How to Evaluate Stocks: An Investor’s Guide

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Updated: 25 March 2020

Stock evaluation is one of the most essential aspects of trading and investments. Many people who trade on the stock market prefer to trade in stocks because they are by far the simplest investment vehicles to understand and are also less volatile, making them good for long term investments. Their risk levels can also be diversified across industry lines, among other factors. One of the reasons stocks, or shares, are so popular is because they are straightforward in the way their values are determined.

This stock evaluation guide will cover the following elements of how to evaluate stocks:
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  • Understanding what stock evaluation is
  • The four ways to evaluate a stock
  • What the value of the stock signals to the market
  • Factors and elements to look out for when investing in a stock

A Basic Understanding of Stock Evaluation

Before you can venture into all the techniques and methods available for stock trading, you need to first familiarise yourself with the concept of stock evaluation. As mentioned above, a stock is an investment vehicle available for trade on the stock exchange. Companies list their stocks on various stock exchanges at an initial price per stock referred to as an initial public offering (IPO). Although the company lists an initial price per stock, the market itself starts to value the share based on a number of factors, the most prominent being company perceived performance.

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As a general standard, the better a company performs, the higher the value of their stock on the market. Stock evaluation is therefore the act of calculating the current value of the share. It is important to remember that ultimately, the market works on a supply and demand system and a stock’s value is subject to the market’s perception. Stock evaluation can therefore be described as a more theoretical basis of valuing the stock.

One of the main reasons why theoretical stock evaluations are conducted is to allow for performance projections. This gives an investor an idea of how the stock is likely to perform. Knowing how to evaluate stocks allows investors to see through current market perceptions to get to the intrinsic value of a stock. If this is done successfully, a stock investor will purchase the stock before it rises and ultimately exploit the capital gain to yield a profit.

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The Four Methods of Stock Evaluation

It is essential that you are aware that there are a number of trading strategies available. While some are more technical and require multiple calculations, others rely mainly on observations.

  • The P/E Ratio (Price to Earnings)
  • The Dividend Yield
  • The P/B Ratio (Price to Book)
  • The Bottom Line Observation

The first method, the P/E ratio, places company earnings on the forefront of a stock’s value. It determines whether the company will be able to sustain earnings growth over an extended period of time. This means that although a stock’s price may raise or increase in the market, if the earnings potential of the company is not steady (determined by the P/E ratio), the price will not last as it cannot be sustained on the basis of the company continuing to be profitable. P/E ratio calculates how long it will take for the stock to pay back its value should company earnings not continue to rise. If an investor purchases a company’s stock for £50 per share on the market with earnings valued at £5 per share, the share yields a P/E ratio of 10, (£50/£5). If nothing changes in the company earnings, it may take an investor 10 years,  to earn back their initial investment. Stock P/E ratios tend to be quite high, owing to a company’s perceived earning potential. P/E ratios should only be compared with companies operating in the same sectors to gauge a realistic evaluation.

The Dividend Yield

The dividend yield is a method used to value stocks on the basis of their dividend payout potential. This is especially common with regards to stocks which pay out yearly or sometimes bi-annual dividends to shareholders. Dividends are earnings that companies pass on to their shareholders. Dividends can assume a number of forms including cash payments, shares of stock, or other property. Dividends may be issued over varying timeframes and payout rates. Many investors are willing to tolerate slow earning growth periods provided they are being paid out a dividend, ; however, sometimes companies decide not to pay out on a dividend yielding stock, which also affects the stock value.

The dividend yield signals a number of things to an investor. Firstly, a company that is able to pay out a dividend year in and year out is signalling to investors that they are performing well enough to afford a dividend payout . The higher the dividend yield, the better the perceived earning potential of the company. A dividend payment is perceived as a sign of a company's strength and a sign that management has positive expectations for future earnings. This can serve to make the stock more attractive and push the stock’s price higher.

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What if no Dividends Are Paid Out?

A company choosing not to pay-out dividends on a dividend yielding stock can signal that the company is struggling financially and usually the company’s stock indicates this by a drop in market value. This is often when most potential investors will shy away from making an investment in fear that they are backing a sinking ship. A limitation in evaluating the actual causes for lack of dividend payouts, should be a prevailing decision-making factor.

Sometimes a decision not to payout dividends can be a good sign, especially if the company has announced plans to expand or grow. Investors assume the company is re-investing the profits to acquire these new expansions, thus predicting future earning potential. The security offered by this acceptable relationship, perceives that growth is a good a thing and steady growth equates to a comfortable measure of steady profits.

It is, therefore, a rather unreliable method of valuing a stock, especially if there are inconsistencies in the yields. Therefore, before using this method as a stock evaluation tactic, it is best to do some background research about the reasons why that specific company’s yield is fluctuating. Novice traders tend to overlook the underlying issues of fluctuation, thereby causing an increase in loss potential, as future expected profits are not realised.

The P/B Ratio (Price to Book)

This method of stock valuation is made for the sceptical investors who have a more cynical approach to situations like these. This is because the P/B ratio calculates the value of the stock if everything were to go awry and the stock needs to be sold immediately. The calculation looks at the company’s current performance according to their books. It accounts for company liabilities and assets, as well as the current profits on hold for the year up to the day the calculation is done. This method comes in handy when you are looking to evaluate the stock according to the value of the company. It works in three stages:

  • It regards the worst possible situation where the company liquidates
  • Pays off its debts and
  • Pays out the remainder of its value to the shareholder

Companies with low P/B ratios are viewed as good investments on the basis that holding the stock promises a potential good payout. The book value includes assets, namely buildings, equipment, machinery, land, vehicles and all other liquefiable assets the company holds. It is also important to remember that financial firms, or those who trade in financial assets, do tend to have fluctuating P/B ratios. This is because they hold assets in the form of money under management, which fluctuates year in and year out.

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The Bottom Line Observation

The final method to be considered is the bottom line observation. The bottom line of the company aims to use all three of the above methods, along with EPS (earnings-per-share), net earnings and a variety of other methods to form an efficient overview of the company’s general performance. Simply put, this is a scrutiny of the company’s viability through accessing their net income reflected on their income statement.

The idea is that this helps to form a more complete and accurate value of the stock’s worth, by
considering all aspects and calculations. It doesn’t rely on only one element which can be incorrectly analysed, but instead focuses on the most accurate data before making a trade or investment move, and is therefore an essential combination of the suggested methods of understanding how to evaluate stocks.

Evaluation is the compilation of factors that make a company either a viable investment or a trading pass over. When combined with research on company information such as management style, future expansion avenues, industry projections, company cash flows and financials reports, you will have a systematic way of evaluating stock. In terms of trading this can make an undisputed difference between financial trading success or loss and generally every trading transaction is aimed at achieving the former.


Factors and Elements to Explore When Investing

Understanding the basics of stock evaluation needs to be accompanied by an understanding of the factors and elements to use when comparing doing a investment sstocks broker comparison.

  • Diversifying between a range of industry books
  • Keeping an eye out for stagnant stocks
  • Examine past projections and company forecasts in past years

In order to ensure that your portfolio of stocks remains balanced, it is essential to diversify your stock undertakings. This includes purchasing stocks from a number of industries and sectors. If you invest in one industry, whenever it’s is suffering or not performing, your portfolio also plummets in value. The proverbial adage of not keeping your eggs in one basket holds true in the trading world. Diversification allows investors to eliminate certain risks and helps to keep a portfolio’s value balanced and potentially profitable. It also allows for steady growth, as stronger stocks within the portfolio can balance out losses experienced from the steadily losing or stagnating ones.

You don’t want to find yourself invested in a stock that never moves or changes. If a stock cannot react with the market and its own sector, then it may prove to be an unfruitful investment. A stock needs to be able to react to market conditions, whether positively or negatively.

Before rushing to purchase a stock, it is important to prepare the necessary information. Knowing how to evaluate stocks come in handy in this regard and could prove vital in your trading success.


A Final Word on Stock Evaluation

To fully understand how stocks work, you need to understand what a stock is and how it can be used as an investment vehicle. This is important when looking at stock evaluation as a theoretical concept. The techniques of stock analysis often affect the market price of the stock. This is because the stock’s market price is largely affected by the market’s perception of how the company is currently performing, as well as how it will perform in the future.

These perceptions are largely based on the four stock valuation methods. The market’s dependence on supply and demand is affected by the company’s performance. The dividend yield can be seen as a less effective method of stock valuation if not analysed on a closer level.

The P/B ratio method is helpful for investors who are looking for security should the company cave. The P/E ratio analyses how long it would take for an investment to pay itself off provided there is little to no earnings growth, while the bottom line aims to bring all these methods together to form a fuller evaluation of the company’s stock. With these in mind, a clear understanding of your stock evaluation basics is all you need to get investing today.

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