1. Understand the two types of stock analysis
When it comes to analyzing stocks, there are two basic ways you can go: fundamental analysis and technical analysis.
This analysis is based on the assumption that a stock price doesn’t necessarily reflect the intrinsic value of the underlying business. This is the central tool value investors use to try to find the best investment opportunities. Fundamental analysts use valuation metrics and other information to determine whether a stock is attractively priced. Fundamental analysis is designed for investors looking for excellent long-term returns.
Technical analysis generally assumes that a stock’s price reflects all available information and that prices generally move according to trends. In other words, by analyzing a stock’s price history, you may be able to predict its future price behavior. If you’ve ever seen someone trying to identify patterns in stock charts or discussing moving averages, that’s a form of technical analysis.
One important distinction is that fundamental analysis is intended to find long-term investment opportunities. Technical analysis typically focuses on short-term price fluctuations.
We at The Motley Fool generally are advocates of fundamental analysis. By focusing on great businesses trading at fair prices, we believe investors can beat the market over time.
2. Learn some important investing metrics
With that in mind, let’s take a look at four of the most important and easily understood metrics every investor should have in their analytical toolkit to understand a company’s financial statements:
- Price-to-earnings (P/E) ratio: Companies report their profits to shareholders as earnings per share, or EPS for short. The price-to-earnings ratio, or P/E ratio, is a company’s share price divided by its annual per-share earnings. For example, if a stock trades for $30 and the company’s earnings were $2 per share over the past year, we’d say it traded for a P/E ratio of 15, or “15 times earnings.” This is the most common valuation metric in fundamental analysis and is useful for comparing companies in the same industry with similar growth prospects.
- Price-to-earnings-growth (PEG) ratio: Different companies grow at different rates. The PEG ratio takes a stock’s P/E ratio and divides it by the expected annualized earnings growth rate over the next few years to level the playing field. For example, a stock with a P/E ratio of 20 and 10% expected earnings growth over the next five years would have a PEG ratio of 2. The idea is that a fast-growing company can be “cheaper” than a slower-growing one.
- Price-to-book (P/B) ratio: A company’s book value is the net value of all of its assets. Think of book value as the amount of money a company would theoretically have if it shut down its business and sold everything it owned. The price-to-book, or P/B, ratio is a comparison of a company’s stock price and its book value.
- Debt-to-EBITDA ratio: One good way to gauge financial health is by looking at a company’s debt. There are several debt metrics, but the debt-to-EBITDA ratio is a good one for beginners to learn. You can find a company’s total debts on its balance sheet, and you’ll find its EBITDA (earnings before interest, taxes, depreciation, and amortization) on its income statement. Then turn the two numbers into a ratio. A high debt-to-EBITDA ratio could be a sign of a higher-risk investment, especially during recessions and other tough times.