Investing in the stock market can be challenging, yet highly rewarding at the same time. For intermediate to advanced traders, the challenge often lies in identifying the right and high potential stocks that offer both value and growth potential. Evaluating stocks effectively goes way beyond surface-level financial ratios and basic market trends. To truly evaluate stocks like a pro, you need to delve into complex metrics, assess market dynamics, and understand the subtleties of qualitative factors.
This article explores advanced techniques to help you evaluate and pick stocks like a PRO!
Advanced Stock Evaluation Techniques
Here are a few metrics and strategies that will help you identify and evaluate stocks like an analyst.
Fundamental Analysis:
Fundamental analysis is used to identify stocks with a high growth potential at a good price by analyzing the company’s business and the industries conditions. It’s often used for long-term investing.
Qualitative Factors:
- Company news: News about a company can cause its stock price to rise or fall, as positive news drives buying and negatives news triggers selling, impacting supply, demand and share price.
- Changes in management: Personnel changes, such as management restructures, are crucial for stock investors as they can affect market perception and directly impact stock prices.
- Financial news: Financial events like interest rate decisions, management changes and large-scale economic shifts can cause market volatility, making them crucial to consider when picking stocks.
Quantitative Factors:
- Balance sheet analysis: The balance sheet offers a snapshot of a company’s financial position at a specific point in time, detailing its assets, liabilities, and shareholders equity. Balance sheet analysis provides insights into the breakdown of funding sources, thus providing data on financial leverage and capital structure.
- Income statement analysis: This presents the company’s revenues, expenses and profits over a period, typically quarterly or annually. It highlights essential metrics such as revenue, cost of goods sold, operating expenses, interest expenses, taxes, and net income.
- Cash flow statement analysis: The cash flow statement offers insights beyond profit numbers by detailing a company’s cash inflow and outflow from operating, investing, and financing activities over time. It reflects the company’s ability to generate cash and meet its financial obligations.
Financial Ratio Analysis:
Financial ratio analysis usually involves calculating and examining metrics from a company’s financial statements, such as annual report, income statement, balance sheet, and cash flow statement. These ratios reveal key relationships and insights, helping traders evaluate a company’s performance and financial health by using mathematical formulas.
Earnings before interest, tax, depreciation and amortization (EBITDA):
EBITDA excludes non-cash expenses from net income, offering a clear picture of the company’s core operational earnings before accounting for financial costs. It is a widely used metric for assessing business performance and valuation.
| Formula: EBITDA= Net income + Taxes + Interest expense + D&A OR EBITDA = Operating Income + D&A [D&A: Depreciation and Amortization] |
Profit after tax (PAT):
PAT represents the net income a company earns after all applicable income taxes are deducted. PAT indicates the company’s financial health by showing the amount of profit remaining after tax expenses.
| Formula: PAT or NOPAT = Operating income X (1-tax) OR PAT = Net profit before tax – total tax expense. Wherein, Operating income = gross profit – operating expenses |
RoE / RoA / RoCE:
Return on Equity (RoE) gauges how efficiently management is using equity to generate profits and provides insights into the returns generated for common stockholders. Additionally, you can also use Dupont Analysis, which breaks down RoE into three components, and helps you understand the drivers of RoE and identifies whether the company’s high RoE is sustainable or driven by leverage.
Return on Assets (RoA) measures a company’s overall operational efficiency by dividing net income by total assets. This ratio assesses how effectively a company utilizes its assets to generate profit, independent of its financing decisions.
Return on capital employed (RoCE) assesses how well a company uses its capital by dividing EBIT by total capital employed. It looks at how a company uses tangible and intangible assets to generate returns.
| Formula: ROE = Net profit margin X Asset turnover X Equity multiplier ROA = Net income/ Average assets ROCE = EBIT/ Capital employed |
Price to earnings ratio (P/E):
P/E ratio helps compare a stock’s value within a sector and assess if it’s overvalued or undervalued compared to historical averages. A P/E ratio is considered to be high or low depending on the type of sector.
| Formula: P/E ratio = Market price per share / Earnings per share |
Price to book ratio (P/B ratio):
This ratio measures the debt of the company against its assets, giving you an insight into the company’s performance in comparison to its competitors. A low ratio could indicate that the company’s funding comes from its shareholders.
| Formula: P/B ratio = Market capitalization / Book value of assets |
Technical Analysis:
Technical analysis focuses on identifying statistical patterns in stock charts to predict future price movements, rather than examining the underlying company’s fundamentals.
Moving averages:
It is a widely used stock indicator in technical analysis. It smooths out price data over a specified period by calculating the average price, which is continually updated. This helps to identify trends and reduce the impact of short-term fluctuations.
Exponential moving average:
It is a type of moving average that prioritizes more recent data points, giving them greater weight compared to older data. This method is commonly used to assess bullish and bearish trends in securities over a specified time.
Stochastic oscillator:
It is a momentum indicator that helps to measures the position of the securities closing price relative to its high-low range over a period. It provides values between 0 and 100, highlighting potential overbought or oversold conditions in the market.
Moving average convergence divergence:
This indicator can detect a change in momentum by comparing two moving averages. It helps to identify if there a possible buy or sell opportunities around the support and resistance levels.
Bollinger bands:
It is a technical analysis tool designed to predict long-term price movements. They can help identify when an asset is trading outside its typical range, highlighting potential overbought or oversold conditions.
Relative strength index:
It is primarily used to gauge market momentum, assess market conditions, and signal potential risk pf adverse price movements.
Factor and Risk Models
Multi-factor models:
Beyond using the capital asset pricing model (CAPM), which only considers i-market risk, professional investors use multi-factor models such as Fama-French Three-Factor model. This model includes factors for market risk, size risk (SMB: Small minus big), and value risk (HML: High minus low).
| Formula: Expected Return = Risk-free rate + βm (Market return – Risk free rate) + βSBM X SMB + βHML X HML |
Stress-test and scenario analysis:
Stress testing involves running a company’s financials through various adverse scenarios (e.g., economic downturn, interest rate hikes, etc.) to see how the company would perform. Scenario analysis helps in understanding the range of possible outcomes and the resilience of the stock.
Conclusion
Evaluating stocks like a pro involves a combination of in-depth quantitative analysis, sophisticated valuation models, risk assessment, and qualitative factors. By mastering these advanced techniques, you can identify high potential stocks and build a portfolio that outperforms the market. Remember, successful investing is not just about how to pick stocks for long term but also about understanding the complexities that drive their performance.