How Do I Evaluate a Stock? (Part Two)

See Part One for the first five evaluating tools.  Here are six other tools.  This list is not exhaustive but is a good start for beginners to get into the evaluation of stocks. 

1.     Market Capitalization:

What is it? This is the value of the company’s stock.  It is measured by taking the company’s current stock price and multiplying it by the shares outstanding.  Companies are generally categorized into large cap (approx. $5 billion or more), medium cap (approx. $1 billion to $5 billion) and small cap stocks (approx. $250 million to $1 billion). 

What does it mean? Large cap stocks are generally the safest investments as they are major global companies that have a stable customer base.  Medium cap companies often provide both growth and safety.  These may be a good option if you want to take on some risk.  Small cap stocks are often start-ups and new companies with the potential for a lot of growth.  These are exciting stocks to invest in as if the growth occurs, the returns can be large. 

2.     Net Profit Margin:  

What is it? This calculation looks at how much of the money the company has made is actually kept as net income (revenue less all the costs of doing business).   

What does it mean? This ratio is a good indication of how the company is doing overall and how efficient it is with respect to addressing its expenses.  A high net margin ratio amount indicates that the management team at the company is able to do a lot with the money it has made and keep its costs in good control.  A high net profit margin is a good sign but it is most useful when comparing companies across the same sector or industry as those companies will have similar inputs and cost outputs. 

3.     Cash flow per share

What is it? While EPS (discussed in Part One) measures the earnings the shareholder makes on their shares, cash flow per share is often a better indicator of the company’s financial strength.  The ratio is (Operating cash flows- preferred dividends) / (Average outstanding common shares). 

What does it mean? A higher value indicates a company that is likely in a healthier position.  This ration may be a bit more difficult to find online but it should be out there.  Check The Wall Street Journal as it appears to have a great deal of analysis information on stocks on their site.

4.     Price to Sales (P/S)

What is it? Price to sales is a ratio that is calculated by dividing stock price by the revenue per share.  “Normal” values vary across industries so you will want to consider this with regard to an industry or sector.  This is often a good ratio to consider because it is more difficult for a company to manipulate their sales data so it can give you a good indication where a company is at in terms of sales and overall health.  It can also be good as a valuation tool for those companies that are young and may have negative earnings or cash flow.  Indeed, that is where this ratio may be most helpful.    

What does it mean? The lower the ratio relative to its peers in the industry may indicate a good value investment opportunity.  It means that the investor is paying less money for each unit of sales the company is making.  The price to sales ratio should be considered along with a company’s net profit margin for a clearer picture of the company. A high net margin would account for a higher price to sales ratio and that is a good thing, not a bad thing so in those instances, a lower number may not be the best thing. 

5.     Price to Book (P/B):

What is it? This ratio compares the market price of the company (its market capitalization) to its book value (the value of its assets according to its balance sheet account balance).

What does it mean? A low P/B ratio is generally more favourable as it can indicate an undervalued stock however it could also indicate a company with some other issues.  Jason Kelly in The Neatest Little Guide to Stock Market Investing indicates that if the P/B ratio is less than 1, it means you are paying less for the stock than its sell off or bankrupt value.  That means if the company does go bankrupt, you should still get your money back (of course that is in theory!).  If the ratio is great than 1, you are paying more than the stock’s sell off or liquidation value.  So the lower the better generally.

This ratio also varies a great deal by industry so pay attention to that aspect.  For example, many extremely successful companies particularly tech companies such as Google may have a high P/B ratio because their assets are more intangible (brand recognition, intellectual property (IP)) but are obviously still profitable, good companies.   

6.     Price to Cash Flow (P/CF):

What is it? This ratio compares a company’s market value to its cash flow.  It is the market capitalization divided by the company’s operating cash flow in its most recent year. 

What does it mean? Generally, the lower the ratio, the better value.  As an example, if two companies are both selling at $50 per share and one company has cash flow of $10 per share and the other is $12 per share, the one with the higher cash flow and lower ratio is the better stock using this metric ($50/$10= 5 v. $50/$12=4.2).  This smaller ratio amount may indicate a company that is obtaining large cash flows that is not yet reflected in the stock price which would be a good buy. 

Between Part One and Part Two of my posts, we now have a significant arsenal of tools to begin evaluating stocks and we should be able to now read those infamous stock tables!  Obviously, this is starting point as there are so many factors and other information you will need to factor into a complete evaluation but this is an excellent start.  In my first company profile post, we can work though these together and see if there is anything else we want to add to the analysis.  Part Three also will provide us with some less mathematical factors to consider. 

Full book cite-- Kelly, Jason. The Neatest Little Guide to Stock Market Investing. New York: Penguin Group, 2012. Print   

*top photo courtesy Kaique Rocha via Pexels