There are two primary techniques investors use to make profitable stock picks: fundamental and technical analysis.
One of the most time-tested methods is the technical analysis, which studies the stock price itself in an attempt to forecast future price moves. Technical analysts believe that all the fundamental information of a company is already reflected in its stock price. By studying price patterns and trading volume, technical analysts can determine the future direction of a stock. [Find out more about this type of analysis here.]
Fundamental analysis, on the other hand, attempts to determine a stock's future value by studying the actual condition of the company itself, the economy in which it operates and the overall market trends. It uses facts gleaned from the company's own accounting, projections and outside economic data to build a picture of the company's future.
To successfully perform a fundamental analysis on a stock, investors should always begin by reading the company's earnings report, which is where the company's most critical information is found. And although many investors still feel overwhelmed by it, it's a really simple document to interpret. All investors need is good attention to details.
Analyzing an earnings report
All earnings reports are designed the same way. They are broken down by the financial information (financial statements, management's analysis of a financial condition, market risk disclosures, controls and procedures) and other information (Legal proceedings, risk factors, unregistered equity sales and use of proceeds, senior securities defaults, additional information, exhibits).
Start with the basic financial numbers
The basic critical numbers are revenue, net income, diluted earnings per share (EPS) and earnings before interest and taxes (EBIT, or EBITDA, if depreciation and amortization numbers are factored in). These are the numbers that will tell whether a company is meeting the bottom line. Compare these items with the previous quarter and year. Then ask yourself: Is the company growing based on increasing numbers? Are the numbers stagnant or decreasing over time?
Move on to the
Look to see from where the cash is coming. Is the company earning cash from operations or using cash to operate? Make sure the cash flow is positive. Remember, companies often show positive net income but negative cash flow. This is a red flag that all may not be as it seems with the company.
Analyse the risks
Once you have ascertained the company is in good financial health, the next step is to ascertain the risks. Legal proceedings are a critical risk factor. Although many companies have multiple small damage suits, pay particular attention to class-action lawsuits. These can do tremendous damage to a company, win or lose, due to the high costs of defense.
The Securities and Exchange Commission (SEC) requires companies to list their risk factors under "Item 1A" in the "Other Information" section of the earnings report. Make sure there is nothing suspicious that could jeopardize the future of the company. Many times, very negative factors are couched using expertly chosen words designed to lessen the effects of the situation. This means a careful reading is critical for a complete understanding of a company's situation.
Action to Take --> Remember, the critical factor that shows a company's good performance is quarterly or year-over-year improvement. A company is either growing -- even if it's slowly -- or dying. Steady growth in the earnings report combined with low-risk factors is a recipe for future success and good returns to investors.