analysts focus on top-line growth, especially in younger businesses.
Operating income: The operating income is the money generated from the business’s operations after all the costs associated with those operations are removed. For example, costs of goods sold, R&D, payroll, etc. The more efficiently the company creates operating income, the more profitable the company.
Net Income: The bottom-line because it is the final entry in the income statement. Also known as the earnings of the company, or net profit. We arrive at the net income after subtracting the operating expenses, taxes, and depreciation from the top-line or revenue.
Earnings Per Share or EPS: We achieve the earnings per share by dividing the net income or earnings by the total shares outstanding. That calculation gives us the earnings per share or EPS, which is a great tool compared to other companies or competitors. It is also a great shortcut to tell us how profitable a company is or its growth.
Wall Street puts a lot of stock in the EPS, which is a major focus of many analysts. But it is far from perfect, and it tells you nothing about the company’s debt, or how it reinvests for its growth or growth plans. It is also the most easily manipulated number by unscrupulous companies, so it is best to beware and don’t put too much stock in earnings.
Price to Earnings Ratio (P/E): We can divide the price per share by the earnings per share to give us a price-to-earnings ratio, which is a quick shortcut for valuation. Using a P/E ratio can tell us the company’s value in the market; generally, the lower the ratio, the lower the value. For example, Walmart trades at a P/E of 31.47 over the last trailing twelve months (TTM) compared to Amazon’s P/E of 65.31. That tells us that the market values Walmart’s earnings less than Amazon’s.
It also tells us how much an investor is willing to pay for $1 of earnings. The example above tells us investors are willing to pay $31 for $1 of Walmart’s earnings and $65 for $1 of Amazon’s earnings.
Remember that the earnings per share calculation are ripe for manipulation and notoriously focuses on the short-term, not the best for long-term results.
Return on Equity (ROE) and Return on Assets (ROA): The return on equity tells investors how much profit a company creates from each dollar shareholders have invested in percentage terms. The equity is the shareholder equity or the part that investors own of the company.
Return on assets tells us the same information by comparing net income to the assets of the company.
To calculate both ratios, we use the net income or earnings of the company compared to either the equity or assets and then express both as percentages. These percentages tell investors how efficiently the company creates revenue from its equity and assets.
The higher, the better, but keep in mind that different industries will have different ratios. For example, banks will have lower returns on assets because of the nature of their business, where industrials such as Johnson & Johnson might have higher ROA ratios than banks. The same rules apply to the return on equity. It is best to use these as comparisons both on the long-term performance of your company and within the industry. A good practice is to look at the ROE of Apple over five to ten years to see how consistent the company performs and compare those to others in the same industry.
To learn more about these terms and ratios and how to put them to work, please check this out:
Put It All Into Practice
Okay, now that we understand how to proceed, let’s talk a little about how to put all this together and what process works best to follow.
As we can see, there are endless ratios, metrics, and resources to follow, and it’s hard to know where to begin. But I want to share one thought with you. It is best to approach researching a stock like eating a pizza; as much as you want to gobble it all down, you can only eat it piece by piece. Don’t get overwhelmed, instead focus on what you can control and work through the process consistently, and you will discover that you have learned a lot.
Here is the process that I follow when researching a company:
- Learn what the company does
- Discover how the company makes money
- Learn as much about the industry as I can
- All of this comes from reading the company financials; what the company does and how they make money are at the top of the 10-k. If I understand what the company does and how they make money, I proceed to the company’s financials. If I don’t, it goes in the too-hard pile, and I move on to the next choice.
- Read through the financials, income statement, balance sheet, and cash flow statement. Calculate any relevant metrics and ratios and compare them to long-term results and competitors.
- Assess the industry and the company’s competitive advantage or moat
- Assess the possible risk associated with an investment or what could go wrong.
- Research the company’s management and incentives to determine if they are shareholder-friendly and what drives them to grow.
- Make my decision to buy or sell
Keep in mind this is my process in a nutshell. But you have to determine what works best for you; some like to look at the company’s financials first and then assess some of the “soft” skills next. Others like to assess the company’s competitive position first and work from there.
There is no right or wrong answer; it is all a personal choice. But following the steps outlined in today’s post is a great guide to getting you started and then branching out from there.
Remember that all the knowledge you gain, whether you buy a company or not, compounds. And over time, that knowledge will come in handy either with that company or in that industry at some point. My dive into lithium batteries gave me insight into that sector, and at some point, I will benefit from that knowledge.
Try to remember that success at investing doesn’t happen overnight, and the best returns come over the long term. Keep at it, and you will reap the rewards.
And with that, we will wrap up our discussion on how to research stocks for beginners.
As always, thank you for taking the time to read today’s post, and I hope you find something of value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,