In the previous article we created our investment profile and seeded it with some parameters. In this article we'll understand how the parameters in the profile are used when buying stocks.

Buying stocks involves knowing the answer to two main questions: "which stocks to buy," and "when to buy the stocks." We'll explore stock analysis techniques (including analysis of the underlying company's health) that answer the first question. A subsequent article will address the second question.

Disclaimer

Stock analysis can only use past data and thus can only tell us how a stock performed in the past. Past performance is not a guarantee for future performance.

What to Buy

A simple way to start is to gather names of companies with publicly traded stock that meet at least one of the following criteria:

• We understand the company's business and revenue model, and the company is growing and constantly innovating. Good examples include both traditional companies and also successful modern companies with clear revenue models.
• We don't know much about the specific company, but understand the industry the company is in and the industry's business and revenue models. Plus, there is great demand for the products from this industry for the foreseeable future. Examples could be companies in biomedical research that come with new drugs for previously incurable illnesses.
• The company provides a product or service that we and millions of others use extensively. And, the company has a lead in this (and a considerable barrier-to-entry for competitors). Phone, telecommunications, and cable companies are good examples.

Occasionally, we could come across stocks that have done very well, but belong to companies or industries that we know nothing about. These are good opportunities for us to learn about the industry and its business models before deciding if these stocks make the cut.

Stock Analysis

Once we have a list of potentially promising stocks, we analyze each of them. Analysis is an important step when buying stocks. Though no amount of analysis can predict the future, the purpose of analysis is to provide a level of confidence about the health of a stock (and its underlying company). It tells us whether a stock has the potential for constant growth, is not volatile, provides a relatively high return, is fairly priced, etc. Randomly chasing the next shiny stock typically results in frustration and capital loss.

Stock Analysis Criteria

Before doing the analysis, let us add a few relevant parameters to our investment profile. These go into the 'Analysis Parameters' section of the profile. The analysis process (described later) will use these.

When analyzing a stock, we assign it a set of health scores for the following aspects of its and its underlying company's health. (Each score is between 0 and 10, inclusive; a higher score indicates better health):

• Stability: This answers the question "how stable is the stock price and the company?" A stable company typically results in a stock price that doesn't bounce around. Such a company's stock is also less subject to fluctuations in the general stock market; the stock price's ups and downs will typically be correlated only with the company's own performance. (Note that when there are really major fluctuations in the general economy, stock prices of almost all companies are typically affected. A stable company's stock price is just less affected than others.)
• Performance: This answers the questions "how performant is the company's stock price?" This in turn depends on the company's profitability, how well its products are received, and how immune the company's products are from its competition. Though all companies' stock prices are subject to market fluctuations, a well-performing company typically results in significant and continuous rise in its stock price.
• Fair price: This answers the question "is the stock price consistent with the current revenue and income of the company?". This is another way of asking whether the company's reputation is consistent with the actual performance of the company. A company may become larger-than-life for a short term causing its stock price to be inflated, without any corresponding revenue or financial stability. (There are many reasons for this: perceived but unproven benefits, a company riding on the coat tails of a hot sector, charismatic leadership, etc.) Not only does an artificially high stock price make the stock not affordable, but larger-than-life reputations are usually short-lived and risky to invest in.

For each health score type (performance, stability, price fairness), we will also specify a threshold value — the threshold values tell us the minimum health scores a stock (or its underlying company) must obtain in order for us to consider investing in that stock.

Updated Sample Investment Profile

Let's take a look at our sample invest profile, now updated with these new values (the new parameters introduced above are shown in green).

Performing The Analysis

Though analysis is perhaps somewhat time-consuming, it is not difficult. (It becomes easier if automated; we'll see more about automation a bit later.) Let's first explore some of the analysis techniques.

There are typically two schools of thought when it comes to stock market analysis:

• The first one says: "the stock price of a company reflects everything about the company's health, and as such, is the only thing we need to consider when evaluating its worthiness. We don't really need to know anything about the company's business."
• The second one says: "I consider myself primarily as an investor in the underlying company and not just a stock trader. Therefore, the company's revenues, efficiency, financial health, forecasts, long-term stability are all important pieces of information; they provide me insights into the progress of the company (and thus its stock price)."

Both of these are valid viewpoints. However, since one of our primary requirements is that we be invested for a long time without having to constantly react to stock price fluctuations, stability of the underlying company matters to us, and we prefer companies with non-volatile stock prices and are run well. The health scores described above do just that — they summarize the important aspects of both the health of a company and the performance of its stock price.

There are several ways to analyze stocks and their underlying companies. We can choose the way that's easiest for us:

• Use the analysis services provided by stock brokers and financial websites: most stock brokers and financial websites provide stock watch lists and stock screeners. (As each service has its own set of health metrics whose names may differ from our health score names, we may have to translate some of our health score names into their terminology.) In the spirit of automation and ease of use, some of the services also allow us to set up alerts and notifications, so that, instead of us having to manually research, we can specify our analysis/research criteria and be notified when stocks meet our health score thresholds.
• Perform the analysis ourselves: learn about the different stock market metrics and what they stand for, and compute the health scores ourselves. Optionally, automate this so that a computer can do this in the background (say, daily), and notify us when the scores meet the thresholds. If you're comfortable with computer programming, you can create a custom analyzer that uses publicly available company metrics and processes them into scores for each of the health score areas. Otherwise, you can simply use a spreadsheet. The process is straight forward.

Irrespective of which analysis method we choose, it is a good idea to learn about the different metrics that describe a company's health, so we can translate these values to health scores.

Commonly Used Metrics

The table below lists some of the metrics about a company and its stock price and which health score they contribute towards. To be sure, there are many more metrics available for a company — We've listed only the commonly used ones. Understanding these metrics and how they pertain to the health of a company is sufficient for us to be able to analyze a company and its stock performance.

All of these metrics can be obtained from freely available stock information services, or derived from them.

Computing Fair Price

It is important to remember that the 'fair price' of a stock is only a hint and not a real thing. It is an indication of whether a stock is overpriced (if we bought it now, it could drop in value later), or is undervalued (it is a good bargain now; the price could go up significantly later).

There are a few ways to compute the fair price for a company's stock. We'll select the simplest way: a good indication of how overpriced (or undervalued) a stock price is to compare the P/E ratio of the stock with the average P/E ratio of all the companies in that market. (The average P/E ratio is usually called the 'market P/E ratio'.) Both these numbers are easily available publicly. We simply use the market P/E ratio instead of the company's current P/E ratio to compute the corresponding stock price.

[As an aside, there are different values for a 'market P/E ratio'. Each market segment each has its own 'market P/E ratio' (examples: financial companies, oil and gas companies, technology companies, health care companies, etc.). Similarly, stock indices (example: S&P 500), stock exchanges (example: Nasdaq) may publish their own 'market P/E ratio' values. Simply choose one that is relevant to the company whose stock we're analyzing.]

Let's now calculate the fair price of the stock we're analyzing:

We know that:
  P/E ratio = Stock price / EPS

In other words,
  Stock price = (P/E ratio) x EPS

Replacing P/E ratio with Market P/E ratio:
  Stock fair price = (Market P/E ratio) x EPS

Sample Analysis Report

Now that we've seen which metrics go into analysis, here's a typical analysis summary report is shown below for two hypothetical stock symbols (AAAA and BBBB). The 'threshold' values from our investment profile are included here for reference.

Metric                   AAAA    BBBB  Threshold
------------------------------------------------
Market price:           41.50  108.09

Performance score:       8.94    2.00       6.0
Stability score:         8.93    8.63       6.0
Price Fairness score:    3.27    1.00       4.0
Overall score:           7.05    3.88       5.5

Remember that even though this sample report looks simple (just a few lines), a lot of number-crunching went into arriving at each score. (Reports generated by financial service companies or websites vary in verbosity; some may be brief and some really detailed.)

What does the above sample report say? We see that one of the stocks (BBBB) falls short of our 'buy' criteria, based on the health score thresholds we had stipulated in our investment profile. AAAA fares much better (except for the 'price fairness' score, all of its other scores are higher than the threshold).

The analysis scores don't have to be the only (or final) arbiters in selecting (or rejecting) a stock. For example: if we happen to know more about the company AAAA (e.g., the company is a very promising start-up in a brand new technology area and is getting a lot of attention, or, the company just recently patented a life-saving drug, and so on) and are thus able to convince ourselves that the low 'price fairness' score is more than compensated by the other high scores, we could decide to discount the 'price fairness' score and focus on the other scores. This is where having a good knowledge of the underlying company and/or the business segment the company operates in is useful.

What Next?

Once we've analyzed and shortlisted the stocks that we're interested in, another set of data points can be used to further understand the stock price performance. In the next article, we'll do a 'what-if' simulation of each stock to understand how the stock would have performed if we had invested in them a few years ago. Though past performance is not an indication of future performance, barring traumatic stock market or company events, recent past performance may give us a hint of how the underlying business is performing, which in turn influences its stock price.

Summary

We learnt about stock market analysis: we augmented our stock investment profile to include parameters related to stock analysis. We also learnt about metrics that describe a company's health, which of those are relevant for us, and how to interpret them.