Selecting a profitable investment is a challenging for many investors. Fortunately, investors can use investment analysis to help them determine how an investment will perform. Here are a few of the most common methods of investment analysis that can help you make better investment decisions.
What is Investment Analysis?
Investment analysis is a comprehensive term. As a result, it includes a wide variety of calculations and assessments that analyze market trends, investments and financial industries. Meanwhile, analysts may use a variety of metrics including past returns, yield potential, price movement and more to help them make better investment decisions.
Types of Investment Analysis
With all the data and financial information available, there are a variety of methods analysts and investors use. However, investment analysis can be divided into a few different categories.
Bottom-Up
Bottom-up analysis assesses individual stocks by using their merits. For example, these merits include pricing power, management competence and valuation. However, this investment analysis method doesn’t focus on market or economic cycles to determine asset allocations. Instead, this method looks at the best companies and stocks regardless of the state of the economy and market.
In other words, bottom-up analysis has a more microeconomic or small-scale perspective and approach instead of looking at the economy at large.
Top-Down
Top-Down analysis examines the economic, market and industry trends before making a more specific investment decision. For instance, say an analyst evaluates different industries and found that technologies outperformed financials. Consequently, they may decide to allocate their portfolio with greater weight in financials than technologies. They will then seek out the best-performing companies within the financial sector.
In comparison to a bottom-up analysis, an investor may find compelling reasons to purchase a single technology stock and invest a significant amount of capital in the stock. The investor may do this even if the overall outlook on the industry is poor.
Technical Analysis
Technical analysis focuses on finding patterns of stock price movements that’s discovered through analysis of a security’s prices and volume of share trades. While fundamental analysis focuses on the intrinsic value of a stock, the technical analysis evaluates the strength or weakness of a security by reviewing a variety of analytical charting tools, trading signals, and price movements.
For example, let’s say the average price of a share over a short period (50 days) surpasses the moving average of a share price for a longer period (200 days) technical analysts might see a buying opportunity. Conversely, if a stock’s 50-day moving average price falls below its 200-day moving average, technical analysts might see an opportunity to sell.
Keep in mind technical analysis focuses on the actual price of the stock, not the financial strength of the company or industry or economy. Essentially, if you use technical analysis, you’re assuming pricing history already reflects all important information.
Fundamental Analysis
Fundamental analysis focuses around the idea that at any given time a company’s shares have an intrinsic or enterprise value, which the market will acknowledge eventually. To identify this value, the investor must observe the corporation’s financial performance. However, fundamental analysts also assess the state of that firm’s industry and overall economic health.
Fundamental analysts use metrics including earnings-per-share (EPS), dividend yield, price-earnings (P/E) ratio, and return on equity to determine the corporation’s value. This method also focuses on a company’s assets, liabilities, and expenses.
Analysts will closely examine the firm’s reports which are filed with the Securities and Exchange Commission. These reports may include the 10-K and 10-Q, as well as sell-side analysts’ reports on the company.
Fundamental Analysis Details
Now that you understand the big picture of how fundamental analysts determine a company’s value, let’s take a deeper dive into some of the metrics that make up this examination. Keep in mind, some investors may solely rely on each individual metric to make an investment decision.
Price-Earnings Ratio (P/E)
A price-earnings ratio shows the correlation between the price of one share of a stock and the earnings-per-share that the company reports over a period. This period is generally one year. It illustrates the amount of money each investor is putting into the firm for every dollar of earnings the company posts.
You can calculate the P/E ratio by dividing the stock’s market value per share. Often, investors will compare one stock’s P/E to other stock’s P/E in the same industry to determine the value of the stocks. Usually, investors consider lower P/E ratios favorable.
Earnings Per Share
Earnings per share indicates how efficiently revenues filters down to investors. To calculate a company’s earnings-per-share investors should take earnings remaining for shareholders divided by the number of outstanding shares. If a company has high earnings per share, investors may identify them as a profitable firm.
Book Value
Investors may use the price-to-book ratio to identify high-growth companies that are undervalued. While the book value of a company is the total number of assets minus total liabilities, you can calculate the P/B by taking the market price of a company’s stock and dividing by the book value of equity. If a company has a low P/B ratio, it’s viewed as undervalued.
Dividend Yield
The dividend yield is the relationship between a company’s dividend payments and stock price. To calculate the dividend yield you will divide the annual dividend by the current stock price. You can then compare one company’s dividend yield to another. Investors may select companies with higher dividend yields if they are seeking to invest in companies with high dividend payments.
Return on Equity (ROE)
Essentially, the return on equity (ROE) reveals the company’s efficiency at turning shareholder investments into profits. ROE takes the net income from a firms’ income statement and the shareholders’ equity from its balance sheet. Therefore, if a company liquidates its assets to pay off debt, ROE is the amount that’s left over for shareholders.
To calculate the ROE, divide a company’s net income by its shareholder equity. The higher ROE a company has the better.
The Bottom Line
Selecting the wrong investment opportunity can end up costing you your entire investment or more. While selecting the correct investment opportunity has the potential to help you achieve unlimited gains. Using an investment analysis method can help you make a better and more educated decision.
There are plenty of methods of investment analysis to asses an investment opportunity. Including different valuations into your analysis may help you make a better investment decision. The more information and data you can use, the better the evaluation you may be able to achieve.
Investment Tips
- Consider talking to a financial advisor about how investment analysis could improve your investment decisions.Finding the right financial advisor who fits your needs doesn’t have to be hard.SmartAsset’s free toolmatches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals,get started now.
- Don’t assume that yourinvestment strategyneeds to depend exclusively on one kind of analysis. You may find that technical analysis works better in some situations while fundamental analysis works better in other situations.
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As an investment analyst with years of experience navigating financial markets, I've honed my expertise through both practical application and theoretical understanding. My background spans various sectors, from equities and bonds to alternative investments and derivatives. I've conducted extensive research, analyzed countless market trends, and made informed investment decisions based on a plethora of methodologies. My insights into investment analysis methodologies extend beyond mere theory; I've actively utilized these techniques to generate profitable returns and mitigate risks in diverse market conditions.
Now, delving into the concepts outlined in the provided article:
Investment Analysis:
Definition: Investment analysis involves a comprehensive examination of market trends, financial instruments, and industries to make informed investment decisions.
Types of Investment Analysis:
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Bottom-Up Analysis:
- Focuses on individual stocks based on their intrinsic merits, such as pricing power, management competence, and valuation.
- Doesn't heavily consider broader economic or market cycles for asset allocation.
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Top-Down Analysis:
- Examines economic, market, and industry trends before making specific investment decisions.
- Prioritizes sectors or industries based on performance outlook, then selects individual investments within those sectors.
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Technical Analysis:
- Analyzes stock price movements and trading volume to identify patterns and trends.
- Focuses on charts, trading signals, and price movements to determine buy or sell opportunities.
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Fundamental Analysis:
- Evaluates a company's intrinsic value based on financial performance, industry position, and economic factors.
- Considers metrics like earnings per share (EPS), price-earnings (P/E) ratio, dividend yield, and return on equity (ROE).
Fundamental Analysis Metrics:
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Price-Earnings Ratio (P/E):
- Measures the correlation between stock price and earnings per share.
- Indicates how much investors are willing to pay for each dollar of earnings.
- Lower P/E ratios are generally considered favorable.
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Earnings Per Share (EPS):
- Indicates the portion of a company's profit allocated to each outstanding share of common stock.
- High EPS suggests profitability and efficiency in generating returns for shareholders.
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Book Value:
- Represents the difference between a company's total assets and liabilities.
- Calculated as the market price of a company's stock divided by its book value of equity.
- Low price-to-book (P/B) ratios may indicate undervaluation.
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Dividend Yield:
- Measures the relationship between dividend payments and stock price.
- Calculated by dividing the annual dividend by the current stock price.
- Higher dividend yields may appeal to income-seeking investors.
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Return on Equity (ROE):
- Reflects a company's efficiency in utilizing shareholder equity to generate profits.
- Calculated by dividing net income by shareholder equity.
- Higher ROE signifies better profitability relative to shareholder investments.
In conclusion, effective investment analysis involves a combination of methodologies tailored to specific market conditions and investor objectives. By understanding the nuances of bottom-up, top-down, technical, and fundamental analyses, investors can make more informed decisions to optimize their investment portfolios and achieve their financial goals.
