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Posted on January 20, 2011

Stock Research Decoded for Beginners

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Finance expert Alvin Hall shares his 8-step checklist for evaluating corporate stocks. From Your Money or Your Life: A Practical Guide to Managing and Improving Your Financial Life

The key items I like to examine concerning any company include:

  • The story of the company. This refers to the basic history of the company: the products or services it sells, the markets it serves, how it is organized, how creatively and progressively it is managed, and what strategies it is pursuing to grow in the future. A convincing, positive story that makes sense in the light of everything you know about business is not enough in itself to make a company’s shares worth buying, but it’s not a bad starting point.
  • The company’s revenue and profit history. Revenue refers to the company’s total sales of products and services; profit is the portion of revenues remaining after costs (including operations expenses, interest payments on debt, taxes, etc.) have been deducted. Generally speaking, a company with a history of strong and steady revenue growth over the past several years is a better investment prospect than one whose sales are flat or declining. (However, you should also look at the sources of the increased revenues; if they come mainly from acquisitions of competing companies, there’s a good chance that the growth will soon stop.) Similarly, the more consistent the company’s profits, the better; and a pattern of steadily increasing profits over time is better still.
  • Recent movements in the company’s stock price. These will indicate how investors have reacted to recent developments in the company’s business. Nearly all share prices have their ups and downs, but a generally upward trend is a sign that the marketplace has confidence in the company’s management and its strategy, while a declining stock price suggests that many investors have doubts about the company’s future. Of course, it’s dangerous to assume that the share price trend of the past year will continue. When a basically sound company has a lagging stock price, it may mean there is a bargain to be had, while a high price may be too high, suggesting that the company may be heading for a fall. So look at past share price movements, but analyze their meaning skeptically in the light of everything you know about the company.
  • Earnings per share (EPS). Every quarter, all public corporations in the United States must report their earnings per share. These are the part of the company’s profits that is available to be paid to its common stockholders. (Note: Preferred dividends are not part of EPS. These dividends are deducted before EPS is calculated.) There are two basic types of EPS: primary and fully diluted. Primary EPS is calculated by dividing a company’s total earnings by the number of common shares outstanding in the market. Fully diluted EPS is calculated by dividing a company’s earnings by the number of outstanding common shares plus any other securities that can be converted into the underlying common shares, thereby increasing the number of outstanding shares. The details are technical, but the main point to remember is that fully diluted EPS is considered to be a more accurate measure. Analysts compare the reported EPS with the EPS for the same period the previous year. The trend is important. Consistent growth in the EPS tends to indicate that a company’s fortunes are good and therefore that the company may be worth investing in. Disappointing EPS (a number below analysts’ expectations) could be a sign of weakness in the company’s revenue growth or the temporary effect of significant onetime expenses.
  • The company’s P/E (price/earnings) ratio. This refers to the ratio of the company’s current common stock price to the company’s annual earnings per share — hence, price/earnings ratio, or P/E. For example, if a company’s shares are currently selling at a price of $24, and the company earned $2 per share during the past twelve months, the P/E ratio is 24 ÷ 2 = 12. One way to think about this is to think of that 12 as representing the number of years it would take for you to recoup the cost of your investment from company earnings. The higher the P/E ratio, the greater the expectations of most investors and share analysts concerning the company’s future prospects, particularly the growth of its earnings. They’re hoping that earnings will grow so that the investment can be earned back more quickly. A high P/E ratio generally means that the share price will be more volatile. Some investors like to buy shares whose P/E ratio is low compared to other companies in the same business sector. They feel that this means that the shares are a relative bargain.
  • The company’s dividend history. Remember that dividends represent the portion of a company’s profits that is paid out to investors. The payment of all dividends is at the discretion of the company’s board of directors. Examining the size of the dividend payout over the past several years can offer a partial indication of the financial health of the company. After all, only a company that is consistently profitable can afford to pay substantial dividends year after year, and occasionally increase them. This is an especially important indicator if you are seeking stocks primarily for current income.
  • The degree of leverage employed by the company. This refers to the amount of debt owed by the company. Owing some money isn’t necessarily a bad thing; an expanding business often must borrow to finance the construction of new factories or stores, for example. But excessive debt is a red flag. Since average debt ratios vary greatly from industry to industry, the best way to evaluate a company’s indebtedness is by comparing it with others in the same sector. Other things being equal, a company with less leverage (and therefore a stronger corporate balance sheet) is likely to be a better investment risk.
  • How stock analysts view the company. Finally, consider the opinions of the experts who track stocks for brokerage houses and other financial firms. These are often cited in the financial press and on television, as well as in reports published by the financial firms themselves. Like anyone else, analysts are human and fallible. They’ve been known to overrate a company because of a convincing presentation by a charismatic CEO. And sometimes the analysts fall prey to fads, crazes, and manias (which occur in finance just as in other human activities). Nonetheless, you may find it informative and educational to read what the professional analysts have to say, especially after you’ve studied a company and drawn your own conclusions.

Does this list of indicators add up to a perfect formula for profitable stock investing? Unfortunately, no. The factors that determine the ultimate success of a company (and therefore the value of its shares) are too complex and unpredictable to be easily reduced to a formula. Even the best investors (including Buffett and Lynch) have picked their share of losers. If you want to invest in stocks, you’ll need to study, experiment, and learn from your successes and failures.

Think of it as being a bit like taking up golf or any other challenging sport. No one hits a hole in one every time out. But those who take the game seriously and put the necessary practice can expect to steadily improve their performance.

ABOUT THE AUTHOR
Alvin Hall, author of Your Money or Your Life: A Practical Guide to Managing and Improving Your Financial Life (Copyright © 2009 by Alvin Hall), has been training and counseling a wide range of financial service companies and institutions in the United States and around the world for the last twenty years. He lives in New York City.

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