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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