How to evaluate a Stock before Investing
There are numerous attitudes and strategies that rely on different parameters and various philosophies, from buying stock cheap to purchasing growth stocks, to investing according to global events. How can you absorb everything that’s happening in the market, from a change in a specific stock to a change in the global economy, from trends in commodities to trends in currencies?
A stock's intrinsic value, rooted in its business fundamentals, is not always the same as its current market price — although some believe otherwise. The value of a stock is made up of several factors, including the company’s ability to continue making a profit, its customer base, its financial structure, the economy, political and cultural trends, and how the company fits within the industry. Understanding that will go a long way toward helping you select stocks for your portfolio.
There are three main techniques for doing that: Net Asset Valuation, relative valuation using multiples, and Discount Cash Flow valuation, which is the most reliable technique.
Current Valuation Analysis
Enterprise Value is a firm valuation proxy that approximates the current market value of a company. It is typically used to determine the takeover or merger price of a firm. Unlike Market Cap, this measure takes into account the entire liquid asset, outstanding debt, and exotic equity instruments that the company has on its balance sheet. When a takeover occurs, the parent company will have to assume the target company's liabilities but will take possession of all cash and cash equivalents.
Enterprise Value = Market Cap + Debt - Cash
Probability Of Bankruptcy
The Probability Of Bankruptcy is used to show its chance of financial distress over the next two years of operations under current economic and market conditions. The Probability Of Bankruptcy is determined by interpolating and adjusting Altman Z Score to account for off-balance-sheet items and missing or unfiled public information. All items used in analyzing the odds of distress are taken from the Editas balance sheet as well as cash flow and income statements available from the company's most recent filings.
The Probability Of Bankruptcy is a relative measure of the likelihood of financial distress. For stocks, the Probability Of Bankruptcy is the normalized value of Z-Score. For funds and ETFs, it is derived from a multi-factor model developed by Macroaxis. The score is used to predict the probability of a firm or a fund experiencing financial distress within the next 24 months. Unlike Z-Score, Probability Of Bankruptcy is the value between 0 and 100, indicating the firm's actual probability it will be financially distressed in the next 2 fiscal years.
Probability Of Bankruptcy = Normalized Z-Score
Z Score
Altman Z Score is one of the simplest fundamental models to determine how likely your company is to fail. The score is used to predict the probability of a firm going into bankruptcy within next 24 months or two fiscal years from the day stated on the accounting statements used to calculate it. The model uses five fundamental business ratios that are weighted according to algorithm of Professor Edward Altman who developed it in the late 1960s at New York University.
To calculate Z-Score one would need to know current working capital of the company, its total assets, and liabilities, amount of latest retained earnings as well as earnings before interest and tax. Companies with Z-Scores above 3.1 are generally considered to be stable and healthy with a low probability of bankruptcy. Scores that fall between 1.8 and 3.1 lie in a so-called 'grey area' with scores of less than 1, indicating the high probability of distress. Z Score is used widely by financial auditors, accountants, money managers, loan processers, wealth advisers, as well as day traders. In the last 25 years, many financial models that utilize z score has been proved to be successful as a predictor of corporate bankruptcy.
Z Score = Sum Of 5 Factors
Book Value Per Share
The naive approach to look at Book Value per Share is to compare it to current stock price. If Book Value per Share is higher than the currently traded stock price, the company can be considered undervalued. However, investors must be aware that conventional calculation of Book Value does not include intangible assets such as goodwill, intellectual property, trademarks or brands and may not be an appropriate measure for many firms.
Book Value per Share (B/S) can be calculated by subtracting liabilities from assets, and then dividing it by the total number of currently outstanding shares. It indicates the level of safety associated with each common share after removing the effects of liabilities. In other words, a shareholder can use this ratio to see how much he or she can sell the stake in the company in the event of a liquidation.
Book Value Per Share = Common Equity/Average Shares
Book value per share will help people who own the share determine the value of their shares if the company should close and liquidate their assets and paying anyone they owe money too. This is important because if you invest in companies that are not stable and may be speculative, you want to know how much you will potentially receive should the company go under. Obviously one should not invest much into these types of situations, but there are times and places where this could be beneficial.
Book value per share could also be a way to measure the potential risk. If you determine a book value to be $10 and the stock is trading above the book value, you could use that as a stop loss. Measuring risk is important to any portfolio and should be done carefully because profits are good, but being safe from risk is also just as good.
What is considered to be a high beta?
Beta measures how much a stock price tends to move in either direction compared to a benchmark. Typically, that benchmark is the broader stock market or S&P 500, but it can also be an industry or an index of companies similar in size. A beta of less than 1 means the stock was less volatile than its benchmark, while a number greater than 1 means it was more volatile, exaggerating the benchmark's moves. Meanwhile, a stock with a negative beta tends to move in the opposite direction of its benchmark.
For example, a stock with a 1.3 beta moves on average x1.3 for every S&P500 move. If the S&P500 gains 10%, the stock with a 1.3 beta gains 10 x 1.3 = 13%. On the other hand, if the S&P500 drops by 10%, the stock drops by 13%. This means that the stock is a high risk high reward. If the general market drops, the stock plunges more; if the general market is rising, the stock could potentially outperform. If you’re wondering how to calculate beta, there’s no need to worry – there are plenty of sites that calculate beta for you; Yahoo Finance is one of them.
High betas are typical of small, speculative companies -- e.g., biotech companies that are developing new treatments and small tech stocks with hot new technologies that have big potential but small market share.
While beta can be a helpful metric when used in combination with other tools, remember that it's only a measure of past volatility against an index -- not a measure of safety. When researching any stock, study the whole business, looking for durable advantages.
Financial ratios to help with stock evaluation
Ratios offer insight into a company’s financial health, allowing for comparisons to other companies in the same industry or against the overall market.
What is a good Earnings Per Share (EPS)?
Earnings per share (EPS) tell investors how much earnings each shareholder would receive if the company was liquidated immediately. Companies are most commonly valued via their earnings. Investors like to see growing earnings, and rising EPS means the company potentially has more money to distribute to shareholders or to roll back into the business.
Also called net income or net profit, earnings are the money left over after a company pays all of its bills. You arrive at the earnings per share by simply dividing the dollar amount of the earnings a company reports by the number of shares it currently has outstanding. Thus, if XYZ Corp. has 1 million shares outstanding, and it's earned $1 million in the past 12 months, it has a trailing (EPS) of $1.
Earnings per Share = (Net Income-Preferred Dividends)/(End-of-Period Common Shares Outstanding)
The earnings per share figure alone means absolutely nothing, though. To look at a company's earnings relative to its price, most investors employ the price/earnings (P/E) ratio.
What is a Good Price-to-Earnings (P/E) ratio?
This is a stock valuation formula that will help you determine how one company’s stock price compares to another. The price-to-earnings ratio is straightforward: It divides the market price of a company’s stock by the company’s earnings per share. The ratio can reveal how many years it will take for a company to generate enough value to buy back its stock.
PE ratio = Current share price / Earnings per share
The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. For instance, if, in our example above, XYZ Corp. was currently trading at $15 a share, it would have a P/E of 15.
Also called a "multiple," the P/E ratio is most often compared against the current rate of growth in earnings per share. Returning to our example, if we find out that XYZ Corp. grew its earnings per share at a 13% over the past year, it would suggest that at a P/E of 15, the company is pretty fairly valued.
Price-to-earnings (PE) ratios can also indicate how much the market expects the company’s profits to grow in the future. A company that is small and growing fast may have a very high P/E, because it may earn little but has a high stock price. When investors buy stocks with a high PE ratio, it typically means they’re “buying” present earnings at a high price, with the expectations that earnings will accelerate going forward. If the company can maintain a strong growth rate and rapidly increase its earnings, a stock that looks expensive on a P/E basis can quickly seem like a bargain. On the other hand, a stock with a low PE ratio could give an investor a good value for their money—but it could also be a sign that investors aren’t confident in the company’s future performance.
Intelligent investors value companies based on future prospects, not past performance, and stocks with low P/Es often have dark clouds looming in the months ahead. If a company has lost money in the past year, or has suffered a decrease in earnings per share over the past 12 months, the P/E becomes less useful than other valuation methods we will talk about later in this series. True, you can still find some great low P/E stocks that the market's simply overlooked for some reason. But when you do, you'll need to confirm these companies' real value by applying some other valuation techniques.
The commonly used applications of the P/E ratio are the P/E and growth ratio (PEG). The PEG ratio is arguably a more meaningful measure of value than the P/E ratio alone. By factoring in growth, the PEG ratio helps an investor evaluate a company’s price in relation to its future earnings growth potential.
What is a good PEG ratio?
The price/earnings-to-growth ratio, or the PEG ratio, is a metric that helps investors value a stock by taking into account a company’s market price, its earnings and its future growth prospects. Relying solely on a trailing P/E in this regard would be like trying to drive with your eyes fixed on the rearview mirror. The PEG ratio can provide a more complete picture of whether a stock is overvalued or undervalued.
Generally speaking, PEG ratio is a 'quick and dirty' way to measure how the current price of a firm's stock relates to its earnings and growth rate. The main benefit of using PEG ratio is that investors can compare the relative valuations of companies within different industries without analyzing their P/E ratios.
The PEG simply takes the annualized rate of growth out to its furthest estimate, then compares this with the trailing P/E ratio. A company that’s expected to grow its revenue, earnings and cash flow at a high rate is, all other things being equal, more valuable than a company with little growth opportunity. Growth companies tend to have higher P/E ratios than value companies for this reason. Investors are willing to pay more for potential growth: When they see the potential for growth, high near-term prices aren’t necessarily a problem.
PEG Ratio indicates the potential value of an equity instrument and is calculated by dividing Price to Earnings (P/E) ratio into earnings growth rate.
PEG ratio = PE ratio/EPS Growth
For instance, if a company is expected to grow at 10% a year over the next two years, and it has a P/E of 20, it will have a PEG of 2 (20 trailing P/E / 10% projected EPS growth rate = 2.0 PEG). To calculate the PEG ratio, an investor needs three things: Stock price, Earnings per share, Expected rate of growth.
Most analysts and investors prefer this measure to a Price to Earnings (P/E) ratio because it incorporates the future growth of a firm. The lower the PEG ratio, the more cheaply a company is valued. A PEG ratio of 1.0 or lower suggests a stock is fairly priced or even undervalued. A PEG ratio above 1.0 suggests a stock is overvalued. For example, a company name A with a PEG ratio of 1.2 would be considered more "expensive" than a company name B with a PEG ratio of 1.0. Another company (C) with a PEG ratio of 0.8 would be considered to have a "fairer" than B company. PEG In other words, investors who rely on the PEG ratio look for stocks that have a P/E ratio equal to or greater than the company’s expected growth rate.
When using the PEG ratio, you are attempting to find the value of the stock or equity. Not only that, but when using the PEG ratio, this is factoring the stocks earnings growth as well. Its close cousin, the PE ratio, is typically used to see if a stock is undervalued or overvalued. With the PEG ratio, if the number ends up being lower, this could be a sign that the company has growth issues.
The PEG ratio or price to earnings to growth ratio is used when evaluating the health and growth of a company. Even though a company may not grow for some time, that does not always make it a poor investment. So when looking at a PEG ratio, a larger number can mean that the stock is overvalued or that growth is in the future. The reverse side of the coin could mean the company is undervalued or that the growth is not there.
While the PEG is most often used for growth companies, the year-ahead P/E and growth ratio (YPEG) is best suited for valuing larger, more established ones. The YPEG uses the same assumptions as the PEG, but it looks at different numbers. Rather than basing the P/E ratio on trailing earnings, it compares the stock price to earnings estimates for the year ahead. It then uses estimated five-year growth rates, which are readily available from several quote sources. Thus, if the forward P/E is 10, and analysts expect the company to grow at 20% over the next five years, the YPEG is equal to 0.5.
Price-to-sales ratio (P/S)
The price-to-sales-ratio, which divides the market capitalization of the company by its revenue, doesn’t factor in profit. This is helpful for valuing companies that haven’t made a profit yet or have a low level of profit. The P/S should be as close to one as possible. If it’s less than one, it’s considered excellent.
Price to Book (P/B)
Price to Book (P/B) ratio is used to relate a company book value to its current market price. A high P/B ratio indicates that investors expect executives to generate more returns on their investments from a given set of assets. Book value is the accounting value of assets minus liabilities.
P/B = MV Per Share/BV Per Share
Price to Book ratio is mostly used in financial services industries where assets and liabilities are typically represented by dollars. Although low Price to Book ratio generally implies that the firm is undervalued, it is often a good indicator that the company may be in financial or managerial distress and should be investigated more carefully.
Return on equity (ROE)
Return on equity is a key guide for investors to measure the growth in profit for a company. ROE is determined by dividing the company’s net income by the shareholders’ equity, then multiplying by 100. The ratio tells you the value you would receive as a shareholder should the company liquidate tomorrow. Some investors like to see ROE rising by 10 percent or more per year, which reflects the performance of the S&P 500.
Debt-to-equity ratio (D/E)
The debt-to-equity ratio, determined by dividing total liabilities by total shareholder equity, gives investors an idea of how much the company is relying on debt to fund its operation. A high debt-to-equity ratio indicates a company that borrows a lot. Whether it’s too high depends on a comparison with other companies in the industry. For example, companies in the tech industry tend to have a D/E ratio of around 2, whereas companies in the financial sector may have D/E ratios of 10.
Debt-to-asset ratio (D/A)
A debt-to-asset ratio can be informative when comparing a company’s debt load against that of other companies in the industry. This allows potential investors to better gauge the riskiness of the investment. Too much debt can be a warning sign for investors.
Current Ratio
Typically, short-term creditors will prefer a high current ratio because it reduces their overall risk. However, investors may prefer a lower current ratio since they are more concerned about growing the business using assets of the company. Acceptable current ratios may vary from one sector to another, but the generally accepted benchmark is to have current assets at least as twice as current liabilities (i.e., Current Ration of 2 to 1).
Current Ratio = Current Asset/Current Liabilities
Current Ratio is calculated by dividing the Current Assets of a company by its Current Liabilities. It measures whether or not a company has enough cash or liquid assets to pay its current liability over the next fiscal year. The ratio is regarded as a test of liquidity for a company.
