Learning to do an in-depth stock analysis is not rocket science. Here's a step-by-step process that can be followed by any beginner stock enthusiast. This has been taught to me by my mentor who is an investment banker and valuing stocks has been his passion since childhood. Yes, childhood. He was 11, when he started investing. He suggests breaking down the process of evaluating the quality of a company into -Growth, Profitability, Financial Health, Risks/Bear Case, and Management. These are the key areas to focus on when you are looking to do a stock analysis. His says are the primary source for this post.
One word of caution, the following discussion is concerned only with evaluating the quality of the company. However, this is only half the story because even the best companies are poor investments if purchased at too high a price. Estimating the right price to pay for a company's shares- or Stock Valuation is the other half of the story (which we would be discussing in another post).
GROWTH
Anyone looking to do a stock analysis for a company is probably attracted to it because of its Growth. The allure of growth has probably led more investors into temptation than anything else. High growth rates are heady stuff - a company that manages to increase its earnings at 30% for five years will triple its profits, and who wouldn't want to do that? Unfortunately a slew of academic research shows that strong earnings growth is not very persistent over a series of years; in other words a track record of high growth earnings growth does not necessarily lead to high earnings growth in the future.
Why is this? Because strong and rapidly growing profits attract intense competition. Companies that are growing fast and piling up profits soon find other companies trying to get a piece of the action for themselves.
You can't just look at a series of past growth rates and assume they'll predict the future - if investing were that easy, money managers would be paid much less!. And this stock analysis much shorter. Its critical to investigate the sources of a company’s growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that's generated by merely cost-cutting or accounting tricks.
Sources of Growth
Investigating the sources of growth is an important element in any stock analysis framework. How to look for sources of growth? In the long run, sales growth drives earnings growth. Although profit growth can out pace sales growth for a while if the company is able to do an excellent job of cutting costs or fiddling with the financial statements, this kind of situation isn't sustainable over the long haul - there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottomline. In general, sales growth stems from one of four areas:
1. Selling more goods or services
2. Raising prices
3. Selling new goods or services
4. Buying another company
