Don’t Get Hosed: 7 Ways You Can Evaluate A Stock Before Buying It

In last week’s post on investing in stocks, I outlined how you could go through a company’s SEC statements such as the income statement and balance sheet to gain a better feel of its financial health- and also whether you should invest in its stock. I’ve also discussed how dividend stocks can help you attain a passive income.

However, there are many other quick and useful measures of a company’s financial health that you can take advantage of. These measures, also commonly called fundamentals, come in handy especially when you are comparing companies in the same industry or wondering if it’s time to sell a given stock. So, without further ado, here are some fundamentals to examine when you are evaluating a company stock:

EPS

EPS (earnings per share) was briefly mentioned last week as the net income a company generates divided by its number of shares. If the company also pays a dividend, that sum is subtracted from net income before that income is divided by share number. This is something to keep in mind when investing in companies that appear to have low reported EPS, such as the REIT stocks Armour Residential (ticker: ARR) or Resource Capital Corp. (ticker: RSO); many companies have a low EPS because they pay out a significant portion of their earnings as dividends.

In essence, EPS is a measure of a company’s profitability. Furthermore, EPS is not always a positive number; companies can post considerable earnings losses or no earnings whatsoever. More than anything else, a company’s reported EPS is a big event in the investment world; investors and analysts eagerly await the day that companies post their quarter or annual earnings in EPS. A reported EPS that beats estimates can cause a company stock to skyrocket; conversely, an EPS report that misses analysts’ estimates can result in a huge stock price drop.

P/E ratio

The P/E (price over earnings) ratio is a measure of a company’s stock price over its annual earnings per share. The P/E is used to judge the value of a stock in terms of how much investors are paying for it; for example, the current P/E of Amazon (ticker: AMZN) is a whopping 316, indicating that its valuation has gone sky-high and the stock currently trades at 316 times its annual earnings. Such high investor expectations for Amazon could easily be dashed, however, causing the stock price to plummet (i.e., undergo a correction).

On the other hand, Altria Group (ticker: MO) has a P/E of just over 15, meaning that it trades at 15 times its annual earnings. This stock is still valuable and is probably not overhyped by investors to the point of being prone to a correction. Incidentally, when a stock is touted as being undervalued or overvalued, the term is being applied to its low or high P/E, respectively.

The P/E is both an emotional and logical measure of a stock’s perceived worth and will vary by industry. Investors love sexy tech stocks like Amazon, which is one reason why its P/E is so high. On a more rational level, though, Amazon is also investing heavily into its business to become and stay #1 in the online marketplace. Investors who follow the company’s financial reports know that Amazon’s retained earnings are a big part of shareholder’s equity, a point I touched on in last week’s investment article. However, Amazon’s high P/E could easily fall if investors suddenly become spooked about the company or its management.

Alternately, because smoking has fallen out of favor with many people, Altria Group’s P/E is just over 15. However, the company makes solid earnings every year and even pays a sizeable dividend. Altria investors are thus less likely to become scared that the stock is overvalued and sell their holdings. This is also reflected in Altria’s low beta, the next stock parameter we will be studying.

Beta

The beta is a measure of a stock’s volatility relative to an index such as the S&P 500 over a period of time. It is a useful parameter to study if you are considering investing in a stock simply to gain its dividend (something I like to call dividend poaching) or are looking to invest in a stock for less than a year. Beta is also useful if you are wondering when you should invest in a particular stock in order to minimize risk and maximize return.

The beta is actually a slope of the stock’s trendline (Remember your high school algebra and y = mx +b? The beta is the m) and can range from negative to positive. If a stock’s beta is 1.0, that means that its price rises and falls in sync with the market’s. A stock beta of 1.4 indicates that this stock is 40% more volatile than the market while a beta of 0.5 indicates that the stock is 50% less volatile than the market. For example, if the stock of a company like Widgets-R-Us (ticker: WRU) has a beta of 1.2, that means that should the market gain 10% in a year, WRU will be up by 12% (or an additional 20% of that 10%). Should the market fall 20% in a year, WRU will fall 24% (or an additional 20% of that 20%).

Conversely, if the company has a beta of 0.5, its stock will fall only 50% compared to that of the market. Thus, should the market fall 20% in a year, WRU will fall by only 10% (or only 50% of 20%). There is a useful online tutorial if you really want to explore the concept and even calculate your own stock’s beta.

Beta is useful because it allows you to predict how a company stock will behave relative to the overall market. Predictability is good if you are risk-averse or need to time your trades in order to gain company dividends and then quickly sell to buy the next dividend-bearing stock (i.e., dividend poach). Likewise, let’s say you have some money to invest in the market but will need it in a year or less to buy a car or house (not recommended, by the way, but I’ve certainly done it). In such a case, you could invest your cash in a company stock that has a low beta, helping to ensure that you don’t lose your original sum- unless, of course, the entire market starts heading down. The criticism to this approach is that you probably shouldn’t invest money that you will need in a year or less.

D/E

The debt to equity ratio is another good measure of a company’s ability to successfully handle its finances. If you think of the company as a person you’re about to lend money to, would you want to lend money to a person who works a minimum wage job yet has massive credit card bills, two car payments, a  mortgage and is paying child support? Even if this individual has big plans for the future, would you trust that your loan will be repaid? A company should be similarly scrutinized.

The debt to equity ratio is calculated using the following formula:

D/E = Total Liabilities/Shareholder Equity

Total liabilities include business loans, mortgages and supplies- in essence, the total leverage potential of the company. This is divided by what the shareholders (as well as the company) have invested into the company. A company with a high D/E ratio may be rewarded by bigger earnings the following quarter or year; however, it may also stagnate under high interest payments and growing pains. A higher D/E ratio tends to raise the company’s beta too. Over time, you generally want to see this ratio decrease.

Incidentally, if you’ve ever obtained a loan, your personal D/E ratio was likely calculated by the lending institution or bank.

P/B ratio

The price to book ratio or P/B is, just like the P/E, another measure of a stock’s perceived worth. The formula for this ratio is the following:

P/B = Stock price/Book Equity (BE = Assets – Intangible Assets + Liabilities)

Assets are defined as cash, inventory, accounts receivable and equipment while liabilities are items such as loans, mortgages and accounts payable. Intangible assets are assets that are certainly valuable to the company but are harder to liquidate; examples include intellectual property, copyrights and trademarks. Thus, book equity is what would be left over if the company went bankrupt and had to liquidate.

A stock with a P/B ratio less than or equal to 3 might be a great bargain or it might have some fundamental issues. Because of this ambiguity, the P/B ratio should never be used as the only measure of a stock’s true value. Some reasons include the following:

1. The P/B ratio favors “old school” companies with a lot of assets.

2. Intangible assets are not accounted for or they are viewed as liabilities. This ignores many research, technology and service-based companies.

3. Events like acquisitions and share repurchases artificially deflate or inflate the P/B ratio, respectively.

Because P/B does not provide a complete picture of corporate health in and of itself, it should be paired with another parameter: the ROE.

ROE

Return on equity is defined as a company’s net income divided by its shareholders’ equity:

ROE = Net Income/Shareholders’ Equity

The ROE restates the EPS but on a hard, dollar-to-dollar basis instead of just dividing the company’s earnings by its number of shares (which can be increased or repurchased anyway). A company’s ROE and P/B should rise and fall with respect to each other- if they don’t, something is intrinsically wrong with the company. After all, a company with a high ROE should attract investors who bid a higher price on the stock. In some cases, though, a company might have a high P/B yet a low ROE. This indicates that company growth in terms of its stock price has not translated to improved company profitability. Without increased profits, shareholder value will stagnate. As such, this company would be a company to steer clear of.

ROI

The whole point of investing is for you to achieve an ROI or return on investment. The most basic ROI can be calculated using the following formula:

ROI = (Gain – Cost)/Cost

While the formula itself seems self-explanatory, remember that stock gains can include dividends, price appreciation or both. Alternately, you may have stock depreciation mixed in with dividends. Then there are the costs to consider, some of which include trading fees and taxes as well as your original investment sum. It’s important to track these numbers because you certainly want to see a return on your investment.

Also, the IRS taxes you at different levels on dividends as well as short and long-term capital gains. Rumors abound that dividends will soon be taxed as regular income. Capital gains taxes could increase from their current 15% maximum to 20% maximum for long-term investments. Meanwhile, short-term capital gains are being taxed at regular income tax levels.

Taxation of your hard-won stock trading profits is the biggest reason why holding onto stocks for at least one year (or longer) is recommended. Other recommendations for maximizing your ROI will be discussed >next week in my ongoing article series on how to successfully invest in stocks and make a passive income.

Photo credit provided by Florian Richter.