How You Can Evaluate And Choose A Winning Stock
The purpose of this blog post is to help you understand how to evaluate stock price and how to pick "good" stocks. There are thousands of stocks to pick from out there, and without the right tools, you can get lost in that jungle. It is written in a simple language and has some equations to better explain the general idea. This, of course, is only some of the information and terms you need to know before you can get a fully wise decision about the stock you want to invest in. Things like par value, LMT (limit order), MKT (market order) and dividends are only some of those things you need to be familiarize with when you are doing your market research in order to find the right stock to invest in.
You can find all the information you need in order to invest in the stock market in our interactive online stock market courseץ If you are making your first steps in the financial world and are looking to start trading than understanding the stock market for beginners is an absolute must for you. Check out the link and find out how fast and easy you can start trading online.
You can also read this basic guide on How To Buy Stocks For Beginners which will give you a great look into choosing stocks.
How do you know which stocks to buy?
There is no proven method for picking a good stock. Stock prices are not like prices of bread and butter. They change minute by minute every single day depending only upon supply and demand. The stock market today is not what it was yesterday, and it will not be the same tomorrow. When a company prospers and earns large profits, the demand for its stock usually rises, as does its stock price. If a company’s profits are shrinking, however, investors will want to sell their shares, and the stock price will fall.
In order to buy a stock successfully, which means that the stock price rises after the purchase, the best policy is to gather as much information as possible about the company, analyze it from many different angles, and test the relationship between the company and its stock price. Knowing that a company is strong is insufficient. An assessment must be made as to whether its stock price is reasonable or inflated (too high). No company -- no matter how good -- is worth any price. Even gold has its price. The opposite situation can also occur: A mediocre company’s stock can fall low enough to make it worth buying.
Two tests for evaluating stocks are recognized by investors:
1. The ratio of price to earnings (P/E ratio).
2. The ratio of market capitalization to the accounting, or book value, of shareholder’s equity is the P/B ratio.
Information needed for these ratios is available on most financial websites, the business sections of newspapers and in companies’ financial statements.
The P/E Ratio
The P/E ratio measures how many years it takes an investor to make back his entire investment from a firm’s annual earnings. For example, if $10 is invested in a stock, and the stock earns $1 per share every year, then the entire investment is recovered in 10 years.
$10 (Total investment in stocks)/$1 (Annual earning per stock) = 10 years
This assumes that earnings per share remains constant at $1.
The P/E Ratio of companies listed on the stock exchange can also be calculated by dividing the firm’s market cap (as calculated above) by its annual earnings.
P/E Ratio = Total market cap/Annual profit
The market cap is the total number of outstanding shares multiplied by the market price. Listed companies publish their earnings every quarter. For example, the P/E ratio of “Caterpillar” on March 9, 2006 was 17.
Caterpillar market cap/Net annual profit = $48.42 billion/$2.854 billion = 17
An investor who buys “Caterpillar” for $48.42 billion will earn back his entire investment in 17 years, assuming that the annual profit remains steady at $2.854 billion per year.
As a rule, the lower the P/E ratio, the better the investment because investors recoup their investments sooner.
The P/E ratio depends upon two important factors: The quality of the company, as measured by its earnings, and its stock price, as measured by its market cap.
The P/E ratio also helps when comparing different companies in the same industry, such as real estate companies and communications industry companies. The company with the lower P/E ratio will usually be considered more attractive than a company with a higher P/E ratio.
Another way of calculating the P/E ratio that is perhaps even more convenient is to divide the share price by the earnings per share. These figures are usually published in the business sections of various newspapers. First calculate the profit per share by dividing the annual profit by the number of outstanding shares:
Profit per share = Annual profit/Outstanding shares = $2,854 million/670.87 million shares = $4.254
P/E Ratio = Stock price/Profit per share = $72.4/$4.254 = 17
The ratio of market cap to shareholders' equity For “Caterpillar”:
Market cap/Equity = $48.42 billion/$8.4 billion = 5.76
This ratio means that investors spend $48.42 billion for $8.4 billion in equity (net assets). In other words, they are willing to spend $5.76 for every $1 in net assets. Why are they willing to spend so much?
There are a number of possible reasons:
The net assets of the company may be worth more because the value of the company’s assets, which is used for calculating its equity, is based on their purchase price. Just as a house can rise in value, a company’s assets can actually be worth more than the amount paid for them.
A firm can produce significant profits from its assets due to the net value of its assets. The lower the ratio of market cap to equity, the lower the price that investors must pay for a portion of those assets.
Financial analysts have concluded that the P/E Ratio is more significant for industrial and commercial enterprises, while the market cap to equity ratio is more relevant for companies in the real estate industry.
Note: These ratios are usually of little value for analyzing young companies. This is especially true with respect to start-up companies, and their value is usually measured by their potential, rather than their achievements. Mirabilis, a famous example, was sold for $400 million, despite a complete lack of both profits and significant assets.
The stock market may seem impossible to understand if you are a beginner in the investment market. That being said, there are some great online courses for for beginners to help you understand the basics of the market, how to pick the right stock and finally investing your capital without risk. So, if you are beginner who is interested in learning how to trade stocks than you should check out this article: Learning The Stock Market