Investing in stocks requires investors to understand a business’s financial statements, competitive position, future growth potential, and more.
This guide walks through a quick process for how you can evaluate stocks, from financial statements to competitive advantages and a stock’s valuation.
Even if you’re new to investing, this article will help to give you the tools you need to make informed decisions and build a portfolio with strong long-term prospects.
Table of Contents:
- Understanding a Company’s Financial Statements
- Competitive Advantage & Market Position
- Growth Potential & Risk Assessment
- Valuation Analysis
- Putting it All Together
Let’s dive in!
Understanding a Company’s Financial Statements
Financial statements provide a snapshot of a company’s financial performance, helping investors assess a company’s profitability, stability, and cash flow.
The three main financial statements (income statement, balance sheet, and cash flow statement) work together to show how a business manages costs, uses debt responsibly, and reinvests profits.
By analyzing these reports, investors can determine whether a company is growing, financially stable, and capable of delivering long-term returns.
Income Statement: Evaluating Profitability
The income statement shows how much a company earns, how much it spends, and what remains as profit.
Investors can quickly gauge a company’s financial strength by focusing on three key areas:
- Revenue Growth: Companies with steady revenue growth often have strong demand for their products. For example, Microsoft has grown its revenue consistently over the past decade as businesses continue adopting cloud services.
- Profit Margins: A company’s gross, operating, and net margins reveal its efficiency. Apple’s high gross margins show its pricing power, while its operating margins demonstrate strong cost management.
- Earnings Per Share (EPS) Growth: EPS measures how much profit is allocated to each share of stock. Investors want to see EPS growth because this shows that the business is increasing in value over time.
If a company’s revenue is stagnating, margins are declining, or EPS is inconsistent, it may struggle to deliver long-term returns.
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Balance Sheet: Assessing Financial Strength
The balance sheet provides a snapshot of what a company owns (assets), what it owes (liabilities), and the value left for shareholders (equity).
Strong balance sheets give companies the flexibility to invest in growth, pay dividends, or weather economic downturns.
- Current Assets vs. Current Liabilities: Companies should have enough current, or short-term, assets to cover their short-term liabilities. Alphabet has nearly $100 billion in cash and marketable securities, which helps to give the company strong current assets.
- Debt-to-Equity Ratio: A low debt-to-equity ratio indicates a company is not overly reliant on borrowed money. Costco maintains low debt levels, which reduces its financial risk.
Investors should be cautious with companies that carry excessive debt, as high interest payments can erode profitability and high existing debt can make it difficult to borrow in an emergency.
Cash Flow Statement: Measuring Liquidity & Cash Generation
The cash flow statement shows how much cash a company generates and how it uses that cash. Unlike net income, which can be affected by accounting decisions, cash flow reflects real money moving through the business.
- Operating Cash Flow: This measures cash generated from core business operations. Companies like Visa consistently generate strong operating cash flow, which shows their ability to convert revenue into cash.
- Capital Expenditures: Companies investing heavily in new equipment or facilities may see lower short-term cash flow but stronger long-term growth. Amazon reinvests heavily in logistics and cloud infrastructure to expand its market reach.
- Free Cash Flow (FCF): FCF is cash left after paying operating expenses and capital expenditures. High FCF gives companies the flexibility to pay dividends, repurchase shares, or invest in new opportunities.
Companies with strong free cash flow can navigate downturns, while those with weak cash flow may struggle to meet financial obligations.
Competitive Advantage & Market Position
A company’s ability to maintain its market share depends on its competitive advantage. Some businesses operate in crowded industries where products are interchangeable, while others have strong economic moats that protect profitability.
- Economic Moat: Warren Buffett describes a moat as a company’s ability to protect itself from competition. For example, Visa benefits from network effects, where more users make the platform more valuable.
- Industry Comparison: Investors should compare companies against industry peers. If a company lags behind competitors in gross margins or return on capital over time, it may not have a durable advantage.
- Pricing Power & Margins: Strong businesses can raise prices without losing customers. LVMH, which owns luxury brands like Louis Vuitton and Dior, maintains high margins due to its brand strength.
Identifying companies with lasting competitive advantages helps investors find stocks that can compound returns over decades.
Growth Potential & Risk Assessment
Evaluating a stock’s growth potential helps investors determine whether the company can increase its revenue and earnings over time.
Growth stocks often trade at higher valuations, but their growth potential justifies the valuation premium.
Revenue & Earnings Growth Rates
A company’s historical growth rate provides insight into its ability to scale. Investors should analyze:
- Revenue Growth: Consistent growth suggests strong demand. Nvidia’s revenue has surged due to increasing adoption of artificial intelligence chips.
- Earnings Growth: Earnings should outpace revenue growth over time, showing that the company is improving efficiency. Meta has grown earnings rapidly by monetizing its platforms and cutting costs.
Total Addressable Market (TAM)
A company’s growth potential depends on how large its Total Addressable Market (TAM) is and how much market share it can capture.
- A small company in a massive industry, like Roku in digital advertising, has room to expand.
- A mature company in a saturated market, like McDonald’s in fast food, may have slower growth but strong cash flow.
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Competitive Risks
Every investment comes with risks that could slow growth or impact profitability.
- New Competitors: If an industry has low barriers to entry, new companies can disrupt existing players. Tesla dominated EVs early on, but traditional automakers are catching up.
- Regulatory Changes: Government policies can impact industries. Big Tech faces increased antitrust scrutiny, which could limit expansion.
- Economic Downturns: Companies reliant on consumer spending, like retailers and travel businesses, often see earnings drop in recessions.
Investors should keep an eye out for a company’s growth potential as well as the risks that could derail it.
Valuation Analysis
A great company can be a poor investment if the stock price is too high. Valuation metrics help investors determine whether a stock is undervalued or overvalued compared to its growth prospects.
Price-to-Earnings (P/E) Ratio
The P/E ratio compares a stock’s price to its earnings per share.
- A high P/E suggests investors expect strong growth. Amazon has historically traded at a high P/E due to its future expansion potential.
- A low P/E may indicate a bargain, but only if the company’s earnings are stable. Banks often trade at low P/E ratios but have cyclical earnings.
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Enterprise Value to EBITDA (EV/EBITDA)
This ratio accounts for a company’s total value, including debt, relative to its earnings before interest, taxes, depreciation, and amortization.
- A low EV/EBITDA may indicate an undervalued stock. Energy companies with strong cash flows often trade at low multiples.
- A high EV/EBITDA suggests the market is pricing in growth expectations. Software companies with high recurring revenue tend to have premium valuations.
Discounted Cash Flow (DCF) Analysis
A DCF model estimates a company’s intrinsic value based on projected future cash flows.
- Investors use DCF to determine whether a stock is trading above or below its fair value.
- If the calculated fair value is higher than the current stock price, the stock may be undervalued.
Valuation methods should be used alongside fundamental analysis to ensure an investment offers attractive risk-adjusted returns.
Putting It All Together: Making an Investment Decision
Investment Thesis
Investors should form a clear investment thesis before buying a stock. A strong thesis explains:
- Why the company is a good investment (e.g., dominant competitive position, strong earnings growth).
- What catalysts could drive future returns (e.g., expanding into new markets, launching new products).
- What risks exist and how they can be managed (e.g., economic downturns, regulatory headwinds).
Risk vs. Reward
An investment should have more potential upside than downside. If a stock is priced for perfection with little room for error, the risk may outweigh the reward.
FAQ Section
How do you analyze a stock before investing?
Investors should analyze a company’s financial statements, competitive position, growth potential, and valuation. Reviewing key metrics like revenue growth, profit margins, and free cash flow helps determine whether the stock offers a strong risk-adjusted return.
What financial metrics are most important when analyzing a stock?
Some key financial metrics that investors can use to analyze a stock include revenue growth, earnings per share (EPS), profit margins, free cash flow (FCF), debt-to-equity ratio, and valuation multiples like price-to-earnings (P/E) and enterprise value to EBITDA (EV/EBITDA).
How do you determine if a stock is overvalued or undervalued?
Investors can compare a stock’s valuation metrics, such as P/E and EV/EBITDA, to industry peers and historical averages. A discounted cash flow (DCF) model can also estimate a stock’s intrinsic value based on projected future cash flows.
What are the biggest risks to consider before buying a stock?
Competitive threats, financial instability, regulatory changes, and macroeconomic risks can all impact a stock’s long-term returns. Investors should assess whether a company has a durable advantage and strong financials to withstand potential challenges.
Why is cash flow more important than earnings in stock analysis?
Cash flow reflects the actual money a company generates, while earnings can be influenced by accounting decisions. Strong free cash flow indicates financial health, supports reinvestment in growth, and provides a cushion during economic downturns.
TIKR Takeaway
Investors can analyze a stock by evaluating its financial health, competitive advantage, growth potential, and valuation.
This can help investors see if a stock might offer strong long-term returns.
The TIKR Terminal offers industry-leading financial data on over 100,000 stocks, so if you’re looking to find the best stocks to buy for your portfolio, you’ll want to use TIKR!
TIKR offers institutional-quality research for investors who think of buying stocks as buying a piece of a business.
Disclaimer:
Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks. We create our content based on TIKR Terminal’s investment data and analysts’ estimates. We aim to provide informative and engaging analysis to help empower individuals to make their own investment decisions. Neither TIKR nor our authors hold any positions in the stocks mentioned in this article. Thank you for reading, and happy investing!
