How to Evaluate a Stock Before You Buy
The value of a stock is made up of several factors, including the company’s ability to continue making a profit, its customer base, its financial structure, the economy, political and cultural trends, and how the company fits within the industry. Understanding those basic factors will go a long way toward helping you select stocks for your portfolio.
If you’ve never bought or sold stocks in the past, the thought of trading for the first time might be daunting. But once you’ve done your homework and have developed the right habits, it may not be nearly as intimidating.
Getting Started with Stock Evaluations
Learning how to evaluate stocks starts with some basic homework. But even for those familiar with the stock market basics, it can be helpful to keep some overarching things in mind.
• When you buy a stock, you’re not simply buying a piece of paper. A stock is an ownership share in a company — you’re buying into that company and its potential performance. When a person invests, they gain an opportunity to join in on its success or failures over the long haul.
• The more you know about the company, its industry, and general stock market trends, the better. Professional advice is important, but so is trusting common sense.
• A consumer may be able to spot investing trends that eventually translate to a company’s strong performance down the line, asking questions like: Why am I investing in this company? Why now?
• It’s important to assess your individual tolerance for risk before investing, and check in on that periodically. Additionally, make time to review your stocks’ performance and watch the market on a regular basis.
• When considering how many stocks to buy, most investors may want to keep portfolio diversification in mind, with stocks across a range of sectors and risks. Being invested in only one stock means that if the company fails, you could lose your invested money.
Understand the Two Types of Stock Analysis
There are two general types of stock analysis: Fundamental, and technical.
Fundamental analysis as it relates to stocks involves analyzing the underlying company’s financial health and operations. It may include looking at financial statements, earnings reports, annual reports, and more, and the overall goal is to get a sense of the stock’s intrinsic value.
Technical analysis, on the other hand, incorporates the use of data and indicators from charts to try and identify patterns and trends. Its goal is to determine where a stock’s value might go next.
Review Stock Materials
With some general evaluation guidelines in mind, the next step is to dig deeper to calculate stock value. This involves reviewing a stock’s materials and documentation.
Balance Sheet and Other Financials
The Securities and Exchange Commission (SEC) requires all public companies to file regular financial documents that disclose their performance. These quarterly filings indicate profit and loss, material issues that can affect performance, expenses, and other key information that will help you gauge a company’s health, and get a better idea of a potential return on equity.
Recommended: FINRA vs. the SEC
Consumers can find these and other reports on SEC.gov:
Balance sheet: This records whether the company reduced or increased their debt. Some major items to look for here are the company’s tax paid and tax rate, along with expenses that aren’t related directly to profits, like administrative expenses.
Income statement: The revenue, major expenses, and bottom-line income may reveal trends in the company’s profitability.
Cash flow statement: Not all income is realized, so the cash flow statement shows you what the company actually got paid during the quarter — not what it’s expected to receive from sales 30, 60, or 90 days from now. The operating cash flow (which excludes a windfall or unusual influx of cash) provides a sense of the real, day-to-day (or quarter) activity of the business: how much cash comes in and how much goes out; how the company handles assets and investments; and the money it raises or distributes to lenders and shareholders. Some companies, most famously Amazon, can have meager profits relative to their sales but impressive cash flows.
In particular, as you read through these statements, pay attention to:
• Revenue: The company’s gross income
• Operating expenses and non-operating expenses: These are typical day-to-day expenses, and also ones that don’t relate to the core business (for example, a non-operating expense might be any interest paid on debt)
• Total net income: This is the company’s actual profit, after deducting all expenses from revenue
• Earnings before interest, taxes, depreciation, and amortization (also known as EBITDA): This figure excludes non-operating expenses
Financial performance ratios offer insight into a company’s financial health.
Form 10-Q
While publicly traded companies tend to release their own financial statements in the form of a presentation for investors, analysts, and the media every three months, they are also required to produce a more comprehensive quarterly report known as the 10-Q, which is filed with the Securities and Exchange Commission (SEC).
This document “includes unaudited financial statements and provides a continuing view of the company’s financial position during the year,” according to the SEC, and can be useful to investors as it provides a comprehensive overview of the company’s performance for the previous three months. The 10-Q also offers insight into other factors that might give an impression of a company’s overall health, including:
• Any risk factors to the business
• Information about legal matters
• Issues that might impact a company’s inventory
Form 10-K
Form 10-K is similar to form 10-Q but it comes out on an annual, as opposed to quarterly, basis. The form is meant to “provide a comprehensive overview of the company’s business and financial condition and includes audited financial statements,” according to the SEC. The annual 10-K can give investors a broader picture of the business through the ups and downs of a year, during which sales and expenses can often fluctuate.
These reports include both detailed financial information and actual writing from the company’s management about how their business is doing. They also outline how executives are paid, which is one more piece of information about the company’s management that can be useful to shareholders.
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How to Value Stocks with Financial Ratios
If learning how to evaluate a stock starts with analyzing financial statements, step two is understanding performance through financial ratios. Ratios offer insight into a company’s financial health, allowing for comparisons to other companies in the same industry or against the overall market.
These are important financial ratios to know.
Price-to-earnings Ratio (P/E)
This is a stock valuation formula that will help you determine how one company’s stock price compares to another. The price-to-earnings ratio is straightforward: It divides the market price of a company’s stock by the company’s earnings per share. The ratio can reveal how many years it will take for a company to generate enough value to buy back its stock.
Price-to-earnings (PE) ratios can also indicate how much the market expects the company’s profits to grow in the future. When investors buy stocks with a high PE ratio, it typically means they’re “buying” present earnings at a high price, with the expectation that earnings will accelerate going forward. On the other hand, a stock with a low PE ratio could give an investor a good value for their money — but it could also be a sign that investors aren’t confident in the company’s future performance.
Looking back historically, the market has tended to have a PE ratio of about 15, meaning investors pay $15 for every $1 of earnings. But different companies and even different sectors can have wildly different PE ratios.
For example, software companies, especially younger ones, tend to have high PE ratios as investors think there’s a chance they could get much, much larger in the future and turn fast-growing revenue into profits. In software, PE ratios can be in the 30s or even much higher when companies see their stock prices take off quickly, with a PE or around 90.
Earnings Per Share (EPS)
Earnings per share (EPS) tells investors how much earnings each shareholder would receive if the company was liquidated immediately. Investors like to see growing earnings, and rising EPS means the company potentially has more money to distribute to shareholders or to roll back into the business. This figure is calculated by taking net income, subtracting any preferred stock dividends, and dividing the result by the total number of outstanding common stock shares.
Return on Equity (ROE)
Return on equity is a key guide for investors to measure the growth in profit for a company. ROE is determined by dividing the company’s net income by the shareholders’ equity, then multiplying by 100. The ratio tells you the value you would receive as a shareholder should the company liquidate tomorrow. Some investors like to see ROE rising by 10 percent or more per year, which reflects the performance of the S&P 500.
Debt-to-equity Ratio (D/E)
The debt-to-equity ratio, determined by dividing total liabilities by total shareholder equity, gives investors an idea of how much the company is relying on debt to fund its operation.
A high debt-to-equity ratio indicates a company that borrows a lot. Whether it’s too high depends on a comparison with other companies in the industry. For example, companies in the tech industry tend to have a D/E ratio of around 2, whereas companies in the financial sector may have D/E ratios of 10.
Debt-to-asset Ratio (D/A)
A debt-to-asset ratio can be informative when comparing a company’s debt load against that of other companies in the industry. This allows potential investors to better gauge the riskiness of the investment. Too much debt can be a warning sign for investors.
How to Evaluate Stocks with Qualitative Research
It’s important to note that using financial ratios and stock materials to evaluate stocks is a form of quantitative research. Investors can also use qualitative research methods to evaluate stocks, too. That can include intangible value and outside influences.
Intangible Value
Some investors have argued that traditional metrics don’t capture the values of intangible assets a company might hold, like brand power and intellectual property. These have become increasingly important to a company’s worth in more recent years, particularly when it comes to tech stock investing.
For instance, a software company’s patents or intellectual property rights may be incredibly valuable. But on the other hand, it wouldn’t have assets like factories or equipment that are easier to appraise.
Investors should also look at a company’s growth trends, such as at what pace it’s growing its revenue or customer base. Paying attention to “company guidance” — the projections the corporation gives when it releases earnings — can also be helpful in trying to gauge growth.
Outside Influences
Investors can also learn a stock’s beta, or its sensitivity to volatility in the broader market. Some companies are more vulnerable to changes in the domestic or global economy, and others may see their fortunes swing depending on the political party in charge of a government.
Learning a stock’s beta or finding one’s portfolio beta are ways investors can better gauge how much volatility their holdings will experience when there’s turbulence in the broader market.
Pay Attention
Once a potential investor has evaluated a stock they’re hoping to buy by analyzing the company’s financial filings and employing a few stock valuation formulas, there is one last step that can help inform the decision: Paying attention.
There are hundreds, if not thousands, of helpful online news sites and tools to help you research companies, screen stocks, and model a stock’s potential in the future. Here are some viable options.
Financial News Sites: There are numerous financial news sites to read, and you can even try looking at stock market forums to stay on top of things.
Online Financial Tools: Stock screeners help you filter stocks according to the parameters you set, whether you’re looking for blue chip stocks or less-established companies in which to invest.
Company Details: Research more than just the financial facts and figures. Find out how it makes money, the core values of the business, CEO performance, and more. Much information can be gleaned by searching reputable news and business media sites for articles and features about the company and its leaders.
Value Traps
Another common term to be familiar with is value trap — a stock that appears deceptively cheap but is actually not a good pick. Investors who follow the value style of investing tend to be very wary of value traps.
Because while these might seem like bargains, they’re usually not good businesses and may be trading at cheap valuations due to a permanent downhill move or industry changes, rises in costs, or bad management.
Whether a stock is a value trap depends on how the stock performs. If it moves back up to its “intrinsic value” or its true worth, it was indeed a bargain. But if it continues downward or stagnates, the market value was basically a true reflection of its intrinsic value.
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The Takeaway
There are a number of key terms, indicators, tools and tips that can help potential investors learn to evaluate a stock and its company’s performance. Investors can review a company’s balance sheets, and forms 10-Q and 10-K to get relevant information about a company’s financial performance and outlook.
Investors looking to evaluate stocks should also be familiar with certain ratios, which can indicate earning potential, debt, and dividend performance, among other indicators that can signal the health of the company and the stock.
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FAQ
What is the difference between price-to-earnings ratio and price-to-sales ratio?
The difference between price-to-earnings ratio and price-to-sales ratio is that P/E ratios compare a company’s share price to its annual profits, and P/S ratios compare share price to annual revenue.
What are some online financial tools that can help me screen and compare stocks?
There are numerous online stock screeners, market simulators, and comparison tools that can be found online, and investors who are interested can try them out to see which they prefer.
How far back should you go when evaluating stocks?
Investors may want to go back a couple of decades when evaluating stocks, as too short of a time frame may not provide enough context, and too much may not prove helpful. But ultimately, it’ll be up to personal preference.
What are some factors that can affect the stock price of a company besides its financial performance?
Stock values can be influenced by any number of factors, including changes to the economy, political changes in a given country, and even things like bad weather.
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