When traders start to look at the stock market with the idea of getting into stock trading, they are faced with an overwhelming amount of options.
There are, quite literally, tens of thousands of different stocks. How do you know which ones might make a good investment? You can’t do a detailed analysis of every one of them.
Some traders rely on other people’s analysis of stocks to choose from. Some rely on generally highly-paid analysts who work for major investment banks, while others look through less reliable social media suggestions.
But, how do those analysts know which stocks to look at?
Understanding that can help you figure out which analysts are more reliable. Additionally, relying on analysts means you get your information ‘second hand’. For example, if a stock picker is suggesting to buy a specific stock, chances are they have already invested.
So, how do you get a leg up on them?
Making a list, checking it twice
Obviously, you don’t have the time to go through every corporate report.
Not even paid professionals have time for that. In fact, they typically specialize in certain sectors, markets, or a pre-defined list of companies. And even then, they tend to rely on a few key data points (“metrics” as they are known in the biz) to quickly scan over a bunch of companies to see which ones deserve a more in-depth look.
These metrics alone are probably not enough to make a decision to buy or sell (put or call, if you are using options) a particular stock, or to tell you how long to hold your position.
That said, their primary purpose is to separate the wheat from the chaff. They do so by highlighting companies that are more likely to be worth your time studying to see if there is a good trading opportunity.
Just the basics
Preferences vary across traders and analysts. Here are some of the most common data points to figure out if a company is doing well, or facing some difficulty that the stock price hasn’t reflected yet:
This is a non-standard accounting metric that stands for “earnings before interest, taxes, depreciation, and amortization”.
Basically, this is what it costs for the company to generate its product or service. If it’s negative, it means it costs the company more money to make the product than they get from selling it. That’s naturally a bad sign.
Companies with higher EBITDA imply they have higher profit potential. If a company stops disclosing its EBITDA, it could be a warning sign that its underlying operations aren’t doing as well as they hoped.
Inventories or backlog
Inventories show how much of the company’s product they have waiting for shipment. Higher inventories imply they are producing more than people are buying and it can be a warning sign.
Backlog is kind of like an “inverse” inventory. It represents how many orders they have waiting to be fulfilled. An increase in the backlog suggests that the company has so much demand that there is an even larger waiting list.
EPS/Revenue ratio (or pretax/revenue ratio in the UK)
That’s simply the division of the company’s earnings per share (profit) by their sales. It’s very similar to the profit margin in that it shows how profitable the company is.
Higher profitability companies tend to be worth more, naturally.
However, tracking it over time can show if a company is making good investment decisions. If sales increase, but the profitability does not, it implies that the company is potentially entering the wrong markets.