When you imagine watching that stock ticker roll by on TV, or listening to a report on the stock market, what’s your reaction? Is it excitement at learning about how your portfolio is likely doing, or a good reason to change the channel?
Fear over the volatility of the stock market is one of the reasons many Americans, especially Millennials, say they prefer cash over other investments, such as investing in the stock market.
But as the old saying goes, with knowledge comes power (or, if you’re an ‘90s kid, The More You Know.) Here are several ways to learn about how to value a stock, better understanding what makes a good investment, and starting to unpack the mystery that is the stock market.
How to Value a Stock
A company’s stock value is determined based on several factors, such as its ability to remain profitable, its customer base, financial structure, and place among industry competitors. Outside influences such as the economy as a whole and the political climate can also play a role.
Several numbers, called valuation metrics, are used to paint a picture of a company’s value and can be used alone or in combination to help guide investment decisions. Here are some of the most common.
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.
It’s 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 less than 15 is considered cheap, and over 20 is considered expensive.
Price-to-Sales Ratio (P/S): This ratio is calculated by dividing the company’s market capitalization (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, maybe 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.
Less than could be considered excellent, because it could indicate that investors are paying less than $1 per stock for each $1 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.
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.
Another common term to be familiar with if you’re parsing stocks is value trap—a stock that appears deceptively valuable, but in fact is likely not a good pick. A value trap can happen when a stock shows better valuation metrics over a period of time than it has in the past.
This might seem like a bargain to investors, but it could be in fact the company taking a permanent downhill turn due to industry changes, rises in costs, or bad management.
Whether it’s a value trap depends on how the stock performs. If it trends back up, it was indeed a bargain. But if it continues downward, so does your investment.
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.
Two factors can help make your query easy and fruitful. First, the SSecurities and Exchange Commission (SEC) requires all publicly traded companies to disclose their performance and file financial documents on the regular. Every quarter, they must report on profit and loss, material issues that can hinder performance, costs, and any other relevant information which can help an investor gauge the situation.
Here are some publicly available documents that you can review:
The balance sheet shows you 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 you may want to look at past filings in order to spot trends.
The cash-flow statement reveals what the company actually got paid that quarter vs. 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.
It’s safe to say that these documents can be cumbersome and confusing if you don’t speak fluent finance. But if you get a feel for which items are the most important to evaluating a stock, you may soon be able to block out the rest.
The second 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. If you have your eye on a stock that appears to be a bargain, for example, but uncover a story about numerous management changes or threats of sale recently, it could point to a value trap.
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.
Preferred or Common – What’s Better?
In general, you can choose your first stock from two different types: common and preferred.
Common stocks make up the bulk of the public trading of stock. Buying one or two shares of common stock makes you a common shareholder, which can come with voting rights as well as the possibility of dividends and a gain in stock value.
Breaking that down further, dividends are paid out by the company on a set schedule as a way to distribute profits and make you, as a shareholder, happy (at least until you have to pay taxes on them.) If the company goes bankrupt, however, common shareholders are last in line behind creditors and preferred stockholders to receive any liquidation payouts.
Preferred stocks, on the other hand, come with a different set of pros and cons. Unlike common stock, shareholders have no voting rights if they own preferred stock. However, dividends are paid to preferred stockholders before common stockholders. Preferred stockholders are also paid first in the case of a liquidation.
Finally, preferred stocks can be called back, which means that a company can buy these shares back — usually at a premium.
Understanding Investment Style
That question sounds like it’s right out of a quiz. But one way to determine which investments could be right for you is to jump ahead to the endgame and work your way back. Figuring out what type of investor you are can be a good place to start.
You’re likely to be a growth investor if you’re looking to generate high returns and take risks, like investing in high-growth stocks that you may never have heard of but have a lot of perceived potential. You might even picture yourself on the stock-exchange floor, cheering when a gamble pays off like a regular Wolf of Wall Street.
Oppositely, if you’re more conservative, perhaps even risk-averse, and in search of stable and well-established stocks from giant companies that have been around for ages, you’re more likely an income or value investor.
Your investment goals are entirely up to you, and the good news is that if you choose to diversify your portfolio, you can even be a little bit of both.
How Much Does Investing Cost?
You’ve done your valuation homework. Now what? Even stocks with the best cash flows won’t help you make money if you don’t have cash flow to invest.
Fortunately, jumping into the stock market doesn’t require a six-figure stack of hundies and a personal broker.
Thanks to the ever-growing number of fintech companies who are offering investment options for the rest of us, it’s become much more affordable to put money where the market is. Even if it’s only a few bucks.
It also means you have options. You can still go the traditional brokerage route if you choose, or you could download an app, deposit the opening minimum, and get going—with no management fees.
And, if your one takeaway from this article is that market math isn’t your thing, you can set up a fully automated investment account and let the bots do the heavy lifting.
Once you’ve learned how to value a company stock, a SoFi Invest® account can help keep all your investment funds in one place.
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