Whether you like it or not, the stock market is going to have a huge influence over your life. The stock market is involved with your 401(k)s, individual retirement accounts, tied to the economy, measures fear and greed, tells the future (6 months at a time), etc.  Due to it’s intimate relationship to your financial well-being, it’s important to know HOW IT WORKS even if your portfolio is professionally managed.

My goal is not to make everyone traders, but to be BETTER investors.  So when the opportunity arises to make an investment decision (like switching your 401k to conservative from aggressive), you will be able to recognize and react instead of DOING NOTHING.  I understand that no one can truly time the market, but a good investor has the ability to mitigate extended losses, especially the ones during a market breakdown.  If you held on during the 2008 financial crash, your portfolio must have sunk  35% in value, possibly even more.  Chances are this market crash is going to happen again in your lifetime, maybe several times (magnitude may vary).  That’s how the market works.  Think BOOMS and BUSTS.

So to be a better investor, we need to understand what the heck we’re looking for from the start.  Let’s start by breaking down the analysis portion of investing.

There are three major schools of analysis when dealing with stock market investing: 1) Fundamental Analysis, 2) Technical Analysis, and 3) Quantitative Analysis.  We will be discussing Fundamental Analysis in this post.  I won’t get into too much detail (there’s books for this!), but I will definitely touch base on some of the most important concepts that professional fundamentalists use in determining their investments.

What is Fundamental Analysis

A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security’s value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management). (SOURCE)

Just reading that makes me snooze.  I’m with you.  However, simply put, it’s analyzing the company’s financial statements and everything that may affect the company’s financial well-being (competitors, interest rates, management decisions, consumer tastes, consumer confidence, the economy, etc).

Here are a few of the MAJOR items that fundamental analysts look at when pricing a stock.  This is definitely overwhelming, but I’ll try to word it in way that even Layman can enjoy.  NOTE: I will not go over calculations or most financial ratios like ROE, ROA, ROI, Turnover Ratios, Current Ratios, etc.  Also this is written from a price appreciation standpoint. For more information definitely pick up a reference book like Stock Investing For Dummies

EPS (Earnings Per Share) – Probably the most important factor in determining the company’s share price.  You’re looking for year-over-year (YOY) growth

EPS Estimate – Created by both analysts and company management.  EPS Estimates are used to gauge the company’s outlook.  Look for raised estimates.

Revenue aka Sales, Top Line – Found on the income statement.  One of the best ways to increase EPS is by increasing Revenue.  Look for YOY growth.

Net Income aka Bottom Line, Earnings, Profit - The company’s profit after all expenses.  Look for YOY growth.

PE ratio (Price to Earnings ratio) – a high PE ratio suggests the company has higher growth in the future compared to companies that have lower PE ratios.  PE ratios alone do not say much.  However, used against other PE ratios from firms within the same industry, against the company’s own historical PE ratio, or even the PE ratio of the company’s entire sector,  you can get a sense of relative price valuation.  It’s okay to compare the PE ratios of Verizon with AT&T.  However, it would not make sense to compare the PE ratio of Verizon with Disney.  Look for a low company PE relative to competing firms, it’s industry, or historical PE.

Ownership and Insider Sales -  If you see management selling their stocks, it could mean many things.  They could be selling because they know something bad is going to happen in the near future, they want to reallocate their portfolio, they need to fund a new vacation home, they intend to retire soon, they have a child that is requesting a huge birthday, etc.  However, if you see management buying stocks at market value, it can only mean ONE thing:  they believe the stock price is undervalued and expect it to appreciate.

Market Share – A company gaining market share usually means higher EPS; translates to higher share price.

Industry Growth - If the company’s industry is growing, then it’s easier for it to capture customers along the way.  If it’s stagnant or shrinking, it has to steal customers from it’s competitors, make adaptations, or reinvent itself.  Look for new trends that bode well for your company. Think HD-DVD vs Blu-Ray.  Blu-Ray won the format war, so HD-DVD is out.

MD&A (Management Discussion & Analysis) – Found on mandatory quarterly filings (10Q / 10Q) to the SEC (Securities and Exchange Commission), it recounts areas the company has done well and obstacles that it faces.  Ideally, it would be nice for a company to address their obstacles, but that’s not always the case.   Look deep into the MD&A and try to figure out if the management is trying to hide anything.

Auditor’s Report - Also found on the mandatory quarterly filings (10Q / 10K).  An independent auditor basically expresses his/her opinion on whether the financial statements were prepared accurately and provide adequate disclosure.  Look for any irregularities the auditor has concerns about.

Find out what metrics are used for the company - A lot of companies have their own metrics to determine profitability.  For example, Airlines have Revenue per Seat while Retail has Revenue per Square Foot.  Find out what your company’s metrics are and look for YOY growth.

Consumer Confidence - the level of optimism that consumers feel about the state of the economy and their personal financial situation.  Look for an increase in the consumer confidence index.  It applies upwards pressure on the overall markets.

Interest Rates – Changes in interest rates cause domino effects to the market.  For now, just know that as long as interests rates are low, it’ll help jump start the economy into an expansionary track at the expense of inflation.

Unemployment Rate - When unemployment is decreasing / improving, it places upward pressure on the market = happy portfolio.  So look for a decreasing rate or an increase that is not as high as what analysts have expected.

GDP (Gross Domestic Product) - The growth and economic health of our country’s economy.  It includes Consumption, Investments, Government Spending, and  Net Exports.  Look for an increase in this number.

So these are some of the major fundamental analysis items you should look for or become acquainted with.  There’s a plethora of other things to look for, but these will suffice for now.  I encourage you to take the time to financially educate yourself.

This is boring stuff I know.  I promise next week will be much funner!!!  Have a great weekend and get going on those costumes, Halloween is 1 week away!

Shalom! (hebrew)

Photo Credit: Eric Liu

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