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 while minimizing risk. That’s why it’s so important to make sure you thoroughly and carefully evaluate a stock before investing.
Key Points:
- Buying a stock means you’re purchasing a small share of a company.
- Several metrics are used to evaluate a stock, including various ratios that determine a stock’s risk and potential return.
- Always consider a company’s financial health before investing in its stocks.
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, and then multiplying that result by 100.
Example:
- You own 1 share of a company that has 5 million shares in total
- 1 ÷ 4,999,999 (remaining shares) = 0.0000002 (% of that company)
After you buy shares of a company, you (the stockholder) also get to earn income from any dividend payouts (if applicable) and have voting rights when it comes to certain corporate issues.
Are Stocks A Risky Investment?
Stocks are generally considered risky and are classified as long-term investments. It’s usually recommended that you only invest money that you can tolerate losing.
So, it’s wise not to use your retirement savings or college fund for your kids, for instance, to invest in stocks. This should help you tolerate any significant fluctuations in the stock market.
How To Evaluate A Stock?
There are several key ratios to look at to effectively evaluate a stock:
Earnings Per Share refers to how much profit each outstanding share of common stock has earned, which shows a company’s profitability. It is calculated by dividing a company’s earnings by its tradable 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
The formula for calculating an EPS ratio is as follows:
(Net Income − Preferred Dividends) ÷ Outstanding Common Shares
To illustrate, let’s say a company’s net income is $400,000. It also has 35,000 shares and pays preferred shareholders $50,000 in dividends. Let’s plug these figures into the above formula:
($400,000 – $50,000) ÷ 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.
Generally, a healthy company is one that has a long and short-term trend of steadily growing EPS, without surprise fluctuations.
Price-To-Earnings (P/E) Ratio
Price-To-Earnings ratios show what investors are willing to pay today 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
The formula for calculating a P/E ratio is as follows:
Stock Price ÷ Earnings Per Share
To illustrate, let’s say a company has a stock price of $50 and an EPS of $4. Let’s use these figures using the above formula:
$50 ÷ 4 = 12.5
In this case, investors agree to pay $12.50 per $1 of the company’s earnings.
Most Wall Street analysts use a P/E ratio of 15 to 20 to evaluate a stock’s desirability. A P/E ratio above 20 is pricey, and a ratio under 15 is cheap. However, this can vary depending on the company’s industry or sector.
A high P/E ratio often means the company is experiencing a boom in value, making its stock desirable. That said, EPS ratios aren’t completely accurate and analysts may only offer short-term forecasts.
Price-To-Book (P/B) Ratio
A Price-To-Book ratio measures the value of a stock by comparing its market price per share to its book value per share. This ratio is useful because it shows the value of a company if it were sold and liquidated completely. Businesses in mature industries often struggle to maintain growth but are still valuable in terms of their assets.
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
Debt-to-equity 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, use the following formula:
Total Liabilities ÷ Total Equity
To illustrate, let’s say a company has $300,000 of shareholder equity and $100,000 of outstanding debt. In this case, the formula would be as follows:
$100,000 ÷ $300,000 = 0.33
Price/Earnings To Growth (PEG) Ratio
The Price/Earnings To Growth 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-growing businesses such as technology and consumer discretionary companies.
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
A PEG ratio is calculated by dividing a company’s P/E ratio by its expected annual growth rate:
P/E ÷ Annual EPS Growth
For instance, let’s say a company has a P/E ratio of 20 and an expected annual growth rate of 40% over the next 5 years. The formula would be as follows:
20 ÷ 40 = 0.5
What Does A Company’s Dividend Yield Say About A Stock?
Traders mainly make income from investments through the following:
- Capital gains — Income made by selling stocks for more than they paid)
- Dividend payouts — Profits made on company investments
In fact, many investors often look for stocks with high dividend payouts, which serve as a regular income stream for investors.
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 that 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.
When considering dividend stocks, it’s essential not to buy solely for the dividend yield. It’s important to remember that, all else being equal, a stock’s price typically drops by the amount of the dividend on the ex-dividend date.
This decrease reflects the payout leaving the company, underscoring that dividends are not “free money” but rather a distribution of earnings that could have been used elsewhere within the company.
Thus, while dividends can be a valuable part of an investment strategy, they should not be the only reason for your investment decision.
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
For example, let’s say a company gets paid a total annual dividend of $5 per share, and its stock currently trades at $25 per share. The calculation would be as follows:
$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, while 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% |
For example, if a company’s net income is $75,000 after taxes and pays out $30,000 in dividends, the DPR would be calculated as follows:
$30,000 ÷ $75,000 = 0.4 (or 40%) DPR
A sustainable payout ratio (typically under 75% for most industries) indicates that the company can comfortably afford its dividend payments without compromising its financial stability.
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 And Liquidity – Next, stock analysts will review the company’s assets, liabilities, and liquidity position (its ability to meet short-term financial obligations).
- Risk factors: Analysts thoroughly examine potential risks that could impact the company’s performance and stability, including market volatility, regulatory changes, competitive pressures, and operational challenges.
- 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 analyzing 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.
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, though they can result in severe losses, too.
What Are Stock Value Traps?
Although cheaper stocks might appear cost-effective on the surface, they can actually be the result of a company struggling financially. That’s why these stocks are often referred to as ‘value traps’.
Common examples of stock value traps include the following:
- Tech company stocks being commoditized (becoming less essential)
- Pharmaceutical company stocks based on patents that are due to expire (this is called a “patent cliff”)
- Cyclical company stocks that are at the peak of their cycle, such as miners and homebuilders.
Final Thoughts
Investing in stocks can be a bit of a gamble, so it’s highly recommended to do your homework before choosing a stock to buy. When you do decide to invest in stocks, be sure to only use capital that you can stand to part with, given the inherent risk involved in stock investing. 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.
