How to evaluate stocks? e.g. Whether some stock is cheap or expensive?

Question

What kind of information do you obtain before buying (or selling) a stock? I know the PE ratio is very important, but not the only thing. Are there any rules of thumb to determine whether some stock is cheap or expensive? Or do you simply listen to 'experts' and hope they are right?

I buy an independent magazine and bet with them.

Edit: I'm looking for a number of properties that can be easily checked, with some kind of rule of thumb that indicates the quality of the stock at hand. For example PE < 16 (or so I heard).

Edit: Each property should be accompanied by a rule of thumb for reference.

Answer 1

If you are looking for numerical metrics I think the following are popular:

Price/Earnings (P/E) - You mentioned this very popular one in your question. There are different P/E ratios - forward (essentially an estimate of future earnings by management), trailing, etc.. I think of the P/E as a quick way to grade a company's income statement (i.e: How much does the stock cost verusus the amount of earnings being generated on a per share basis?).

Some caution must be taken when looking at the P/E ratio. Earnings can be "massaged" by the company. Revenue can be moved between quarters, assets can be depreciated at different rates, residual value of assets can be adjusted, etc.. Knowing this, the P/E ratio alone doesn't help me determine whether or not a stock is cheap.

In general, I think an affordable stock is one whose P/E is under 15.

Price/Book - I look at the Price/Book as a quick way to grade a company's balance sheet. The book value of a company is the amount of cash that would be left if everything the company owned was sold and all debts paid (i.e. the company's net worth). The cash is then divided amoung the outstanding shares and the Price/Book can be computed. If a company had a price/book under 1.0 then theoretically you could purchase the stock, the company could be liquidated, and you would end up with more money then what you paid for the stock. This ratio attempts to answer: "How much does the stock cost based on the net worth of the company?"

Again, this ratio can be "massaged" by the company. Asset values have to be estimated based on current market values (think about trying to determine how much a company's building is worth) unless, of course, mark-to-market is suspended. This involves some estimating. Again, I don't use this value alone in determing whether or not a stock is cheap.

I consider a price/book value under 10 a good number.

Cash - I look at growth in the cash balance of a company as a way to grade a company's cash flow statement. Is the cash account growing or not?

As they say, "Cash is King". This is one measurement that can not be "massaged" which is why I like it. The P/E and Price/Book can be "tuned" but in the end the company cannot hide a shrinking cash balance.

Return Ratios - Return on Equity is a measure of the amount of earnings being generated for a given amount of equity (ROE = earnings/(assets - liabilities)). This attempts to measure how effective the company is at generating earnings with a given amount of equity. There is also Return on Assets which measures earnings returns based on the company's assets.

I tend to think an ROE over 15% is a good number.

These measurements rely on a company accurately reporting its financial condition. Remember, in the US companies are allowed to falsify accounting reports if approved by the government so be careful. There are others who simply don't follow the rules and report whatever numbers they like without penalty.

There are many others. These are just a few of the more popular ones. There are many other considerations to take into account as other posters have pointed out.

Answer 2

Its like anything else, you need to study and learn more about investing in general and the stocks you are looking at buying or selling. Magazines are a good start -- also check out the books recommended in another question.

If you're looking at buying a stock for the mid/long term, look at things like this:

• P/E relative to peers. A high P/E isn't necessarily a bad thing, depending on the company.
• Is the stock undervalued? Sometimes companies get mis-categorized and the stock suffers. Example: Is Amazon.com a retailer or a technology company?
• Is the company a victim of guilt by association? Example: Many regional banks were punished by the subprime collapse, although they had zero exposure.
• Look at dividends... there have been some great coups in the past couple of years in dividend stocks in the last several years.
• Once you decide to buy a stock, but it in batches to protect against daily swings.

Selling is more complicated and more frequently screwed up:

• Don't get emotional, ever. A stock isn't your friend -- it isn't loyal to you.
• Sell in lots as the stock rises.
• Sell high.
• Keep good records for tax purposes.

Answer 3

• Are the products the company sells going to be in demand?
• What competition does the company have?
• What intellectual property advantage do they have?
• How much debt do they carry?

Answer 4

duffbeer's answers are reasonable for the specific question asked, but it seems to me the questioner is really wanting to know what stocks should I buy, by asking "do you simply listen to 'experts' and hope they are right?"

Basic fundamental analysis techniques like picking stocks with a low PE or high dividend yield are probably unlikely to give returns much above the average market because many other people are applying the same well-known techniques.

Answer 5

I look at the following ratios and how these ratios developed over time, for instance how did valuation come down in a recession, what was the trough multiple during the Lehman crisis in 2008, how did a recession or good economy affect profitability of the company.

Valuation metrics:

Enterprise value / EBIT (EBIT = operating income) Enterprise value / sales (for fast growing companies as their operating profit is expected to be realized later in time) and P/E

Profitability:

Operating margin, which is EBIT / sales Cashflow / sales

Business model stability and news flow

Answer 6

P/E is the standard metric to value a stock based on historical earnings. It is an important metric. However, it doesn't give insight into future growth rates for a company. The PEG ratio is a way to incorporate the stock's current price and it's projected earnings growth. I find this important because you could look at 2 companies which have the same PE ratio, but one is growing substantially faster than the other (or projected to anyways)

Take a look at Fidelity.com as they have an amazing amount of information available for non-customers and customers alike. https://www.fidelity.com/learning-center/trading-investing/overview. In the "News and Research" tab, look for the 'Learning Center'. The below definitions are straight from their website.

Price-to-earnings ratio (P/E) looks at the relationship between a company's stock price and its earnings. The P/E ratio gives investors an idea of what the market is willing to pay for the company's earnings. The ratio is determined by dividing a company's current share price by its earnings per share. For example, if a company is currently trading at $25 a share and its earnings over the last 12 months are $1.35 per share, the P/E ratio for the stock would be 18.5 ($25/$1.35). As the P/E goes up, it shows that current investor sentiment is favorable. A dropping P/E is an indication that the company is out of favor with investors.

Price-to-book value (P/B) is a measurement that looks at the value the market places on the book value of the company. It is calculated by taking the current price per share and dividing by the book value per share. The book value of a company is the difference between the balance sheet assets and balance sheet liabilities. It is an estimation of the value of the company if it were to be liquidated. For example, a company with a share price of $60 and a book value of $65 per share would have a P/B ratio of 0.9. A ratio over 1 generally implies that the market is willing to pay more than the equity per share, while a ratio under 1 implies that the market is willing to pay less.

The price-to-sales ratio (P/S) shows how much the market values every dollar of the company's sales. To calculate it, take the company's market capitalization and divide it by the company's total sales over the past 12 months. A company's market cap is the number of shares issued multiplied by the share price. The P/S ratio can be used in place of the P/E ratio in situations where the company has a net loss. One of the advantages of using the P/S ratio is that sales are much harder to manipulate than earnings. Since a company's sales are generally more stable than its earnings level, any large changes in the P/S ratio are often more likely to indicate a departure from the intrinsic value of the company (either up or down).

Price-to-cash flow ratio (P/CF) evaluates the price of a company's stock relative to how much cash flow the company generates. It is calculated by dividing the company's market cap by its operating cash flow in the most recent 12 months. It can also be calculated by dividing the per-share stock price by the per-share operating cash flow. P/CF ratio is an alternative method to P/E ratio. Many investors prefer to use a P/CF metric because it is considered harder to manipulate cash tallies than it would be to massage earnings reports under generally accepted accounting principles, which could make the cash-based benchmark a more reliable indicator.

Price/earnings-to-growth ratio is the relationship between the P/E ratio and the projected earnings growth of a company. It is calculated by dividing the P/E ratio by the earnings-per-share growth. For example, if a company’s P/E ratio is 16.5 and its earnings-per-share growth over the next 3 years is expected to be 10.8%, its PEG ratio would be 1.5. A PEG of 1 or less is typically taken to indicate that the company is undervalued. A PEG of more than 1 is typically taken to indicate that the company is overvalued. To get a clearer picture of value, the PEG of the company should also be compared with the PEG of the market and with the industry that the company competes in.