If you’ve never bought or sold stocks in the past, the thought of trading for the first time might be daunting. But once you’ve done your homework and have developed the right habits, it’s not nearly as intimidating.
One of the key skills to learn is how to evaluate a stock. Here are some ground rules that can help educate and empower you to choose stocks for your portfolio.
What Determines Stock Value?
When you buy a stock, you’re not simply buying a piece of paper. A stock is an ownership share in a company — you’re buying into that company and its potential performance. When a person invests, they gain an opportunity to join in on its success or failures over the long haul.
The value of a stock is made up of several factors, including the company’s ability to continue making a profit, its customer base, its financial structure, the economy, political and cultural trends,and how the company fits within the industry. Understanding that will go a long way toward helping you select stocks for your portfolio.
The more you know about the company, its industry, and general stock market trends, the better. Professional advice is important, but so is trusting common sense. A consumer may be able to spot investing trends that eventually translate to a company’s strong performance down the line, asking questions like: Why am I investing in this company? Why now?
Also remember, stock trading doesn’t necessarily benefit from a passive “set it and forget it” strategy. It’s important to assess your individual tolerance for risk before investing, and check in on that periodically. Additionally, make time to review your stocks’ performance and watch the market on a regular basis.
Finally, when considering how many stocks to buy, most investors keep portfolio diversification in mind, with stocks across a range of sectors and risks. Being invested in only one stock means that if the company fails, you could lose your invested money.
With the above guidelines in mind, the next step is to dig deeper to calculate stock value. These are three ways to evaluate stocks.
1. Balance Sheet and Other Financials
The Securities and Exchange Commission (SEC) requires all public companies to file regular financial documents that disclose their performance. These quarterly filings indicate profit and loss, material issues that can affect performance, expenses, and other key information that will help you gauge a company’s health.
Consumers can find these and other reports on SEC.gov:
Balance sheet: This records whether the company reduced or increased their debt. Some major items to look for here are the company’s tax paid and tax rate, along with expenses that aren’t related directly to profits, like administrative expenses.
Income statement: The revenue, major expenses and bottom-line income may reveal trends in the company’s profitability.
Cash flow statement: Not all income is realized, so the cash flow statement shows you what the company actually got paid during the quarter — not what it’s expected to receive from sales 30, 60 or 90 days from now.
The operating cash flow: This excludes a windfall or unusual influx of cash. The cash flow provides a sense of the real, day-to-day (or quarter) activity of the business: how much cash comes in and how much goes out, how the company handles assets and investments, and the money it raises or distributes to lenders and shareholders.
Some companies, most famously Amazon, can have meager profits relative to their sales but impressive cash flows.
In particular, as you read through these statements, pay attention to:
- Revenue: The company’s gross income
- Operating expenses and non-operating expenses: These are typical day-to-day expenses, and also ones that don’t relate to the core business (for example, a non-operating expense might be any interest paid on debt)
- Total net income: This is the company’s actual profit, after deducting all expenses from revenue
- Earnings before interest, taxes, depreciation and amortization (EBITDA): This figure excludes non-operating expenses
2. Form 10-Q
While publicly traded companies tend to release their own financial statements in the form of a presentation for investors, analysts, and the media every three months, they are also required to produce a more comprehensive quarterly report known as the 10-Q, which is filed with the Securities and Exchange Commission.
This document “includes unaudited financial statements and provides a continuing view of the company’s financial position during the year,” according to the SEC, and can be useful to investors as it provides a comprehensive overview of the company’s performance for the previous three months.
The 10Q also offers insight into other factors that might give an impression of a company’s overall health, including:
- Any risk factors to the business
- Information about legal matters
- Issues that might impact a company’s inventory
3. Form 10-K
Form 10-K is similar to form 10-Q but it comes out on an annual, as opposed to quarterly, basis. The form is meant to “provide a comprehensive overview of the company’s business and financial condition and includes audited financial statements,” according to the SEC.
The annual 10-K can give investors a broader picture of the business through the ups and down of a year, during which sales and expenses can often fluctuate.
These reports include both detailed financial information and actual writing from the company’s management about how their business is doing. They also outline how executives are paid, which is one more piece of information about the company’s management that can be useful to shareholders.
Financial Ratios to Help with Stock Evaluation
If learning how to evaluate a stock starts with analyzing financial statements, step two is understanding financial performance ratios. Ratios offer insight into a company’s financial health, allowing for comparisons to other companies in the same industry or against the overall market.
These are important financial ratios to know.
1. Price-to-earnings ratio (P/E)
This is a stock valuation formula that will help you determine how one company’s stock price compares to another. The price-to-earnings ratio is straightforward: It divides the market price of a company’s stock by the company’s earnings per share. The ratio can reveal how many years it will take for a company to generate enough value to buy back its stock.
Price-to-earnings (PE) ratios can also indicate how much the market expects the company’s profits to grow in the future. When investors buy stocks with a high PE ratio, it typically means they’re “buying” present earnings at a high price, with the expectations that earnings will accelerate going forward.
On the other hand, a stock with a low PE ratio could give an investor a good value for their money, but it could also be a sign that investors aren’t confident in the company’s future performance.
Looking back historically, the market has tended to have a PE ratio of about 15, meaning investors pay $15 for every $1 of earnings. But different companies and even different sectors can have wildly different PE ratios.
For example, software companies, especially younger ones, tend to have high PE ratios as investors think there’s a chance they could get much, much larger in the future and turn fast-growing revenue into profits. In software, PE ratios can be in the 30s or even much higher when companies see their stock prices take off quickly, with a PE or around 90.
2. Price-to-sales ratio (P/S)
The price-to-sales-ratio, which divides the market capitalization of the company by its revenue, doesn’t factor in profit. This is helpful for valuing companies that haven’t made a profit yet or have a low level of profit. The P/S should be as close to one as possible. If it’s less than one, it’s considered excellent.
3. Earnings per share (EPS)
Earnings per share (EPS) tell investors how much earnings each shareholder would receive if the company was liquidated immediately. Investors like to see growing earnings, and rising EPS means the company potentially has more money to distribute to shareholders or to roll back into the business.
This figure is calculated by taking net income, subtracting any preferred stock dividends and dividing the result by the total number of outstanding common stock shares.
4. Return on equity (ROE)
Return on equity is a key guide for investors to measure the growth in profit for a company. ROE is determined by dividing the company’s net income by the shareholders’ equity, then multiplying by 100.
The ratio tells you the value you would receive as a shareholder should the company liquidate tomorrow. Some investors like to see ROE rising by 10 percent or more per year, which reflects the performance of the S&P 500.
5. Debt-to-equity ratio (D/E)
The debt-to-equity ratio, determined by dividing total liabilities by total shareholder equity, gives investors an idea of how much the company is relying on debt to fund its operation.
A high debt-to-equity ratio indicates a company that borrows a lot. Whether it’s too high depends on a comparison with other companies in the industry. For example, companies in the tech industry tend to have a D/E ratio of around 2, whereas companies in the financial sector may have D/E ratios of 10.
6. Debt-to-asset ratio (D/A)
A debt-to-asset ratio can be informative when comparing a company’s debt load against that of other companies in the industry. This allows potential investors to better gauge the riskiness of the investment. Too much debt can be a warning sign for investors.
Quick Tips for Evaluating Stocks
Once a potential investor has evaluated a stock they’re hoping to buy by analyzing the company’s financial filings and employing a few stock valuation formulas, there is one last step that can help inform the decision.
There are hundreds, if not thousands, of helpful online news sites and tools to help you research companies, screen stocks, and model a stock’s potential in the future. Here are some viable options.
1. Financial News Sites
From the Wall Street Journal and Bloomberg to Food Business News (useful if one is investing in food stocks) there are dozens of top, investor-trusted sites to help you learn more about how to calculate stock value.
2. Online Financial Tools
Stock screeners help you filter stocks according to the parameters you set, whether you’re looking for blue chip stocks or less-established companies in which to invest.
There are several free stock screeners available to everyone, including FINVIZ, Zacks, StockCharts and the Motley Fool, although some do charge a subscription fee for higher levels of service.
3. Company Details
Research more than just the financial facts and figures. Find out how it makes money, the core values of the business, CEO performance and more. Much information can be gleaned by searching reputable news and business media sites for articles and features about the company and its leaders.
There are a number of key terms, ratios, tools and tips that can help potential investors learn to evaluate a stock and its company’s performance. Investors can review a company’s balance sheets, and forms 10-Q and 10-K to get relevant information about a company’s financial performance and outlook.
Investors looking to evaluate stocks should also be familiar with certain ratios, which can indicate earning potential, debt, and dividend performance, among other indicators that can signal the health of the company and the stock.
Once investors do get serious about stock trading, it can also be helpful to dedicate an account for stock trading, so that their regular finances are not commingled with their investment savings.
The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member
FINRA / SIPC.
Image Credit: gopixa / iStockAlertMe