Learn the basics of how to analyze stocks for potential investment opportunities
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Conducting a fundamental analysis of a stock is not the easiest thing to do for new investors, but an assessment of the quantitative and qualitative factors of stock can serve as a toolbox for helping answer the question: Is this company’s stock a good investment? The intent of this article is to teach basic principles of how to analyze a stock. This is not an exhaustive guide but is meant to serve as a cheat sheet to the fundamental language and thought process behind stock analysis. Because Bits has the ambition of making its users fluent in the language of finance — relevant terms are defined throughout this article. Throughout this article, when we reference stock, we are speaking to all the shares into which ownership of the publically-traded company is divided.
The first thing to evaluate when looking at a stock is the Earnings Per Share (commonly referred to as EPS). EPS is generally considered to be the most important variable in determining a share price for a company. We’ll use Bit’s Investing Dictionary, which defines the terms “Shares” and “Earnings Per Share” in the following way:
Shares — A unit of ownership interest in a corporation. These days, share ownership is recorded electronically. Owning shares in a corporation is achieved by purchasing a share of that corporation’s stock.
EPS — An indicator of a company’s profitability. The EPS is an important fundamental used to evaluate a company because it breaks down a company’s profits on a per share basis. Investors care about EPS because by dividing a company’s share price by the Earnings Per Share an investor can determine the fair market value of a stock in terms of what the market is willing to pay based on a company’s current earnings.
Now that we have an understanding of what EPS means, we can evaluate a potential stock investment by asking the following questions:
- Compare the current EPS to the EPS from the same quarter last year. Has EPS growth occurred? Is that EPS growth significant?
- Is there a pattern of positive EPS growth?
- Has the company’s EPS growth outperformed the S&P 500 index? (NOTE: You can find data on the S&P 500 index by searching for the ticker SPX)
- How does the company’s EPS growth compare with the rest of the industry average?
- Has the net income growth percentage increased compared to the same quarter last year?
- What is the company’s gross profit margin? What is the company’s net profit margin? How do these margins compare with the industry average?
As an example, let’s evaluate the EPS and other profitability measures of Amazon (AMZN) based on the above criteria. NOTE: We use a number of sources to obtain current and historical data, though we generally get data from MarketWatch, Yahoo Finance, Y Charts, and CSI Market. It’s also good to check out the company’s annual SEC filings such as the form 10-K, which is a required annual report providing a comprehensive overview of the company for the past year.
Based on the historical data from MarketWatch, we can see the EPS for AMZN has increased from .41 on June 30th, 2017 (same quarter last year — Q2 2017) to 5.21 on June 30th, 2018. This is significant growth as it represents an increase in EPS of 1170% during that time. We can also tell from this data there is a pattern of positive EPS growth.
To answer the question: Has the company’s EPS growth outperformed the S&P 500 index? We use YCharts to see what the S&P 500 Index’s (SPX) EPS is currently and what it was the same quarter last year. In the screenshot below you can see the index has an EPS of 33.02 (as of Q1 2018) and that same time last year the index had an EPS of 27.46 which represents a 20% increase. Amazon’s EPS increase of 1170% is markedly better than the index’s 20% increase.
Now we look to see if Amazon’s net income growth percentage has increased since the same quarter last year. MarketWatch displays this data under Net Income:
Amazon’s net income growth percentage has increased from 197M in Q2 2017 to 2.53B in Q2 2018, which is a growth of 12742%. The next metric to assess is Amazon’s EPS growth compared to the EPS growth of Amazon’s peers. What industry is Amazon in? Again we use MarketWatch to obtain this information. We can see that Amazon is in the Mixed Retailing industry.
Industry — A group of companies that have related primary business activities. The US economy has dozens of industry classifications and these industries are grouped into larger categories called sectors. Companies that have multiple business activities are generally classified into an industry based on their largest source of revenue.
The industry category that Amazon falls into can vary from site to site, but the companies that fall into that category are generally the same. In order to compare Amazon’s EPS growth with the industry average, I use CSI Market to find the quarterly EPS growth by industry. According to the data, the Retail industry enjoyed an EPS growth of 16% in Q2 2018 (compared to Q2 2017). As we’ve already seen, Amazon had an increase in EPS of 1170% during that time, which is far better than the industry average.
Looking at profitability measures for Amazon such as gross profit margin will reveal how profitable a company is. Using industry data obtained from CSI Market and Amazon-specific data obtained from MarketWatch we can see that the average gross profit margin in the Internet, Mail Order & Online Shops Industry is 38% while Amazon has a gross margin of 37%. Amazon is on par with the industry average along with this metric.
Gross Margin — Represents the percent of total sales revenue the company retains after subtracting out the direct costs associated with producing the goods and services it sells. The higher the percentage, the more money the company makes on each dollar of sales. In this example, the chart above indicates that Amazon retains $0.37 from every dollar of revenue generated and the Technology Retail industry, on average, retains $0.15 from every dollar of revenue generated.
Stock Price Analysis
The above analysis focused on the profitability measures of Amazon and how those metrics compare to industry averages. It appears that Amazon is a good investment, but profitability is only a single quantitative metric. Another important metric to evaluate is the company’s stock price history. Here are some basic questions to ask when evaluating the price history of a stock:
- How has the stock performed over the past year? How does that growth compare with the growth of the S&P 500 index?
- Is the stock price lower or higher than the average share price of the rest of the industry?
- Is the higher or lower price justified?
How has the stock performed over the past year? How does that growth compare with the growth of the S&P 500 index? We use the “compare” feature in MarketWatch to compare Amazon’s (AMZN) stock performance over the past year to the performance of the S&P 500 Index (SPX). From the chart, we can tell that Amazon has increased in value by 99% while the S&P 500 index has increased by 16%.
Comparing the stock price of Amazon to the average share price of the rest of the industry using CNN Money reveals that Amazon trades at a much higher price than its industry peers. Is this higher price justified? The answer is somewhat subjective, but the higher price is justified in Amazon’s case given its brand recognition, Year to Date (YTD) performance of +70% and its Market Cap, which is an impressive $970 Billion. It’s also worth noting that Amazon recently became the second company in US history to reach a $1 Trillion Market Cap.
Market Capitalization (Market Cap) — The total dollar market value of the all the shares owned by the company’s shareholders. Calculated by multiplying the number of shares owned by the current market price of a share. Investors care about Market Cap because it can be compared to the company’s book or accounting value and provide an indication of how investors value a company’s future prospects.
So far we’ve evaluated a number of industry profitability measures, compared them to the stock under evaluation, and also assessed the stock’s price, but we’ve yet to analyze the industry. When conducting industry analysis, the following pertinent questions should be answered:
- What are the major companies in the industry?
- Has the industry pattern shifted in the last five years? How so? (e.g. from catalog-based to Internet-based sales)
Now that we understand the Market Cap, we can use this metric to determine the major companies in Amazon’s industry. We use Yahoo Finance to see a list of companies in Amazon’s industry with the largest Market Caps. Based on the results, we can determine if Amazon is a major player in its industry, what products/services competitors offer, and what other investment opportunities exist within the industry. Looking at the chart below it’s clear that Amazon is an industry leader.
Assessing industry patterns and trends is as simple as gathering opinions and data via online searches. We won’t go too deeply into this as it will be entirely dependent on the industry you’re assessing and when you’re doing it, but there are always interesting analyses of this sort published on WolfStreet.
Revenue Growth & Earnings Yield
The next step to fundamental analysis is to look into some of the quantitative measures of the company. When conducting this part of the analysis, We seek to answer the following question:
Companies that exhibit both a high earnings yield and high revenue growth are generally more attractive than those with low revenue growth and low earnings yield — does this company have a high earnings yield and revenue growth rate compared to peers of similar size?
Revenue Growth — The increase (or decrease) in a company’s sales from one period (e.g. a quarter) to the next. Revenue growth is given as a percentage. Investors care about revenue growth because it gives an idea of how much a company’s sales are increasing (or decreasing) over time.
Earnings Yield — Refers to the Earnings Per Share (EPS) for the most recent 12-month period divided by the current market price per share. Investors care about earnings yield because it can be used to compare the earnings of a stock against bond yields. This is a relevant comparison since bonds are viewed as risk-free investments while equities (i.e. individual company stocks like AMZN) are considered to be riskier investments. As a result, earnings yields of equities are higher than the yield of risk-free treasury bonds. If a company has an earnings yield of 64%, investors are purchasing $0.64 of earnings per dollar invested. Earnings yield is given in percentages.
To find a company’s revenue growth rate and compare it to its peers, we use CSI Market since it provides a growth comment as well as data to easily determine the company’s revenue growth percentage and provides a comparison.
Using the metric of revenue growth, Amazon appears to be a solid investment as it ranks among the highest (#3) in its industry.
We use Y Charts to find a company’s earnings yield and compare it to industry benchmarks. Since we already determined that AMZN is trading at a price much higher than its peers, it’s not surprising that Amazon’s earnings yield is lower than many other companies in the industry at 0.64%.
Comparing a company’s earnings yield to industry benchmarks is easy in Y Charts as the site provides a comparison for the company you’ve searched for automatically.
Again we can see that Amazon is trading at a premium compared to other companies in the same industry, but as mentioned previously the higher stock price is justified given the company’s brand recognition, historical stock performance, and massive market cap.
Strengths & Weaknesses Analysis
The final step of any fundamental analysis is an assessment of the company’s strength and weaknesses. This will not be a subjective measure but instead based solely on the company’s income statement (or statement of cash flows), return on invested capital, beta, and dividend yield.
Income Statement — A financial statement that reports a company’s financial performance over a specific period of time. In this statement, the company provides a summary of how the business creates revenues and incurs expenses. This statement also shows the net profit or loss the company incurred over the specific period of time covered by the statement. Investors care about the income statement because the data it contains can be used to calculate financial ratios such as return on equity, return on assets, gross profit, and earnings before interest and taxes. This statement can also be referred to as a statement of cash flows.
Return on Invested Capital (ROIC) — A calculation which provides a measure of how well a company is using its money to generate profits. ROIC is calculated in the following way:
ROIC = Net Income — Dividends / Total Capital
ROIC is given as a percentage and is usually expressed as an annualized value. Investors care about ROIC because companies that can consistently generate a high rate of return on invested capital will probably trade at a higher price than other stocks.
Volatility — A statistical measure of the range of returns for a given stock or market index. Most commonly stocks that have higher volatility are considered to be riskier investments. Volatility is a measure of the amount of uncertainty or risk related to the size of changes in the price of a stock. Investors care about volatility because it can indicate to an investor how much the price of a stock has changed historically in either direction.
Beta –A measure of volatility of a security or portfolio in comparison to the market as a whole. Usually the S&P 500 index is used as a comparison. A beta of 1 indicates that the security’s price moves with the market. A beta of less than 1 indicates that the security is theoretically less volatile than the market while a beta greater than 1 means that the security is theoretically more volatile than the market.
- Growth: Measure the growth of the company’s income statement and cashflow. How does this compare to other companies in the sector/industry? How does this measure up with other companies you invest in?
- Efficiency: Measure the strength and historic growth of the company’s return on invested capital — does the company generate more income per dollar than other companies?
- Price Volatility: Measure the volatility of a company’s stock price historically. For this I use Beta. Is the stock less/more volatile than other stocks you’ve analyzed?
Let us use MarketWatch to assess the company’s income statement and cashflow growth. For the purposes of this assessment, we will only compare that growth to other companies in the same industry as Amazon.
Amazon’s net income growth, as we’ve already evaluated, is massive (12742%). In order to evaluate this against the net income growth of the industry, we use CSI Market. Based on this data, we can see that although the industry as a whole has enjoyed net income growth of 601% since the same quarter last year, Amazon’s net income growth is way ahead of its industry.
We use MorningStar to determine Amazon’s return on invested capital (ROIC) — which is 15.8%
Since it’s difficult to determine the ROIC for an industry, we compare Amazon’s ROIC to the industry’s return on equity (ROE). The differences between these two metrics are slight and you can read more about the differences in the underlying formulas for each of these measures here.
We use CSI Markets to find the ROE for the industry. The ROE for the internet, mail order and online shops industry is slightly over 20%, which is better than Amazon’s 15% — this could be an indication that Amazon is not spending its money as efficiently than its peers. If all other metrics we’ve used to measure Amazon against its industry were equal, this 5% difference would be more impactful, but since Amazon is generally an industry leader across the other metrics it’s not a reason to avoid AMZN as an investment.
Finally, to complete the stock analysis lets evaluate the stock’s Beta in order to get an idea of what kind of volatility or price swings we can expect as a shareholder. Let's use Yahoo Finance to find Amazon’s Beta. Amazon has a Beta of 1.76, which indicates that AMZN is slightly more volatile than other stocks in the S&P 500 Index.
That’s how Bits analyze companies and their stock in order to find potential investment opportunities. Keep in mind that although you may put a significant amount of time into the analysis before making an investment, historical data is not a predictor of future performance. Unexpected events happen all the time, people and media opinions can drastically affect the price of a company’s stock, and irrational price movements happen all the time. Often, the market can remain irrational far longer than the average investor can remain solvent. Some of the best methods for decreasing risk is to set a price point or percentage point at which you will exit a position (i.e. buy/sell a stock), set stop-loss orders (an order placed with a broker to sell or buy a stock if it drops to a certain price level) to prevent losing your initial investment and don’t invest 100% of your invested capital in a single stock. You’ve heard it before. Diversity, diversity, diversity.