How Do I Evaluate A Stock? (Part One)
Have you ever wanted to be able to actually read the stock tables in the newspaper or online? Ok, maybe it is just me but here is your chance! Everyone has their own methods of evaluating which stock to buy but there are some fundamental ratios or methods that most, if not all, people in the industry would use to evaluate a stock before buying. Obviously, there are tons of higher mathematics that I am sure the experts use to crunch various numbers but that is way beyond us not in the finance industry.
Here are some basic evaluating tools that can get us started on our evaluations and are commonly found on the stock tables.
I will cover five tools in this post, six in Part Two and then some other miscellaneous factors in Part Three.
1. Price of the stock as compared to its earnings (P/E):
What is it? You will want to buy a stock that is earning and making money. Companies that are making lots of money and doing well are likely going to have stock that costs more. This is not necessarily a bad thing as it may mean the company is doing well and is on track to continue to do well. The P/E ratio takes the price of the share and divides it by the company’s earnings per share. You can figure out this ratio yourself using the company’s financial statements but to save yourself a great deal of time and effort, you should be able to find out the P/E (and all other ratios) online. You may find one that works best for you (Google Finance, The Globe and Mail, Yahoo Finance, etc.) but the one I have found that contains the most information is Morningstar. You just need to search the company name or stock symbol (for example, Amazon’s is AMZN) and generally will use the Key Ratios and Valuation tabs.
What does it mean? Different industries have different P/E ratios and that is not a bad thing. You will want to use the ratio to determine if the stock is under or overpriced within the same industry or sector. Generally, but not always, a lower P/E number is better because it suggests you are not overpaying for the stock relative to its earnings. For example, if two companies in the same industry are both selling for $50 per share, one might be a better buy once we consider the P/E ratio. For example, if Company X has earnings per share of $10 and a P/E of $5 and Company Y has earnings per share of $20 and a P/E of 2.5, Company Y may be the better buy all things considered. For the same price of $50 per share, you will be getting $20 of earning power as opposed to $10. (Again, all of this information will be available already calculated once you search the company on whatever online tool you decide to use).
On the flip side though, a higher P/E is not always bad as the P/E may be higher because investors are anticipating the company to pick up and earnings to increase so investors are willing to pay higher now to get into the stock. You should compare to other stocks in that industry or sector to get a better idea of what the P/E of your particular stock means.
2. Dividend Yield:
What is it? As discussed on my Investing in the Stock Market post, a dividend is a share of a company profit that the company may dole out to you on a regular basis. It is almost like an interest rate paid on your investment by the company. Typically, smaller companies that are focused on growing do not pay a dividend and instead reinvest the cash to continue growing. Large, established companies are more likely to pay a dividend. The dividend yield of the company is determined by taking the annual dividend amount and dividing it by the current stock price. So, if a company pays $1 every quarter (that means every four months or one quarter of the year), its annual dividend is $4. If the stock price is $50, the dividend yield is $12/$50= 0.08.
What does it mean? If the stock price goes up and the annual dividend stays the same, the dividend yield number goes down. If the stock price goes down and the annual dividend stays the same, the dividend yield number goes down. The dividend yield for most investors is a symbol of how stable a company is as in most cases, large, stable companies are the ones able to pay an “interest rate” on your investment. Further, if the company has paid out a dividend for some period of time, that is usually seen as a sign of stability and a safer bet than other companies. A higher dividend yield is most likely preferable but that can also mean the company is a greater risk. Whereas a lower dividend yield can symbolize a more stable company with a long history of dividend payouts.
3. Earnings per share (EPS):
What is it? This ratio calculates the net income (income after all expenses are paid) available to common shareholders of the company (you and I) and divides that by the number of shares outstanding. This is a main evaluation tool because it focuses on earnings or how well a company is actually doing! A company’s earnings can be manipulated by various accounting practices to appear higher than they are so beware of that potential issue.
What does it mean? By and large, the larger the EPS number, the more likely it is that the company is earning well and that means it may be a good company in which to invest money. Historical EPS data can be found online as well and you can see how the company has been performing in years past to get an idea if it is growing or not. If the EPS number is increasing, that is a good sign. The EPS tells us how much we are actually making on our shares.
What is it? Revenue is the gross income of a company before any deductions, like expenses, are made.
What does it mean? This figure is an intuitive number to evaluate a company because it is fairly simple- if revenue is increasing, the company is likely growing and the stock price is more likely to increase in value along with that revenue growth. If revenue is decreasing, this may be cause for concern. Revenue figures can also be found on the online tools.
5. Return on Equity (ROE):
What is it? This ratio takes the annual net income of the company and divides it by the average shareholders’ equity. You should be able to find this done for you online again at Morningstar (search "[stock ticker symbol] and ROE") or through some other free online tool.
What does it mean? Many investors closely study the ROE of a company to determine what type of return the company is providing to the shareholders based on the amount of equity (or shareholder money) in the company. How much profit is the company really making with all that money the shareholders (i.e. you and I when we buy a stock) have put into the company? Again, if the ROE is increasing, that is a good sign.
Look for the other six tools in my next Post!
*top photo courtesy of Matheus Bertelli via Pexels