Stock Analysis: Different Methods for Evaluating Stocks (2024)

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.

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.

The notion of stock analysis relies on the assumption that available market information can be used to determine the intrinsic value of a stock. In the primary methods discussed below, investors use financial statements, stock price movement, market indicators, or industry trends to make investment decisions.

Much of this strategy relies on leveraging historical information. For instance, investors may analyze a company's stock based on it's financial performance. An analyst that is trying to determine the fair price of that stock may strive to understand how similar companies of similar performance performed in the past.

There are two basic types of stock analysis: fundamental analysis and technical analysis. Each method is discussed more in-depth below.

Fundamental 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 U.S. 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 in revenue, expenses, and profits a company made.

Fundamental Analysis and Ratios

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.

Fundamental Analysis and Comparative Information

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 portion 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 its variable or operating costs.

Technical Analysis

The second method of stock analysis is technical analysis. Technical analysis focuses on the study of past and present price action to predict the probability of future price movements. 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 Analysis and Comparability

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. Like other forms of analysis, analyzing stock price trends using technical analysis is more complicated as more variables are considered.

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. These unpredictable events may occur that were essentially impossible to forecast or plan for.

Other Forms of Stock Analysis

Aside from fundamental analysis and technical analysis, analysts can leverage other less formal ways to analyze the price of a stock. With the interconnectivity and complexity of social media, analysts can perform sentiment analysis by engaging with social media and news to gauge public perception of the company.

Quantitative analysis is similar to technical analysis in that it relies on complex financial calculations to determine future price projections. Quantitative analysis relies on mathematical and statistical modeling to review data; the goal of these models is to identify general trends based on what has happened in the past (not necessarily tied specifically to the stock price).

Analysts may also perform either a top-down analysis or bottom-up analysis. Top-down analysis requires an analysis of the overall economy, then narrows down to the specific performance of a company. On the other hand, bottom-up requires analyzing individual companies, then reviewing how the broader economy is performing. Both types of analysis are used to more generally understand factors that impact price such as broad market conditions.

Limitations of Stock Analysis

Many investors rely on stock analysis to deploy their best investment strategies. However, stock analysis may result in misplaced confidence or misguided strategies.

Stock analysis is often performed with limited information. This is due to a few reasons. First, public companies may not fully disclose all situations of their company to the general public. Second, stock analysis strives to project the future (in which the information is simply not available).

Because of this reliance on future events to occur, there is broad uncertainty around all stock analysis techniques. The stock market may rapidly change in either direction based on prevailing market conditions. For example, should political climates change rapidly and redefine political risk, there may be an unpredictable impact to investments no previously foreseen.

As analysis dig into stock data, there is always an inherent risk of bias. If the data being analyzed is not anonymous, analysts may find themselves favoring certain outcomes based on what they know about the investment options. In addition, analysts and investors may be lured into confirmation bias that steers decisions to match a desired outcome.

Last, stock analysis is often complex. It isn't easy to pull together, and it requires a substantial amount of time. In addition, as variables change everyday, stock analysis requires continual thoughtfulness and analysis to evaluate morphing conditions.

The Bottom Line

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.