How to Evaluate a Stock
When you begin stock trading, it’s important to understand how to determine a stock’s value before you invest in it. This is because your potential for gains depends on the growth and performance of the companies you’re investing in. To effectively evaluate stocks, there are several aspects of a company’s value — and therefore stock value — that you’ll need to keep in mind. We’ll cover what to look at when valuing stocks and how to evaluate stocks through a process that can help you learn more about the securities you’re trading.
Here are several key takeaways from this guide:
- Evaluating stocks is highly important for making profitable trading decisions, including deciding whether a specific stock is going to be worth investing in.
- The best way to evaluate stocks consists of several steps that look at both qualitative and quantitative aspects of a company. Quantitative factors will give you financial information about a company, including its potential growth and profitability,
- Qualitative factors are equally important when learning how to evaluate a company stock. Several of these aspects include consumer market, industry, and comparison with competitors.
Why Is It Important to Learn How to Evaluate a Stock?
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When you purchase a stock, you’re not just investing in a paper contract; you’re investing in a company and its future growth and performance. The stocks you purchase are your owner’s shares of the companies you invest in, and the company stocks you buy and sell are only as profitable as the company.
The key to identifying which stocks are worth buying — that is, the stocks with the most potential to earn you a profit — is to evaluate the stock’s value before purchasing it. This way you’ll have up-to-date information, like financial data and performance history, of the company stocks you’re thinking about trading.
Learning how to evaluate stocks is essential in the long run if you want to have the best advantage of finding and trading profitable stocks.
How to Evaluate a Stock
Typically, traders evaluate stocks by looking at both quantitative and qualitative information about a company. This includes different factors like a company’s profit, consumer market, industry, and financial structure. The steps below outline the overall process traders generally go through to evaluate a stock’s value:
1. Research the Stock Company’s Financial Data
Start evaluating stocks by finding the financial information about the companies you’re purchasing shares of. The SEC makes regular financial documents available to the public to disclose the performance of companies and corporations, and it’s these documents you’ll want to take a look at. Several key financial documents you’ll want to research include:
- Company income statements: A company’s income statement is useful for reviewing its revenue, net income, and expenses.
- Company balance sheets: Company balance sheets can tell you what the company’s debt, or liabilities, look like. For instance, this financial document can tell you whether the company reduced or increased any debt it has, giving an indication of its overall performance.
- Company cash flow statements: Cash flow statements include income that’s not realized on income statements or balance sheets and can give you insight into what the company actually earned during the time period rather than projected earnings.
These documents give traders an insight into how a company generates cash flow through normal business operations instead of through one-time payments or an unlikely influx of revenue.
2. Look at These Key Measures of a Stock Company
When you’re looking into the financial documents of a company, it’s helpful to understand several important financial performance ratios that can give you even more information about a company’s financial status and future health. These financial data are also useful for comparing companies to competitors within the industry or against others within a market.
- Price-to-earnings ratio (P/E): The P/E ratio tells traders how company stocks compare to each other. The P/E ratio takes the market value of a stock and divides it by the earnings per share. It can be used to determine how long it will take for a given company to generate enough cash flow to buy its stocks back.
- Price-to-sales ratio (P/S): Traders look at the P/S ratio as a way to value companies that haven’t earned profits yet or have low profit levels. This ratio comes from dividing a company’s market capitalization (market cap for short) by its revenue. The company’s market cap is the dollar value of all of its outstanding shares, or a P/S ratio as close to one as you can get for potential profit on your investments. If the P/S ratio is less than one, it’s considered by traders to be excellent.
- Earnings per share (EPS): EPS gives insight into how much in earnings shareholders might receive if a company gets liquidated suddenly and immediately. Traders generally look for increasing earnings because a rising EPS indicates whether a company may have more money to disperse to its shareholders. You can calculate a company’s EPS by subtracting any preferred dividends from the net revenue and dividing this value by all of the company’s outstanding shares.
- Return on equity (ROE): ROE gives information about a company’s profit growth overall and can tell you how much you would receive as a shareholder if the company immediately liquidates. To get the ROE, divide the company’s net revenue by shareholder equity then multiply this result by 100. The result is the company’s ROE.
- Debt-to-equity ratio (D/E): D/E ratios tell investors about how much a company depends on debt for funding its business operations. The D/E ratio is calculated by dividing the total debt of a company by the total amount of equity shareholders have in the company. A higher D/E ratio can indicate that a company takes out debt frequently for funding.
- Debt-to-asset ratio (D/A): Traders use the D/A ratio to compare the amount of debt a company has against other companies within the same industry. This information is useful for gauging risks associated with specific stock investments. Since too much debt can be a red flag for traders evaluating company stocks, the D/A ratio is important for assessing whether a company takes on a reasonable debt load.
3. Monitor Both the Company’s and the Stock’s Performance
In addition to researching the financial information about a company to value its stock, it’s helpful to stay updated on the overall performance of the stocks you’re investing in. If you use a brokerage service, you can speak with a stockbroker for advice on the current market activity, your stocks’ performance, and other information.
You can take advantage of financial resources like news websites that give you current and real-time information on stocks you own and stocks you’re researching to buy. Financial tools like stock screeners and stock charts are useful for staying up to date on movements in the market and overall stock performance.
You could also use these resources and trading tools to help you monitor your portfolio’s performance, along with the financial information you find through the SEC. However, it’s essential to watch both the company’s overall financial and market performance and the individual performance of the share you’re investing in.
4. Research Qualitative Factors That Can Affect the Value of a Stock
Quantitative research of company stocks provides a clearer picture of how a given company operates, what its objectives and values are, and how it attracts customers. Since purchasing a stock means you’re a shareholder and have a stake in the company, it’s crucial to look at these aspects and others when valuing a company stock. Here are several considerations investors tend to make when purchasing stocks:
- Look at how the company makes its money. While it might seem obvious, like an apparel outlet that makes its profits selling clothes, it’s not always so clear-cut with some companies. For example, a company could generate most of its revenue from providing customer financing where interest gets included.
- Find out whether there’s a competitive advantage for the companies whose stocks you’re investing in. This means you’ll look for indicators that make the company difficult to match for other competitor companies. This could be information about the company’s business model, brand, innovative approaches, or other aspects that would give it an edge over others in the industry.
- It’s also important to assess potential risk factors to the companies you’re investing in, especially if you’re long-term investing. This means figuring out what potential challenges a given company could face down the road that would affect its growth and profitability. An example would be if a company starts to adopt a completely new and different business model or if it loses its competitive advantage.
- Take a look at how the leaders of the company move it forward. In addition to financial documents, you can usually find transcripts from company board meetings and yearly reports that can prove beneficial in gaining insight into how the management teams run the business.
These qualitative aspects of a company’s operations and performance are highly useful for investors and traders evaluating company stock. With the combination of these and the hard data concerning your investment interests, you can have a solid foundation for starting your evaluation of a stock’s value.