While investing in index funds can provide great returns in the long-run, you can never beat the market. That’s because when you invest in index funds, you invest in the market as a whole. The benefit of investing in index funds however is that you minimize your losses (To learn more about index fund investing, check out this blog). That being said, great companies within index funds get diminished by companies that do poorly. In a perfect world, you can tell which companies are great and just invest in those companies (unfortunately, we don’t live in a perfect world).
It’s much harder to make money with individual stocks than it is with index funds. If you are looking for best stocks for beginners with little money, the minimum requirement is to first understand the fundamentals of stock analysis.
This blog will dive into these fundamentals that will provide the basics of analyzing a company.
Revenue
Revenue is a basic indicator of how much a company is able to sell to their customers. On its own, revenue tells just a piece of the puzzle. That’s because each company has different cost structures, supply chain, and labor force to name a few. For this reason, two different companies with the same revenue can have very different profits (Revenue minus expenses).
That’s why when checking a company’s revenue it’s important to see how it changes every year. Did their revenue grow consecutively in the past 5 years? If revenue has increased consecutively in the past 5 years, the company has passed the initial smell test. It means they are probably growing and they might be a good investment.
If revenue is not increasing annually, try asking yourself why. Was there an industry recession, change in management, new competition? All of this information is available in the company’s 10k report, which is present on the company website in the investor relations section.
Earnings Per Share
Now that we understand how to look at revenue, let’s look at earnings per share. Earnings per share (EPS) is a basic way of analyzing a company’s profits (revenue minus expenses). It’s important to have an understanding of the company’s profitability because it provides insight into how well the business does with their expenses. To calculate EPS, simply divide the company’s net income in one quarter by the number of outstanding shares. You can find this information from the company’s reported quarterly earnings report, or you can google it. Since every company has different outstanding shares and profits, it’s generally bad practice to compare EPS’. Instead, look to see how a company’s EPS is growing over time. If it is increasing every quarter it could be a good investment.
Price Per Earnings Ratio
The next basic way to analyze a stock is to look at their price per earnings ratio, otherwise known as P/E ratio. This ratio compares the stock price to its EPS, and indicates how expensive a stock is compared to its value. A high P/E ratio means the stock is expensive compared to the value the company provides, and a low P/E ratio is indicative of a potential bargain in stock price. A phrase I like about investing is “you make money when you buy a stock, not when you sell”. This phrase emphasizes that most of the money you make is by spotting good deals in the stock market, and selling when that value is eventually recognized by other investors. Understanding P/E ratios helps you do this analysis.
Also, you can compare a company’s P/E ratio to the P/E ratio of an index fund that invests in a similar market. This tells you how expensive a stock is compared to the rest of it’s industry. Typically, I use P/E ratios to understand if a company is trendy.
Often, you find that trendy companies have a high P/E ratio because demand went up for the stock, not because the company has good fundamentals. A trendy company is one that has a lot of excitement around their product, but they don’t have any proven track record of profit. The excitement about the product may increase demand for the stock, and this will increase stock price at a faster rate than what the company can deliver in value. In this case, the P/E ratio is unusually high compared to others within their industry. It’s best not to invest in expensive stocks that others buy because of hype, and understanding P/E ratio will help you make this decision.
Price/Earnings-Growth Ratio
One pitfall of the P/E ratio is that it doesn’t account for a company’s growth. It just tells you how a company performed in the past. However, we know that past performance is not always suggestive of the future. For that reason, it’s also important to look at a company’s Price/Earnings-Growth ratio (PEG). This ratio looks at a company’s value in the near future by dividing P/E by projected EPS for the following year. Both of these metrics are provided in the company’s earnings report online.
Ideally a company’s anticipated earnings per share (EPS) is higher than their cost per earnings (P/E). That would mean a PEG lower than 1 is an attractive investment. If over 1, the PEG ratio tells us that the projected earnings is not as high as the price you pay for the stock. You may want to reconsider investing in this overpriced stock.
Summary
This blog talks about four basic ways to analyze a company stock. This list is not fully exhaustive, and serves as a bare minimum before you consider buying a stock. I say that because I have personally made mistakes buying stocks that were trendy or recommended to me. This blog provides the initial smell test to let you know if it’s worth pursuing more information about the company.
In general, I would recommend investing in individual stocks in an industry you are an expert in. If you understand the company’s financial fundamentals plus you understand their products/services, you will have an edge over other investors looking to invest within that industry. For exampe, if you’re a doctor, look at companies in the medicine industry. If you’re in the semiconductor industry, look at Silicon/IP companies. Basically, invest in something where you understand the industry and products. That coupled with the financial fundamentals described in this blog will provide you with the basis for investing in individual stocks.
To learn more about investing fundamentals from another free source, I recommend checking out morning star investing classroom. Thats where I personally learned a lot about investing.