In this piece, we'll give you a basic structure of how to evaluate a stock before buying it. We’ll also go over some common concepts and what to look for within those documents to help you understand how it all fits together.
What is a Stock Evaluation?
Stock evaluation refers to a reasoned and objective analysis of a company’s finances. This includes looking at current and past earnings reports, understanding the basics of a company's balance sheet as well as relevant financial ratios. Evaluating stocks also means understanding a company’s position within its sector. This can include knowing who the company competes with and how much market share it has.
Stock evaluation also requires you to consider your own investment objectives and risk tolerance. For example, if your portfolio consists of high-quality dividend-paying stocks, you shouldn’t waste time learning how to evaluate a stock of an unprofitable company with little-to-no revenue. Riskier stocks, on the other hand, might be right for growth-oriented investors willing to take on additional risk.
Stock evaluation is also different for traders and investors. Traders are more concerned about short-term price movement in a stock (measured in days or weeks and sometimes just hours) and can include concepts such as uptrend gaining momentum. Therefore, a trader’s research falls into the area of technical analysis and involves looking at buying and selling signals.
Why Evaluate a Stock?
Some people say investing in stocks is like gambling. However, investing is more similar to a major purchase, like a house. When you buy a house, you take steps to give yourself every chance that the house and property will be worth more than what you paid for it when you sell it.
These steps might include:
- Having a home inspection performed.
- Doing an analysis of the market to make sure you’re not paying too much.
- Understanding the area that you’re buying in to help ensure there are buyers for the house when you want to sell.
You may encounter a similar thought process (although on a smaller scale) when making investment decisions. The saying “buy low, sell high” simply means you buy a stock today with the idea that it will be worth more when you want to sell it. That may be in one year, but more than likely, it’s in five years, 10 years and sometimes 20 or more years.
What Determines Stock Value?
You may hear about undervalued stocks or overvalued stocks, but how do analysts decide on the fair market value for a stock and a target price? They usually take a look at some common documents that publicly traded companies must provide by the Securities and Exchange Commission (SEC).
You can typically find these forms on investor relations pages of companies' websites. MarketBeat also provides many of these documents under the "financials" tab for an individual stock. For example, you can check out the financials for Tesla (NASDAQ: TSLA).
Let's take a look at some other important documents and what to look for.
Balance Sheet and Financials
Looking at a company’s balance sheet allows you to get an objective analysis of the company’s financial position. If you were seeking the advice of a financial advisor, the advisor would require you to furnish a list of all your assets and liabilities (debts). They do this to understand the current state of your finances and how that fits with your stated goals.
In the same way, looking at a company’s balance sheet helps you understand the health of a business and whether or not it is growing. A certain amount of debt is expected and can even be healthy. However, if the company doesn't generate enough income to pay that debt, it can be a concern. This is particularly true when interest rates rise and the dollar doesn’t go as far.
As part of a company’s earnings report, they are required to file a 10-Q form, an overview of the company’s performance and a comparison point for investors between previous quarters. The 10-Q contains relevant financial statements, commentary by management and any disclosure the company wishes to make relevant to that quarter. Companies must file the 10-Q 40 or 45 days after the end of the quarter. The 10-Q is not audited.
The 10-K form is more comprehensive than the 10-Q form. The SEC requires companies to file a 10-K annually. It contains significantly more detail than the 10-Q, including information about the company’s history and organizational structure. It is similar to an annual report sent to all shareholders but contains more detailed information since it summarizes an entire year.
Financial Ratios for Evaluating Stocks
In addition to studying the company’s balance sheet, investors will frequently hear several ratios thrown around such as price-to-earnings (P/E) ratio and price-to-book (P/B) ratio. Take a look at a brief description of each and why they are important.
Debt-to-Asset (D/A) Ratio
The debt-to-asset ratio lets investors see the percentage of a company’s total assets that it paid for with borrowed money. This is a measure of how solvent a company is, which can be a key indicator of how likely it would be to fall into financial distress.
For example, if a company has a debt-to-asset ratio of 0.50%, that means that the company uses debt to finance 50% of its assets. That would mean the company’s equity financed the other 50%.
Debt-to-Equity (D/E) Ratio
The debt-to-equity ratio is similar to the debt-to-asset ratio but uses total equity as its denominator as opposed to only total assets. This allows investors to have an understanding of how a company’s capital structure is based on debt and how much is based on equity financing.
Earnings per Share (EPS)
This ratio takes a company’s profit after subtracting taxes, bond interest and preferred stock payments and divides it by the number of outstanding common shares. A company’s EPS is typically referred to as the “bottom line” when a company delivers its earnings report.
Price-to-Earnings (P/E) Ratio
The price-to-earnings ratio is one of the most commonly cited ratios. It measures how much an investor will have to pay for $1 of a company’s earnings. To calculate the P/E ratio, investors divide the price of a stock by either its most recent earnings per share (trailing P/E) or by its predicted earnings (forward P/E).
The P/E ratio is used to compare stocks, particularly those that are within the same sector. This is because some sectors, such as technology stocks, generally have higher P/E ratios on the expectation of larger earnings.
Price-to-Sales (P/S) Ratio
The price-to-sales ratio is a measure of a stock’s relative value. To calculate the P/S ratio, investors will divide the company’s stock price by its latest annual sales per share. The conventional wisdom is that the lower the P/S ratio, the better value the stock has. Like the P/E ratio, this ratio should be compared with other stocks in a sector.
Price-to-Earnings Growth (PEG) Ratio
One limitation to the price-to-earnings (P/E) ratio is that it is limited to a moment in time. That’s why some investors prefer the price-to-earnings growth (PEG) ratio. This is also referred to as the “price-to-earnings plus growth” ratio. The PEG ratio takes the P/E ratio and divides it by the anticipated growth rate of a company’s earnings over a specific time period.
The price-to-book (P/B) ratio is a measure of how valuable a company would be if it had to be sold off today. In other words, if the company goes bankrupt, how much — if anything — could investors expect to receive for their investment?
A company’s book value includes assets such as equipment, buildings and land plus anything else a company can sell for cash, including its stock and bond holdings.
Return on Equity (ROE)
Return on equity (ROE) measures how efficiently a company uses its capital for investments to generate earnings growth. This is one of the key measures of profitability for an investor. The ratio calculates the company’s net income or profit in comparison to its shareholder equity.
Investors interested in buying dividend stocks will want to pay attention to the company’s dividend yield. To calculate, divide the stock’s annual dividend by its stock price. However, because it is based somewhat on the company’s stock price, dividend yield by itself can be misleading. Investors should also consider how much of a dividend they will receive on an annual basis as well as consider the ability of the company to continue issuing — and even better — increasing its dividend amount.
Steps for Evaluating Stocks
Knowing which financial metrics to look at and what they mean can help you evaluate a stock. But how do you know which stocks to evaluate or why? In this section, we’ll give you some tips for deciding which stocks to consider evaluating.
Step 1: Have a game plan.
You know the saying: If you don’t know where you want to go, any road can get you there. Before you start evaluating stocks to buy you should understand your goals and investment style. It can start by answering questions like:
- How much money will I be putting in? You may not have an exact figure in mind. But you should have a rough idea of how much money you plan to invest over time. Since most investors own many stocks, you’ll have to decide how much you’re willing to invest in any particular stock. Many online trading apps such as Webull and Robinhood allow investors to buy fractional shares.
- When will I need the money? The longer your timeframe, the less concerned you’ll likely be about daily or monthly price movement.
- What is my risk tolerance? Only you can answer this. You can start by asking how you would feel if your investments dropped 25% or more in one year. This is because many investors find they are more willing to accept risk when the market goes up. But stocks never move in one direction all the time. It’s always realistic to consider how you will react when stock prices are falling.
- Am I looking for growth or income? This is not to say you can’t or shouldn’t have both in your portfolio. In fact, there’s a whole category of stocks that are labeled “growth and income” stocks. But you should ask yourself what your primary purpose for owning the stock will be. For example, Apple Inc. (NASDAQ:AAPL) pays a dividend. But it’s not really an income stock. It’s a growth stock that happens to pay a dividend. Similarly, a utility stock such as Duke Energy Corporation (NYSE:DUK) may provide you with some stock price appreciation. However, the stock is likely to underperform the market. However, you may want to invest because of the company’s dividend, which is historically one of the most generous in the utility sector.
Step 2: Narrow the field.
There are literally hundreds, if not thousands, of publicly traded companies that can be good investments. However, for most individual investors, a portfolio of between 10 to 20 companies is considered optimal. That number allows you to diversify your portfolio without having too much exposure in one single sector. Consider these questions:
- What do I know about? There’s something deceptively simple about buying stocks in areas in which you have expertise. This doesn’t mean that these are the only stocks you buy, but having an area of expertise may alert you to some great stocks that other investors may overlook.
- What do I know about the company? This question relates to the one above. In fact, this is a strategy often attributed to Warren Buffett. The Oracle of Omaha strongly believes in only buying stock in a company when you understand how they make their money and only if they offer a competitive advantage.
- What is the company’s management team like? Every quarter, most publicly traded companies host analysts and investors on a conference call to discuss quarterly earnings. Investors can hear the CEO speak and get a sense of his or her vision and outlook for the company. It’s also a good idea to look at the composition of the company’s board of directors. Specifically, you want to see people likely to provide the company with independent and possibly contrarian thinking.
- What do analysts say about the stock? Analysts give stock ratings. In general, a “buy rating,” or “outperform rating,” means the stock is likely to outperform the market. A sell rating, or an “underperform rating,” also sometimes called a “moderate sell,” means the stock is likely to underperform the market. A “hold” rating, or “neutral” rating means the stock is likely to perform in line with the market. Make sure you access legitimate ratings from reputable sites like MarketBeat.
- Does the stock trade at a good volume? This is also known as liquidity. The idea is that you want to invest in the most active stocks. These stocks are easier to buy or sell because there is demand for the company’s shares. It doesn’t mean you can’t buy a share that trades on lower volume, but it may be tougher to buy or sell for the exact price targets you want.
Step 3: Challenge your assumptions.
Ask yourself, “What market conditions would make me feel negatively about this company and its stock? How likely is that scenario to play out?”
It’s important to understand how a company makes money and how strong they are financially. Companies that operate from a position of financial strength carry much less risk than those still dependent on debt to finance their day-to-day operations. Both can be profitable stocks, but one may not fit your risk tolerance as well as the other.
Step 4: Seek professional help.
The process of evaluating a stock is not based on some proprietary formula not available to individual investors. However, sometimes you don’t have time to evaluate stocks on your own — you likely have a life and a job and simply may not have the time to perform the due diligence that you can.
Experienced professionals and brokerage firms can do the hard work of evaluating stocks for you. They can be a good resource when you’re too busy to do it yourself. Going back to the idea that investing in stocks is similar to buying a house, when most people buy a house, they use a realtor for their expertise. They know the market and have already performed a lot of research. More than likely, they have access to data unavailable to you.
In the same way, an investment advisor can do some of the legwork for you (for a fee, of course). But that may be money well spent if they guide you into profitable stocks (or mutual funds for ample diversification). Choose advisors who take a fiduciary position, which means they only profit when your portfolio does well.
Analyzing Stocks to Buy Gets Easier with Practice
When you first try to analyze a stock or first learn how to evaluate stocks, you may still feel overwhelmed. That’s a good reason to lean on the tools that MarketBeat provides. On a stock’s profile page, we include many of the common metrics and ratios that we listed in this article. Now that you have an idea of what they mean, you can start to get a picture of what stocks you would like to buy within the overall market.
Practice makes perfect. Before you commit money to a stock, consider putting it on your watchlist. It can help you make stock decisions that fit your investment strategy and risk tolerance. If it fits your needs, take the step of buying the stock. If it doesn’t, there are plenty of other stocks out there, just waiting to be discovered, guided by informed investing decisions.