Let’s say you are interested in buying XYZ stock because you like what the company does and how they do it. That’s fine. But how do you know if the stock is a good investment or not?
There are of course many ways to evaluate a stock and no one method is necessarily better than the other. What follows are a few tools you can use to look under the hood of a security before you pull the trigger. This way you’ll have a good reason to make your investment and you might even increase the odds of things working out well.
Is the company in trouble or not?
Some investors like to buy stocks in companies that are in financial trouble. This is known as value investing and people who like this approach do so because they believe they can pick up lots of value for pennies on the dollar.
I am not a particular fan of this method but it might work for you. The best way to find out what is really going on with the company is to read the annual report and shareholder letters. Look for companies that spell out exactly what is going on, what the problem is and what they are doing about it. If you think they have a good shot at turning the situation around, you may have a winner on your hands.
Online broker TradeKing provides easy access to company stats like profit margins, earnings data, sales, return on equity, earnings forecasts and much more. This tool could make your search for value plays much easier.
Price to Earnings Ratio or P/E
Another rule of thumb to look at is price to earnings ratio or P/E. It is the per share price compared to the per share earnings. Historically the S&P 500’s average P/E has been around 15.5. This isn’t a hard and fast rule but anything above that might be a little pricey while anything below that might be value. Currently the S&P 500’s average P/E is about 19.55.
P/E isn’t the end all be all of stock picking, but you can use it as a general rule of stocks to continue looking at or stocks to be very skeptical of. A great example of this are two tech companies: Apple and Facebook.
Apple’s P/E is currently 16.97. The company has a massive pile of cash and is trading at a moderate P/E. I’m not saying I would invest in Apple immediately, but I would continue my research.
Facebook is a different story. Facebook’s P/E is currently 69.83. That means it’s about 4 times as expensive as Apple. Clearly Facebook is more speculative.
Let’s say you are keen on a XYZ because it’s climbed 15% over the last 12 months. That is a tidy return indeed, but is it spectacular? You don’t know unless you compare it to something. Personally I recommend that you compare any stock you are thinking of buying to the S&P 500 index. This is an easy way to know if your stock candidate is really something special or not. You can easily chart and compare stocks against the indexes by using any number of financial websites including Yahoo!
Investing Rules of Thumb
Again, these rules of thumb are just that. They don’t indicate terrible or great purchase options, but can be used as a guide to take a massive number of stock choices and whittle them down to a manageable group. You should do full research including reading annual reports before deciding to invest in individual stocks. Additionally, once you purchase shares in a company you need to pay attention to what is going on with them in the news. You can’t just set it and forget it when it comes to individual stock purchases which is why many people decide to not purchase individual stocks.
Do you buy individual stocks? How do you do your stock research?