Before You Buy That Stock, Make Sure It Passes These Simple Tests
When you’re buying individual stocks instead of investing in mutual funds or ETFs, you’re going up against some stiff competition: Professional traders and institutional investors, all of whom have various ways of analyzing stocks. While amateur investors might not be prepared to do advanced stock analysis, they can use these simple forms of analysis to make sure they’re making a smart investment.
A Primer on Fundamental and Technical Indicators
Stock analysis falls into two main camps: fundamental analysis and technical analysis. Fundamental analysis focuses on a company’s financial results, such as revenues, expenses, assets, liabilities, and cash flows. Technical analysis is focused on recent and long-term stock trading trends.
For most beginner investors, a focus on fundamentals is key to success. Technical analysis is used heavily by short-term traders while long-term investors tend to lean on fundamentals. With fundamental analysis, the focus is finding the true, intrinsic value of a stock to decide if it is a good investment. With technical analysis, investors focus on trend lines to decide whether or not to invest.
Growing Revenues and Profits
Starting with fundamentals, look at the revenue and profit trend of a stock you are considering purchasing. Your brokerage is one source for this information, as are many free investment sites around the web.
When looking for this information, you can view both quarterly and annual histories.
Look at both revenue and profits over time, and look for a trend of growth. One bad year or quarter shouldn’t shake you too much, but a recent bad result or negative trend should be enough for you to skip this stock and move on to another investment idea.
If the revenue and profits pass the trend test, the next place to look is fundamental ratios. Three noteworthy and easy-to-use ratios are the price/earnings ratio, the “acid test,” and the book value by share.
- Price/Earnings: The Price/Earnings ratio, or PE ratio, tells you how the share price relates to company profits. The PE ratio tends to vary by sector, but if one company is a far outlier from industry peers, it may be a sign of an upcoming price swing.
- Acid Test: The Acid Test ratio, also called the quick ratio, is a measure of liquidity. This test divides current assets by current liabilities to help understand the company’s ability to pay its bills.
- Book value per share: Championed as an important indicator by Warren Buffett, book value per share shows the value of assets on the books after taking out liabilities.
This is only a small taste of the ratios and tests available to investors, but all three are a great place to get started with stock analysis before your first stock purchase.
Mind the Trends
While fundamental analysis is more important for new investors, don’t ignore the technical indicators. While the day-to-day trend lines introduce a lot of noise, a useful but often overlooked technical indicator is the Bollinger Bands, named for analyst John Bollinger.
Bollinger Bands include three key technical indicators: the moving average and upper and lower bands based on statistical analysis of recent results. The outcome shows likely upper and lower price points with an average in the middle. Generally, you should avoid buying if the current price is above the upper band and try to buy if the price is below the lower band. However, if the price is moving dramatically based on company or market news, these indicators can become less useful. For an example, here are the Bollinger Bands for Apple’s stock.
Check in With the Analysts
One last place to look before buying is the analysis. While stock analysts are far from infallible, they are a great resource to check in on before buying or selling. Like the information above, you can generally find analyst reviews or summaries in your brokerage account.
Rather than look at each analyst alone, look at the averages and consensus numbers among analysts. This gives you a view of what educated, full-time investors think about the stock.
Follow the Numbers and Your Gut When Investing
While investment gains and losses are black and white, the decision to invest often leads to many gray areas. To make the best decision, review both the fundamental and technical indicators, along with the overall sentiment from the investment analyst community. For new investors, fundamental indicators should hold the most weight in your decision.
But there is one investment guide you will never have a number for: your gut. And just as you might find a big red flag from looking at a company’s numbers, so too might your gut instincts on a stock sway you one way or another.
When your instincts and the numbers align, you have likely found a winner. If it passes fundamental analysis tests and technical trend lines; the investment analysts give the thumbs-up; and your instincts say to buy, it is time to move forward and click the ‘buy’ button. While there’s no guarantee the stock will go up, you can be assured that you’ve done your homework.