How do you know whether buying a particular stock is a good idea? Or when you should sell shares that you hold? To get answers, first use fundamental research analysis. Second, understand that evaluating stocks is largely about earnings. Third, use numerical measures to evaluate stock values. And fourth, use beta values to compare a stock to similar investments.
Use Fundamental Analysis to Evaluate Stocks
The premise underlying fundamental analysis is that each stock has an intrinsic (or true) value based on its expected stream of future earnings. Most professional stock analysts and investors take this approach to investing as they research economic, corporate, and industry financials. Fundamental analysis suggests that you can identify some stocks that will outperform others. The fundamental approach presumes that a stock’s basic value is largely determined by current and future earnings trends, expected levels of interest rates, industry outlook, and management’s expertise. The aim is to seek out sound stocks perhaps even unfashionable ones that are priced below what they ought to be.
An opposing and minority view on valuing common stocks is advocated by proponents of technical analysis, often newsletter authors. This method of evaluating securities analyzes statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value but instead use charts, graphs, mathematics, and software programs to identify and predict future price movements. Technical analysis has proved to be of little value, although some novice investors may find technical analysts’ logic appealing.
Corporate Earnings Are Most Important
Corporate earnings are the profits a company makes during a specific time period. If a company cannot generate earnings now or in the future, stock market analysts and investors are not going to be impressed. As people reach this conclusion, there quickly will be more sellers than buyers of the company’s common stock, and that will depress the stock’s market price. Here are some numerical indicators of earnings.
Earnings per Share A company’s earnings per share (EPS) is annual profit divided by the number of outstanding shares. It indicates the income that a company has available, on a per-share basis, to pay dividends and reinvest as retained earnings. The EPS is a measure of the firm’s profitability on a common-stock-per-share basis, and it is helpful because investors can use it to compare financial conditions of many companies. The EPS is reported in the business section of many newspapers. In our example, assume that, next year after payment of $9000 in dividends to preferred stockholders, Running Paws had a net profit of $32,000. With 20,000 shares of stock, the company’s EPS would be $1.60 ($32,000 20,000).
Price/Sales Ratio The price/sales ratio (P/S ratio) indicates the number of dollars it takes to buy a dollar’s worth of a company’s annual revenues. The P/S is obtained by dividing a company’s total market capitalization by its sales for the past four quarters. For example, if Running Paws Cat Food Company’s common stock currently sells for $25 per share and 20,000 shares of the company’s stock are outstanding, its total capitalization is $500,000. If company revenues (sales of cat food) were $750,000 over the past year, the stock’s P/S would be 0.67 ($500,000 $750,000). Stock analysts suggest investors avoid companies with a P/S greater than 1.5 and favor those having a P/S of less than 0.75. Many investors ignore the P/S, but it works better than the highly acclaimed P/E ratio in predicting which companies provide the best return, as explained in James P. O’Shaughnessy’s What Works on Wall Stree
Numerical Measures to Evaluate Stock Prices
Several other numerical measures are used to evaluate stock performance. These numbers are readily available to investors on the Internet. Here are some numerical indicators that will help you assess future stock prices.
Cash Dividends Stocks usually pay dividends. Cash dividends are distributions made in cash to holders of stock. They are the current income that you receive while you own shares in the company. The firm’s board of directors usually declares a dividend on a quarterly basis (four times per corporate year), typically at the end of March, June, September, and December. Dividends are ordinarily paid out of current earnings, but, in the event of unprofitable times (low earnings or none), the money might come from cash reserves held by the company. Occasionally, a company will borrow to pay the dividend so as to maintain its reputation of consistently paying dividends. Later profits can be used to repay any funds borrowed for this purpose.
Dividends per Share The dividends per share measure translates the total cash dividends paid out by a company to common stockholders into a per-share figure. For example, Running Paws might elect to declare a total cash dividend of $8000 for the year to common stockholders. In that case, cash dividends per share would amount to $0.40 ($8000 20,000 shares).
Dividend Payout Ratio The dividend payout ratio is the dividends per share divided by earnings per share. It helps you judge the likelihood of future dividends. For example, imagine that Running Paws Cat Food Company earned $32,000 (after paying preferred stockholders), paid out a cash dividend of $8000 to company stockholders, and retained the remaining $24,000 to facilitate growth of the company. In this case, the dividend payout ratio equals 0.25 ($8000 $32,000). For that year, Running Paws paid a dividend equal to 25 percent of earnings. Newer companies usually retain most, if not all, of their profits to facilitate growth. An investor interested in growth would, therefore, seek a company with a low payout ratio. The lower the payout ratio, the greater the likelihood that the company will grow, resulting in capital gains for investors.
Dividend Yield The dividend yield is the cash dividend paid to an investor expressed as a percentage of the current market price of a security. For example, the $0.40 cash dividend of Running Paws divided by the current $25 market price for its stock reveals a dividend yield of 1.6 percent ($0.40 $25). Growth and speculative companies typically pay little or no cash dividends, so they have limited dividend yields. Such companies are attractive to investors who are interested in capital gains.
Book Value Book value (also known as shareholder’s equity) is the net worth of a company, which is determined by subtracting the company’s total liabilities from its assets. It theoretically indicates a company’s worth if its assets were sold, its debts were paid off, and the net proceeds were distributed to the investors who own the outstanding shares of common stock.
Book Value per Share The book value per share reflects the book value of a company divided by the number of shares of common stock outstanding. Running Paws has a net worth of $230,000, which, when divided by 20,000 shares, gives a book value per share of $11.50. Often little relationship exists between the book value of a company and its earnings or the market price of its stock. A stock’s price usually exceeds its book value per share. The reason is that stockholders bid up the stock price because they anticipate earnings and dividends in the future and expect the market price to rise even more. When the book value per share exceeds the price per share, the stock may truly be underpriced.
Price-to-Book Ratio The price-to-book ratio (P/B ratio), also called the market-to-book ratio, identifies firms that are asset rich, such as many banks, brokeragefirms, and insurance companies. The P/B ratio is the current stock pricedivided by the per-share net value of the company’s plant, equipment, and other assets(book value). It tells you the premium that you are paying for the net assets of the company.
Corporate earnings are the profits a company makes during a specific time period. If a company cannot generate earnings now or in the future, stock market analysts and investors are not going to be impressed. As people reach this conclusion, there quickly will be more sellers than buyers of the company’s common stock, and that will depress the stock’s market price. Here are some numerical indicators of earnings.
Earnings per Share A company’s earnings per share (EPS) is annual profit divided by the number of outstanding shares. It indicates the income that a company has available, on a per-share basis, to pay dividends and reinvest as retained earnings. The EPS is a measure of the firm’s profitability on a common-stock-per-share basis, and it is helpful because investors can use it to compare financial conditions of many companies. The EPS is reported in the business section of many newspapers. In our example, assume that, next year after payment of $9000 in dividends to preferred stockholders, Running Paws had a net profit of $32,000. With 20,000 shares of stock, the company’s EPS would be $1.60 ($32,000 20,000).
Price/Sales Ratio The price/sales ratio (P/S ratio) indicates the number of dollars it takes to buy a dollar’s worth of a company’s annual revenues. The P/S is obtained by dividing a company’s total market capitalization by its sales for the past four quarters. For example, if Running Paws Cat Food Company’s common stock currently sells for $25 per share and 20,000 shares of the company’s stock are outstanding, its total capitalization is $500,000. If company revenues (sales of cat food) were $750,000 over the past year, the stock’s P/S would be 0.67 ($500,000 $750,000). Stock analysts suggest investors avoid companies with a P/S greater than 1.5 and favor those having a P/S of less than 0.75. Many investors ignore the P/S, but it works better than the highly acclaimed P/E ratio in predicting which companies provide the best return, as explained in James P. O’Shaughnessy’s What Works on Wall Stree
Numerical Measures to Evaluate Stock Prices
Several other numerical measures are used to evaluate stock performance. These numbers are readily available to investors on the Internet. Here are some numerical indicators that will help you assess future stock prices.
Cash Dividends Stocks usually pay dividends. Cash dividends are distributions made in cash to holders of stock. They are the current income that you receive while you own shares in the company. The firm’s board of directors usually declares a dividend on a quarterly basis (four times per corporate year), typically at the end of March, June, September, and December. Dividends are ordinarily paid out of current earnings, but, in the event of unprofitable times (low earnings or none), the money might come from cash reserves held by the company. Occasionally, a company will borrow to pay the dividend so as to maintain its reputation of consistently paying dividends. Later profits can be used to repay any funds borrowed for this purpose.
Dividends per Share The dividends per share measure translates the total cash dividends paid out by a company to common stockholders into a per-share figure. For example, Running Paws might elect to declare a total cash dividend of $8000 for the year to common stockholders. In that case, cash dividends per share would amount to $0.40 ($8000 20,000 shares).
Dividend Payout Ratio The dividend payout ratio is the dividends per share divided by earnings per share. It helps you judge the likelihood of future dividends. For example, imagine that Running Paws Cat Food Company earned $32,000 (after paying preferred stockholders), paid out a cash dividend of $8000 to company stockholders, and retained the remaining $24,000 to facilitate growth of the company. In this case, the dividend payout ratio equals 0.25 ($8000 $32,000). For that year, Running Paws paid a dividend equal to 25 percent of earnings. Newer companies usually retain most, if not all, of their profits to facilitate growth. An investor interested in growth would, therefore, seek a company with a low payout ratio. The lower the payout ratio, the greater the likelihood that the company will grow, resulting in capital gains for investors.
Dividend Yield The dividend yield is the cash dividend paid to an investor expressed as a percentage of the current market price of a security. For example, the $0.40 cash dividend of Running Paws divided by the current $25 market price for its stock reveals a dividend yield of 1.6 percent ($0.40 $25). Growth and speculative companies typically pay little or no cash dividends, so they have limited dividend yields. Such companies are attractive to investors who are interested in capital gains.
Book Value Book value (also known as shareholder’s equity) is the net worth of a company, which is determined by subtracting the company’s total liabilities from its assets. It theoretically indicates a company’s worth if its assets were sold, its debts were paid off, and the net proceeds were distributed to the investors who own the outstanding shares of common stock.
Book Value per Share The book value per share reflects the book value of a company divided by the number of shares of common stock outstanding. Running Paws has a net worth of $230,000, which, when divided by 20,000 shares, gives a book value per share of $11.50. Often little relationship exists between the book value of a company and its earnings or the market price of its stock. A stock’s price usually exceeds its book value per share. The reason is that stockholders bid up the stock price because they anticipate earnings and dividends in the future and expect the market price to rise even more. When the book value per share exceeds the price per share, the stock may truly be underpriced.
Price-to-Book Ratio The price-to-book ratio (P/B ratio), also called the market-to-book ratio, identifies firms that are asset rich, such as many banks, brokeragefirms, and insurance companies. The P/B ratio is the current stock pricedivided by the per-share net value of the company’s plant, equipment, and other assets(book value). It tells you the premium that you are paying for the net assets of the company.
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