Evaluating Stocks

When you buy a stock, you're buying part ownership of a company, so the questions to ask as you select among the stocks you're considering are the same questions you'd ask if you were buying the whole company:

  • What are the company's products?
  • Are they in demand and of high quality?
  • Is the industry as a whole doing well?
  • How has the company performed in the past?
  • Are talented, experienced managers in charge?
  • Are operating costs low or too high?
  • Is the company in heavy debt?
  • What are the obstacles and challenges the company faces?
  • Is the stock worth the current price?

Because each company is a different size and has issued a different number of shares, you need a way to compare the value of different stocks. A common and quick way to do this is to look at the stock's earnings. All publicly traded companies report earnings to the Securities and Exchange Commission on a quarterly basis in an unaudited filing known as the 10-Q, and annually in an audited filing known as the 10-K.

If you check those reports, the company's annual report, or its Web site, you'll find its current earnings-per-share, or EPS. That ratio is calculated by dividing the company's total earnings by the number of shares. You can then use this per-share number to compare the results of companies of different sizes. EPS is one indication of a company's current strength.

You can divide the current price of a stock by its EPS to get the price-to-earnings ratio, or P/E multiple, the most commonly quoted measure of stock value. In a nutshell, P/E tells you how much investors are paying for a dollar of a company's earnings. For example, if Company A has a P/E of 25, and Company B has a P/E of 20, investors are paying more for each dollar earned by Company A than for each dollar earned by Company B.

There's no perfect P/E, though there is a market average at any given time. Over the long term that number has been about 15, though higher in some periods and lower in others. Value investors tend look for stocks with relatively low P/E ratios—below the current average—while growth investors often buy stocks with higher than average P/E ratios.

While P/E can be a revealing indicator, it shouldn't be your only measure for evaluating a stock. For example, there are times you might consider a stock with a P/E that's higher than average for its industry if you have reason to be optimistic about its future prospects. Remember, though, that when a stock has an unusually high P/E, the company will have to generate substantially higher earnings in the future to make it worth the price. At the other end of the scale, a low P/E may be a sign that significant price appreciation is possible or that a company is in serious financial trouble. That's one of the determinations you'll want to make before you buy.

A P/E ratio can only be as useful as the earnings numbers it's based on. While there are standards for reporting earnings, and a company's financial reports are audited, there may still be a lack of consistency across earnings reports. You've probably seen stories in the financial press about companies restating earnings. This happens when an accounting error or other discrepancy comes to light, and a company must reissue reports for past periods. Inaccurate or inconsistent earnings statements may make P/E a less reliable measure of stock value.

Even though P/E is the most widely quoted measure of stock value, it's not the only one. You'll also see stock analysts discussing measures such as ROA (return on assets), ROE (return on equity), and so on. While all of these acronyms may seem confusing at first, you may find, as you get to know them, that they can help answer some of your questions about a company, such as how efficient it is, how much debt it's carrying, and so on.

One way to learn more about individual stocks is through professional stock research. The brokerage firm where you have your account may provide research from its own analysts and perhaps from outside sources. You can also find independent research from analysts who aren't affiliated with a brokerage firm, as well as consensus reports that bring together opinions from a variety of analysts. Some of this research is free, while other research comes with a price tag.

In the past, there have been conflicts of interest at brokerage firms that provide investment banking services to public companies, since analysts may sometimes have felt pressure to review those stocks positively. However, brokerage firms are required to establish strict separations between their investment banking and stock analysis departments to comply with regulations designed to minimize any such potential conflicts of interests.