How to analyze a stock?

Here is my attempt at simplifying and giving structure to the process of stock analysis.

The process of analyzing a stock, and then ultimately deciding whether to buy or sell a particular issue may consist of three broad areas of research.

1. Sectoral analysis
2. Company analysis
3. Peer comparison

Sectoral analysis

All companies operating in an economy fall under a broader umbrella of similar companies referred to as a sector.

Each sector has its own method of operation and valuation. A company making end products that people use will be valued very differently from a company that mines metallic ore, even if both companies are generating equal profits.

Some sectors experience secular growth (read linear) (eg. IT service, Finance, FMCG), while others are cyclical (eg. Commodity) due to their profitability being dependent on macro factors outside their control, such as inflation, geo-political factors, interest rates, etc.

Companies in different sectors have different life cycles and may age quickly (Tech) or remain relatively stable over long periods of time (auto-mobile).

It is a good idea to study the sector as a whole while analyzing a stock that comes under its domain.

Following are the sectors along with their respective resources.

Company analysis

This simply consists of being a thorough reader of:

1. Annual reports (AR)
2. Quarterly earnings reports
3. Con-call transcripts and presentations

Do note that simply picking up the latest AR will not be sufficient, rather one has to go back at least 3-5 years and see how things have been developing at the company level, what are the promises that the management has been making all this time and whether they have kept their word along the way by delivering on those promises.

This will give you a feel of the nerve, the pace at which the company operates, with what temperament, and whether you would personally like to be vested in this company’s future.

“Write down one thing that you would change about this company if you were given a majority stake!”

There is a multitude of things that you might want to screen the financial statements for. For example, you might want to see whether the current assets are sufficient to cover the current liabilities (current ratio) and whether the firm has the capacity to pay back its long-term debts (for this you might want to see the overall debt to assets ratio, for shariah compliant companies this should not exceed 33%).

See whether the firm is generating revenue, and how much revenue is it generating given its asset base, calculated as sales/assets (asset turnover ratio). What percentage of that is turned into operating income (Revenue - Cost of goods sold) i.e. the operating margin. High or low margins do not necessarily indicate good or bad companies, but it does highlight the cushion the company has to absorb an uptick in its costs and still be profitable. Study whether the company has been growing its revenue in a stable manner and able to maintain (or improve) its margins along the way.

See what percentage of the operating profit is reinvested back into the business (capital expenditure or CAPEX, purchase of fixed assets such as plant & equipment), and how this practice has been affecting the growth of the company in the last 5 years. If the management sees the company growing in the coming years (which is good), it shall reinvest heavily. Such a stock is generally referred to as a growth stock and attracts to itself higher (and also more fluctuating) valuations than other companies. Although the risk is high (if you equate risk to price variations), the payoff could be extremely rewarding if you catch such a bird early on i.e. before it takes off.

Whereas if the firm has consolidated its position in the market and reached maturity, it will see lower prospects for expansion and return the profits back to its owners (dividends). If such is the case, then the investment decision would be a value play, indicating a buy if the price of the stock is considerably less than your calculated fair value of the firm.

After deducting all other costs you arrive at net profit, see whether the free cash flow (FCF) of the company closely tracks the net profit because it should. If the profits are high, but that is not resulting in FCF, then serious questions can be raised about the feasibility of the company’s business model and/or the management’s ethics.

It is good practice to check the balance sheet for management integrity, see Financial shenanigans .

While researching a stock, it would initially be a good idea to focus exclusively on the official company material and keep away from the opinion of other analysts and news gurus.

Once you are past this stage, then you may read analyst coverage on this stock (if available), and do a thorough background check of the company management and promoters.

The second best resource after the financial statements is the company’s quarterly con-calls. Listen to the audio recordings of the last 10 years (at least 5) if possible, otherwise, transcripts must be read.

This gives us a chance to see how the management responds to stockholder questions, and whether their claims turn out to be true or not.

A good way to judge the credibility of the management is to see whether they are answering the questions actually asked during the call, or are they intelligently redirecting the narrative to what suits them better instead of facing the line of inquiry head-on.

Peer Comparison

The idea of a free market, where anyone can exchange goods and services at a mutually agreed upon price inevitably leads to competition, where being good is not good enough if others are offering the same value at a lower cost. The market prefers the highest possible value, achieved in lowest possible cost and time.

This is what makes comparing a business with its peers a key component of the investment research process.

There are qualitative and quantitative aspects to this.

Let’s start with qualitative. Apple iPhone’s are inferior to their android counterparts in terms of technical specifications such as RAM, camera megapixels, battery capacity, etc. But despite the technical low ground, iPhone enjoys a much higher brand loyalty than android phones, and the unique ecosystem that Apple has created around its iPhone and iOS has allowed it to build a moat around its entire business across all its product lines. The result is that iPhones that cost just $450 to build sell for a whopping $1250, a profit margin of about 200%, and while iPhones account for only 33% revenue share in the smartphone market, they still end up taking a 66% profit share of the entire sector.

You might comment that these are in fact quantitative factors and not qualitative. But if you look again, it is the unique qualitative advantage of the company that is giving it an edge in numbers.

Quantitative. This should come as a no-brainer. If a particular company in a sector is performing well, we may ask “are others performing better?” or if a particular company is suffering, then the question may be “are others doing worse?”. Better or worse could be in terms of revenue growth, earnings growth, ROCE, ROE, margins, etc, or valuation metrics such as PE and PEG, etc.

Significantly improving financial metrics for a company still mostly unknown (or overshadowed by its more established peers) could hint towards a potentially reasonable investment, while deteriorating metrics for a praised brand could mean certain on-lookers are ready to heavily short the stock.