Methods of Investment Analysis
Investment Analysis is the analysis of the financial information of a business in order to make an investment decision. The analysis is done to determine the best way to invest in a company, based on its financial situation and outlook. The goal of this kind of analysis is usually determining whether to buy, sell or hold the stock for a potential investment. The analysis can also be done as part of an ongoing management effort, such as restructuring debt or finding new sources of capital. The goal at this point is to improve the company so that it can provide greater returns for shareholders.
The 4 Basic Methods of Investment Analysis
1. The Fundamental Analysis
The first and most commonly used method of investment analysis is known as Fundamental Analysis. The fundamental analyst attempts to find companies that will provide high returns on capital as opposed to those that are cheap or ones that seem like a good deal at first glance. The primary goal of this type of investment analysis is to identify companies with strong underlying business models and to measure the company’s performance. The analyst will look for companies that can continue to grow their revenue and earnings, regardless of economic conditions. The result is a stock portfolio with greater long-term returns than the broader market.
2. The Technical Analysis
The second method used in investment analysis is called technical analysis. The primary goal of technical analysis is to identify short-term trends in stock prices. The analyst assumes the market, over time, will move toward equilibrium, which means that supply and demand for stocks will balance out. The focus on this type of investment analysis is price movement instead of company fundamentals like with the fundamental analysis method. The result is a shorter timeline from the time of the research to when you get your results. The margins for error are also much smaller compared to fundamental analysis, but this method can help determine which companies have a greater probability of growth in the short term based on past stock price data. The analyst will then use this data to attempt to predict future market prices and potential investment returns.
3. The Quantitative Analysis
The third method used in investment analysis is called quantitative analysis or quant for short. The goal of this type of analysis is to understand how a company’s management team can maximize shareholder value. The analyst will look at the business operations from different angles, including capital expenditure, working capital management, and cash flow. The quant analyst looks for strong net income, high operating margins, and low debt relative to assets. The analyst will use this data along with industry averages to determine how the company measures up on key financial ratios that are important when analyzing a company’s performance. The end result is an assessment of risk, valuation, and potential return. Quantitative analysis is a great starting point for beginners who want to know how their investments are performing against industry peers and other benchmarks. The analyst may not have knowledge of the company’s operations, but the data provides valuable insight into how strong it is relative to its competitors.
4. The Behavioral Analysis
The fourth method used in investment analysis is behavioral analysis, which focuses on understanding the decisions and biases of individuals as they make financial transactions. The goal is to understand what drives a specific investor or investor type to make certain types of decisions. The analyst will study the psychology of investors and how it can affect their investment choices. The result is a better understanding of market trends that you might not have otherwise known about had you not studied behavioral factors. The benefit of this kind of analysis is that it can help provide insight into a wide range of different financial assets, even if they are not stocks. The behavioral analyst can also help investors understand what types of investment advice provides the greatest benefit over others.
Investment Analysis Tools and Techniques to Help You Make a Decision
1. The Price-to-Earnings Ratio (P/E)
This ratio is used to determine the price of a stock relative to its earnings and can be calculated as: As you can see, the higher the P/E, the more expensive it is to buy one dollar’s worth of that company’s earnings. The lower the P/E, the cheaper it is to buy a dollar’s worth of its earnings.
2. The Price-to-Book Ratio (P/B)
This ratio measures the price of a stock relative to its book value and can be calculated as: This is the price you would be paying per dollar of the company’s assets. The lower the P/B, the cheaper it is to buy a dollar of assets.
3. The Shiller P/E Ratio
This is a price-to-earnings ratio that uses an average of the inflation-adjusted earnings from the previous 10 years instead of just 1 year. The reason to use an average is that one year’s net income can be greatly affected by unusual events like the sale of assets or an extraordinary item, so using this data brings more stability to the equation. The name of this ratio is a reference to Robert Shiller, but it is also known as the cyclically adjusted price-to-earnings (CAPE) ratio or PE 10. The following formula can be used to calculate this type of ratio:
4. The Graham Number
This is a formula that uses the company’s stock price, earnings per share, and book value per share to determine if it is undervalued or overvalued. The result of this calculation can also be used to calculate the Graham Value for an entire index like the S&P 500:
5. The Market Capitalization (MC)
This is the price of a company’s share compared to its total market value. The result can be graphed as an easy way to determine if a company’s stock is overvalued or undervalued:
6. The Dividend Yield Ratio (DY)
The dividend yield ratio is used to determine how much annual income you’re receiving from a stock. The higher the percentage, the more income you are receiving relative to the current price of the shares. The calculation can be performed using this formula:
7. The Debt-to-Equity Ratio (DE)
The debt to equity ratio is used to measure how much debt a company has compared to its total equity. The result of this calculation is the number of dollars of debt for every dollar of equity, which can also be graphed as a trend to determine if the company’s debt level is rising or falling over time:
The Bottom Line
The methods of investment analysis can be used to predict financial trends and future stock price movements. The goal is to better understand how a specific investor type, such as a value investor or a growth investor, will make financial decisions. The analyst’s knowledge on behavioral factors allows them to more accurately predict what investments individuals are likely to buy and sell at certain times. The analysis can also be used to predict the direction of the market as a whole. The goal is to use an analysis method that helps you determine how much risk you need but also allows you to invest in ways that help achieve your desired return. The different methods discussed here will help you create a plan for investing money in any number of financial instruments.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.