4. The Stock Analysis Process

This chapter of the tutorial will go through the analysis process that an investor should undertake before deciding whether a particular stock in the market is a good buy or not. Before we go into that, we should first ascertain what type of stocks an investor should be looking to invest in. Let us broadly classify companies into "great", "average" and "bad".

Great companies are companies which have an excellent business story. These companies have a competitive advantage over its peers in the industry and are therefore generating large profits and are growing from year to year. They also have healthy cash flows and working capital which allows the company to pay its debt (if any) on time and have enough resources to take advantage of any opportunity if it arises. An average company also generates healthy, stable profits and strong cash flows. However, the difference between these companies and great companies is that they do not have a competitive advantage; therefore they lose out in terms of market share which results in smaller or no growth. Lastly bad companies do not generate profits and they may even be incurring losses. They have problems paying off their debtors and need a drastic change in strategy or management if not they will probably go into bankruptcy in the near future.

Next, we also classify the stocks of these companies. They could be undervalued, fully valued or overvalued. Undervalued stocks means that the price of the stock is cheaper than what the company should have been worth based on its underlying business; overvalued stocks means that the price is more expensive than what it should have been worth and lastly, a fully valued stock means that the price of the stock is the same as what the company should have been worth.

Taking a look at the table above, it shows you that you should be looking for great companies whose stock price is undervalued, as highlighted by the green box. These should form the bulk of your portfolio if possible and you can count on these stocks to provide you with the best returns once their values have been identified by the wider market. Now look at the yellow boxes. These are second tier stocks that you could potentially still look at buying to add diversity to your portfolio. The rest of the table is red, meaning that you should not, at any time, purchase such stocks in the market and you would have been better off holding on to your cash because these stocks might potentially incur losses for your portfolio and should be avoided at all costs. The tricky thing is to learn to differentiate between great, average and bad companies within the market and how to determine whether the stock price is undervalued, fully valued or overvalued.

An investor who wants to identify whether a particular stock falls under a great category and is undervalued should use the following process when conducting his or her analysis:

A. Identify a company/stock of interest

The following resources should be used to identify a potential company or stock that you may wish to invest in:

i. Newspaper/magazines

Read your country's newspapers or investment magazines and you might come across interesting articles about listed companies and their business activities. If you find positive news about a company's new strategy for example and feel that its prospects for the future are good, this might spur you to go into a more in depth analysis of the company to determine whether it is a good investment.

ii. Online portals

Online portals such as Bloomberg.com or WSJ.com can give you an update on the status of the global markets and the main drivers of the major economies of the world, which has a large correlation with stock movements. By reading up on this news, it will allow you to have a sense of how weak or strong the global markets are performing, which can potentially give you some information on the number of undervalued or overvalued stocks in the market. For example, during the 2009 financial crisis, the stock market was hit very badly and although there are many companies who are not that badly affected by this crisis, many, if not all of them, dropped sharply in prices due to unjustified fears, which resulted in many stocks being undervalued.

iii. Analyst Reports

You can get analyst reports on the economy or a particular company in the internet trading platform that you use (please make sure the brokerage house in which you use has this service). These reports will give you a more in depth analysis of the economy for example, telling you which sectors are undervalued or overvalued and how the market is expected to perform in the future. You can also read up on various companies to get a sense of which stocks are potential good buys. Of course, these recommendations are all based on opinions which may not be true but it will give you a good starting point to identify potential targets for an in depth analysis thereafter.

B. Read the latest annual report of the company

The next thing that you should always look at is to read the annual report of the company. Every listed company all over the world has to publish an annual report to its shareholders. This report will comprise of a few things which is a must read for a potential shareholder.

1. Overview of the business's core activities

This chapter of the report gives a detailed synopsis of the company's core activities, basically what it does to make money. Most companies have more than one revenue stream and it is good to identify all these streams and identify the most important ones. In here, you will also find the different geographical locations that the company is based at. The main aim of reading this excerpt is to identify the key assets of the company, i.e. the main revenue drivers, and also a sense of the key risks of the company, i.e. the areas which the firm has offices in or maybe the main projects in which the firm is currently overseeing.

2. Discussion of past year performances and future strategy by the CEO

This excerpt gives a summary of the performance of the company in the past year, highlighting some of the key events that had happened. It will also explain the reasons behind these wins/losses what the company intends to do about the situation. The CEO will also describe some of the firm's key strategy moving forward and how it intends to achieve its growth targets or increase its market share. It is an interesting read for the potential shareholder and gives you a better understanding of the company's business model and objectives.

3. Financial Statements

The financial statements in the annual report show you how the story in the earlier chapters presents itself in terms of numbers. It is by far the most important read of the annual report and will give you a sense of how well the company is actually performing. There are 3 things that you should always read in this chapter: Income Statement, Balance Sheet and Statement of Cash Flows. This chapter just gives you an introduction to these 3 statements. We will go more into detail on how you can analyze these numbers in the next chapter.

3.1 Income Statement

The "Income Statement" section gives you a detailed breakdown of the revenue and costs of the company, showing the change in profits for last year as compared to the year before. The main objective of reading the Income Statement of any company is to see if its revenue streams have been stable or increasing, of if it is not, find the reasons behind the drop in these numbers. Also, we can also see whether the company is managing its costs well by looking at the expenses line. Lastly, we do a comparison between last year and the previous year's numbers to see what has changed over the course of the year.

3.2 Balance Sheet

The "Balance Sheet" section summarizes what the company holds and how much it owes to its stakeholders. It is spilt into 3 broad categories; Assets, Liabilities and Equity. Assets are items which could potentially generate cash or profits for the firms. Examples of these are cash, investment in other companies, the buildings and equipment that it owns etc. Liabilities, on the other hand, describe items in which the company owes to its stakeholders. This include payments for suppliers (categorized under accounts payable), and debt that it has borrowed from banks (categorized under borrowings). Therefore, assets less liabilities give the total equity of the company, basically its total value to shareholders. This value, divided by the number of shares, gives the Book Value per share of the company, which describes how much the stock price is worth based on the firm's current assets and liabilities. Note here that this number does not take into account future profits that the firm is expected to earn.

The main objective of the balance sheet is to see how healthy the firm is in terms of paying its debt, maintaining its business activities and how much the company is worth per share based on its current holdings. It also shows the different kind of assets the company is holding, which can determine which assets are the biggest uses of cash.

3.3 Statement of Cash Flows

Last but not least is the "Statement of Cash Flows". This section follows on the cash that are generated or spent by the company. It is spilt into 3 categories; Cash flow from Operating Activities, Cash flow from Investing Activities and Cash flow from Financing Activities. Cash flow from operating activities shows the cash that is received by the company in the course of the year. Generally, the larger this number, the healthier and more profitable the company is in terms of its business activities. Cash flow from investing activities describes the amount that is spent or generated by the company in buying/selling of equipment or acquiring a stake in other companies. A company which is spending money on equipment generally is a positive indicator that it is poised for growth in future years. Lastly, cash flow from financing activities describes the amount of cash generated from borrowing funds from banks or spent in paying dividends to its shareholders. The sum of these 3 cash flows gives the total cash flow to the company in the year.

The main objective of the cash flow statement is to analyze how healthy the firm is in terms of generating cash. Sometimes, even though a company is earning huge profits, a large percentage of these profits could come in the form of account receivables, which means that the customers will pay for its goods and services at a later date. It will mean the company will have less cash at any point of time, which may affect its position to repay its debt or take advantage of any investment opportunities. The statement also shows how aggressive the company is in terms of borrowing company to invest in new equipment.

In summary, the 3 financial statements give you a much deeper insight in terms of the company's revenue and profits, the type of assets or debt it is holding and the ability to generate cash from its core businesses or new borrowings from banks for its investment in new equipment to further spur future growth. Many people do not read the annual reports of the companies that they invest. They feel intimidated by the sheer number of pages in the report and the complexities of the numbers embedded in it. However, once you get a feel of what is actually in these reports, understanding them is not as difficult as it seems and they are a key driver to making sound investment decisions which can potentially give you very rewarding returns.

C. Do an in depth analysis of financial statements

After getting a sense of the company's key business strategies and activities, it is time to delve into doing an in depth analysis of the financial statements introduced to you earlier. This step of the process involves doing some calculations based on numbers in the financial statements and the current stock price to come up with certain ratios to determine whether the company is doing well but is currently undervalued compared to its peers. The next chapter of the tutorial will give you a step by step guide to computing these ratios and will also help you to have a better grasp of these simple yet important calculations which will increase your financial knowledge as well as allow you to make a better investment decision.

After analyzing the financial statements in the annual report, you should also look at these statements based on the last quarterly report released by the firm. For example, if you are analyzing a company in September 2010, the annual report of the company will only give you the numbers up to December 2009; hence it makes sense to look at the quarterly numbers up to June 2010 if available to get the most updated data. Make sure that the numbers and ratios in these statements are in line with the analysis that you have done for the annual report. Do also check if there is any significant news or activity that might potentially change the company's outlook. All these are potential red flags that you can identify which will assist you in your investment decision.

D. Read related analyst reports

Next, if there are any analyst reports on the target company that you are analyzing, it is good to have a look at what the professionals are saying about the company. You do not have to believe everything that the analyst reports tell you since these are mostly based on opinion and not facts; however there might have been certain issues on the companies that these analysts have identified which may give you additional perspective on the company. Also, many ratios such as profitability and debt have been calculated in these reports and it is good to compare these with your own to see if the story is in line.

E. Combine story and make investment decision

After considering all these factors, if the story of the company relative to its current stock price still looks attractive, consider buying these shares into your portfolio and wait for the price to reach its potential. A valuation table will be used to aid you in this process which will be highlighted in the next chapter: Valuation Methods