How to approach analyzing a stock？
Selecting how to invest can be likened to shopping for a vehicle, but with far more significant consequences. Initially, you should determine your personal preferences and requirements. Subsequently, you can explore various options and compare them based on their cost and potential performance. Evaluating investments necessitates a comparable but more comprehensive examination. For numerous individuals, appraising investments may not come as naturally as browsing through a car dealership, particularly if it's your first time. However, learning the fundamentals can aid you in identifying what to seek and what to evade.
Regardless of whether you're purchasing a solitary stock or constructing a diversified portfolio, making intelligent choices can influence your portfolio's results. So, how do you differentiate between a sensible investment and a terrible one? While there are no guarantees, there are several methods to enhance your chances of selecting an investment that aligns with your objectives. Below are four steps to take into account when scrutinizing a potential stock investment.
Go in with a plan
Just like you select a car that suits your lifestyle, your investments should align with your goals. Your investment plans will determine the duration of your investment and the level of risk you are willing to take. Some investment goals may eliminate certain volatile investments from your options. For example, if you need money in the short term, investing in unpredictable assets could put your money at too much risk. Although stocks have historically been a good opportunity for growth, they can also fall rapidly, endangering your plans for the money. However, holding stocks for extended periods reduces the risk of loss, making them useful for supporting long-term goals like home purchases, education, or retirement. To make this strategy work, you need to be able to tolerate market downturns, which is not always easy.
When deciding how much risk you can handle, you may want to consider how your investments are distributed. In other words, what percentage of your portfolio is assigned to each investment type? All investments carry risks, but the risk usually increases as the potential for return increases. Therefore, some investors allocate a portion of their portfolio to lower-return investments like bonds to balance out higher-risk, potentially higher-return investments like stocks.
Know the different makes and models
Similar to the assortment of vehicles available at a car dealership, every stock has its own unique characteristics. These factors include size, intended use, and cost. The decision of whether to choose a family minivan or a high-performance sports car, or something in between, is entirely up to the individual. When examining a stock, important considerations include its market capitalization, industry sector, and its potential fit in a portfolio. Other factors to evaluate include any dividend payments or potential for growth.
To help categorize stocks and evaluate their potential, there are several key filters to consider.
Size: Similar to choosing between a SUV or a sedan when car shopping, investors often consider a company's size. Market capitalization, or market cap, is a common measure of a company's size, calculated by multiplying the number of outstanding shares by the current share price. Small-cap companies are typically valued between $250 million and $2 billion, mid-caps between $2 billion and $10 billion, and large-caps at $10 billion or more. However, market cap can also be influenced by perception rather than fundamentals, with some investors valuing stocks based on intrinsic value while others consider popularity or market sentiment. Small-cap companies are often unproven and face challenges such as expanding beyond their existing customer base or dealing with incumbents and regulations. Large-cap companies, on the other hand, tend to be more stable with experienced management and cash reserves to weather competition and sustain performance. Large-cap companies are also more likely to pay dividends and can be found in the S&P 500 Index, which comprises some of the largest publicly-traded companies in the US.
Sector: Sectors are created when businesses are categorized according to the industry they belong to. Examples of sectors include financial, information technology or communication services, healthcare, consumer staples, and more. The Global Industry Classification Standard is a widely used tool for identifying sectors, and it designates 11 sectors in the stock market. When considering investing in stocks, it is useful to compare potential investments with others in the same sector. Diversifying investments across different sectors can help mitigate losses from poor performance in one sector with gains from strong performance in another.
Style: Are you interested in purchasing a brand-new, trendy vehicle? Or would you prefer to search for a mode of transportation that has been disregarded? The manner in which an investor classifies their investment is more a matter of how they perceive style than the company itself. "Growth investors" tend to seek out companies that are rapidly expanding, often those that receive significant media attention and are labeled as disruptors. On the other hand, "value investors" seek out companies that they believe are undervalued. Both investment styles have advantages and disadvantages, which is why many investors hold a combination of value and growth stocks.
Dividends (or not): Investing in stocks can yield returns in two ways - firstly, by selling an investment for more than what was paid due to the increase in the company's stock price, and secondly, by collecting dividends, which is a portion of the profits distributed among shareholders. While not all companies pay dividends, those that do typically do so on a quarterly basis. Dividends are not guaranteed and can be reduced or eliminated without notice, but they can provide investors with an additional source of income. The dividend yield, which is calculated by dividing the total dividends paid by the company in the last fiscal year by its share price, can help investors understand a company's growth stage. Early-stage companies often do not pay dividends, while mature companies are more likely to offer a higher dividend yield. Investors can choose to reinvest their dividends by using a Dividend Reinvestment Plan (DRIP), which allows them to buy additional stock or fractional shares of the company. DRIPs are typically offered by brokerage firms and sometimes by the company directly to its shareholders.
Individual issue or fund: If you're worried about the stress of choosing a single stock to invest in, there is an alternative. You can invest in a collection of stocks through an ETF or mutual fund, which provides diversification and reduces the risk associated with selecting only one stock. These funds are available in various sectors and risk levels. Using a stock screener tool can help sort through investment options based on factors such as size and price. Some investors prefer to analyze companies they are familiar with and compare them to others in the same industry.
Take a test drive
Observing and tracking a stock for a while before investing can be an effective method of assessment. Although historical performance data can offer valuable insights into the stock's behavior, experiencing the ups and downs of being a shareholder can provide a more accurate understanding. Despite taking precautions like diversification, asset allocation, and research, investment losses can still occur. Therefore, it's essential to remember that these strategies do not guarantee immunity from financial losses.