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How to Research Stocks: A step-by-step guide
Here's how to research and evaluate a company for investment, step-by-step
I'm not a car guy.
But, in 2011, one caught my attention.
At that time, climate change was still a topic of debate.
The options for hybrid vehicles were minimal. Options for fully electric ones were virtually non-existent.
But, that year, I started seeing a fully electric sports car around town.
It seemed to keep showing up in areas surrounding the offices of big tech companies.
After asking around, I learned the car was called: The Tesla Roadster.
Since the car seemed to be popular with wealthy tech executives, it occurred to me that maybe the company could have a promising future.
So, I went to see if this "Tesla" company was publicly traded.
Sure enough, it was.
Tesla had been around since 2003, but it was still a young company at the time.
The stock was trading at around $24.30 per share.
I looked at what the price was in prior days and it'd been trading around $24.15 to $24.20.
So, I decided I'd buy the stock when its per-share price dropped down below $24.20.
I checked the price a couple times a day for a week or so.
But, the stock never went below $24.20.
In fact, it did the opposite. Cent by cent, the price kept increased.
And, in the end I never bought shares of Tesla.
A share of Tesla (ticker: TSLA) purchased in 2011 is worth $3,870.30 today. (This accounts for its shares splitting a total of 15:1 and a per-share price of $258.02 as of writing.)
That means the stock's grown 160x from the price I refused to purchase it at. ($3,870.30 ÷ $24.20 = 159.93).
That would've turned a $1,000 investment into $160,000.
I was there at the f****** keyboard, ready to buy.
And, I didn't because I refused to pay more than yesterday's price per share.
I gave up $159,000 because I didn't want to pay $4.13.
That was the miss of a lifetime.
It still hurts.
As I've said before, I've bought stocks throughout most my life, but was never really investing.
My "research" process looked something like this:
Save some money
Tell myself I need to buy stocks because that's how people get wealthy
Read articles on Yahoo Finance
Get excited about some speculative recommendation
See if the stock's price is higher or lower than yesterday
Buy the stock if its price is lower
Hold the stock, no matter what, until I need to sell it because I need the cash
Tell people I invest in stocks
So, instead of buying Tesla, I bought Banco Santander Brasil (ticker: BSBR) for $13 per share. It's now at $5.25.
And, when everyone was buying Peloton (ticker: PTON) bikes during the pandemic in 2021, I bought the stock for $90 per share. It's now at $4.34.
Needless to say, my "research" process was a disaster.
If I'd done actual research back in 2011, I still might not've bought Tesla.
But, I definitely wouldn't have missed a 160x opportunity for something stupid like a fractional difference in the day-to-day share price.
When I committed to becoming an investor earlier this year, I started forming a more robust research process.
But, even with the improvements, I realized I didn't really know how "real" investors do it.
Successful investors like Guy Spier, Tom Gaynor, and Chuck Akre mostly talk about investment philosophy.
They don't really give us newbies a step-by-step process we can follow until we get the hang of things.
So, I gathered up a couple articles that talk about how to do investment research and just made one myself.
If you just want to skip straight to the result, just scroll down to the bottom of the article.
Before: The process I've been using the past couple months
This is what I started doing after committing to learning to invest:
Search for potentially interesting companies using stock screeners
Quickly look through financial metrics to filter out companies of interest
For companies of interest, look at trends in metrics (revenue, profit margin, etc.)
Learn about what the company does and any notable history
Look at the most recent quarterly report (10-Q) and annual report (10-K)
Listen to latest earnings call (or read the transcript)
Find content by, and/or about, the company's executive (leadership) team
Look more closely at both current and past 10-Q's and 10-K's
Investigate any concerns (mostly via searching the web)
Decide whether to invest
This is better than before, but still has a lot of gaps.
Let's take a look at the take-aways from the references I found.
Summaries of 5 Stock Research Guides
Here're summaries of the 5 references used to help build my new step-by-step process.
Summary 1: "On the Job With Simple As... My Research Process"
Article: On the Job With Simple As... My Research Process
Author: Unknown (posted via username "Simple As")
Publisher: Wall Street Oasis
Retrieved on: September 20, 2024
One of the investment communities I find most helpful is the Security Analysis sub on Reddit.
I found this article on their list of "useful links".
I don't really know who the author is. But, to me, they have credibility by association.
The articles's main objective is to describe the process for research and investment decisions in hedge funds.
Key points:
The research process is personal: Everyone has their own process
It's important to think independently
Your goal's to know the company you're researching inside and out
Note: A lot of successful investors comment on the importance of independent thinking. Jeff Henriksen, an investor who teaches a class on valuation at Oxford University, gave an interesting example of this in this interview (see time 3:46). He found that when he gave students a valuation problem to work on, the average across their results was most accurate when they worked individually. When they worked in teams, their influence on one another caused the overall accuracy to decrease.
Process:
Develop an understanding of how the company makes money
Understand its profit margins
Understand its cash flows
Understand its maintenance and/or growth plan
Understand how management thinks about positioning and competition
Evaluate the company's positioning with respect to competitors and customers
How does the market view the company?
How do competitors view the company?
How do customers view the company?
Evaluate the management team
Identify and evaluate the management team's structure and incentives
Assess the management team's capital allocation decisions
Talk to peers about the thesis you've developed thus far and get feedback
Dig deep into the financials: Line-by-line and numerous years into the past
Prepare a list of questions for the management team
Ensure there isn't any bad accounting behavior
Verify that financials reflect what you've found in research up to this point
Speak with the management team and ask questions
Value the company
Develop a range of values based on various possible situations
Assess the way the stock's price moves in reaction to various types of news
Summary 2: "A Guide on How to Write an Equity Research Report"
Article: A Guide on How to Write an Equity Research Report
Author: Jan Strandberg, CEO of Acquire.Fi
Publisher: Acquire.Fi
Retrieved on: September 20, 2024
This article’s focused more on how to build a research report.
So, it includes some information about report structure in addition to the research process.
Key points:
Research takes a lot of time ("countless hours")
A key goal is to provide an objective and unbiased assessment
Research needs to account for numerous aspects of a company: What it does, who's running it, the industry it operates in, etc.
Preparation:
Gather generic info about:
The company's primary business
The company's history
The management team and key executives
Etc.
Find this in the company's website, annual reports, regulatory filings, etc.
Understand the company’s products/services
Analyze financial statements:
Using financial ratios to evaluate health
Using financial modeling to forecast future results
Analyze the industry and competitors:
Build an understanding of the industry the company operates in
Analyze the company's competitors
Assess the company's strengths and weakenesses in the context of the industry and competitive landscape
Report Structure:
Executive Summary
Brief company overview
Overview of the industry
Overview of the company's financial performance
Investment recommendations
Buy, hold, or sell
Target price
Time horizon
Business model and strategy
Description
Evaluation of competitive advantage
Analysis of growth strategy
Financial analysis (financial health)
Financial ratios
Cash flow
Valuation
Discounted Cash Flow (DCF)
Multiples analysis (comparison of financial ratios to peers)
Precedent transactions (prices paid for similar companies in the past)
Investment recommendations
Buy, hold, or sell
Risk factors
Target price and time horizon (when target price's expected to be achieved)
Process:
Gather relevant information about the company
Analyze the company's financial health
Evaluate the company's business model and strategy
Provide investment recommendations
Format and present the equity research report
Summary 3: "Equity Research Overview"
Article: Equity Research Overview
Author: Scott Powell, Co-Founder & Chief Content Officer of Corporate Finance Institute (CFI)
Publisher: CFI Education
Retrieved on: September 20, 2024
This article focuses primarily on the content of a research report.
Key points:
The main work of in equity research is producing reports
Reports range from in-depth analyses to short updates
Professional analysts have an advantage over individual investors since they have more access to company management teams
Components of a research report:
Industry research
Industry trends
Competition
Framework-based analysis
PEST Analysis (PEST: Politics, Economics, Social trends, Technological innovation)
Management overview and commentary
Assess the quality of the company's management team
Direct access to management may be difficult, so use whatever information's available
Historical financial results
Analyze historical financial results
Compare past guidance given by the company to actual results
Forecasting
Top-down forecasting: Start with the industry, forecast the company's market share, and work down to revenue
Bottom-up forecasting: Start with the basic drivers of revenue and work towards a revenue forecast from there
Valuation
Use financial modeling to create one or more estimates of the company's intrinsic value
Recommendations
Make a buy/hold/sell recommendation based on the analysis
Note: Even though we, as individual investors, don't have equal access to management teams, many interactions with management are recorded. For example, earnings calls, investor days, interviews, etc.
Summary 4: "Master Equity Research Process: Complete 7 Steps Guide For Investors"
Article: Master Equity Research Process: Complete 7 Steps Guide For Investors
Author: S. K. Singh, Founder of Ace Equity Research
Publisher: Ace Equity Research
Retrieved on: September 20, 2024
Unfortunately, since I started writing this article, the Ace Equity Research website is no longer available.
Fortunately, there's an archived version of the article at Archive.org: Archived copy of Master Equity Research Process: Complete 7 Steps Guide For Investors
It's a detailed and well-structured article describing the research process.
Key points:
The goal of the research process is to evaluate the value and risk associated with a given stock
It's critical to tailor it to then needs of the people who'll use it to make decisions
It's a multi-step process that requires ongoing updates after the initial research is concluded
Process:
Define the research objective
Identify the purpose of the research
For example, to evaluate financial performance, growth potential, or industry dynamics
Set clear goals for the research
Clearly identify the target industry or company
Align with investor needs: Understand the target audience, objectives, limitations, etc.
Gather relevant data
Access sources like:
Company reports and financial statements
Market data and economic indicators
Industry research and news sources
Regulatory filings and disclosures
Collect and prepare data:
Review data for accuracy, reliability, consistency, completeness, and integrity
Use cross-referencing to identify and correct issues
Organize and structure the data
Analyze financial statements
Assess financial performance
Look at: Profitability, liquidity, solvency, cash flow, etc.
Use techniques like: Ratio analysis, trend analysis, comparative analysis
Assess risk and return
Assess strengths and weaknesses
Conduct industry and competitor analysis
Understand industry dynamics by assessing:
Market size and growth trends
Regulatory environment
Competitive landscape
Evaluate competitors by assessing:
Financial performance (compare metrics with the target company)
Competitive advantages
Product and service offerings (identify overlap, differentiation, market gaps)
Consider using frameworks like: SWOT analysis, Porter's Five Forces analysis, etc.
Valuation
Calculate intrinsic value using techniques like:
Discounted Cashflow Analysis (DCF)
Comparable company analysis (compare company's financial ratios)
Precedent transaction analysis
Recognize limitations like:
Uncertainty
Subjectivity
Market inefficiency risk
Formulate an investment recommendation
Analyze research findings
Financial performance and health
Industry and market trends
Competitive positioning
Risk assessment
Valuation analysis
Develop a balanced view and buy/hold/sell recommendation
Monitor and update research
Revisit financials when new information's available
Monitor for news and events that could impact the company
Monitor for industry research
Monitor macroeconomic indicators and trends
Re-evaluate and update the analysis, as appropriate
Summary 5: "How To Research Stocks"
Article: How To Research Stocks
Author: E. Napoletano, Freelance Financial Journalist
Publisher: Forbes Advisor
Retrieved on: September 20, 2024
This article's a little lighter than the others. But, it gives a nice overview and provides some encouragement to those of us without a background in finance.
Key points:
Anyone can do, and eventually master, equity research
There's no magic number; research takes work
Every investor has unique goals and interests, so research is a personal process
Process:
Gather data
Equity analyst reports: Check for access via your brokerage firm
Data on fundamentals: Annual and quarterly financial reports (10-K's and 10-Q's) filed with the Securities and Exchange Commission (SEC)
Online research sites: Yahoo Finance, Seeking Alpha, Motley Fool
Understand the numbers
Use the info gathered to evaluate the company's financial health
Look at key metrics like:
Price-to-Earnings (P/E) ratio
Price-to-Earnings-Growth (PEG) ratio
Price-to-Book (P/B) ratio
Return on Assets (ROA)
Return on Equity (ROE)
Learn about the company
Leadership
Culture
Environmental, Sustainability, and Governance (ESG) initiatives
Trends
Assess the company based on your investing strategy and goals
My shiny, new research process
The key things I want to know are:
What am I looking for?
Does this business have the potential to fulfill it?
What's the probability of success and what're the risks?
The steps listed are roughly sequential.
But, my expectation is to continually revisit previous steps as I gather new information.
As I make progress through the list, I intend to continually form new questions that drive additional investigation.
For example: Why did revenue drop 50% in quarter X only to recover in the next? How’s management preparing for increasing costs of debt with rising interest rates?
My time’s limited, so I want to make sure most of it’s spent investigating the companies most likely to match what I'm looking for.
That means minimizing time spent on companies that don't.
So, I'll terminate the research process at any point where I have enough evidence to feel confident the company's not a match. (Unless I'm going through the process just to practice researching.)
Okay, so at long last, here's the process:
Choose a company
Identify a company I want to research
Specify why the company's of interest
Assess how it might fit into my investment strategy (Dividend? Growth? Value? Hedge? Something else?)
Create a repository (folder) for my research
Use this to store all data, analysis, and notes generated by this process
Sniff test
Based on how the business makes money, decide if I’m comfortable owning and funding it
Scan over the company’s financial metrics for any red flags
These can come from general sites like Yahoo Finance or info provided by my brokerage firm
IMPORTANT: Take data from general sites with a grain of salt. I've found that sometimes the data's incorrect or not calculated in the way I was expecting.
Flags might include general concerns, like a business that's loaded with debt and losing money
Or, they might include personal concerns like a mismatch with my investing objectives
Evaluate if it's worth spending more time
Review financial trends
Choose a couple key metrics
Look at trends for the past 10 years (e.g. on FinanceCharts.com)
Evaluate if it's worth spending more time
Learn about what the company does and its history
Find the company website and learn what I can from it
Search for additional info about the company, its business, its history, and important events
Good staring points are: Yahoo Finance, Google search, Google News, YouTube, and Wikipedia
Scan over the company's most recent annual report (10-K) and quarterly report (10-Q)
Evaluate financial metrics
For example: Gross Margin, Operating Margin, Price-to-Earnings (PE) Ratio, Price-to-Book (PB) Ratio, Capital Structure, etc.
Consider both vertical analysis and horizontal analysis
Start forming a picture by relating the the financials to what I've learned about the business thus far
Make note of any key items to follow up on
This can include positive surprises, negative surprises, or anything where I want stronger confirmation
Evaluate if it's worth spending more time
Learn about the industry and and the company's competitors
Identify the industry/space the company operates in
Look for reports on the industry and trends within it
Identify competitors
Understand the company's positioning
Build deeper clarity of who the company's customers are
Compare the company's financials with those of competitors
Evaluate if it's worth spending more time
Evaluate performance
Gather several years of financial reports
Evaluate how the financial metrics have changed over time
Evaluate how cash flows have changed over time and how management's allocated capital
Evaluate how the balance sheet and Capital Structure has changed over time
Review as many earnings calls as possible
Review investor presentations, press releases, and other records
Evaluate the company's progress and performance against management's goals
Estimate the business's intrinsic value
Discounted Cash Flow (DCF) analysis, including best, worst, and most-likely cases
Liquidation Value
Other valuation methods, as-appropriate (e.g. comparison of financial ratios to peers, precedent transactions, etc.)
Get familiar with the management team and the board
Identify key members of the management team
Identify members of the board
Look into each of their backgrounds
Build profiles using info from LinkedIn, Google search, etc.
Look for interviews and presentations on YouTube and Spotify
Assess the board's control/influence (e.g. can they actually remove the CEO, if needed?)
Review SEC filings for insider holdings and transactions (SEC Form 4)
Any additional flags
Check any SEC filings I haven't looked at yet
Check the potential impact of macro trends
For example, regulatory, economic, technological, social, etc.
Check for expiring lock-up periods or other upcoming one-time events
Check for current and past legal action by and/or against the company
Check customer sentiment
Check company culture and employee sentiment
Check stock holder sentiment
Seeking Alpha, Yahoo Finance, Reddit, etc.
Evaluate the current market situation based on the story I’ve constructed and estimation of intrinsic value
Look at the current stock price and historic behavior
Evaluate the current price against value
Evaluate any challenges in building or exiting a position
For example, potential challenges related to liquidity (how much demand there is to buy and sell the stock at any given moment)
Look for external input
Do this after everything else to form an independent opinion first
Look for analyst reports
Look for hedge fund ownership via filings of SEC Form 13F’s
It's easiest to start via the site Insider Monkey
Socialize research with others
Make a plan of action (invest, don't invest, monitor)
Conclusion
That's it for now.
Hopefully, someday, I'll find another 160x investment and not f*** it up again.
Meanwhile, I'll be applying my new process and refining it as I learn.
In the coming weeks, I'll try to put together an article where I apply the process.
Until then, happy hunting!
And now for something completely different
Last week, I completed Aswath Damodaran's (free) self-study course on Accounting for Finance and Investing.
It includes tests and solutions.
I got a fair number of the questions incorrect.
As in, I'd probably fail his class if it were in-person.
It made me feel kind of bad.
But, then I realized that each time I get a question wrong, it means I'm fixing my misunderstandings. 💪
So, then, in a weird turn of events, I started getting excited when I got answers wrong.
This makes me think about how backwards school feels. Getting things wrong should be exciting because it's a learning opportunity.
Anyways, I thought the class was great! I'd recommend it as a low-commitment way to boost your financial knowledge.
I plan on doing his Foundations of Finance class as well. And, ultimately, his full class on Valuation.
References
Articles summarized:
On the Job With Simple As... My Research Process. Wall Street Oasis. Retrieved 2024-09-20.
Jan Strandberg. A Guide on How to Write an Equity Research Report. Acquire.Fi. Retrieved 2024-09-20.
Scott Powell. Equity Research Overview. CFI Education. Retrieved 2024-09-September 20.
S. K. Singh. Master Equity Research Process: Complete 7 Steps Guide For Investors. Ace Equity Research. Retrieved 2024-09-20.
E. Napoletano. [How To Research Stocks](https://www.forbes.com/advisor/investing/how-to-research-stocks/]. Forbes Advisor. Retrieved 2024-09-20.
Additional resources:
SEC instructions for Form 4. SEC. Retrieved 2024-10-04.
SEC instructions for Form 13F. SEC. Retrieved 2024-10-04.
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