What you need to know when you buy a stock.
Its easy for new investors to get overwhelmed by the sheer amount of information and choices out there. There are thousands of different stocks and endless complicated tools, metrics and charts available to analyze them. Theres no strategy thats 100% effective for choosing the best stocks to buy. But for investors simply looking for a place to start in the complicated world of investing, learning some basic analysis tools and terminology can help provide a general understanding of a company and its stock. Here are seven basic steps any investor can take to analyze a stock before buying.
Earnings per share
When it comes down to it, the ultimate goal of any company is to turn a profit. Earnings per share, or EPS, is reported quarterly and is a rough indication of how much profit a company is generating per share of stock. In general, the higher the EPS the better. However, EPS growth over time is also critical. Companies can temporarily boost EPS by selling assets or cutting costs, so its important to get a sense of how an EPS changes over time. A consistent negative EPS growth may be a red flag for investors of trouble down the road.
Earnings per share can give investors a sense of how well a companys business model is working. However, revenue is an indicator of how much business the company is doing. Positive trends in revenue indicate a company that is expanding its business. High-growth companies like Amazon.com (AMZN) and Netflix (NFLX) can go many years without generating positive EPS because these companies are investing all of their profits into growing the business. At the same time, a struggling company like retailer Macys (M) is generating consistent profit, while its revenue is down 11% in the past five years.
The price-earnings-growth ratio, or PEG, is one way to combine earnings, revenue growth and share price into one easily digestible number. Price-earnings ratio, or P/E, is a stocks share price divided by its EPS. P/E gives investors a sense of how much they are paying for $1 of EPS. Unfortunately, P/E does not incorporate growth. PEG, on the other hand, is calculated by dividing a stocks P/E by its projected 12-month forward revenue growth rate. Typically, a PEG below 1 represents a good value, whereas a PEG above 2 is potentially a red flag that the stock is overpriced.
If a companys earnings and revenue growth are on track, one of the only other under-the-radar issues that is often hiding in plain sight is debt. If a company is relying on debt to fuel its growth, it is vulnerable to credit downgrades or a tightening of the credit market. Debt-to-equity ratio is a measure of a companys leverage that is calculated by dividing a companys total liabilities by its shareholder equity. A debt-equity ratio less than 0.1 is ideal, but anything above 0.5 could be a sign of potential trouble down the road.
The stock market is considered to be forward looking. Stocks are not just priced based on the past or current performance of the companies. They are also priced based on expectations for future performance. Fortunately, many companies let investors know what to expect on a quarterly or annual basis by issuing guidance along with their earnings report. Companies often disclose their own internal expectations for revenue and/or EPS, as well as any industry-specific metrics such as subscriber growth or same-store sales. A stocks share price will often react more significantly to guidance than current-quarter earnings and revenue numbers.
Outside of the companys own guidance, one of the best sources of information about a stock are Wall Street analyst reports. Analysts from investment banks like Morgan Stanley and Goldman Sachs periodically release in-depth reports on individual stocks that include financial projections, stock ratings and 12-month targets for a stocks share price. Stocks often react when analysts upgrade or downgrade their ratings for a stock or adjust their price targets. These analysts are far from perfect at predicting stock movements, but paying attention to their updates helps investors stay informed about the important issues facing a company and its investors.
A stocks share price fluctuates on a daily basis, but reliable dividend payments come like clockwork every quarter. Mature companies often take a percentage of their quarterly cash flow and pay it out to shareholders directly via dividend payments. A companys dividend yield is its total annual dividend payment divided by its share price. The average S&P 500 stock pays a dividend yield of around 2%. Dividend yields above 3% are typically considered high. However, companies can cut their dividends at any time, so investors should be particularly careful with stocks paying dividend yields above 5%.
Best ways to analyze a stock:
-- Earnings per share.
-- PEG ratio.
-- Debt-equity ratio.
-- Analyst recommendations.
-- Dividend yield.
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