#5: How To Analyze Stocks (Fundamental Analysis)
Let’s talk about how to analyze a stock.
How to analyze a stock
There are two main ways on how to analyze a stock…
- Fundamental Analysis
- Technical Analysis
You can think of it as this…
Fundamental analysis tells you what to buy.
Technical analysis tells you when to buy.
For now, we are focusing on the Fundamental aspect.
Don't worry, we will discuss technical analysis in the later videos but for now, let's begin with Fundamentals.
How to analyze a stock (Fundamental Analysis)
When you talk about Fundamental analysis, it can be broken down into two categories…
- Qualitative Fundamentals
- Quantitative Fundamentals
Here's the thing about Fundamentals…
What you're trying to do is to gather insights or information about the economy or financial states from the company to derive intrinsic value.
This is what Fundamental analysis tries to do!
If the stock price drops below the intrinsic value, you buy.
If the stock price is above the intrinsic value, you sell.
That pretty much sums up the role of someone trying to use Fundamental analysis in your investment or in their trading.
As mentioned, there are two broad ways to do Fundamental analysis.
Qualitative, and Quantitative Fundamental analysis.
So let's have a look at them in more detail…
These are Fundamentals or other information that can't be quantified…
- Technology Disruption
- Economic Moat
Let me explain…
Let's say I have an oil company and I'm in profit now as I send my guys to dig up oil from the earth.
But let’s say that there is this new rare commodity that can replace the oil that’s less hazardous and cheaper.
So when this new commodity comes to the market, you can see that my business is going to suffer because nobody needs oil anymore!
My stock price is going to collapse!
So, how do you actually quantify this?
This qualitative analysis is an insight that someone can glean from and realize that this would be disruptive to the oil stock companies.
Another one could be…
This is a term that I think Warren Buffett came up with.
For example, coca-cola has a strong economic moat, they sell Cola.
But if you want to challenge against them, it can be pretty damn difficult, because they have the brand and the reputation which they've been in business for a long time.
You can't really quantify what this economic moat is and that's another way of looking at the qualitative analysis.
Qualitative analysis can also be involved with analyzing the management.
It can be where the management and CEO are good that continues to improve operations and reduce expenses.
So these are things that cannot be quantified in numbers.
Now, here are the Pros and Cons of using Qualitative analysis
- You can digest information and make sense of what's going on in the world and in the company
- You can gain insight that not many traders or investors will see
- You can make a profit because you can actually buy a stock below its intrinsic value
- It could be difficult as there is so much information out there
- Identifying what is relevant or not may give you an analysis paralysis
Moving on, we have something that we call…
These are Fundamentals that can be quantified like…
- Revenue, Earnings, Cash flow, etc.
- Ratios (P/E, PB, P/CF, etc.)
Now, here are the Pros and Cons of using Quantitative analysis
- You can actually use quantified data and backtest to see whether that data yields you a market-beating return in the long run
- There could be too much information and that it could be very hard to filter out what is the stuff that matters and what doesn’t
With that said, let’s do a quick summary…
There are two types of analysis in the stock market:
- Qualitative Analysis
- Quantitative Analysis
If you ask me, Qualitative or Quantitative?
I won't say one is better than the other or one is wrong.
But I do know that quantitative Fundamental analysis can be backtested and is worth paying attention to.
What are some of the Fundamental metrics that you should pay attention to?
Which Fundamental Metrics to Look at?
Based on studying momentum stock traders and also if you've read the book “How to make money in Stocks” by William J. O’Neil…
Stock traders like to focus on earnings and net income.
Why is that?
Because most stock traders don’t have the skill to analyze the company.
They use a shortcut or a so-called “screening process” by looking at earnings and net income.
If you think about this…
If a company would disrupt a sector just like the oil example I gave a while ago wherein a new element that can replace oil is discovered…
You can be sure that people will flock to whichever company that's producing the new element.
And this company will make money and earnings will increase naturally which will reflect on a company’s statement.
Another example could be that a company has been in decline and has lost its competitive edge in the markets.
Then, new management comes in that starts to shake things up as they improve the company by focusing on the stuff that is bringing in revenue.
From a qualitative perspective, it can be quite difficult to determine whether the new management is able to turn things around.
But one thing that doesn't lie is the earnings and net income report.
When it starts to improve yearly and quarter-on-quarter…
You can be sure that management is doing something good.
I'm not guaranteeing this because there are many cases of fraud.
But chances are is that the Fundamentals of the company is doing well!
So this something that you want to pay attention to.