Evaluating Stocks

In assessing investments such as stock, investors considers valuation, strategy, diversification and appetite for risk. Stocks are evaluated in many ways. The most basic measure involves a company’s earnings. When you buy a stock, you’re acquiring a piece of the company, and profitability is an important consideration. Imagine buying a store. Before deciding how much to spend, you want to know how much money to acquire it. 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 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 dividend. It can continue to expand the business, increasing profitability and thereby increasing the overall value of the business. Not every company pays a dividend. In fact, many fast-growing companies prefer to reinvest their cash rather than pay a dividend. Large, established companies are more likely to pay a dividend than are their smaller companies.

The most common measure for stocks is the price/earnings ratio. This measure takes the share price and divides it by a company’s annual net income. So a stock trading for P20 and boasting annual net income of P2 a share would have a price/earnings ratio or P/E, of 10. In basic analysis, a P/E lower than the market would be described as trading at a “discount” to the market. As a general rule of thumb, stocks with P/Es higher than the broader market, P/E are considered expensive, while lower P/E stocks are considered not so expensive.

One of the most basic questions in the investment world is: Growth or value stocks? The distinction between growth and value is flawed. Warren Buffett doesn’t seem to differentiate much between growth and value. “Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication,” he explained in his 2000 annual letter to Berkshire Hathaway shareholders.

To Buffett all investing is about value. Assessing a company’s growth prospects is simply one part of gauging value. Rapid growth in sales and profits can add a ton of value to companies whose shares may at first glance look pricy. Buffett wants a firm’s earnings to have increased reasonably consistently over the prior decade, and he looks at a number of other earnings-driven variables. These include return on equity, return on retained earnings, free cash flow and debt – which should be no more than five times annual earnings. Buffett is concerned with the quality of a company’s earnings and its sustainability over the long haul.