How Financial Analysts Decide Which Stocks to Invest In
A picture showing stocks and their analysis, plus projected growth
Analyzing the stock market sounds like a skill reserved for people with multiple monitors and a concerning amount of coffee. In practice, it is applied arithmetic aimed at one question: what is this company worth, and is the market currently charging a fair price for it? The arithmetic is completely learnable, once explained. The complication, which most introductory guides skip, is that decades of research suggest even professionals struggle to use it to consistently understand the market.
Imagine you could buy a small piece of Nike, Apple, or another company. If the company becomes more valuable, your investment might grow. But how do you know whether a stock is worth buying, or whether its price is too high?
Financial analysts try to answer this question using mathematics, financial data, and research. Two common approaches are fundamental analysis, which examines the business, and technical analysis, which studies its stock price
Two Schools of Analysis
All companies and figures below are invented for illustration.
Fundamental analysis examines the business itself: how much money it makes, how much it owes, and how fast it grows. Technical analysis ignores the business and studies price history for patterns.
Fundamental Analysis: Ratios
A stock represents partial ownership of a company. When you buy a share, you become one of its shareholders. Analysts examine whether the company makes money, manages its debts, and has room to grow.
A picture showing how shares are split up in a company
Imagine a company called Northwind Robotics that makes robots for factories:
Share price: $60
Shares outstanding: 10 million
Annual revenue: $500 million
Net income (profit): $50 million
Total debt: $40 million
Shareholders' equity: $80 million
Revenue is the money a company earns from selling products. Profit is what remains after paying its expenses. Debt is money the company owes to lenders.
Analysts use several ratios to understand these numbers.
Measure | Formula | Northwind Robotics |
Earnings per share (EPS) | net income ÷ shares | $50M ÷ 10M = $5.00 |
Price-to-earnings (P/E) | price ÷ EPS | $60 ÷ $5 = 12 |
Profit margin | net income ÷ revenue | $50M ÷ $500M = 10% |
Debt-to-equity | total debt ÷ equity | $40M ÷ $80M = 0.5 |
Let's look at the P/E ratio. Northwind's ratio is 12, meaning investors pay $12 for every $1 of annual earnings per share.
Is that cheap? Not necessarily. A fast-growing technology company might deserve a higher P/E than a business whose sales are declining. Analysts compare companies in the same industry before deciding whether a stock looks expensive or inexpensive.
The profit margin also matters. Northwind keeps $10 of every $100 in sales as profit (so, as seen in the table, 10%). If another company keeps $20, it may be more efficient, or it may simply operate in a more profitable industry.
The key idea is that a good company is not always a good investment. Even a successful business can be a poor purchase if its stock price is too high.
Growth, Compounded
Investors often look for companies whose sales and profits are growing.
Suppose Northwind's annual revenue increases from $400 million to $500 million over three years. Its total growth is:
(500 - 400) / 400 * 100 = 25%
However, 25% growth over three years is different from 25% growth in one year. To compare growth fairly, analysts calculate the compound annual growth rate (CAGR):
This means revenue grew at an equivalent compounded rate of approximately 7.7% per year.
Why does this matter? A company with steadily growing sales may have better prospects than one whose sales have stopped increasing. However, past growth does not guarantee future success.
What Is the Company or Stock Worth?
Suppose a friend offers you $100 today or promises to give you $100 in three years. You might prefer the money today because you could invest it and earn a return. Analysts apply the same principle when estimating what a company is worth. This is called discounting.
The present value (PV) of future money is
where r is the annual discount rate (the return you could earn elsewhere) and t is the number of years until the payment. If Northwind is expected to generate $10 million of free cash each year for three years, and r = 8%:
Imagine an investment will pay you $100 in one year. If your required annual return is 10%:
PV= 100/1.10= $90.91
In other words, receiving $100 in a year is equivalent to approximately $90.91 today at a 10% required return.
Analysts use this principle in discounted cash flow (DCF) analysis to estimate a company's value from the cash it may generate in the future. If the estimated value is higher than the current market valuation, the stock may be undervalued. If it is lower, the stock may be overvalued.
However, these calculations depend on forecasts. If the company earns less money than expected, its estimated value can change significantly.
Technical Analysis: Averages and Returns
Instead of studying a company's finances, technical analysts examine its stock price over time.
One common tool is the simple moving average (SMA), which calculates the average closing price over a set number of days.
Suppose a stock closes at $10, $12, $11, $13, and $14 over five days:
SMA = (10+12+11+13+14) / 5= $12
The five-day average is $12. As each new trading day passes, the analyst updates the calculation.
Some traders interpret a price rising above its moving average as a possible sign of upward momentum. Others look for patterns in trading volume or repeated price levels.
But there is a problem: patterns can appear by chance. A stock's price rising above its average does not guarantee that it will continue rising. Technical analysis can help traders organize market information, but it cannot reliably predict every price movement.
Risk Is Also a Number
Imagine two investments both earn an average return of 6% per year. One produces returns close to 6% each year, while the other alternates between large gains and losses.
Would you consider them equally risky?
Analysts measure one aspect of this uncertainty using standard deviation, which describes how widely returns vary around their average.
Consider annual returns of 10%, −5%, 15%, 8%, and 2%.
First, calculate the mean return = (10 − 5 + 15 + 8 + 2) ÷ 5 = 6%
Next, subtract 6 from each return and square the differences:
16, 121, 81, 4, 16, which sum to 238
For a sample of five observations, the sample variance is:
Sample variance = 238 ÷ (5 − 1) = 59.5
Taking the square root gives the standard deviation:
Standard deviation = √59.5 ≈ 7.7%
Therefore, the standard deviation is approximately 7.7 percentage points.
Higher volatility can make an investment harder to predict, although volatility is not the only measure of risk.
Why Diversification Works
Suppose you invest all your money in one airline. If fuel prices rise or travel demand falls, your investment could suffer.
Now imagine splitting your money between an airline and a supermarket. The supermarket may perform well even when the airline struggles.
This is diversification: spreading investments across different companies, industries, or asset types to reduce reliance on any single investment.
The mathematics depends partly on correlation, which measures how closely two investments move together. For a portfolio split equally between two stocks, portfolio volatility is:
σ_p = √(0.25σ₁² + 0.25σ₂² + 0.5ρσ₁σ₂)
Here, σ₁ and σ₂ are the stocks' standard deviations, and ρ is their correlation, which ranges from −1 to +1.
Suppose both stocks have a standard deviation of 20% and a correlation of 0.5:
σ_p = √(0.01 + 0.01 + 0.01) = √0.03 ≈ 17.3%
The portfolio's volatility is lower than either stock's 20%. When correlation is +1, both stocks move perfectly together, so combining them does not reduce volatility. Diversification cannot eliminate all risk, but it can help protect a portfolio from problems affecting one particular company or industry.
The Probability Problem
The efficient market hypothesis suggests that stock prices already reflect available information, making it difficult to consistently outperform the market. Probability helps explain why some investors appear extraordinarily successful.
Imagine 1,000 fund managers, each with a 50% chance of beating the market in a given year purely by chance. Assuming independent outcomes and the same probability each year, the expected number who beat the market for ten consecutive years is:
1,000 × (0.5)^10 = 1,000 ÷ 1,024 ≈ 1
That is approximately one manager.
Even if nobody possesses exceptional skill, chance alone could produce a manager with a perfect ten-year record. Impressive results do not automatically prove that someone can repeat them.
Many professional funds have struggled to outperform their market benchmarks over long periods after fees. This helps explain the popularity of low-cost index funds, which aim to track a market rather than pick individual winning stocks.
Financial analysts use mathematics to evaluate a company's profitability, growth, value, and risk. Fundamental analysis asks whether the business is financially strong and whether its stock price is justified. Technical analysis looks for patterns in market prices. Risk calculations and diversification help investors understand uncertainty.
None of these methods guarantees success. Their real purpose is to replace guesswork with evidence, helping investors make more informed decisions about where to put their money.
