Page 109 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Personal Financial Planning

Notes 6.2 Evaluating Investment in various Stocks

Investors have access to a wealth of information about stocks, but making sense of it may seem
like a daunting task. Evaluating stocks isn’t that difficult if you follow some basic steps.

In assessing investments such as stock, investors consider the stock’s valuation, strategy, plans
for diversification and appetite for risk. Stocks are evaluated in many ways, and most of the
common measuring sticks are easily available online or in the print and online versions of The
Wall Street Journal.

The most basic measure of a stock’s worth involves that company’s earnings. When you buy a
stock, you’re acquiring a piece of the company, so profitability is an important consideration.
Imagine buying a store. Before deciding how much to spend, you want to know how much
money that store makes. If it makes a lot, you’ll have to pay more to acquire it. Now imagine
dividing the store into a thousand ownership pieces. These pieces are similar to stock shares, in
the sense that you are acquiring a piece of the business, rather than the whole thing.
The business can pay you for your ownership stake in several ways. It can give you a portion of
the profits, which for shareholders comes in the form of a periodic dividend. It can continue to
expand the business, reinvesting money earned to increase profitability and raise the overall
value of the business. In such cases, a more valuable business makes each piece, or share, of the
business more valuable. In such a scenario, the more valuable share merits a higher price,
giving the share’s owner capital appreciation, also known as a rising stock price.
Not every company pays a dividend. In fact, many fast-growing companies prefer to reinvest
their cash rather than pay a dividend. Large, steadier companies are more likely to pay a
dividend than are their smaller, more volatile counterparts.
The most common measure for stocks is the price to earnings ratio, known as the P/E. This
measure, available in stock tables, takes the share price and divides it by a company’s annual net
income. So a stock trading for $20 and boasting annual net income of $2 a share would have a
price/earnings ratio, or P/E, of 10. Market experts disagree about what constitutes a cheap or
expensive stock. Historically, stocks have averaged a P/E in the mid teens, though in recent
years, the market P/E has been higher, often nearer to 20. As a general rule of thumb, stocks with
P/Es higher than the broader market P/E are considered expensive, while stocks with a below-
market P/E are considered cheaper.
But P/Es aren’t a perfect measure. A company that is small and growing fast may have a very
high P/E, because it may earns little but has a high stock price. If the company can maintain a
strong growth rate and rapidly increase its earnings, a stock that looks expensive on a P/E basis
can quickly seem like a bargain. Conversely, a company may have a low P/E because its stock
has been slammed in anticipation of poor future earnings. Thus, what looks like a “cheap” stock
may be cheap because most people have decided that it’s a bad investment. Such a temptingly
low P/E related to a bad company is called a “value trap.”
Other popular measures include the dividend yield, price-to-book and, sometimes, price-to-
sales. These are simple ratios that examine the stock price against the second figure, and these
measures can also be easily found by studying stock tables.

Investors seeking better value seek out stocks paying higher yields than the overall market, but
that’s just one consideration for an investor when deciding whether or not to purchase a stock.
Picking stocks is much like evaluating any business or company you might consider buying.
After all, when you buy a stock, you’re essentially purchasing a stake in a business.

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