Passive income is one of our holiest pursuits. And smart investing is one of the best routes to achieve this holy grail. But whether you’re looking at Cramer’s stock picks, or consulting with a random stock picker, you’re at least going to be better off doing your own stock research. So check out this stock advice on how to pick some stocks that can increase your financial situation.
The Why and How of Stock Evaluation
In 2015, the number of companies headquartered within the United States that had stock actively trading topped 8,000. Around the world, non-American companies with trading stocks came in just under 40,000 during the same time period. As the economy continues to provide fertile ground for business growth, one can safely predict the addition of even more companies with available stock to trade. Consumers, other businesses, and most importantly, investors, have ample opportunity to partake in the growth of new and established businesses by purchasing shares of stock as they see fit.
Participating in stock investing carries with it substantial allure, but getting started is often overwhelming. Regardless of how much one has to invest, if they’re working with a broker or going it alone, most novice investors are unaware of what makes a stock worthwhile, and where to find the right data on past and potential performance. However, knowing which stocks to add to an investment portfolio gets far easier with some basic guidance. Here we break down the process of stock evaluation to help you determine if your stock pick is a potential boom or a bust.
Know the Company
There is a common phrase directing investors who are just starting to invest: pick companies you know and/or love. Most of us have a tendency to buy the same brands over and over, whether for vehicles, accessories, groceries or technology, and these brands often have a strong reputation in their respective industries. Investing in large, well-established companies provides some safety in that they have already captured a substantial share of the market with proven products or services. Investing in these companies often leads to predictable outcomes: steady dividends, relatively stable share price and the potential for respectable earnings. However, while investing in companies we know is a smart place to start, being comfortable with a brand is only the first step.
Selecting companies in which to invest should be based on the financial history of the business and its trajectory for growth in the future. That is most easily accomplished by analyzing specific metrics including price-to-book ratio, price-to-earnings ratio, price-to-earnings-growth ratio, and dividend yield. Let’s briefly take a look at each.
The price-to-book ratio, or P/B ratio, allows you as the investor to understand the underlying value of a company based on assets such as equipment, buildings, land, and stock or bond holdings. The P/B ratio is calculated by taking the current stock price divided by total assets minus intangible assets and liabilities. The metric is incredibly valuable in determining the investment worthiness of well-established companies that have substantial physical assets, as it ultimately reveals how the market value of the company’s stock compares to its book value. A lower P/B ratio could mean the stock is undervalued, making it a smart buy; in other cases, however, a low P/B ratio indicates a flaw within the company’s financial stability.
One of the most used and equally debated ratios in evaluating a stock’s value is the price-to-earnings ratio, or P/E. Calculated as the market value per share of stock divided by the earnings per share, the P/E ratio helps investors pinpoint the investment dollars necessary to receive one dollar of the company’s earnings. For instance, a company with a P/E ratio of 20 leads one to believe that investors are willing to pay $20 to generate $1 of earnings. A higher P/E ratio indicates that earnings growth may be on the horizon, while a lower P/E ratio may mean the company is undervalued or has experienced exceptional profitability in recent quarters.
As an extension of the P/E ratio, investors can also look to the price-to-earnings-growth ratio, or PEG. This metric is calculated as a stock’s P/E ratio divided by the rate of growth on earnings for a certain time frame. PEG allows investors to understand more about the company’s stock value in relation to its actual growth over time, and often provides a better overall evaluation than the P/E ratio alone.
For some investors, the focus of a stock’s viability is not in growth but instead in its ability to pay dividends. The dividend yield provides an evaluation of a company’s dividend paying capability, and is calculated by dividing the annual dividend of a stock by its current price. The higher the percentage, the greater chance your stock pick will produce a dividend when the company generates enough profit to do so.
Fortunately for investors, all publicly traded companies are required to publish financial data, including balance sheet, income statement, and cash flow, making it relatively easy to find the data necessary to perform a basic stock evaluation. The information necessary to conduct each calculation can be found through this research site, or by a simple Internet search with the company’s name. Each of the stock evaluation metrics listed above prove beneficial in determining whether or not a stock purchase (or sell) is a sound choice; however, investors should look into more than one metric for a well-rounded analysis.