Investment analysis

What Are the Basic Concepts of Investment Analysis?

Investment analysis is a field that encompasses many different techniques and methodologies.

Some are simple, while others are more complicated and involve lots of math.

Investment analysts use these techniques to help them make investment decisions, such as when to buy or sell an investment asset or which stocks to buy in a particular sector.

After working through this article, you’ll have a solid grasp on the basics of investment analysis so that you can start making your own decisions about where and how to invest your money!

The Five Major Areas of Investment Analysis

The five major areas of investment analysis are the following:

  1. Financial statements
  2. Expected rate of return
  3. Cash flow
  4. Industry comparisons and benchmarks
  5. Valuation methods

How to Analyze a Company’s Financial Statements

The financial statements of a company can be used to analyze its performance.

The balance sheet, profit and loss statement, and cash flow statement are all forms of financial statements that are commonly used by investors to analyze companies.

The balance sheet is a snapshot of the company’s financial situation at a given point in time. It shows you how much money the company has on hand, how much debt it owes to creditors, and what assets it has (such as property).

The profit and loss statement is probably the most familiar type of financial report that you’ve probably seen before—it’s just called something else when it comes from your bank or credit card company!

This report will tell you how much money was brought in by sales compared with how much money was spent during an accounting period (usually one year).

The amount left over after paying expenses is referred to as net income or net earnings for short.

If expenses exceed revenue during any period of time then this results in negative net earnings which means that there was actually less money available afterwards than before due to costs incurred during production/marketing etcetera.

Expected Rate of Return

The expected rate of return is the average annualized return an investment is expected to generate, based on its historical performance.

This can be calculated as follows:

(1 + Expected Rate of Return)^Number of Years in Period = Expected Rate of Return

For example, if you are considering investing in a mutual fund that has generated a 10% average annualized return over the past 25 years and you expect its future performance to be similar to its past 25-year history, then your expected rate of return will be 10%.

You would use this calculation when comparing two or more investments because it allows you to make apples-to-apples comparisons between them.

Cash Flow Analysis

Cash flow is a measure of the actual cash that a company brings in and out.

It’s also an important indicator of a company’s financial health since it shows how much money it’s generating on a regular basis.

Cash flow can help you determine if a company is healthy or not by comparing its current cash flows to historical performance and industry norms.

Cash flows are calculated for different periods of time (monthly or annually), but the most common period used in investment analysis is called “yearly.”

The most common way of calculating cash flow is by summing up operating activities, financing activities, and investing activities.

Industry Comparisons and Benchmarks

To begin, you need to understand how an industry is defined. Industries are groups of companies that have similar business goals and traits.

For example, airlines and hotels are considered part of the same industry because they often compete for the same customers.

You should also be familiar with key terms such as “market capitalization” and “price-to-earnings ratio” (P/E).

These metrics help you determine whether a stock is undervalued or overpriced relative to its competitors in the same market sector or across different sectors altogether.

How to Calculate Beta and R-Squared

The concept of beta is a measure of how volatile the price of an individual stock or a portfolio is compared to the market as a whole.

It can be calculated by dividing the standard deviation of returns for that asset by its correlation with the S&P 500 index, which represents the entire U.S. stock market. For example, if you had measurements for three stocks:

Apple Inc.: Beta = 1.5 (standard deviation = 20%)

Google Inc.: Beta = 0.9 (standard deviation = 10%)

Microsoft Corp.: Beta = 0.5 (standard deviation = 10%)

The Importance of Operating Margin and Asset Turnover

The concepts of operating margin and asset turnover are important because they can help you gauge the financial strength of a company.

Operating margin is simply the percentage of revenue that remains after all costs have been paid, which means that it shows how well companies are using their assets to generate revenue.

Asset turnover is measured by dividing total sales by average total assets (or the number of times a company’s assets were used to generate revenue).

A high operating margin means that the company has few costs and is, therefore, able to use its resources wisely; likewise, a high asset turnover could indicate that it uses its assets efficiently or even has excess capacity (which would be good for investors).

The Significance of Debt Ratios in Investment Analysis

Debt ratios are used to determine the financial health of a company.

They provide investors with valuable information about the ability of a company to pay interest on its debt, as well as how heavily it relies upon debt financing.

For example, if a company has more than 60% of its total capital in the form of debt, then it is considered highly leveraged, meaning that its ratio will be higher than 1 (or 100%).

In this case, high leverage means that the business has a considerable risk because it is highly leveraged and therefore unable to meet repayment schedules or repay principal in full when due.

A number of ratios are available for assessing debt levels:

Valuation Methods, Including Discounted Cash Flow (DCF) Analysis and Relative Valuation Methods

The two most common valuation methods are discounted cash flow (DCF) analysis and relative valuation methods.

Discounted cash flow (DCF) analysis is used to value assets that are expected to produce cash flows into the future, such as bonds and stocks.

The technique involves calculating the present value of all future expected cash flows, discounting them back to today’s dollars using a discount rate that reflects the riskiness of investing in those assets.

For example, if you were planning on purchasing shares in Alphabet Inc., one of Google’s parent companies, you would need to use DCF analysis because it provides an estimate of how much money you would receive from selling your shares at different times in the future.

Multiplying an asset’s price by its earnings per share (EPS) yields another popular way of valuing stocks: EPS multiples or price multiples.

Bottom Line

So, there you have it! A brief overview of some of the most fundamental concepts in investment analysis.

As we’ve seen, many of these concepts overlap with one another, but each can also be used as a standalone tool for making better decisions about where to put your money.

The next time you’re looking at an investment opportunity, take some time to consider whether or not it fits into one of these major categories and which methods might help you evaluate it more effectively.


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