Assessing a company from a quantitative standpoint and determining whether you should invest in it is as important as looking at the company's management. Qualitative analysis is one of the easiest methods for taking a quick look to determine if a company fits your profile for the long-term. But, for an in-depth look at a firm we need to consider tangible, measurable (quantitative) factors. This means crunching and analyzing numbers from the financial statements. If used in conjunction with other methods, this can produce excellent returns.
Quantitative analysis has been around since the early beginnings of the stock market. Looking at revenues, earnings, expenses, inventory, cash flow, among other factors has been one of the traditional strategies for picking stocks. If these factors looked good, then the company was said to have "good fundamentals". For the most part, this approach is alive and well today.
This strategy has not gone without snags though. Remember when the NASDAQ had those double and triple digit rises in technology stocks, for those only using "quantitative analysis" missed out on these tremendous gains, because most of the companies had no fundamentals, only potential growth prospects.
Common with almost every investment strategy is consideration for historical performance. This is particularly true for quantitative analysis, which will often look at data that dates back 5-10 years in order to detect any trends in the numbers as well as determining if the stock seems over or under valued compared to its historical performance. Businesses and the economy tend to grow cyclically. With sufficient historical data and quantitative analysis, we have the ability to capitalize on these changes. For example, if the economy appears to be entering a recession the quantitative investor will look at how the company performed the last time we entered a recession and if there are any similarities in the fundamentals.
Factors to Consider
While there are hundreds of financial valuation ratios used by analysts, there are a couple factors that they pay particularly close attention to. The first factor is year-over-year earnings growth; this shows if a company has been growing at a steady and solid rate for the past few years. The same is true for sales revenues, which is the backbone to earnings growth.
The P/E Ratio has historically been used to see if a stock is over or under valued. But this is quickly being taken over by the PEG ratio, which incorporates growth as well as the stock price and earnings. Investors are getting pickier. Many have abandoned the P/E ratio, not because it is worthless, but because they desire more information about a stock potential before investing.
With all of these factors, quantitative investors will set limits as to whether they should buy or sell a stock. For example, they may only buy stocks with at least 20% annual earnings growth, a P/E under 20, and a profit margin of at least 30%. Should any of these factors not be met, then quantitative investors will not buy a stock, and if the fundamentals are really bad they will even consider shorting the stock.
What do these figures tell us?
Looking at the fundamentals of a company is second nature for many investors, but for others these numbers are only trivial. Some short-term momentum investors don't put as much emphasis on quantitative analysis because these factors are not likely to affect the stock price over the next few minutes, days or weeks. Long-term investors take the stance that they are able to detect inefficiencies in a stock over the long run if the fundamentals don't support a particular price.
For quantitative analysis, setting limits is half the battle. They avoid getting emotionally attached to a stock and set numerical limits at which they will buy and sell stocks. The limits are always based on value and growth principles, and these principles are not just a guide, but also a strict law to be followed. All of these numbers can be found in the company's annual report.