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How Do You Analyze Potential Investments?

One of the biggest challenges investors can face is coming up with possible stocks to invest in.  Here are three ways you can analyze potential investments to decide if they are worth it – quantitative analysis, fundamental analysis, and technical analysis.  The investment strategy you choose will depend on how much time and energy you are willing to put into the research.

Quantitative Analysis

This approach uses filters and screens to narrow down the huge list of available investments to meet certain criteria that you have predefined.  For example, you might want to look at utility companies or any stocks priced under $10 regardless of sector.  Make sure your criteria are not too broad or you’ll get too many results.

Pure quantitative analysts believe that actively managing your investments is a complete waste of time.  They prefer a computerized system that chooses their stocks.  This takes any emotion out of the process and also can introduce you to companies that you’ve never heard of.  It requires the least amount of time.

One example of this approach is Couch Potato investing – choosing index mutual funds or ETF’s.  Another is the Dogs of the Dow or Beating the TSX approach.

Fundamental Analysis

Fundamental analysis determines the value of an investment.  It is probably the most complex and time-consuming way to make evaluations.  Most of the information comes from the companies’ quarterly or annual reports and include a balance sheet, income statement and cash flow statement, and provides a good amount of information about profitability.

Calculating ratios (one component of fundamental analysis) gives investors valuable information and provide an easy way to compare the stocks of different companies.

  • Earnings-per-share (EPS) ratio is the net earnings (income) of a company divided by the number of shares outstanding.  This shows whether or not a company is profitable.
  • Price-to-earnings (P/E) ratio is a calculation of a company’s stock price (P) divided by their earnings per share (E).  It tells you how much investors are willing to pay for the stock.  It can tell you whether a stock is overvalued or undervalued.  It can also provide a relative value when compared to the company’s peer group or to itself in the past.
  • Price-to-Book ratio compares a stock’s current market price to its book value (assets minus liabilities).  To calculate, find the latest price of the stock and divide it by the book value.  This ratio shows how much the company would be worth if it was forced to close down.  The ideal ratio is 1:1 (each share has assets backing it) but a good value is 2 and under depending on the company.

You should look at a number of ratios, not just one or two in isolation.

Technical Analysis

Technical analysis uses charts to track the prices of stocks.  This type of analysis often requires less time because you just watch the chart price trend to see if it’s moving higher or lower and it gives more timely information.  Make sure you understand how the charts are constructed and what each piece of information represents – the price and the time period.

These methods are best used in combination.  Begin with quantitative analysis to narrow down your options.  Then do a fundamental analysis to determine value and finally apply technical analysis to figure out price point.

It used to be time consuming to find the information you needed to analyze potential investments.  Now you can find all these tools (even all the ratios calculated for you) on the market research tab of your online brokerage as well as Globe Investor, MSN Money and various other financial websites.

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11 Comments

  1. My University Money on August 30, 2011 at 8:35 am

    I honestly believe that technical analysis is absolutely ridiculous for long-term investors. The only possible reason to use it is to consider the short-term best entry point for a positions, but I would weight it far less than fundamental analysis. Despite what the talking heads and “experts” would have you believe, I am still strongly in the Warren Buffet camp of, “The stock market will always be about placing capital in the hands of the best and most efficient companies, end of story.” The tough part is being able to do fundamental analysis in-depth enough to be sure the prospective company isn’t keeping something off their balance sheets, or hiding a major liability through various tricks.

    • Boomer on August 31, 2011 at 8:01 pm

      @My University Money. Calculating the ratios in fundamental analysis is useful but I leave in-depth analysis to professional stock analyzers who get paid the big bucks for their research. Generally I think that dividend payers are least likely to hide liabilities or “fudge” the books. Checking prices can be a good way to find an entry point for buying.

  2. Ian Brennan on August 30, 2011 at 10:31 am

    I have always been fascinated by the number of analysts who rely on only one method rather than a combination of all of them. I use technical analysis even for longer term investments. History shows that buying and selling index ETF’s in a tax exempt account at the 200-day moving average will generate returns which even outperform the market over longer periods of time.

    • Boomer on August 31, 2011 at 8:04 pm

      @Ian Brennan
      Moving averages are not as useful for buy and hold investors but all methods of analysis give good information especially when used together.

  3. My Own Advisor on August 30, 2011 at 5:50 pm

    Nice post.

    Like MUM, technical analysis is almost useless. Charts are nice, but that’s about it.

    Quantitative is an excellent approach.

    Then again, you can always buy and forever hold what the big mutual funds buy and not do any analysis at all 😉

  4. The Passive Income Earner on August 30, 2011 at 6:41 pm

    I’d say that I like to do Quantitative Analysis to filter down stocks followed by Fundamental Analysis. Usually, I’ll focus on an industry but you don’t want to miss bargain in other sectors.

  5. Ash on August 31, 2011 at 1:29 pm

    I have better things to be doing than staring at charts! 🙂 If it’s a good company and it’s cheap, I’ll buy it today regardless of the price yesterday, last week or last month.

  6. Vijay Arora on August 31, 2011 at 6:58 pm

    Where do you get the 5 Year Average Dividend Yield and the 5 Year Average Dividend Growth number from?

  7. The Wealthy Canadian on August 31, 2011 at 7:28 pm

    I never focus exclusively on one approach when analyzing stocks.

    I try to combine a mixture of my own methods, followed by researching articles and news surrounding a particular company.

    Once I have developed my own interpretation with respect to a company of interest, I try to confirm my findings by seeing what other analysts are thinking and saying.

    If the stars align, it gets jotted down in my notebook.

    Nice post!

  8. Alan on March 19, 2013 at 12:28 am

    I’m with “The Wealthy Canadian” on this one. I don’t like to be tied down with just one investment philosophy or theory. Whether it’s value investing, growth stock investing, day trading, options, or pure speculation, I use what works and cast aside what doesn’t when I’m analyzing potential investments.

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