How to Analyze The Stock Market:Do Your Research

Analyze the Market to Prepare

Man reading the news on the stock market.

How to Analyze The Stock Market:Do Your Research

On my last post I talk about credit cards and how it is important not to go too far into debt. I will talk more about that in a later post but I wanted to switch gears for a moment and talk about how I analyze and conduct my own research and how you can too. I have mentioned before that it is vitally important for teens to invest in stocks because they produce the greatest returns over the long run. Many market experts have even stated that while the market has it’s ups and downs, the younger generations have time to ride out the bumps. While that is true, it is important to know what to do with your money as well. No one is going to have your interest at heart more than you do. That is why I am going to show you how to analyze market trends and how to do research to better understand what investments you should or should not invest in.

 

How to Analyze Stock Levels

How can you predict when the stock market is going to crash? How do you know when you should or should not invest in stocks?

There are several ways and tools that i use to analyze stocks or choose which investments are best. One way I check is to first do a macroeconomic view. What is a macroeconomic view? I look at what’s happening around the world and I look at the valuations of all companies on the stock market. Short note: Valuing a stock is merely looking at the company’s financial statements and income statement and other metrics to see if a company has a higher or lower stock price than it should have. If after doing thorough research you discover a certain company’s stock is valued at $50 a share and the current stock price is $35 then you know the stock is undervalued. If however, the valuation shows the stock is worth $18 a share then you know by the current stock price of $35 that the stock is overvalued.

One way to see the macroeconomic trend is to look at margin debt levels. Margin debt is money borrowed from brokers to buy more shares of a company than otherwise would be possible. If you had $1,000 and wanted to buy shares of a company whose stock price is $50, then you would only be able to buy 20 shares. But if you borrowed money from your broker by opening a margin account you could buy more. Say you borrow $500,so you pay $25 and your broker pays $25. You would be able to purchase 30 shares instead of 20 shares. Your investment is used as collateral on the loan. However, if the stock drops in value after you bought it, you will owe your broker more money. Brokers charge a certain rate of interest to borrow from them so you can end up paying even more than you realize on both collateral, interest and losing your entire investment if the stock tanks. That is why it is important that you understand the risks with margin accounts. For a better understanding see the SEC rules here.

 

Chart of Margin Debt

Analysis Shows Margin Debt Peak

The chart above depicts margin debt over the years 1995 through the present. As you can see, whenever margin debt peaks too far ahead of stock prices it usually coincides with a market crash. What this chart illustrates are the peaks of the 2000 dot com bubble burst, the Housing bubble and crash of 07-08 and we look to be on the verge of another bubble and bust. Now i must say everyone is free to do with their money as they see fit but stocks seem overvalued at this point and time. Another way you can view margin debt is to view http://www.advisorperspectives.com/dshort/updates/NYSE-Margin-Debt-and-the-SPX.php which shows the margin debt levels and updates them every month.

 

Tools to Analyze Individual Stocks

If you don’t completely know how to do in depth research using the financial statements I still highly recommend you learn, however there are tools to help you do research. One such tool to use is http://www.moneychimp.com/articles/valuation/dcf.htm Money Chimp has a calculator you can use to help you determine the share price of a company. To use this tool you would simply start at the top and input the earnings per share of a company which can be found on their financial profile on websites like google finance or my favorite, MarketWatch:http://www.marketwatch.com/ in the search bar type in a company name or ticker symbol. We will use Facebook for the the example. The ticker symbol of Facebook is FB. Now a profile of facebook will appear and if you scroll down the page, on the left hand side you will see overview of things like Market Cap, P/E ratio and Earnings Per Share(EPS), ect. For Facebook the earnings per share is 2.08 as of the latest quarter of 2016. You would input EPS of 2.08 into the Discounted Cash Flow calculator. Next is growth assumptions, the growth rate currently which is usually averaged out over 5 years and the expected growth of the next 5 years. You can find out Facebook’s past growth rate by averaging the net income of the income statement, which is in the “financials” tab on MarketWatch. If you take the net income from the year 2011 (668M) and net income from year 2015 (3.67B) average the numbers over 5 years and you are left with a compounded annual growth rate (CAGR) of 40.60%! (3.67/0.668^1/5)=40.59~40.60%. Since the millions and billions are expressed in decimal form you can just plug in using the same system ie. 1.0 represents 1 billion dollars, half a billion would be expressed 0.5 ect.

Now plug in 40.6% into the growth assumptions in the discount cash flow calculator. Leave the future years as 5 years and for any growth over 5 years it is best to keep at 0%. However, many financial analysts use the growth rate of the U.S. economy, which is roughly 3%. (It is worth noting that Warren Buffet uses a future growth rate of 0% beyond the 5 or 10 year initial projection. Using such conservative estimates makes sure he never overpays for an investment.)

Next, you would add in the discount rate. The discount rate is basically the rate of return you would expect or require of such an investment. The discount rate is also thought of as the time value of money and the risks and uncertainty in the market. For example, suppose you have two investment options: 1) You can invest your money in a 10 year treasury bond with a yield of 2% a year. 2) You can invest your money in a stock with a 2% dividend yield but in addition the company’s outlook is stable and has enjoyed compounded annual growth rates in the stock price of 10% a year. You might be better with the stock prospects of asset appreciation vs the guaranteed 2% return. Another scenario is if we were in the same environment of the 70’s where bond yields were 8% and the 80’s when yields were as high as 12%-15%! Compare that to stock holdings with similar returns and you might agree it would be less risky to just hold bonds with that low risk of default with the substantial double digit returns compared to the risk of the stock market. Only you can make that decision about where to put your money given the right return given the risk of capital. But because the market is so overvalued (my opinion) i will say there is a higher risk of downward prices than in the past and will assign the discount rate of 11%.

Wrap-Up

Whether you use 0% or 3%, based on the current earnings per share and the 40.6% growth rate for the next 5 years the valuation of Facebook stock shows a intrinsic value of $83.99 and $109.66 respectively. Both of these numbers is lower than the current price of $130.86 so as of now i would say Facebook is overvalued. Note: This is my opinion based on my facts and research. Just because a stock is overvalued does not necessarily mean it will crash in value. A company can have a lower outlook and perform well over the coming months before going down. Another thing to consider is the average historical value of a company. Depending on industry, a company can have a higher or lower value. A soap company for instance my historically trade at 10-12 times earnings because its a stable industry and business. A tech company however, may historically trade at 20 or 25 times earnings because it is in a high growth industry. These are some things to keep in mind when valuing your investments. As always, hope everyone the best in their financial futures. It is your right to be rich!