you have decided to invest, but are not sure how to determine what is a good
investment choice or what will be simply like throwing your money away.
There are many ways of evaluate stocks and the companies behind them.
We will discuss three methods of analyzing
Analysis - Investors generally figure out how
much a stock is worth by assessing the company's financials in terms of
per-share values. This allows them
to calculate how much the stock’s proportional share of the business is worth.
This is known as "fundamental" analysis by some, and most who use it
view it as the only kind of rational stock analysis.
of evaluation such as Value, Growth, Income, GARP, and Quality are used when
doing a Fundamental Analysis. Below
is a general definition of each. Specific
definition of these terms may vary from investor to investor, so double-check
what someone using them really means.
- The goal of
the value investor is to purchase companies at a large discount to their
intrinsic value - what the business would be worth if it were sold tomorrow. In
a sense, all investors are "value" investors - they want to buy a
stock that is worth more than what they paid. Typically those who describe
themselves as value investors are focused on the liquidation value of a company,
or what it might be worth if all of its assets were sold tomorrow. However,
value can be a very confusing label as the idea of intrinsic value is not
specifically limited to the notion of liquidation value.
value investors tend to have very strict, absolute rules governing how they
purchase a company's stock. These rules are usually based on relationships
between the current market price of the company and certain business
fundamentals. Some examples include:
ratios (P/E) below a certain absolute limit
yields above a certain absolute limit
value per share at a certain level relative to the share price
sales at a certain level relative to the company's market capitalization, or
Growth investing is the idea you should buy stock in companies whose potential
for growth in sales and earnings is excellent. Growth investors tend to focus
more on the company's value as an ongoing concern. Many plan to hold these
stocks for long periods of time, although this is not always the case.
investors look at the underlying quality of the business and the rate at which
it is growing in order to analyze whether to buy it. Excited by new companies,
new industries, and new markets, growth investors normally buy companies they
believe are capable of increasing sales, earnings, and other important business
metrics by a minimum amount each year. Growth is often discussed in opposition
to value, but sometimes the lines between the two approaches become quite fuzzy
Although today common stocks are widely purchased by people who expect the
shares to increase in value, there are still many people who buy stocks
primarily because of the stream of dividends they generate. Called income
investors, these individuals often entirely forego companies whose shares have
the possibility of capital appreciation for high-yielding dividend-paying
companies in slow-growth industries. These investors focus on companies that pay
high dividends like utilities and real estate investment trusts (REITs),
although many times they may invest in companies undergoing significant business
problems whose share prices have sunk so low that the dividend yield is
consequently very high.
is an acronym for Growth At a Reasonable Price. GARP investors combine the value
and growth approaches and add a numerical slant. Practitioners look for
companies with solid growth prospects and current share prices that do not
reflect the intrinsic value of the business, getting a "double play"
as earnings increase and the price/earnings (P/E) ratios at which those earnings
are valued increase as well.
of the most common GARP approaches is to buy stocks when the P/E ratio is lower
than the rate at which earnings per share can grow in the future. As the
company's earnings per share grow, the P/E of the company will fall if the share
price remains constant. Since fast-growing companies normally can sustain high
P/Es, the GARP investor is buying a company that will be cheap tomorrow if the
growth occurs as expected. If the growth does not come, however, the GARP
investor's perceived bargain can disappear very quickly.
Most investors today use a hybrid of value, growth, and GARP approaches. These
investors are looking for high-quality businesses selling for
"reasonable" prices. Although they do not have any shorthand rules for
what kind of numerical relationships there should be between the share price and
business fundamentals, they do share a similar philosophy of looking at the
company's valuation and at the inherent quality of the company as measured both
quantitatively by concepts like Return on Equity (ROE) and qualitatively by the
competence of management. Many of them describe themselves as value investors,
although they concentrate much more on the value of the company as an ongoing
concern rather than on liquidation value.
we stated earlier, Fundamental Analysis is just one of three methods of analysis
we will be discussing. Those who do not use Fundamental Analysis have two major
arguments against it. The first is they believe this type of investing is based
on exactly the kind of information all major participants in publicly traded
markets already know, so therefore it can provide no real advantage. If you
cannot get a leg up by doing all of this fundamental work understanding the
business, why bother? The second is that much of the fundamental information is
"fuzzy" or "squishy," meaning it is often up to the person
looking at it to interpret its significance. Although gifted individuals can
succeed, the nay-sayers reason, the average person would be better served by not
paying attention to this kind of information.
2) Quantitative Analysis - Pure quantitative analysts look only
at numbers with almost no regard for the underlying business. Although even
fundamental analysis requires some numerical inputs, the primary concern is
always the underlying business, focusing on things like management's expertise,
the competitive environment, the market potential for new products, and the
like. Quantitative analysts view these things as subjective judgments, and
instead focus on the incontrovertible objective data that can be analyzed.
Management could always lead one astray, but the numbers hold the truth.
In recent years as computers have been used to do a lot of
number crunching, many "quants," as they like to call themselves will
only buy and sell companies on a purely quantitative basis, without regard for
the actual business or the current valuation - a radical departure from
fundamental analysis. "Quants" will often mix in ideas like a stock's
relative strength, a measure of how well the stock has performed relative to the
market as a whole. Many investors believe if they just find the right kinds of
numbers, they can always find winning investments.
Some of those numbers a "quant" looks at are:
- Some investors purposefully narrow their range of investments to only
companies of a certain size, measured either by market capitalization or by
revenues. The most common way to do this is to break up companies by market
capitalization and call them micro-caps, small-caps, mid-caps, and large-caps,
with "cap" being short for "capitalization." Different size
companies have shown different returns over time, with the returns being higher
the smaller the company. Others believe that because a company's market
capitalization is as much a factor of the market's excitement about the company
as it is the size, revenues are a much better way to break up the company
universe. Although there is no set breakdown used by all investors, most
distinctions look something like this:
- MICRO - $100 million or less
- SMALL - $100 million to $500
- MID - $500 million to $5
- LARGE - $5 billion or more
Screen-Based Investing -
Many quantitative analysts use "screens" to select their investments,
meaning they use a number of quantitative criteria and examine only the
companies that meet these criteria. As the use of computers has become
widespread, this approach has increased in popularity because it is easy to do.
Screens can look at any number of factors about a company's business or its
stock over many time periods.
While some investors use screens to generate ideas and
then apply fundamental analysis to assess those specific ideas, others view
screens as "mechanical models" and buy and sell purely based on what
comes up on the screen. These investors claim that using the screen removes
emotions from the investing process. (Those who do not use screens would counter
that using a screen mechanically also removes most of the intelligence from the
- Momentum investors look for companies that are not just doing well, but are
flying high. "Well" is defined as either relative to what investors
were expecting or relative to all public companies as a whole. Momentum
companies often routinely beat analyst estimates for earnings per share or
revenues or have high quarterly and annual earnings and sales growth relative to
all other companies, particularly when the rate of this growth is increasing
every quarter. This kind of growth is viewed as a sign things are really good
for the company. High relative strength is often a category in momentum screens,
as these investors want to buy stocks that have outperformed all other stocks
over the past few months.
- CANSLIM is a system pioneered by William J. O'Neil that is a hybrid of
quantitative analysis and technical analysis, detailed in his book How to Make
Money in Stocks. According to Investor's Business Daily, O'Neil's newspaper, the
"C'' and ''A'' of the CANSLIM formula
tell investors to look for companies with accelerating Current and Annual
earnings. The ''N'' stands for New, as in new products, new
markets, or new management. ''S'' stands for Small
capitalization and big volume demand. ''L'' tells investors to
figure out whether the company is a Leader or Laggard. ''I''
has them look for Institutional sponsorship, and ''M''
concentrates on the direction of the Market. O'Neil originally created
Investor's Business Daily to be a tool investors could use to practice CANSLIM,
although it has become a very widely read business publication by all types of
investors. CANSLIM also includes components of the next type of analysis -
3) Technical Analysis - Some investors have taken a unique route,
attempting to create a set of tools that might tell them what other investors
thought about a stock at any given time, particularly looking for the footprints
of large institutional investors that tend to cause the most extreme price
changes. Investors who focus on this kind of psychological information call
themselves technical analysts and believe charts can sometimes provide insight
into the psychology surrounding a stock. Although there are plenty of pure
chartists, some investors just use charts to time investments after looking at
them from a fundamental or quantitative perspective.
There is no set of clearly defined approaches to
technical analysis, but there are a number of different tools. The most
important indicators seem to be specific chart formations that show certain
price movements at times when trading volume is at a certain level. The most
common kinds of charts include point and figure charts, logarithmic charts, and
Japanese candlesticks, to name a few.
Technical analysis assumes certain chart
formations can indicate market psychology about either an individual stock or
the market as a whole at key points. However, most of the statistical work done
by academics to determine whether the chart patterns are actually predictive has
been inconclusive at best. Much of the faith in technical analysis hinges on
anecdotal experience, not any kind of long-term statistical evidence, unlike
certain quantitative and fundamental methodologies that have been shown in many
instances to be pretty predictive. Critics of technical analysis feel it is
basically as useful as reading tea leaves.
Now we have run down the basics on fundamental,
quantitative, and technical approaches to picking stocks. Chances are, like most
investors, you'll find elements of each suit your investing style. As your
education continues, you'll develop your own investing philosophy that targets
your needs and goals with bull's-eye precision. If you're itching to start
putting your newfound philosophy to practice, then it is time to start looking
for a broker, and invest smartly.
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