Picking a good stock starts with a good company. Stock picking for long-term investments should be based on the company’s fundamentals.
Value investors are those who pick stocks based on the intrinsic value of the company. Intrinsic value is compared to the market value, if it’s higher then buying the stock makes sense.
To find out the intrinsic value, investors analyze the company’s fundamentals. It’s also known as fundamental analysis of a stock.
The other widely used method of choosing stock for trading is known as technical analysis. In it, you look at stock charts, different candlestick pattern formation, technical indicators, volume and historical stock prices to know whether the stock should be bought or sold.
Now a days, both fundamental and technical analysis are used before investing.
In this article, we have listed the most important accounting tools that are used in picking stocks as a part of fundamental analysis.
Accounting tools for stock picking
Financial statements are the most important reports that every investor is interested to have a look at after it gets published. You can find these in the company’s annual report.
Here are the three financial statements that help investors to undetstand the overall performance of the company;
- Balance sheet
- Income statement
- Cash flow statement
As discussed above, a value investor always looks for a company which is undervalued. Which means, the company is worth more than the price its stock reflects.
Balance sheet is one statement from which you can calculate a company’s net worth. You can calculate it by deducting total liabilities from total assets.
Assets refer to what the company owns. Liability is what the company owes to outsiders.
After you subtract what the company owes from what it owns, you get net worth. It’s also known as book value, fair value, net equity or net stockholder’s equity.
If the book value is more than the market value, then the company is undervalued.
When market value is substantially higher than the book value, investors become more reluctant to buy as the stock is overvalued.
Market value is also referred to as market capitalization. It’s determined by multiplying the current market price of the stock with the number of shares outstanding.
Income statements will tell you whether or not the company is making profit. If it’s not making profit and will not make profit, then there is no point in investing even though book value is less than the market value.
This is why we have said your decision of investing should not be based on only one factor. You should take multiple or if possible all factors into account before going long.
Sales and earning are references to the company’s ability to make money. Earnings or profit for a company is like oxygen for human beings. Without profit a company can’t survive.
From the income statement try to find out;
- What product and services generate sales for the company?
- Is sales for the company increasing year on year?
- What is the impact of core sales on a company’s overall performance?
- How expenses are managed?
- What is the company’s net earnings?
- What is the growth in sales and net earnings for the company?
- Is the company working at a good operating margin and net profit margin compared to competitors?
Cash Flow Statement
Cash flow statement will help you understand how the company has managed its cash. How much cash has come into the company and what are the sources through which cash has gone out.
You are also required to find out the free cash flow and compare it with the net earnings to know the financial position better.
Financial tools used to select stocks
Financial ratios are numerical tools that can be used to find out the financial health of a company. You can use information available in above financial statements to find out how the company has performed and will perform in future.
We have a number of financial tools that can help you to assess a company’s financial health.
Most importants financial tools are produced below;
- Price to sales ratio
- Price to earnings or P/E ratio
- Debt to equity ratio
- Return on Investments (ROI)
- Earnings growth rate
- Revenue growth rate
- Current ratios
- Asset Turnover
Each of these important tools used to help analyse different factors affecting company’s profitability and financial health.
For example, debt-to-equity ratio reflects the company’s debt load on the balance sheet and helps you to understand how cost of debt can affect profitability.
Remember, a company with a lot of cash on its balance sheet is superior to one burdened with lots of debt.
As a part of your fundamental analysis, you should also look into other factors in addition to the above accounting tools to analyse the company.
Here are certain additional important parameters which might help you to analyse the company better;
- How powerful company’s brand is
- Does the company has a history of dominance
- Are these beloved products
- How the company is allowed to earn excess profits over others
The cardinal rule of investing, investment portfolio should be diversified across multiple sectors. Once you select stocks, make sure that your portfolio is not dependent on a sector or one/two company’s performance.
Remember, value investors sell stocks only for two reasons;
- They need money
- Stock ceased to perform as expected
Finally as experts like Warren Buffest suggest, do not invest in a company whose business you don’t understand.