Interactive Investor

How to research stocks and shares

Why it’s important to understand the stocks you’re buying, and how to go about researching companies before you invest


The benefits of researching stocks

Buying equities on the stock market can involve large sums of money, and a raft of considerations. Is the company a good choice for the dividend income you need, for example? Is it well run? Does it operate in an area with a promising long-term future? Do the various financial metrics and ratios look healthy? And is the stock fairly priced? 

If you don’t research  the stocks you buy, you are much more likely to pay over the odds for something everyone else is buying too, or think you’re getting a bargain and find you’ve bought a business on its last legs.

So where do you start? First, it’s important to think about your own risk tolerance and income requirements. 

If you’re a beginner in direct share investing, inherently cautious about the markets or looking for a reliable dividend income, you might well prefer to stick to big multinational companies with generous payouts. 

If you can take a longer-term perspective and are not focused on generating an income, you could look at smaller companies as part of a diversified portfolio. They are inherently riskier, but there are more opportunities for strong growth. 

And if you want broader coverage or exposure to stocks that are thin on the ground in the UK, you might look overseas. US tech stocks were snapped up by UK investors in recent years, for instance.

Once you have some idea of the kind of stocks you’re interested in, there are two main approaches to researching them. 

Understanding the two types of stock analysis

Fundamental analysis

This involves trying to work out the intrinsic value of the company by looking at a wide range of factors affecting how it’s doing: 

  • the economic climate
  • prospects for that sector
  • its main competitors and position within the market
  • the quality of the management
  • the business’s financial strength and security

The aim is to assess qualitative factors and also calculate a number that can be compared with the company’s current share price to see if it’s cheap or expensive.

Technical analysis

Technical analysis starts from the basic premise that the fundamentals of the company are already factored into its price. It therefore focuses instead on studying charts of statistical trends in the stock, such as its price or trading volume, in order to work out what it will do in the future.

Various popular indicators are used to work out buy or sell signals. These include: 

  • momentum
  • simple moving average
  • support and resistance price indicators(specific price points on a chart that are expected to attract the maximum amount of either buying or selling). 

What is momentum? 

The continuation of an existing trend in the market

What is a simple moving average?

The average price of a stock over a period of time - for instance 20 days. This can then be used as a a benchmark for the current price to work out whether the stock is trending up or down.

What is a support indicator?

A price point on a chart that is expected to attract the maximum level of buying. 

What is a resistance indicator? 

A price point expected to attract the maximum level of selling.

Where to find research data

  • Company websites - Look under the investor relations tab for documents, annual and interim reports and other announcements.
  • Company reports and interim financial statements - There are several online sources for company reports and updates, including WebCheck, a company name search tool offering access to information on more than 2 million companies and provided free of charge by Companies House; Northcote, which offers direct links to UK company reports; and FT Markets Data.
  • Online brokers such as interactive investor - A useful source for news updates and broader analysis, as well as regulatory news.
  • London Stock Exchange  - The LSE’s news explorer facility lets you search free for real-time regulatory and financial communications from companies
  • Online financial news providers - These include news companies such as Reuters and the BBC; Google Finance for financial data; and Motley Fool UK.
  • 10-K and 10-Q forms, for US companies - These are comprehensive reports that must be filed annually (10-K) and quarterly (10-Q) by every listed US company, giving details of its financial performance. The 10-K includes audited financial statements; the 10-Q includes unaudited updates. They are available from the SEC’s EDGAR database, using the company search facility.

Key stock research metrics

While any company’s financial statement will have plenty of numbers to pore over, it’s generally more useful to look at how different measurements relate to each other by using financial ratios. These can provide insights into the overall financial health of a company and its prospects going forward.

Price to earnings (PE) ratio

Divide a company’s current share price by earnings per share over the last 12 months to get a trailing PE ratio, or use forecast earnings from broker analysts to get the forward PE ratio. PE shows what investors will pay for £1 of earnings, and indicates whether a stock is over- or undervalued.

As with other ratios, you can compare companies in the same sector, or track a single company’s PE over time to see changes in valuation.

Price/earnings to growth (PEG) ratio

This is the PE ratio divided by the expected growth rate of its earnings for a specified time. It gives a more rounded perspective on a stock’s value by factoring in future earnings growth. Again, a low PEG may indicate a stock is undervalued.

One rule of thumb is that a company’s PE and expected growth should be equal, which would mean a PEG of 1. Stocks with a PEG of more than 1 may be overvalued, and vice versa.

Price to book (PB) ratio

PB is another measure of valuation. To work it out, divide the stock price of the company by its book value (total assets minus liabilities) per share.

Again, a lower PB could indicate good value. For instance a PB of less than 1 indicates the stock is trading at less than the value of the company’s assets. But it can also flag a business in difficulties, so it should be used in conjunction with broader analysis.

Debt to EBITDA ratio

The ratio of a company’s debt divided by its EBITDA (earnings before interest, taxes, depreciation and amortization) is used to measure the income available to pay down debt before taking into account those outgoings.

It is a measure of the ability of the company to pay off its debts: a ratio higher than 4 or 5 suggests that the business may face difficulties in keeping up with debts and be less able to raise further money to expand the business.

Price to sales (PS) ratio

To calculate the PS ratio, divide the company’s share price by its sales or revenue per share over the past 12 months. It’s a description of how much investors will pay for a share, relative to the amount that share generates in revenue. A low PS ratio can indicate an undervalued stock with good prospects.

Dividend yield

Dividend yield is the value of annual dividends per share divided by the share price. A high yield may indicate a generous payout, but it can also be a sign of an undervalued stock. Too high a yield could be a warning sign that the current level of dividends is not sustainable, so it’s important to look at dividend cover as well.

Dividend cover

This is the number of times a company could pay out its dividend from net income. A well-covered dividend is typically considered to have dividend cover of 2 (so it’s able to cover its dividends twice from income). Dividend cover of less than 1 means the company has to supplement income from other sources to pay that level of dividend.

Free cash flow

This is the cash available to repay loans or make dividend payments. It’s a way to measure how much cash the company is generating after taking into account the costs of running the business, and it can be a useful indicator of a company’s financial strength.

It is important to note that these factors are very unlikely all to demonstrate strength at the same time. Investors need to consider the interaction of these metrics in the context of their own priorities. For instance, someone looking for long-term capital growth might look for a low PE ratio, while someone looking for income is more likely to prioritise the strength and reliability of the dividend.

Look beyond the numbers to analyse stocks

Many crucial aspects of a company’s strength cannot be quantified through metrics.

How does the company make money?

This is about understanding what the company does – what it manufactures or the service it provides, its target markets, expected costs. You may know a lot about it because you’re a customer; or you may need to do some research into its business model.

The legendary US investor Warren Buffett stands by the principle that you should only invest in businesses you understand, and avoid jumping on the bandwagon of those you don’t.

Does it have a competitive advantage?

As well as looking at the company in isolation, it’s important to consider its position within its market. A successful company will have competitive advantages that enable it to produce better products or services than its rivals or undercut them on price.

The best competitive advantages are those that are difficult for other businesses to duplicate, such as brand identity or a patented process. These “economic moats” can give a company real strength because customers will stick with it.

Potential for growth

In today’s fast-moving world, businesses need to have plans to grow – whether that involves reducing costs, venturing into new regions, refocusing or expanding into new product ranges, or research and development. Growth may be organic, or through the acquisition of other companies.

Management quality

Leadership is fundamental to corporate success. Read up on the record of the chief executive and key directors, but also on their record as a team. Rapid turnover of senior staff could be a cause for concern.

The implications of overseas exposure

Investing in stocks listed on overseas exchanges is a great way to diversify your portfolio and potentially to reduce volatility to some extent, as different markets don’t all move in tandem with each other. However, there are various considerations to bear in mind.

How easy is it to research the stock?

There is plenty of company information readily available for large-cap US or European stocks, but it can be harder to source reliable information or figures on smaller companies, or those listed in less mainstream markets.

This is one area where a fund or investment trust run by a professional manager with resources and access to specialist analysts can make sense for many people.

What’s the cost of investing overseas?

This vary significantly between brokers, so do your research if you plan to do a lot of overseas investing. There is a foreign exchange fee to cover the cost of converting to and from the overseas currency, on top of dealing charges. With some brokers, including ii, you have the option of holding other currencies within your account, which gets around these trading costs.

You’ll also need to factor in the impact of exchange rates imposed by the platform.

Currency movements

Macroeconomic movements in exchange rates - between the dollar or euro and sterling, for instance –can have a big impact on your returns in the short term. If the pound gains strength against the dollar and you then sell a US stock, you’ll receive less in sterling terms from the sale of the stock than you would have earlier.

Political, economic and social risks

Factors such as natural disasters, war or political unrest can rock local stock markets. Emerging markets with less mature economies may be particularly vulnerable to these risks.

Tax implications

Direct investing in overseas shares can also have tax implications, if you’re investing through an ISA or a direct trading account. For instance investors in US shares need to fill in a W-8BEN form to qualify for a reduced tax rate of 15% instead of 30% on dividends and interest.

Other countries also have tax requirements so do check these out before you get started with overseas trading.

The takeaway...

As with any other financial commitment, it can really pay to do your homework if you’re serious about investing in stocks and shares. If you would rather leave the hard work to a professional stock picker, consider using funds or investment trusts instead.

Please remember, investment value can go up or down and you could get back less than you invest. The value of international investments may be affected by currency fluctuations which might reduce their value in sterling.