If you do enough research and make smart choices, investing is often a great way of earning passive income and saving for the future. On the other hand, it can be tough to find stocks that will not only help diversify your portfolio but keep performing well over time. Not sure which stocks you should invest in, here are some factors you can use to evaluate a stock.
What Is A Stock?
A stock is a single share of a company that’s available for purchase. Once you buy a stock, you own a small portion of the company and now have a stake in its business. Your percentage of ownership is calculated by dividing the number of shares that you own by the total number of remaining shares, then multiplying that result by 100.
Example:
- You own 1 share of a company that has 5,000,000 shares in total.
- 1 ÷ 4,999,999 = 0.0000002(% of that company).
After you buy shares of a company, you (the stockholder) also get to earn income from any dividends payouts and have voting rights when it comes to certain corporate issues.
How To Evaluate A Stock?
Stocks are generally considered risky and are classified as long-term investments. It’s usually recommended that you only invest money that you won’t need for at least 3 to 5 years. This should help you deal with any significant changes in the stock market. While there are several ways you can evaluate a stock, some of the primary elements to look at are its ratios:
EPS is calculated by dividing a company’s earnings by its tradable shares. This shows the profitability of its outstanding common shares. The more profitable the company is, the higher its EPS will be and the more potential dividends it can pay investors later on.
How To Calculate An EPS Ratio
- A company’s net income is $400,000
- It also has 35,000 shares and pays preferred shareholders $50,000 in dividends
- Formula: (Net Income − Preferred Dividends) ÷ Outstanding Common Shares
- $400,000 – $50,000 = $350,000 ÷ 35,000 = $10 per share/EPS
EPS has limitations, as it doesn’t show how companies use their capital or what kinds of liabilities they have. Companies will often reinvest the earnings into the business or pay them to shareholders as dividends. EPS can also be ‘diluted’, wherein all convertible securities and shares are evaluated to determine the total shares in the denominator.
Price-To-Earnings (P/E) Ratio
P/E ratios show what investors are willing to pay for every $1 of a company’s earnings. There are two ways to assess this. To calculate a company’s “trailing” P/E ratio, divide its stock price by its EPS (typically from the past 12 months). To calculate its“forward” P/E ratio, divide its stock price by its forecasted earnings according to Wall Street.
How To Calculate The P/E Ratio
- A company has a stock price of $50 and an EPS of $4
- Formula: Stock Price ÷ Earnings Per Share
- $50 ÷ 4 = 12.5 (investors agree to pay $12.5 per $1 of the company’s earnings)
Most Wall Street analysts use a P/E ratio of 15 – 20 to evaluate a stock’s desirability. A P/E ratio above 20 is pricey and a ratio under 15 is cheap. A high P/E ratio often means the company is experiencing a boom in value, making their stock desirable. That said, EPS ratios aren’t completely accurate and analysts may only offer short-term forecasts.
Price-To-Book (P/B) Ratio
Also known as P/B, price-to-book ratios are useful because they show the value of a company if it were sold. Businesses in mature industries often struggle to maintain growth but are still valuable in terms of their assets. Essentially, a P/B ratio measures the value of a stock by comparing its market price per share to its book value per share.
A company’s book value can include real estate and other sellable assets, like stocks and bonds (intangible assets are excluded). P/B ratios under 1 are usually considered undervalued and ratios above 1 are overvalued. P/B ratios can vary between industries but, for the most part, you’ll receive a better return from stocks that have lower ratios.
How To Calculate The P/B Ratio
You can use either of these formulas to calculate a company’s P/B ratio:
- Market Capitalization ÷ Net Assets OR Price Per Share ÷ Net Book Value Per Share
The P/B ratio formula is composed of these calculations:
- Market Capitalization = Market Price Per Share × Total Outstanding Shares
- Book Value Per Share = Net Assets ÷ Outstanding Shares
- Net Assets = Total Assets − Total Liabilities (as seen on company balance sheets or statements of financial position).
Debt-to-Equity (D/E) Ratio
D/E ratios can help evaluate a company’s financial leverage, since they tell you how much debt it has in relation to its equity. If their D/E ratio is higher than 1, it’s because the company is using more debt than equity to fund its business (or vice versa).
How To Calculate The D/E Ratio
To calculate a company’s D/E ratio, divide its total liabilities or debt by its total equity.
- A company has $300,000 of shareholder equity but $100,000 of outstanding debt
- $300,000 ÷ $100,000 = 3 (the company has a 3:1 D/E ratio)
Price/Earnings To Growth (PEG) Ratio
The PEG ratio is a slightly more complex factor. It builds upon the P/E ratio by taking into consideration expected growth in earnings and not just current earnings. Using a combination of stock prices, EPS and expected annual growth rate, PEG helps a company adjust for the implicit bias that the P/E ratio has for fast-growth businesses.
Since a company’s forecasted and actual growth rates aren’t always the same, PEG ratios have limitations of their own. Plus, they may not accurately assess the value of large companies with solid dividends but slow growth (which can be incorrectly labelled as “overpriced”). Otherwise, here’s how a company’s PEG ratio works:
- PEG ratio of 1 = The company’s stock is fairly priced
- PEG ratio above 1 = The company’s stock is expensive/overvalued
- PEG ratio below 1 = The company’s stock is cheap/undervalued
How To Calculate The PEG Ratio
It’s calculated by dividing a company’s P/E ratio by its expected annual growth rate.
Example:
- A company has a P/E ratio of 20
- It also has an expected annual growth rate of 40% over the next 5 years
- Formula: (P/E ÷ Annual EPS Growth)
- 20 ÷ 40 = 0.5
What Does A Company’s Dividend Yield Say About A Stock?
Traders mainly make income from investments through capital gains (income made by selling stocks for more than they paid) and through dividend payouts (from profits made on company investments). In fact, many investors often look for stocks with high dividend payouts.
As such, many investors use a measurement called ‘dividend yield’ to evaluate a stock, because it gives them the estimated yearly payout/return they would receive on that investment.
Do note, dividends aren’t 100% accurate and can vary by industry. However, there are a couple of key takeaways you can get from evaluating a stock’s annual dividend yield, such as:
- The higher the dividend yield is, the more valuable the stock normally is.
- Avoid stocks with histories of inconsistent dividends or suspended payments.
- Older companies often pay higher dividends than new ones, since managers can afford to reinvest their earnings back into the business, promoting growth.
- A steadily rising dividend yield could mean that a company’s stock price is falling, which is frequently a sign of the company’s internal financial turmoil.
How To Calculate Dividend Yield
This formula measures the annual dividend yield of a stock (shown as a percentage):
- Annual Dividend Per Share ÷ Current Stock Price Per Share
Example:
- A company gets paid a total annual dividend of $5 per share
- Its stock presently trades at $25 per share
- $5 ÷ $25 = 0.2 or 20% dividend yield
What Is A Dividend Payout Ratio (DPR)?
A dividend payout ratio measures the amount of dividends a company will pay its shareholders after taxes. Some businesses hold onto their stock earnings, others will pay out a portion of them in dividends or use them to buy back unclaimed shares.
The higher the DPR, the more desirable the stock. That said, even companies with high DPRs can’t guarantee those levels in the long-term. If a company’s DPR falls, so will its stock prices. Mature companies often have higher ratios, while new ones may have less sustainable DPR levels as a large portion of their earnings are tied up in the growth phase.
How To Calculate The DRP
You can use either of these formulas to calculate a company’s DPR into a percentage:
- (Total Dividends ÷ Net Income) × 100% OR (Dividends Per Share ÷ Earnings Per Share) × 100%
Example:
- A company’s net income is $75,000 after taxes
- It also pays out $30,000 in dividends
- $30,000 ÷ $75,000 = 0.4 or 40% DPR
What To Look For In A Company’s Financial Statements
Analysts use numerous factors to measure the value of a stock, including:
- Company Profitability – First, the company’s financial statements and quarterly results are examined. This helps determine its current and future profit margins.
- Debt Levels & Liquidity – Next, stock analysts will review the company’s assets, liabilities and liquidity position (its ability to meet short-term financial obligations).
- Other Details – Analysts may also base their decisions on commentaries from the company’s managers, as well as market information from its peer group.
When combined with the ratios above, a company’s financial statements give stock analysts a much better idea of how its investments will perform over time. Since those ratios aren’t 100% accurate, analysts just use them to compare companies and gain exposure to multiple sectors. In turn, it may be smarter than investing in a single industry.
What Does The Stock’s Beta Mean?
A stock’s ‘beta’ is used to evaluate its volatility or the fluctuations of its prices/returns compared to a particular market (also called a ‘benchmark index’). It’s calculated by analysing the regression of a stock’s returns data and representative index:
- Beta value lower than 1 – the stock is less volatile than the benchmark index
- Beta value higher than 1 – the stock is more volatile than the benchmark index
- Beta value of 1 – the stock’s price/return correlates with the benchmark index
For example, a company with a stock beta of 0.70 means their stock price/return is 30% less volatile than the market/benchmark. Stocks with higher beta levels tend to be riskier than lower-beta stocks as they produce a higher volatile return.
Then again, higher-beta stocks can yield greater returns under the right circumstances (they can result in severe losses too). So, if you’re looking for a risk-free stock, assets like cash and treasury bills have zero beta.
Stock Evaluation FAQs
What are stock value traps?
- Tech company stocks being commoditized (becoming less essential)
- Pharmaceutical company stocks based on patents that are due to expire
- Cyclical company stocks that are at the peak of their cycle
Can a company’s financial statements help me choose a stock?
How do you know if a stock is worth buying?
Bottom Line
If you’re unsure about a stock, it may be a good idea to speak with a financial advisor or stock analyst, so you can get the most input possible. Investing is sometimes a risky endeavor, especially if you don’t evaluate a stock before you buy it. Remember, when it comes to any financial matters like the stock market, you can never have too much knowledge.
