A Quick Way to Analyze a Stock

Given that we are currently in the heart of first-quarter earnings season, I thought it would be timely to publish an updated version of suggestions for quickly analyzing a stock. 

Much of what I wrote in the original version, published in 2017, remains valid today. This is because the rules don’t change much. A stock with an attractive valuation, strong financials and rising earnings expectations among analysts generally has favorable odds of rising in price.

A helpful metric that was introduced between the original version and now is our A+ Stock Grading system. These grades quickly tell you whether a stock has a low valuation, good growth rates, strong momentum, positive earnings estimate revisions and good quality. If you have set up a portfolio in My Portfolio at AAII.com, you can go to the Investing Ideas page and scroll down to the A+ Stock Grades section. You’ll see a tab labeled “My Stocks.” It will show grades for all the stocks you saved in My Portfolio that we can calculate grades for. The grades are just like ones you received in school: A’s and B’s are good; D’s and F’s will get you grounded.

For those of you who want to dig further below the surface, here is an overview of some of the key things to look at when evaluating a stock. The suggestions are not meant to be a comprehensive guide to everything you should consider. They may also leave you exposed to risks that further research would have identified. They do cover a lot of ground, however.

Valuation Ratios: You simply don’t want to overpay for a stock. Lower valuation ratios (price-earnings, price-to-book, price-to-sales, price-to-free-cash flow, etc.) are better than higher ones. Very high ratios, like price-earnings and price-to-book ratios, can also signal low levels of earnings or book value, respectively.

Earnings Estimates: Look to see if analysts are raising their forecasts (good) or cutting them (bad). Also, check to see if the company is beating forecasts or missing them. Finally, check future growth and the number of analysts making their forecasts available. Are earnings projected to rise or fall? Do the projections reflect the expectations of a single analyst or several analysts?

Financial Statements: There is no substitute for looking at the financial statements. Not just for the current year, but also for past years. Five to seven years of data will give you a good idea of the growth trends in sales, profits, cash flows and dividends. Start with the income statement and then go to the cash flow statement. Look to see if cash from operations is consistently positive (it’s a negative sign if it isn’t) and whether it’s greater than income after taxes (if cash flow is smaller, the company might be aggressive with its accounting practices). Scroll down to, or calculate, free cash flow (cash from operations less capital expenditures). Free cash flow should be positive for most years. Finally, glance at cash from financing. Positive numbers for cash from financing indicate that the company has raised cash either through debt or by selling stock. Jump over to the balance sheet and compare shareholder equity to total liabilities; disproportionately high liabilities imply the company has significant levels of debt.

Financial Ratios: Gross and operating margins will quickly tell you if the company is becoming more or less profitable. Return on assets shows how efficient a company’s management is at using its assets to generate earnings. Companies using share buybacks to reduce the net number of shares outstanding will have positive buyback yields. A decline in total liabilities relative to assets is a sign of a company becoming less reliant on debt.

10-K: The 10-K form is an annual filing required by the U.S. Securities and Exchange Commission (SEC). You can locate it, and other regulatory filings, on the EDGAR database. Scan through the 10-K to understand what the company does and what its potential risks are. If something seems suspicious or otherwise not right, trust your gut and find a different stock to invest in.

Earnings Releases: I find it helpful to look at the 10-K first or in conjunction with the earnings statement. This is particularly the case if the company’s executives are using internal or industry lingo. Determine how the company has performed, the reasons for the performance and what the executives expect to happen in the foreseeable future. You’ll find the earnings releases on a company’s investor relations website. You may also find it useful to read the conference call transcript or listen to it. Replays of the conference calls can often be found on companies’ investor relations websites.

Presentations: Many companies publish slides from their presentations on their investor relations websites [thank the SEC’s Regulation Fair Disclosure (Reg FD) for this]. The slides can provide a good overview of the business and what trends management is seeing.

If this seems like a lot, it’s not. You can do a quick version of this analysis in about 15 minutes. The analysis won’t identify all risks, but it will give you a good sense of whether a stock is attractive. It’s certainly much better than not doing any research or relying on someone else’s opinion. I will add that if you have a few extra minutes and have access to brokerage research, call up the reports to see if there is something important you overlooked.