When investing in a company's stock, you're aiming to pay a price that's less than the value of the company's future profits.

Unfortunately, this is easier said than done. After all, if you had a crystal ball to predict the future revenue and earnings of every publicly traded company, getting rich would be easy!

So we use the next best thing when investing in the stock market: stock analysis.

Analyzing stocks helps investors find the best investment opportunities at a given time. By using analytical methods, we can attempt to find stocks trading for a discount to their true value, which therefore will be in a great position to capture market-beating returns in the future.

Two professional men looking at stock charts on a monitor.

Image source: Getty Images.

Fundamental vs. technical analysis

When it comes to analyzing stocks, there are two basic ways you can go: fundamental analysis and technical analysis. 

  • Fundamental analysis is based on the assumption that a stock price doesn't necessarily reflect the true intrinsic value of the underlying business. Fundamental analysts use valuation metrics and other information about a company's business to determine whether a stock is attractively priced. Fundamental analysis is designed for investors looking for excellent long-term returns. 
  • Technical analysis generally assumes that a stock's price reflects all available information and that prices generally move according to trends. In other words, by analyzing a stock's price history, technical analysts believe you can predict its future price behavior. If you've ever seen someone trying to identify patterns in stock charts or discussing moving averages, for example, that's a form of technical analysis.

One important distinction is that fundamental analysis is typically intended to find long-term investment opportunities, while technical analysis is often geared toward profiting from short-term price fluctuations. 

We generally are advocates of fundamental analysis and believe that by focusing on great businesses trading at fair prices, investors can beat the stock market over time. 

Four metrics to use in your stock analysis

With that in mind, let's take a look at four of the most important and easily understood metrics you should have in your analytical toolkit:

  1. Price-to-earnings (P/E) ratio: Companies report their profits to shareholders as earnings per share, or EPS for short. The price-to-earnings ratio, or P/E ratio, is a company's share price divided by its per-share earnings, typically on an annual basis. For example, if a stock trades for $30.00 and the company's earnings were $2.00 per share over the past year, we'd say it traded for a P/E ratio of 15, or 15 times earnings. This is the most commonly used valuation metric in fundamental analysis, and is most useful for comparing companies in the same industry with similar growth prospects.
  2. Price-to-earnings-growth (PEG) ratio: Different companies grow at different rates. The PEG ratio takes a stock's P/E ratio and divides by the expected annualized earnings growth rate over the next few years. For example, a stock with a P/E ratio of 20 and 10% expected earnings growth over the next five years would have a PEG ratio of 2. The idea is that a fast-growing company can be "cheaper" than a slower-growing one, even if its P/E ratio makes it look more expensive.
  3. Price-to-book (P/B) ratio: A company's book value is the net value of its assets. Think of book value as the amount of money a company would theoretically have if it shut down its business and sold everything it owned. The price-to-book or P/B ratio is a comparison of a company's stock price to its book value. Like the P/E ratio, this is most useful for comparing companies in the same industry that have similar growth characteristics. You should use it in combination with other valuation metrics.
  4. Debt-to-EBITDA ratio: One good way to gauge financial health is by looking at the company's debts. There are several debt metrics, but the debt-to-EBITDA ratio is a good one for beginners to learn. You can find a company's total debts on its balance sheet, and you'll find its EBITDA (earnings before interest, taxes, depreciation, and amortization) on its income statement. If a company's debt-to-EBITDA ratio is significantly higher than its peers', it could be a sign of a higher-risk investment, especially during recessions and other tough times. 

Looking beyond the numbers to analyze stocks

While everyone loves a good bargain, there's more to analyzing a stock than just looking at valuation metrics. It is far more important to invest in a good business than a cheap stock. With that in mind, here are three other essential components to stock analysis that you should watch:

  • Durable competitive advantages: As long-term investors, we want to know that a company will be able to sustain (and, hopefully, grow) its market share over time. So, it's important to try to identify a durable competitive advantage -- also known as an economic moat -- in the company's business model when analyzing potential stocks. This can come in several forms. Just to name a few possibilities, a well-known brand name can give a company pricing power, patents can protect it from competitors, and a large distribution network can give it a cost advantage over peers.
  • Great management: It doesn't matter how good a company's product is or how much growth is taking place in an industry if the wrong people are making key decisions. Ideally, the CEO and other main executives of a company will have successful and extensive industry experience and will have interests that align with shareholders'.
  • Industry trends: Long-term investors should focus on industries that have favorable long-term growth prospects. For example, there's a clear marketwide trend toward online retail sales. Over the past decade or so, the percentage of retail sales that take place online has grown from less than 5% to more than 11% today. So e-commerce is an example of an industry with a favorable growth trend. Cloud computing, payments technology, and healthcare are just a few other examples of industries that are likely to grow significantly in the years ahead. Trends can be helpful to you in determining which industries you should focus on (and avoid) in your analysis.

A basic example of stock analysis

Let's quickly look at a hypothetical scenario. We'll say that I want to add a home-improvement stock to my portfolio and that I'm trying to decide between Home Depot (NYSE:HD) and Lowe's (NYSE:LOW).

First, let's take a look at some numbers. Here's how these two companies stack up side by side in terms of some of the metrics we've discussed:

Metric

Home Depot

Lowe's

P/E ratio (last 12 months)

24.5

22.3

Projected earnings growth rate

4.5%

19.1%

PEG ratio

5.44

1.17

Debt-to-EBITDA ratio

1.71

2.26

Data sources: CNBC, Ycharts, Yahoo! Finance. Figures as of June 25, 2020.

Here's the key takeaway from these figures. Lowe's actually appears to be the cheaper buy on both a P/E and a PEG basis. Lowe's does have a higher debt-to-EBITDA multiple, so this could indicate that Lowe's is the riskier of the two.

I wouldn't say that either company has a major competitive advantage over the other. Home Depot arguably has the better brand name and distribution network, but not so much that it would sway my investment decision, especially when Lowe's looks more attractive. I'm a fan of both management teams, and the home improvement industry is one that will always be in demand.

If this sounds like I'm picking a few metrics to focus on and essentially giving my opinions on the company, you're right. And that's the point: There's no one perfect way to evaluate stocks, which is why different investors choose different stocks to invest in.

Solid analysis can help you make smart decisions

As I just mentioned (and it's worth reiterating), there's no one correct way to analyze stocks. The goal of stock analysis is to find companies that you believe are good values and great long-term businesses to invest in. Not only does this help you find stocks likely to deliver strong returns over the long run, but using analytical methods like those described here can help prevent you from making bad investments and losing money in the stock market.