If you’ve never bought or sold stocks, trading for the first time might be daunting. But once you’ve done your homework and have developed the proper habits, it’s not nearly as intimidating.
One of the critical skills to learn is how to evaluate a stock. Some ground rules can help educate and empower you to choose stocks for your portfolio.
Getting Started with Stock Evaluations
You’re not buying a piece of paper when you buy a stock. 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 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 that will go a long way toward helping you select stocks for your portfolio.
The more you know about the company, industry, and general stock market trends, the better. Professional advice is essential, 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?
KEY TAKEAWAYS
- Stock trading doesn’t necessarily benefit from a passive “set it and forget it” strategy.
Also, stock trading doesn’t necessarily benefit from a passive “set it and forget it” strategy. It’s essential to assess your tolerance for risk before investing and check in on that periodically. Additionally, review your stocks’ performance and watch the market regularly.
Finally, when considering how many stocks to buy, most investors keep portfolio diversification in mind, with stocks across various sectors and risks. Being invested in only one stock means that if the company fails, you could lose your invested money.
What Determines Stock Value?
With the above guidelines in mind, the next step is to dig deeper to calculate stock value. These are three ways to evaluate stocks.
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 affecting performance, expenses, and other essential information that will help gauge a company’s health.
Consumers can find these and other reports on SEC.gov:
Balance sheet: This records whether the company reduced or increased its 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, significant expenses, and bottom-line income may reveal company profitability trends.
Cash flow statement: Not all income is realized, so the cash flow statement shows you what the company 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 the following:
• 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 (EBITDA): This figure excludes non-operating expenses
Form 10-Q
While publicly traded companies tend to release their 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.
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 helpful to investors as it provides a comprehensive overview of the company’s performance for the previous three months. The 10Q 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
KEY TAKEAWAYS
- Financial performance ratios offer insight into a company’s financial health.
Form 10-K is similar to form 10-Q but comes annually instead of quarterly. 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 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.
Financial Ratios to Help with Stock Evaluation
If learning how to evaluate a stock starts with analyzing financial statements, step two is understanding financial performance ratios. Ratios offer insight into a company’s financial health, allowing for comparisons to companies in the same industry or against the overall market.
These are critical financial ratios to know.
Price-to-earnings ratio (P/E)
This stock valuation formula will help you determine how one company’s stock price compares to another. The price-to-earnings ratio is straightforward: It divides a company’s market price by its 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. 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. 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.
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 more prominent 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 of around 90.
Price-to-sales ratio (P/S)
The price-to-sales ratio divides the company’s market capitalization by revenue and doesn’t factor in a profit. This helps value companies that haven’t made a profit yet or have a low-profit level. The P/S should be as close to one as possible. If it’s less than one, it’s considered excellent.
Earnings per share (EPS)
Earnings per share (EPS) tell investors how much earnings each shareholder would receive if the company were 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 preferred stock dividends, and dividing the result by the total number of outstanding common stock shares.
Return on equity (ROE)
Return on equity is crucial for investors to measure a company’s profit growth. 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 relies 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 comparing it with other industry companies. 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 a D/E ratio 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 gauge the riskiness of the investment better. Too much debt can be a warning sign for investors.
Quick Tips for Evaluating Stocks
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.
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: From the Wall Street Journal and Bloomberg to Food Business News (useful if one is investing in food stocks), there are dozens of top, investor-trusted sites to help you learn how to calculate stock value.
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. Several free stock screeners are available to everyone, including FINVIZ, Zacks, StockCharts, and the Motley Fool, although some charge a subscription fee for higher service levels.
Company Details: Research more than just the financial facts and figures. Please find out how it makes money, its core values, CEO performance, and more. Information can be gleaned from reputable news and business media sites for articles and features about the company and its leaders.
The Takeaway
Several vital terms, ratios, tools, and tips 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 specific ratios, which can indicate earning potential, debt, and dividend performance, among other indicators that can signal the health of the company and the stock.
Once investors get serious about stock trading, it can also be helpful to dedicate an account for stock trading so that their stable finances are not commingled with their investment savings.
Note: ZPEnterprises is not a licensed investor/financial advisor, but we are trying to share awareness of financial topics. Please do further research and work with a licensed financial advisor.
