How to evaluate a stock before buying

Choosing the right stocks at the right time can save you a lot of money. As an investor, it is crucial to understand how to analyze a stock.

After reading this article, you will be able to evaluate a stock price. You will learn the basics of a company’s financial statements to understand its performance and identify the underpriced and overpriced stocks.

Getting Started:

When you buy a stock, you buy a share in that company. And that’s why you need to understand what the company does, what industry the company works in, how well the company is performing, and the potential for future growth.

Let’s assume someone approached you and offered you to become a partner in their company. What is the first thing you will ask?

Most probably, you would do two things:

1. Ask the company owners to show you the company performance so you can understand if that company is profitable or not.
2. Evaluate if the company’s performance is worth the price you will be paying for becoming a partner. 

Similarly, when investing in stocks, you need to do the same two steps to understand the company’s performance you are investing in and evaluate if the price you are paying for the stock is low, fair, or high.

Understanding the Company Performance:

If you want to understand any company’s performance, you need to be looking at three financial statements. Public companies must report those statements quarterly, and any investor can find them on the company website.

The three financial statements you need to be looking at to evaluate the company performance are:

–         Profit & Losses Statement (P&L):

The profit & losses statement reports the company’s revenue, cost, and profits. It’s an important statement that shows how much the company sales, what the company costs are, the profit margin the company is making, and the net profits.

• Revenue:

When evaluating a stock, you need to look at the company’s revenues for at least five years and make sure that revenue increases every year. If its revenue keeps on rising, it will give you a sign that the company is growing.

•  Profits:

 Having high revenues doesn’t necessarily mean that the company is profitable.

Many companies have very high revenues, but their operating costs are higher, so they are making losses.

It would be best to make sure that the company you are considering investing in is making consistently growing profits.

–         Balance Sheet:

The balance sheet is a statement that shows you what the company owns (assets), such as buildings, cash in hand and cash to be collected, and inventory. On the other side, it shows how much the company owes to lenders, such as bank loans, suppliers, and shareholders.

When evaluating any company, you need to look at its balance sheet and ensure that it has enough assets to cover its liabilities. The assets are growing and adequately managed over the years, and liabilities are not increasing.

–         Cash Flow Statement:

Cash flow is one of the most important financial statements. It shows the cash in and cash out. In other words, it shows how much the company is generating cash from its operations and from selling its assets, and how much it is paying for lenders, loans, and shareholders.

Any company must manage its cash flow properly. No matter how much revenue the company generates, if it doesn’t collect the sales, it will go bankrupt, or if its payment to lenders is more than what it is generating, it will probably go out of business soon.

Evaluating the Stock Price:

Now that you know how to read the basics of financial statements properly and determine the company’s performance, the next step is to evaluate whether the price you are paying for the company stock is higher than the fair price or lower.

 To do this evaluation, you need to run some financial ratios which facilitate comparison with other firms in the same sector or with the overall economy. 

–         Price to Earnings Ratio (P/E):

P/E ratio simply tells you how much investors are willing to pay to receive $1 of the company’s earning.

 Keep in mind that the lower P/E ratio, the better it is, and the higher the P/E ratio, the worst it is. 

The best way to understand P/E ratio is through the following example:

Suppose you have two companies working in the same industry and generate the same earnings but have different stock prices.

1. Company X generates $1,000 of earnings, and its stock price is $10 – the number of stocks the company has issued is 100 stocks.

2. Company Y generates $1,000 of earnings, and its stock price is $20 – the number of stocks the company has issued is 100 stocks.

It’s very obvious that investing in company X is better; simply because for the same earnings, you are paying $10 to buy company X stock, while you are paying $20 to get company Y stock.

 But let’s say now that earnings are different and we have the following companies:

 Company X generates $32,000 of earnings, and its stock price is $10 – the number of stocks the company has issued is 10,000

Company Y generates $183,000 of earnings, and its stock price is $85 – the number of stocks the company has issues is 20,000

 You can’t say which company’s stock price is cheaper relative to its earning until you run the P/E ratios. 

P/E = Share Price ÷ Earning per Share

 Let’s apply the above formula to both companies and see

Company X P/E = $10 / $3.2 (earnings divided by number of shares) = 3.125

Company Y P/E = $85/ $9.15 (earning divided by number of shares) = 9.28

The above example shows that company X stock price is cheaper than company Y relative to the earnings. In other words, you are willing to pay 3.125 for every $1 earnings of company X, while you need to pay 9.28 for every $1 earned in company Y

 Keep in mind that each industry has a different average of P/E, so it wouldn’t make sense to compare a technology company’s P/E with a real estate one.

–         Earning Per Share (EPS):

EPS measures the profitability and shows how much money a company has earned for each of its outstanding common shares. It’s calculated as follows:

EPS = Net Income ÷ No. of Shares Outstanding

For example, Company X has a net income of $1m, and total of 100,000 shares outstanding. If it pays its preferred shareholders a total dividend of $200,000, its EPS is:

$(1,000,000 – 200,000)/100,000 = $800,000 / 100,000 = $8 per share

 The higher EPS is, the more profitable the company is.

–         Price to Book Value (P/B):

Determining a company’s price-to-book ratio is another tool used to assess a stock price. Usually, investors use this approach to identify undervalued high-growth companies.

P/BV ratio tells us how much investors are paying for each $1 of company book value.

 The price to book ratio can be calculated using the formula:

 P/B ratio = (Price per Share ÷ *Book Value per Share)

*Book value: Value of company’s assets on its balance sheet less the value of company’s liabilities on the balance sheet.

–         Dividend Payout Ratio (DPR):

It is a measure of how much of a company’s earnings are paid out to its shareholders as dividends.

 Usually, companies may choose to retain their earnings; pay a portion out as dividends, or use its earnings to reinvest in the business.

 The dividend payout ratio is usually expressed as a percentage and is calculated as follows:

DPR = (Total Dividends ÷ Net Income) x 100%

 For example, if Company X has a net income of $250,000 and pays out $80,000 as dividends, its DPR is:

 $(80,000/250,000) x 100% = 32%

 The dividend Payout Ratio might range from 0% to over 100%. A high DPR may attract investors who prefer dividend income stocks over capital gains stocks.

 However, if DPR is very high, it’s most likely that the company will not be able to maintain the same level of dividends in the future, and if the DPR is reduced in the future, the stock’s price will fall.

Bottom Line:

There are many more methods to analyze and evaluate a stock, but we tried to mention the important and the most commonly used ratios.
Even though the financial measures mentioned in this article can be obtained from many websites, investors must understand the rationale behind the numbers and how the calculation works.