How to Evaluate a Stock
There are moments in history when people have claimed investment choices don’t matter because if the market is up across the board, you cannot fail. That is not true. In fact, that should never be guiding financial advice. However, there is no doubt that the market has been up for many years — notwithstanding the market correction in March 2020, early in the pandemic. For 2021, year to date, the S&P 500 has climbed more than 20%, double the historical average return of about 10%.
If security investing is appropriate for your portfolio, perhaps picking up more stocks is a good idea — but it is not a good idea to invest in just anything. It’s important to conduct due diligence to understand the fundamentals of a company’s financial situation and market prospects. Then decide if that play is appropriate for your asset allocation and whether to make it a short- or long-term situation. If you’d like help vetting particular security or market sector, please feel free to contact us.
Public companies that trade on the stock market are required to file certain reports with the Securities and Exchange Commission. These include Form 10-K, an annual report with audited financial statements, and Form 10-Q, a quarterly update for operations and financial results.
Be aware that you can find highlights of this information on various financial news websites. The following can give you an idea of which metrics to look for and what they mean:
- 52-week high or low – the year-long price range showing how a stock is trading relative to its most recent history
- Dividend yield – calculated by dividing the annual dividend rate per share by the stock price; compare the company’s dividend rate to its peers, the rest of the stock market, and the 10-year Treasury note yield
- Gross profit margin – this is calculated by dividing gross income by sales revenues; compare it to competitors as a measure of the company’s profitability over the long term
- Price-to-earnings (P/E) ratio – this is the price of the stock divided by earnings per share, which shows how much the investor pays for each $1 of the company’s bottom line; compare that cost over time and against competitor P/E ratios
While many websites provide this type of information, it’s important not to focus on any one single measurement. These ratios, combined with other fundamentals (e.g., management experience and track record, market potential, product diversification) can offer a more complete picture of the stock’s long-term viability and upward potential.
But don’t forget the other, perhaps more important, factor: determining if a particular stock is appropriate for your portfolio. Not just which stock, but how much to buy and at what price, because these decisions will determine what percentage of your portfolio will be represented by that stock. Too much of any one allocation can move overall performance in one direction or the other, which is why it is important to diversify securities. If you believe a certain sector is well-positioned to rise, you might consider investing in several different competitors to take advantage of the rising tide.
There is one other factor you may want to consider, long touted by famed investor Warren Buffett. He recommends that an investor buys into a company because he or she wants to own it, not because he or she wants the stock to go up. In other words, if you like the product, believe it has mass-market appeal, and wish you’d thought of it yourself, those are good criteria for purchasing the company’s stock.
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