Basic Stock Analysis
There are literally hundreds of variables that one can analyze when evaluating individual stocks. There is a possibility that by the time you collect all the necessary data, analyze it, interpret it, and make a buy decision, you’ll buy too late to get the price you want. As we all know, the way to make money in the stock market is to buy low and sell high. With this in mind, let’s discuss some basics; we can always get more sophisticated as time goes on.
It is important to note that individual investors have a major advantage over professional and institutional investors for several reasons. Professional and institutional investors spend a lot of time analyzing possible investments, thus entering the market late, basically following the herd. In the same vein, a stock does not become attractive to brokerage houses until large institutional investors recognize the possible opportunities. As a result, professional investors jump on the bandwagon after the stock has already been run up in price by these large institutional fund managers.
As people are trying to make a living and being tuned in to “what’s hot and what’s not” in the marketplace, with our families and friends, we are literally years ahead of the big-time analyzers. As investors, if we know nothing else, we should only invest in companies with products and/or services that we know are quality product offerings, at a value. If we truly believe in and use the product, then chances are the company will be successful. We should buy and hold the stock as long as we truly believe in the company’s product offering. The first rule of investing is to understand and believe in the company and its products in which you are investing. Some obvious examples today would be McDonald’s and Wal-Mart.
Besides our own visceral (gut) feelings, there are two other variables, at a minimum, that we need to analyze. These two important variables are earnings per share (EPS) and price-to-earnings ration (P/E ratio).
The earnings per share (EPS) ratio is one of the most widely used measures of a stock’s valuation. At face value, the EPS ratio is a good measure of the stock, but if you are unaware of its limitations, it can be greatly misleading. First, let’s look at the basic formula for computing Earnings Per Share.
Formula: Net Income ¸ Total Shares Outstanding = EPS (earnings per share)
The higher the EPS, the better; thus it might be a good tool to use when evaluating a company. One thing we need to take notice of is whether the company also has preferred stock. If so, dividends payable to preferred stock need to be deducted from net income before calculating the EPS. There are other variables you will want to check out before relying on EPS in your investment decisions. Some companies have convertible securities, like stock options and warrants. Convertible securities means that there is a potential for the number of common stock shares outstanding to increase when these options are activated, thus having a negative effect on EPS.
In conclusion, most investors view EPS as an important tool in evaluating stocks. Because of the popularity of this ratio, most financial papers and journals report the EPS daily. Furthermore, corporations are required to report the EPS of their stocks in quarterly and annual reports.
Another widely used tool for assessing stocks is the price-to-earnings ratio (P/E ratio). A high P/E ratio suggests that the market expects good earnings growth. A low P/E ratio would indicate that the market expects earnings growth to be sluggish. Let’s look at the formula for calculating a firm’s P/E ratio.
Formula: P/E ratio = Price per share ¸ EPS (which is calculated above)
The P/E ratios of all stocks are reported daily in the popular financial papers and journals. As said earlier, a high P/E ratio is typically viewed as good. However, if the firm had little or no net income, and because of the way the P/E ratio is calculated, the P/E ratio would be artificially high and, in this case, would be bad. So, once again, investors beware—if it looks too good to be true, then it probably is. One way to verify whether a stock’s P/E ratio is abnormally high or low is to check a reliable source like the Wall Street Journal, Barron’s, or Investor’s Business Daily.
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Biedenweg, Ph.D., Karl, (2003). Understanding Investment & The Stock Market. Mark Twain Media, Inc., Publishers.