When evaluating a stock to invest in, you may have to look at an overwhelming number of variables. Is it a long-term or short-term investment? Are you looking to receive dividends? Do you want something that is low-risk or high-risk? In this post, we are going to help you understand what factors to look at when deciding to invest in a stock.
Evaluating a Stock
Since its inception in 1928, the S&P 500 has provided an average annual return of 7%, adjusting for inflation. The S&P 500 tracks the performance of 505 stocks from 500 of the largest companies in the world. Each company has a multibillion-dollar market cap, with a total market cap of approximately $23.9 trillion as of Dec. 31, 2017.
This average annual return of 7% is the reason why the stock market is one of the first places that people invest their money. It has outperformed the bonds market and continues to give investors respectable returns over the long-term. This is why investing in stocks, stock mutual funds, or ETFs, is crucial for retirement or other far-off goals. But what if you are looking to make money over the short-term?
Determining A Stock’s True Value
The first thing that you want to do when evaluating a stock is to establish if the current market value reflects what you believe could be its actual value. This is much easier said than done, and there is no exact way to calculate this, so it is essential to do as much research as possible.
First, you will want to understand the stock’s current value in more depth. The most common way to do this is through the price-to-earnings (P/E) ratio. The P/E ratio is equal to the stock price/earnings per share (P/E = stock price/earnings). Because this is the current value, you can plug in the stock price and the earnings per share to solve for the P/E ratio. The earnings per share can be easily found through a little bit of research.
The next part is where your creativity and insight will come into play. It is up to you to conduct a thorough analysis of the company that you are investing in to predict their future earnings per share. Once you have made your report, plug your estimated earnings per share back into your equation to see where the stock price would theoretically go if those earnings became a reality.
Here are some things to consider when making estimations about a company’s earnings and evaluating a stock:
- Will there be any future product releases or technological advancements?
- Will they become more profitable?
- Who are their competitors and how will they perform?
- You should read their 10-K (annual), and 10-Q (quarterly) reports.
- Are there any red flags? (ongoing litigation, significant debts or fines, etc.)
There are many other factors that you should take into account when making predictions about the performance of a company. Do your research, and as long as you make the best decision you can with your available resources, then everything should be fine.
Outside of earnings reports and performance, the value of a stock and the way you are evaluating a stock can be heavily influenced by the public’s perception of that stock or company. Tesla is one good example. Many believe that Tesla’s stock is overvalued, but if you were to talk to people who truly believed in Elon Musk’s vision, they would say that it is undervalued. It is all about perception.
There are also some companies like Snap Inc. and Twitter, who are widely prevalent regarding usage but are losing hundreds of millions of dollars. For these companies, it is more about where they believe the company will be a year or two down the road, if not longer.
Start Small And Safe
If you are just getting started evaluating a stock, the smartest thing to do may be to purchase some of the more stable stocks like Apple, Amazon, Facebook, etc. — ones that usually see steady, long-term growth. Check out our app at Stockpile to learn how you can invest as little as $5 into these stocks and other big-name companies. When you are feeling more comfortable, try researching the lesser-known companies and go into the details with earnings reports and projections.