Discover how to read stocks for long-term investing success through these tools
How to read stocks? It’s a simple enough question, and one all Successful investors must confront. Generally, they all try to arrange their portfolios so they profit more or less automatically over long periods. Investors who learn how to read stocks can do this by tapping into long-term growth that inevitably comes to well-established companies when they operate in relatively free economies during relatively prosperous years and decades.
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Use technical analysis to support—not determine—your view of a company. A far better approach is to look at chart reading as one tool among many. But focus on how to read stocks and charts as a way to predict what’s going to happen. Look to see if the pattern on the chart seems to support your view of the stock, based on its finances and other fundamentals. But remember that the stock market follows a multitude of factors to varying extents, and the most important or influential factors continually change.
It’s encouraging if your analysis and the chart seem to match. But sometimes they don’t. If a company looks promising, but its chart shows a lengthy falling trend, insiders may know something you don’t. That’s when you know you have to dig deeper, and perhaps wait until the situation clarifies itself.
How to read stocks: Using a break even analysis
A break-even analysis is basic arithmetics, but has significant value in analyzing potential gains—and losses—on stocks. For example, if you lose X% in the stock market, you’ll need X% to recover, or break even. An understanding of this relationship can help you stay out of poor-quality stocks where the risk of a big decline is high. For example:
If you lose 10%, you need an 11% gain to break even.
If you lose 20%, you need to make 25% to break even.
If you lose 40%, you need to make 66.6% to take you back to where you started.
If you lose 50%, you need a 100% gain to break even.
An 11% gain is relatively common; in fact, the market has gained nearly that much annually, on average, over the past 75 years or so. A 25% gain is a little harder to achieve. You need an above-average year to make that kind of return. Gains of 66.6% to 100% or more can take years. Even if you make enough money to regain your losses, however, that only brings you back to where you started.
How to read stocks: Using a debt to equity ratio analysis
Experienced investors will often undertake a debt to equity ratio analysis. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity. In essence, you assume an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of its capital.
In that case, excess profits accrue to shareholders, and that in turn raises shareholders’ equity on the balance sheet. But leverage works both ways. If the total return falls short of interest payments, the difference comes out of shareholders’ equity.
A high ratio of debt to equity increases the risk that the company won’t survive a business slump.
However, a debt to equity ratio analysis can mislead, because it compares a hard number with a soft one.
Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are not as precise. They mostly reflect asset values as they appear on the balance sheet—minus debt, of course.
But figures on a balance sheet may be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance-sheet figures by trimming them back or “taking a writedown.”
Or, the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate and other investments.
How to read stocks to find the best ones for your portfolio
No one can predict which stocks will be average performers, which will be losers, and which ones will turn into the superstocks that wind up rising five-fold, 10-fold or more. You may avoid some temporary losses if you sell every stock you own that goes up faster than you guessed. But do that, and you will also sell any superstocks you stumble upon, often when they are just getting started. That could mean that your stock investing strategy never pays off.
Note that our Successful Investor approach, automatically limits your involvement in notoriously trouble-prone areas like new issues, start-up companies and illiquid investments.
Of course, you also need to stay out of companies when you have doubts of any sort about the integrity of insiders. You need to recognize the special risks of investing in fashionable or excessively popular minefields, such as Internet stocks in the late 1990s, or income trusts in the previous decade, or green energy in the current decade, and be profitable by using our three-part Successful Investor philosophy:
No matter how you invest for retirement, you should take care to spread your money out across the five main economic sectors: Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.
By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.
You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.
There are a variety of techniques used on how to read stocks. How do you figure out which stocks you want to buy? Have your investing methods evolved over the years? Have you used investing methods that did not work and you recommend avoiding? Share your thoughts with us in the comments.
This article was originally published in 2017 and is regularly updated.
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