How to Evaluate a Stock

If you are thinking about investing in individual stocks, you need to remember that you are going to become a shareholder in the company.  This makes you andowner, and you should be doing due diligence as such.  Great investors like Warren Buffett spend weeks going through a company’s financials and learning about a company’s management before investing.  Here is what you should look at when evaluating a stock.

The Market

The first thing you should look at when evaluating a stock is the economy and market that the company does business in.  Times are always changing, and companies need to adapt to the changes.  In fact, of the original companies in the Dow Jones Index, only a few remain today.  The reason – their business models died or they were bought by another company.

So, consider if that company that makes widgets will still be able to sell those same widgets in five years?  Even a company like Apple – will it still be able to innovate in five years, when iPods are no longer the “in thing”?

The Basics of Financials

The next thing you need to look at are the company’s financials.  This is the bread and butter of individual stock selection.  It’s called fundamental analysis, because this is the fundamental thing that makes a stock profitable.  When you buy a stock, you want to make sure that the company is making money (usually).  You also want to make sure that you know the value of all the company’s assets (called book value), as well as any debt the company has.

The easiest way to look at earnings is known as the P/E or Price-to-Earnings ratio, which judges a company’s earnings to its price.  Every stock on the market has a P/E ratio, and traditionally, stocks with a P/E in the low teens or less have been considered cheap.  However, remember, cheap can mean value, and cheap can mean cheap, so do your homework.

Your homework should also include looking at debt – specifically, does the company have more debt than it’s peers.  Some industries, like utilities, have a lot of debt because they build big things (like power plants).  But more debt than similar companies can be trouble.  Also, look at assets, or book value.  You want a company with a positive book value.

You should also look and see if the company pays a regular dividend.  This is usually a positive sign that the company knows how to balance its cash flow.

Finally, I like to look at the notes to the financials, located near the back of annual reports.  This is where companies elaborate on their financials, as well as share the potential risks to their business.  Look for the risks, and see if they make sense.  You may find information in there, like pending litigation, which may make the company less attractive.  For example, if the EPA outlaws a certain chemical, will the company go out of business?  These are important questions that can only be answered by reading the end of the annual statement.

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