Researching a stock is a lot like shopping for a car. You can base a decision solely on technical specs, such as torque, mpg and seating capacity. But it’s also important to consider how the ride feels on the road, the manufacturer’s reputation and whether the color of the interior will camouflage dog hair.
Investors have a name for that type of research: fundamental analysis.
Fundamental analysis involves looking at numbers and other measures in a company’s financials as well as assessing the less tangible aspects of a business. This holistic approach can help you decide whether a stock deserves a parking spot in your portfolio.
How to perform quantitative research
Quantitative research begins with financial information that companies are required to file with the U.S. Securities and Exchange Commission:
- Form 10-K is an annual report including key financial statements that have been independently audited. Here you can review a company’s assets and liabilities via the balance sheet, its sources of income and how it handles its cash via the cash flow statement, and its revenues and expenses via the income statement.
- Form 10-Q provides a quarterly update on operations and the already mentioned financial results.
- Annual reports include a company’s 10-K and all quarterly updates. They also provide a business overview and often color commentary about the state of the company for prospective and existing shareholders.
You’ll find highlights from these filings and important financial ratios on your brokerage’s website or on major financial news websites. This information will help you compare a company’s performance against other candidates for your investment dollars.
Don’t get too hung up on specific numbers. But starting with these line items will get you familiar with the measurable inner workings of a company:
This is the amount of money a company brought in during the specified period. It’s the first thing you’ll see on the income statement, which is why it’s often referred to as the “top line.” Sometimes revenue is broken down into “operating revenue” and “nonoperating revenue.” Operating revenue is most telling because it’s generated from the company’s core business. Nonoperating revenue often comes from one-time business activities, such as selling an asset.
This “bottom line” figure — so called because it’s listed at the end of the income statement — is the total amount of money a company has made after operating expenses, taxes and depreciation are subtracted from revenue. Revenue is the equivalent of your gross salary, and net income is comparable to what’s left over after you’ve paid taxes and living expenses.
EARNINGS AND EARNINGS PER SHARE (EPS)
When you divide earnings by the number of shares available to trade, you get earnings per share. This number shows a company’s profitability on a per-share basis, which makes it easier to compare with other companies. When you see earnings per share followed by “(ttm)” that refers to the “trailing twelve months.”
Earnings is far from a perfect financial measurement because it doesn’t tell you how — or how efficiently — the company uses its capital. Some companies take those earnings and reinvest them in the business. Others pay them out to shareholders in the form of dividends. It’s also easy for company management to manipulate the number by using “creative” accounting.
PRICE-EARNINGS RATIO (P/E)
Dividing a company’s current stock price by its earnings per share — usually over the last 12 months — gives you a company’s trailing P/E ratio. Dividing the stock price by forecasted earnings from Wall Street analysts gives you the forward P/E. This measure of a stock’s value tells you how much investors are willing to pay to receive $1 of the company’s current earnings.
Keep in mind that the P/E ratio is derived from the potentially flawed earnings per share calculation, and analyst estimates are notoriously focused on the short term. Therefore it’s not a reliable stand-alone metric.
RETURN ON EQUITY (ROE) AND RETURN ON ASSETS (ROA)
Return on equity reveals, in percentage terms, how much profit a company generates with each dollar shareholders have invested. The equity is shareholder equity. Return on assets shows what percentage of its profits the company generates with each dollar of its assets. Each is derived from dividing a company’s annual net income by one of those measures. These percentages also tell you something about how efficient the company is at generating profits.
Here again, beware of the gotchas. A company can artificially boost return on equity by buying back shares to reduce the shareholder equity denominator. Similarly, taking on more debt — say, loans to increase inventory or finance property — increases the amount in assets used to calculate return on assets.
There’s No Perfect Financial Ratio
There are endless metrics and ratios investors can use to assess a company’s general financial health and calculate the intrinsic value of its stock. But in all things, context is key.
Looking at a company’s revenue or income from a single year tells you nothing about the quality of the business. You have to look at its historical data to spot trends and a general business trajectory. You must also compare key ratios to individual businesses in the same industry and industry averages. Then dive into qualitative research.
If quantitative research reveals the black-and-white financials of a company’s story, qualitative research provides the technicolor details that give you a truer picture of its operations and prospects.
How to perform qualitative research
Warren Buffett famously said: “Buy into a company because you want to own it, not because you want the stock to go up.” That’s because when you buy stocks, you purchase a personal stake in a business.
Doing qualitative stock research with a business-buyer mindset helps investors focus on the qualities of a company that truly matter in long-term stock investing.
Here are some questions to help you screen your potential business partners:
HOW DOES THE COMPANY MAKE MONEY?
Sometimes it’s obvious, such as a clothing retailer whose main business is selling clothes. Sometimes it’s not, such as a fast-food company that derives most of its revenue from selling franchises or an electronics firm that relies on providing consumer financing for growth. A good rule of thumb that’s served Buffett well: Invest in common-sense companies that you truly understand.
DOES THIS COMPANY HAVE A COMPETITIVE ADVANTAGE?
Look for something about the business that makes it difficult to imitate, equal or eclipse. This could be its brand, business model, ability to innovate, research capabilities, patent ownership, operational excellence or superior distribution capabilities, to name a few. The harder it is for competitors to breach the company’s moat, the stronger the competitive advantage.
HOW GOOD IS THE MANAGEMENT TEAM?
A company is only as good as its leaders’ ability to plot a course and steer the enterprise. What is their industry experience? Tenure and career trajectory? How big a personal stake do the corner-office dwellers have in the company they run, and are portions of their salaries tied directly to company performance?
You can find out a lot about management by reading their words in the transcripts of company conference calls and annual reports, and how they respond to questions from the press. Also research the company’s board of directors, the people representing shareholders in the boardroom. Be wary of boards comprised mainly of company insiders. You want to see a healthy number of independent thinkers who can objectively assess management’s actions.
WILL THIS COMPANY BE AROUND IN 20 YEARS?
You want to buy a stake in a business so you can share in its long-term prosperity, right? So, bottom line, what could go wrong? We’re not talking about developments that might affect the company’s stock price in the short-term, but fundamental changes that affect a business’s ability to grow over many years. Identify potential red flags using “what if” scenarios: An important patent expires; the CEO’s successor starts taking the business in a different direction; a viable competitor emerges; new technology usurps the company’s product or service.
Put it all together
Pick a company you’re interested in, and dig in. Read current and past annual reports and letters to shareholders. Gather the numbers and financial ratios and put them all into context by comparing the company’s performance history to the industry and its peers. Then put on your business-buyer hat and work through the list of qualitative questions.
A combination of quantitative and qualitative research helps you more deeply understand a company’s operations, its place in the industry, its competitors, its long-term potential and, ultimately, if it’s worth making room for in your portfolio for the long road trip ahead.
This story originally appeared on NerdWallet.