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Stocks
Evaluating Potential Stock Investments
By Roger Wohlner
CERTIFIED FINANCIAL PLANNER™ Practioner, Asset Strategy Consultants
With thousands of stocks to choose from, developing a systematic approach to evaluating stocks can make it easier to make your selections. The first step is to narrow the options from the thousands of possible choices to ones most likely to meet your objectives. That typically involves screening companies based on criteria important to you. For instance, if you are interested in growth stocks, you might look for earnings growth over a certain percentage. Or for value stocks, you might look for companies with low price/earnings ratios or low price-to-book values.
Once you've narrowed the list, evaluate each company's financial information, comparing it to industry and market information. Some factors to consider include:
Historical prices
It's often useful to review a stock's historical prices and trading volume for at least a one-year period. This gives you a feel for price volatility, the pattern of the stock's movements, and how much interest investors have in the stock.
Earnings per share (EPS)
EPS equals the company's net income after taxes divided by the average number of common shares outstanding. You'll typically want to look for companies with steadily increasing EPS.
Price/earnings (P/E) ratio
This equals the company's share price divided by earnings per share, and is generally considered indicative of how the market values a stock. Review the company's historical P/E ratio, the P/E ratios of other companies in similar industries, and the P/E ratio of the market as a whole. Typically, companies with higher growth rates command higher P/E ratios.
Return on equity (ROE)
ROE equals the company's net income divided by shareholders' equity and is viewed as an indicator of how well a company utilizes shareholders' money.
Price-to-book value
This ratio is calculated by dividing share price by book value, which equals a company's assets less its liabilities, per share. This ratio is typically relevant when evaluating companies with significant assets. Companies with low price-to-book values are often viewed as value stocks.
Price-to-cash-flow ratio
This ratio equals a company's share price divided by cash flow per share. Cash flow equals earnings plus depreciation, amortization, and other non-cash expenses. This ratio can be helpful when evaluating companies with significant noncash expenses.
Price-to-sales ratio
This is calculated by dividing share price by annual sales per share and can be useful when evaluating companies with little or no profits.
Payout ratio
This ratio is calculated by dividing dividends per share by earnings per share and indicates the percentage of profits the company is distributing to shareholders.
PEG ratio
This ratio equals a company's P/E ratio divided by its expected earnings growth rate and is generally useful when evaluating growth stocks.
The decision to purchase a stock can't be made solely from a review of financial ratios. You should also evaluate subjective factors, such as the quality of management, prospects for the company's industry, and where the company stands in relation to competitors.
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