How to Think Like a Stock Analyst

Investing is about more than just crunching numbers. It’s also about observing the world around us, recognizing trends, and understanding what those trends will ultimately mean in terms of dollars.

Let’s look to an example that’s not directly about stock investing: the observation that fast-food restaurants tend to be located near each other. Why do you think that is? Wouldn’t it make things harder for Wendy’s WEN to be located next to McDonald’s MCD, and thus have to compete with them? There must be a reason why Wendy’s would be built next to McDonald’s.

This is what it means to think like an analyst. It’s about sharpening your observational skills, so you can understand the world in an organized way.

Though the details are complex, there are four broad questions that you can use to kick-start a business analysis.

1. What is the goal of the business?
2. How does the business make money?
3. How well is the business doing?
4. How well is the business positioned relative to its competitors?

#1: What Is the Goal of the Business?

Don’t assume a business’ purpose is obvious. Be sure you have a good idea of what it’s really trying to achieve.

For example, the goal of a fast-food chain like McDonald’s is to feed customers in a timely, cost-effective manner, whereas the restaurants owned by Darden Restaurants DRI (such as Olive Garden and Ruth’s Chris Steak House) aim to provide a more comfortable, enjoyable experience.

From there, ask if it makes sense for this business to try to achieve this objective.

Let’s say Darden Restaurants announced that it was going to start providing entertainment in its restaurants. How do you expect that would land, versus if the announcement came from somewhere like McDonald’s?

#2: How Does the Business Make Money?

Once you have a good idea of what the business is trying to do, think about how it makes money.

For the restaurant example, consider food costs. Darden purchases higher-quality, more expensive food than McDonald’s, yet can still generate profits because guests are willing to pay more on a per-meal basis, partially attributable to the pleasant ambience diners find in its restaurants and their tendency to linger in a way that they would not with most fast-food competitors.

With McDonald’s, on the other hand, the food is cheap, but they’re able to sell more of it to a broader swath of people, generally facilitating more transactions at lower price points than casual diners.

#3: How Well Is the Business Doing?

A business is measured by its profits, but you can get a sense for how well it is doing by breaking down the factors that influence its success—and considering your own experiences with the business.

Think of experiences you’ve had with a particular restaurant. Is the restaurant always busy, suggesting that consumers are gravitating toward its fare? In addition to quality food, maybe it has numerous restaurants in convenient locations, an exceptional caliber of wait staff, and an overall pleasant ambience.

On the flip side, there may be reasons why a business isn’t doing as well. Maybe the restaurant was once known for its quality wait staff, but headcount reductions have seen service get slower as fewer staff handle more tables. Or maybe the restaurant’s locations don’t get the same foot traffic that they did 20 years ago, so the convenience factor has slipped.

#4: How Well Is the Business Positioned Relative to Its Competitors?

From there, spend some time thinking about how well the company functions in its industry. In other words, assess the competition.

Industries like restaurants have plenty of competitors, but more niche businesses that don’t have a lot of competitors still need to earn their place in the industry.

Consider a field like artificial intelligence, which doesn’t have nearly as many players as the restaurant space. Why is that? There are many reasons: For example, the quickly evolving field is harder to keep up with, there’s a higher-cost barrier to entry, and it’s considered a riskier investment.

How to Think Like a Stock Analyst

These kinds of questions can give you a good idea of how well a specific business is positioned to cope with the challenges it may encounter.

Thankfully, there are also experts who have done a lot of this thinking already, and many of them have developed useful frameworks to help organize our thinking even more.

This article includes updated content that originally appeared in Morningstar’s stock investing course, which was distributed by The Professional Education Institute.