How to evaluate a stock

As investors, learning how to evaluate a stock is extremely important. Proper evaluation of a stock means attempting to value its current and future earnings, examine its place in its industry, the competitive environment around the company and also external stock market conditions.

When evaluating an investment, it really comes down to analyzing the future cash flows of the investment. With stocks, this typically takes the form of dividends paid to shareholders and potentially selling the stock for a higher price. When considering how to evaluate a stock, most seasoned investors don’t factor in future share price gains, they simply look at the business, its cash flows and whether today’s share price warrants a situation where the stock is undervalued or not.

Benjamin Graham popularized a concept known as “margin of safety” which refers to the gap or margin between the current share price and the intrinsic value of the stock. If the market price of a stock is significantly below the estimated intrinsic value of the company, the difference there is sometimes called the margin of safety.

How to evaluate a stock: traditional methods

The P/E ratio

The price-to-earnings (P/E ratio) is likely the most commonly used valuation metric when referring to individual stocks. The ratio essentially refers to the multiple investors are willing to pay of the earnings of the company. For a simplistic example, if a company earns $10/share, and its stock is trading at $100/share, then the P/E ratio is 10.

The P/E ratio is sometimes looked at as a measure of how long a stock might take to pay you back on your investment. If the company is earning $10/share, and you pay $100 for your shares, assuming nothing changes, it will take you ten years to make your money back. Note: This isn’t the best way to look at investments.

Most importantly, you can’t compare companies by P/E ratio alone. The reason for this is that growth rates differ widely between companies. A very mature company that has been selling beverages for 100 years and is growing at single digits might have a P/E ratio of 12, and a new tech company that might be growing revenues at 75% a year might have a P/E ratio of 90. Yes, in a traditional sense, the tech company is more expensive, but that doesn’t mean the mature beverage company is the better buy.

P/E ratio can be deceiving. For one, it’s a trailing metric. It’s examining how expensive the stock is with respect to recent earnings in the past. Properly learning how to evaluate a stock means that you can take the P/E ratio and examine its context when making investment decisions. This brings us to our next metric…

The PEG ratio

Because the P/E ratio by itself can be deceiving, the PEG ratio attempts to bring more of its context into the metric and provide a fuller picture when comparing companies. The PEG utilizes a similar concept in looking at the multiple of earnings, but also factors in the growth rate of the company. It’s calculated by taking the P/E ratio of a company, then dividing it by the year-over-year growth rate of its earnings. The lower the value of the PEG ratio, the better the multiple looks with respect to its growth rate.

Let’s look at an example to drive the concept home. If a company is growing earnings at 25% a year and has a P/E ratio of 25, then the PEG ratio is 1. If another company is growing earnings at 12.5% a year and also has a P/E ratio of 25, then its PEG ratio is 2. Remember a lower PEG ratio is better.

What are the limitations of the PEG ratio? Again, among other things, it doesn’t factor in outside factors of the company such as competition or secular trends in the industry. If you know for a fact that an industry is about to head into a massive decline, the P/E ratio or PEG ratio is likely irrelevant because you know earnings are probably going to be taking a dip in the future. Like most metrics, the PEG ratio is just one of your tools as you learn how to evaluate a stock.

Book Value

Traditional investors used to consider book value as an important tool in stock evaluation. Book value refers to how much money a company would have if it essentially sold all its assets. Its assets might be its equipment, buildings, land, inventory, etc. The idea is that no matter what happens to the business, you can’t really go below the book value because the worst case scenario is just liquidating all the assets.

This isn’t necessarily true because in a major economic downturn, the value of the physical assets likely declines as well (as other companies are attempting to liquidate too). But its still a decent metric to at least consider.

Note that book value is rarely going to come into play as an investor except in very volatile scenarios where stocks are down dramatically. In most normal investing time periods, stocks will trade at valuations much higher than book value. As such, some prefer to look at the price-to-book ratio which measures the multiple of stock market value against the book value of the company.

Dividend Yield

Investors love to factor in dividend yield into its evaluation process. I think probably too much, frankly. Yes, a dividend yield can essentially give you a margin of safety by giving you a cash return cushion. And, some dividend growers such as Philip Morris / Altria have been growing dividends for decades all while providing stellar returns to shareholders year after year.

But sometimes dividends can be overrated. Many of the dividend companies are typically more mature companies with lower growth than other companies. Frankly, if your goal is to find some dividend stocks to build a portfolio around, I’d encourage just buying some index funds. Typically a portfolio full of dividend stocks isn’t going to outperform the market over a long period of time, so why not just remove the single company / stock picking risk and go for market returns via index funds?

How to evaluate a stock: future cash flows

The discounted cash flow (DCF) process is used in business and finance regularly as a valuation method of potential businesses or investments. It attempts to estimate the present value of expected future cash flows by applying a discount rate. If the present value of future cash flows is lower than the current market price of a company, then many might consider that a good time to buy the stock.

The formula for calculating a discounted cash flow is shown below where r is the discount rate and CFn refers to the cash flow of time period n.

Using the appropriate value for the discount rate, r, is important. When utilizing DCF for evaluating a stock, the discount rate typically is viewed as the expected rate of return. What is your expected rate of return? One way to consider this is to think og what you can earn with safer investments, say a certificate of deposit (CD). If your CD is paying 3%, you wouldn’t use 3% as your discount rate for evaluating a stock because you should expect a higher return than a CD if you’re taking on the risk of the stock market. Perhaps consider average market returns in the 7% range. Also, you can run DCF formulas using a few different values for r to get a more complete picture.

To really master the DCF process of evaluating a stock, you’ll want to work through some examples. You can search the web for DCF examples and work out the examples on your own. This is a good idea if you really want to learn how to evaluate a stock.

How to evaluate a stock: other considerations

The reality is that most retail investors are terrible at picking stocks. Even when picking “winners,” the winning stocks are often just returning about the same as if you would have put that money in S&P 500 index funds. Simply put, most investors shouldn’t pick stocks. They should instead just go with a simple three-fund portfolio to accomplish their financial goals.

However, I also realize that some investors like to be a bit more active than a simple dollar-cost averaging, three-fund portfolio approach year after year. They’ve got maybe a little bit of a gambling streak, think they’re pretty good at this, and want to take a stab at picking a few stocks. Perhaps, you’ve got 85% of your assets in a three-fund portfolio, and you leave the remaining 15% for tactical moves and/or stock picking. Nothing wrong with that.

What else should you be considering in your stock evaluation process? To me, really understanding where a company fits within its industry and where an industry fits within the overall economy is huge. Let’s take the industry part first. What’s happening in the industry? Is it facing consolidation as a result of new tech-based disruption? Is the industry stagnant? Is the overall industry growing (the pie getting larger)? What are the catalysts that can lead to companies operating in this space gaining value faster than a typical company? If you can’t answer these questions, you might want to stick to some broad index funds.

Next, how is the company positioned within its industry? There are typically a few key ways that a company grows: gain new customers, sell more things to your current customers or raise your prices. Ideally a company is capable of doing all of these at once, but most companies can’t. Can you articulate what the company’s growth strategy is with respect to the stock you’re evaluating?

Are the companies in this industry mostly engaged in price wars to gain market share, or is the company you’re looking at able to command market share gains due to a superior product or technology? What new products or services is the company working on to tack-on to the offerings currently being offered to customers? Has management exhibited a good steward of company cash? Have the acquisitions or investments made by the company been value adding or would it had been better if the company just returned cash to shareholders?

Lastly, it’s important to understand the context of the overall economy and the stock market. You may have somehow stumbled onto the best company and stock in the world, but the stock can still go down when the stock market is getting rattled due to overall macro and external factors. When global growth is slowing, central banks are hiking rates or financial systems are dealing with systemic issues (or a host of other external events), the stock market can get volatile. In fact, moves lower are often more fierce and sharp than slower moves higher over longer periods of time.

However, if you’ve done your due diligence and you’ve learned how to evaluate a stock properly, these macro events can simply provide excellent buying opportunities. If you know a business is executing its strategy to perfection, growing market share and poised for major future earnings gains in the future, a lower stock price dragged down by the overall market simply provides you with a buying opportunity. Few investors maximize these opportunities and instead buy the stock when it’s high, but sticking to a disciplined process can enable an investor to buy at more opportune times.