A company’s stock value can be determined by several factors. For instance, the ability to stay profitable, customer loyalty, financial structure, and industry competition can all help investors decide how much shares are worth. Sensitivity to outside influences, such as the broader economy and political climate, can also play a role.
While even seasoned stock investors can fall prey to bad valuations, what any investor can do is research and carefully evaluate a stock before purchasing it. Taking the time to learn about one’s investments can help individuals spot trends that will affect a company’s performance. Knowing some of the different stock valuation metrics that are typically used can make that process easier.
Using Earnings Reports to Value Stocks
The Securities and Exchange Commission (SEC) requires all publicly traded companies to disclose their performance and file financial documents. Every quarter, companies report a profit or loss, material issues that can affect performance, and any other relevant information that can influence an investor’s view on a stock.
Investors can find these documents on the SEC’s EDGAR website. EDGAR, which stands for Electronic Data Gathering Analysis and Retrieval, is the regulator’s filing system for corporate documents. Here are some publicly available figures that an investor can review:
• The balance sheet shows how the company is handling its debt. Has it gone up or down since the last filing? One thing to remember is that a balance sheet only represents a three-month period, so an investor may want to look at past filings to spot trends.
• The cash-flow statement reveals what the company actually got paid that quarter against any forecasts. A good line item to focus on is the operating cash flow, which is how the company makes money during the normal course of business.
• A third document to check out is a company’s income statement. It will report on revenue, any major expenses, and bottom-line income. It can also be a good indicator over time of where a company is heading.
Different Stock Valuation Metrics
As you dig into a stock, here are some different stock valuation metrics you might use.
Earnings-per-Share (EPS)
This metric tells investors how much money a company makes for each share of its stock. It’s devised by taking net income, subtracting any preferred-stock dividends, then dividing that by the total number of outstanding shares of common stock.
What it tells you: A company’s EPS is an indicator of how much the market is willing to pay for each dollar of earnings. A high EPS equals more value, because investors will pay more for a company with higher profits.
EPS is also a factor in determining one of the most commonly used valuation metrics, the price-to-earnings ratio.
Price-to-Earnings Ratio (P/E)
This valuation metric is calculated by dividing the price per share by the earnings per share. The P/E ratio shows you what the market is willing to pay for the stock based on its earnings (past or future.)
What it tells you: If the P/E ratio is high, it could mean that the stock’s price is high compared to its earnings, and possibly overvalued. The opposite could be true for a low P/E ratio. Generally for American companies, a P/E of less than 15 is considered cheap, and one over 20 is considered expensive.
Price-to-Sales Ratio (P/S)
This ratio is calculated by dividing the company’s market capitalization (market cap), which is the value of all its outstanding stock in dollars, by its revenue. Unlike the P/E ratio, the P/S ratio doesn’t factor in profit. Rather, it focuses on growth.
What it tells you: The P/S ratio is one way to value companies that don’t have a steady history or profitability. This could be because they’re up-and-coming or part of a cyclical industry that doesn’t always show a profit. A good P/S ratio should be as close to 1 as possible.
A P/S ratio of less than could be considered excellent, because it could indicate that investors are paying less than $1 per stock for each dollar in a company’s sales. It could also mean the exact opposite though — that investors expect the future to not be as good and therefore don’t want to pay a high price. Context, in addition to cold, hard numbers, can help when evaluating whether a stock price makes sense.
Recommended: Investing in Growth Funds
Debt-to-Asset Ratio (D/A)
If you’ve ever applied for a loan, you may be familiar with this metric. Lenders use a version of it (called the debt-to-income ratio, or DTI) as one factor in determining a borrower’s risk. In stock valuation, the D/A ratio (also just called the debt ratio) is based on the same concept, and it’s determined by dividing a company’s total debt by its total assets.
What it tells you: If the D/A ratio is higher than 1 (or 100%), it could signal that a company is funding its business with debt. This means that if interest rates were to take a sudden jump, it may have a higher probability of defaulting on its loans.
Conversely, a ratio that’s less than 1 means assets are funded by equity. And, as can be the case in mortgage lending, there’s no agreed-upon threshold for a good debt ratio.
As a general rule, however, the lower that number is, the better. Different industries also tend to have different average levels of debt, so it may be worthwhile to see what other companies within the same industry look like.
Debt-to-Equity Ratio (D/E)
This debt-based metric hones in on a company’s debt vs. its shareholder equity. Dividing total liabilities by total equity paints a picture of how much a company is relying on debt for funding.
What it tells you: If the company were to liquidate, a high D/E ratio could signal that shareholders would be on the hook to cover liabilities. Generally speaking, a high D/E ratio means a company may not be able to pull together enough cash to satisfy its debts. Oppositely, a low ratio isn’t necessarily good — it could indicate that a company isn’t leveraging a growth in profits.
The D/E ratio can be calculated several ways. If you use this ratio, be sure to understand what type of debt and equity was used to come to the number and what comparable companies look like.
Recommended: Value vs. Growth Stocks
Value Traps
Another common term to be familiar with is value trap — a stock that appears deceptively cheap but is actually not a good pick. Investors who follow the value style of investing tend to be very wary of value traps.
Because while these might seem like bargains, they’re usually not good businesses and may be trading at cheap valuations due to a permanent downhill move or industry changes, rises in costs, or bad management.
Whether a stock is a value trap depends on how the stock performs. If it moves back up to its “intrinsic value” or its true worth, it was indeed a bargain. But if it continues downward or stagnates, the market value was basically a true reflection of its intrinsic value.
Going Beyond the Ratios
One way to avoid a potential value trap is to view a stock’s ratios as only the starting point — because it likely isn’t the whole story. A little bit of good, old-fashioned research into the company as a whole can help give you a better look at the big picture. Here are some additional tips to keep in mind.
Intangible Value
Some investors have argued that traditional metrics don’t capture the values of intangible assets a company might hold, like brand power and intellectual property. These have become increasingly important to a company’s worth in more recent years, particularly when it comes to tech stock investing.
For instance, a software company’s patents or intellectual property rights may be incredibly valuable. But on the other hand, it wouldn’t have assets like factories or equipment that are easier to appraise.
Investors should also look at a company’s growth trends, such as at what pace it’s growing its revenue or customer base. Paying attention to “company guidance” — the projections the corporation gives when it releases earnings — can also be helpful in trying to gauge growth.
Outside Influences
Investors can also learn a stock’s beta, or its sensitivity to volatility in the broader market. Some companies are more vulnerable to changes in the domestic or global economy, and others may see their fortunes swing depending on the political party in charge of a government.
Learning a stock’s beta or finding one’s portfolio beta are ways investors can better gauge how much volatility their holdings will experience when there’s turbulence in the broader market.
Paying Attention
The last way you can get a peek behind the company curtains is to take to the web. Stock-market gurus, investment-focused sites, business publications, and even discussion forums can reveal elements of an organization that can help you fill in the blanks.
One way to keep tabs on a company that you’ve either already invested in, or have an interest in, is to set up news alerts for topics like the name of the business, CEO, or other important players. Staying on top of business news can not only help determine which stocks to buy, but when to buy them.
How Much Does Investing Cost?
You’ve done your valuation homework. Now what? Even stocks with the best valuations won’t help you make money if you don’t have cash to invest. Fortunately, jumping into the stock market doesn’t require six-figure cash levels.
An ever-growing number of brokerage firms, as well as industry practices like payment for order flow, has caused the cost of retail investing to collapse in recent years. Nowadays, zero-commission trading and mobile investing is widely available. Many brokers also allow individual investors to start investing with as little as $1.
And if there’s a company whose share price is out of an investor’s reach, fractional shares — the ability to buy a slice of a whole stock — is an option that’s available at some brokerage firms.
The Takeaway
Valuing a stock can be a tricky endeavor for even the most seasoned investors. Value traps, growth projections, and CEO management are all dynamic factors that investors need to take into account when it comes to determining a company’s worth. While good old-fashioned metrics like price-to-earnings ratios are important, investors can also pay attention to intangible assets, like intellectual property as well as growth trends.
For investors who want to try their hand at valuing company stocks, SoFi’s Active Investing platform may be a good option. The platform will give investors access to company stocks, fractional shares, as well as exchange-traded funds (ETFs). For those who want a more hands-off approach, the Automated Investing service may be a good option because it provides and rebalances portfolios for investors.
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