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How to Evaluate a Stock in 4 Simple Steps (2021 Guide)

Knowledge Crunch | Tuesday, September 14, 2021 3:49 PM GMT

Welcome to our latest knowledge crunch. Today's topic will be stock evaluating. It may sound confusing, but using fundamental tips and advice this blog can help you find long-term investing opportunities. 

Ratio analysis isn't only for individual stock pickers, as this type of study also benefits fund investors. Financial ratios are used to compare stocks with peers and within an industry; some of the stats based on historical performance can yield a deeper understanding of asset value. While the fundamental analysis may not guarantee a stock's future success, it can serve as a useful way to measure it.

 

Table of Contents

What is Stock Valuation?

6 Most Common Stock Valuation Metrics

How to Evaluate a Stock in 4 Simple Steps

Frequently Asked Questions (FAQs)

 

 

What is Stock Valuation?

Stock valuation is the process of calculating how much a company stock is worth using methods that consider economic factors such as past prices and forecast data. Some may say valuation is more of an art rather than a science, having to do with the inspiration and general perception of the market. The timing that an investor can develop and can be considered a “gut feeling”. This in turn can help provide you with a potential edge in price prediction, help you increase your chances of successful asset allocation.

Valuation is a fundamental aspect of investing. If you discover a stock is undervalued, you may be able to capitalise by buying it in anticipation that you can sell it at a higher price in the future. If a stock is found to be overvalued, you can avoid the stock or sell your current holdings before the price drops.

Stock valuation requires great attention to detail. To place a value on a stock you need to examine the company’s cash flow, prospects of future earnings and market value of assets. Psychological factors, such as fears of an economic crisis, should also be taken into consideration as this may affect investor behaviour. 

The value can be calculated in several different ways. The most common methods used are the discounted cash flow method and price-to-earnings ratio. Whichever approach you take, it must be done with great accuracy.

 

6 Most Common Stock Valuation Metrics

Valuation metrics and models can be invaluable when assessing stocks to invest in. These ratios are by no means failproof, but they can give you an idea of whether a stock is trading at a premium or discount to its fair value based on profitability, growth, and its balance sheet.

In this section, we break down different valuation metrics and highlight their strengths and weaknesses. We also discuss the types of analysis that can be used to complement valuation analysis.

Source: Shutter stock

 

Valuation Metric #1: Price to Earning Ratio (EP Ratio)

The price to earnings ratio (PE Ratio) is the measure of the share price relative to the annual net income earned by the firm per share. PE ratio shows current investor demand for a company share. A high PE ratio generally indicates increased demand because investors anticipate earnings growth in the future. 

The PE ratio has units of years, which can be interpreted as the number of years of earnings to pay back the purchase price. PE ratio is often referred to as the "multiple" because it demonstrates how much an investor is willing to pay for one dollar of earnings. PE Ratios are sometimes calculated using estimations of next year's earnings per share in the denominator. 

 

Valuation Metric #2: EV/EBITDA

EV to EBITDA is the ratio between enterprise value and Earnings Before Interest, Taxes, Depreciation, and Amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a certain company to the parallel company in the industry as a whole, or other comparative industries. 

Just like the P/E ratio (price-to-earnings), the lower the EV/EBITDA, the cheaper the valuation for a company. Although the P/E ratio is typically used as the go-to-valuation tool, there are benefits to using the P/E ratio along with the EV/EBITDA. For example, many investors look for companies that have both low valuations using P/E and EV/EBITDA and solid dividend growth.

 

Valuation Metric #3: PEG Ratio

The PEG ratio is a company’s Price/Earnings ratio divided by its earnings growth rate over some time (typically the next 1-3 years).  The PEG ratio adjusts the traditional P/E ratio by taking into account the growth rate in earnings per share that are expected in the future.  This can help “adjust” companies that have a high growth rate and a high price to earnings ratio.

While the ratio helps adjust for growth over some time, it typically only takes into account a short period, such as 1-3 years.  For this reason, one or two years of high growth may overstate the benefit of buying the faster-growing company.

 

Valuation Metric #4: Price to Free Cash Flow Ratio

The Price to Free Cash Flow Ratio, or P/FCF Ratio, values a company against its Free Cash Flow. It is the Share Price of the company divided by its Free Cash Flow per Share. This is measured on a TTM basis and uses diluted shares outstanding.

This ratio is similar to Price to Earnings, but omitting purely "paper only" expenses. Some companies report high profits, but they can't turn those profits into cash! A company can't survive without cash, and if it can't generate it internally then it will have to turn to outside investors to support it, resulting in either share dilution or increased borrowing.

 

Valuation Metric #5: Price to Sales Ratio

The price to sales ratio (PS ratio) is calculated by dividing the stock price by the revenue per share. It is most useful for comparing companies within a sector or industry because "normal" values for this ratio vary from industry to industry. In general, low price to sales ratios are more appealing because they suggest that a company is undervalued.

As with all valuation techniques, sales-based metrics are only part of the solution. Investors should consider multiple metrics to value a company. Low P/S can indicate unrecognized value potential—so long as other criteria exist, like high-profit margins, low debt levels, and high growth prospects. Otherwise, the P/S can be a false indicator of value.

 

Valuation Metric #6: Discounted Cash Flow

Discounted Cash Flow is a method of estimating what an asset is worth today by using projected cash flows. It tells you how much money you can spend on the investment right now to get the desired return in the future. Whether you want to calculate the value of another business, a bond, stock, real estate, equipment, or any long-term asset, discounted cash flow calculation can help determine if an investment is worthwhile. 

It can also be used for reasons other than buying another company. The financial modelling method can be used to help someone determine if making a big purchase is a good long-term investment. If you want to buy an expensive piece of equipment, you can use the Discounted Cash Flow analysis to help you determine if it’s a good long-term investment. Now let’s see four simple steps on how we can evaluate our stock.

 

 

How to Evaluate a Stock in 4 Simple Steps

Though investors may find it easier to build a diverse portfolio using exchange-traded funds or mutual funds, investing small amounts in individual stocks can be a good way to learn the intricacies of the market. 

However, it usually isn’t enough to just throw your money into the market. You'll need to do some research first. If you invest your money strategically using a method that works for you, you could minimize your risk and maybe even earn higher returns. Here are 4 simple steps to take as you learn how to research stocks before choosing which ones to invest in.

Source: Katana Capital

 

Step #1: Do your quantitative research

Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use quantitative information gleaned from financial statements to make investment decisions. The three most important financial statements are income statements, balance sheets, and cash flow statements.

The Balance Sheet The balance sheet represents a record of a company's assets, liabilities, and equity at a particular point in time. The balance sheet is named by the fact that a business's financial structure balances in the following manner: Assets = Liabilities + Shareholders' Equity

 

Step #2: Focus on the main elements of your research

Every publicly-traded company is required to publish reports. Using that information, investors can find companies that align with their investment interests. If investors did not have access to this information, they would be unable to make educated decisions about their investments.

Here’s some of the most important information for investors to look for: 

Net income: Check to see if the company finished with a gain or a loss at the end of the period. You can find this number at the bottom of the income statement. It equals total revenue minus expenses, depreciation, taxes and more. 

Price-to-earnings (P/E) ratio: The P/E ratio is calculated by dividing the market value of a share by the earnings per share. Although the ratio often is calculated based on how the stock has performed in the past, it can show you how the market thinks this stock will perform in the future. If a company has a relatively high P/E ratio, it could indicate that the market expects healthy growth in the near future. Compare the company’s ratio to others in the industry to understand where this company stands against its competition. 

Return on equity: The company’s return on equity helps you better understand how effectively the company uses its investors’ money and returns investments to its shareholders. 

 

Step #3: Do your qualitative research

The third step is assessing the current value of the investments that have been made to support the firm’s product-market strategy. The product-market strategies require investments in various current assets such as accounts receivable, inventories and non-current assets such as equipment, plant, etc. or even acquisitions. Investors should assess the value of these assets over the next two to three years. 

These estimates can be made from analysing the firm’s past performance patterns. Ratios and other indicators derived from current financials and studying the firm’s past include the following items as collection period, days of inventory, and plant and equipment as a percentage of the cost of goods sold and the like. A reasonable value should be applied to the sales and cost of goods while developing an accurate forecast.

 

Step #4: Investigate how the stock fits into the bigger picture

A company must have a profitable outlook for the future. The magnitude of profitability has a strong influence over several vital financial elements. First, the firm’s access to debt finance is heavily influenced. Second, the value of the firm’s common stock and the willingness to issue is affected. Third, the firm’s sustainable sales growth looms upon the level of profitability. The firm’s past financial performance is an indicator of how the firm will perform in the future. 

So, investors should try to find out answers for the following questions such as (a) what is the average level, trend, and volatility of the firm’s profitability (b) whether the current level of profitability is sustainable in the future (c) what effect does competition and regulatory guidelines have on profitability (d) in case market conditions and competition improve, will profitability also improve (d) whether the management has any plan on implementing profit improvement programme and, if yes, what is the plan (e) Is there any inefficiencies such as large inventory build-ups or lower than industry average accounts receivables. 

To conclude, as an investor, one should devote a significant amount of time in exploring the corporate financial system which is driven by the company’s goals, strategies, market conditions, operating characteristics and risks. The information relevant to the above aspects could be observed directly from the financial statements and by referring to the management discussion and analysis report which is part of the annual report of most companies.

 

Source: Pixabay.com 

Now Over to You

Start looking at what we’ve mentioned in this blog and have a go at investing in stock yourself. Why not try what you’ve learnt from this blog and head over to ZuluTrade. We have traders that you can follow that invest in both and you may learn much more by copy trading.

We hope you enjoyed this edition of the knowledge crunch blog just as much as we enjoy writing them! Stay tuned for more and be sure to check out our other helpful blogs with advice and tips to reach your investment goals with ZuluTrade. 

Join the best trading community today!

 

Disclaimer: The views expressed do not constitute investment or any other advice/recommendation/suggestion and are subject to change. Reliance upon information in this material is at the sole discretion of the reader. Opinions expressed in this article do not represent the opinion of ZuluTrade Social Trading Platform and do not constitute an offer or invitation to anyone to invest or trade. Every metric and the statistical number is a result of a past performance which does not constitute a promise or a certainty for a future one.

 

Frequently Asked Questions (FAQs)

Q1. What is the difference between a stock's value and its price?

The stock's price only tells you a company's current value or its market value. So, the price represents how much the stock trades at—or the price agreed upon by a buyer and a seller. If there are more buyers than sellers, the stock's price will climb. If there are more sellers than buyers, the price will drop. On the other hand, the intrinsic value is a company's actual worth in dollars. This includes both tangible and intangible factors, including the insights of fundamental analysis.

Q2. What are some indicators of a healthy stock?

Here are some of the basic indicators you can use to help determine a stock’s health and potential for growth. 

Company Earnings - The most basic tool to assess a stock’s value and potential is the underlying company earnings. The more profitable the company, the more profitable the stock can be.

Price to Earnings Ratio - As we talked about in this blog, one of the most common measurements of a stock’s value and potential is the P/E ratio. You can calculate it yourself by taking the share price and dividing it by the company’s net annual income per share.

Dividend Payout & the Consistency - A company that can consistently pay and raise their dividend over time is generally demonstrating that it’s a healthy enterprise.

Debt Ratio - Finally, consider evaluating the company’s ability to pay their debt, and how much debt they have. The debt ratio measures the number of assets that have been financed with debt and is calculated by dividing the company’s total liabilities by its total assets. The higher the debt, the greater the possibility that the company could be heading for financial trouble. 

Remember to do your research and make smart investment choices for yourself.

Q3. Is it necessary to evaluate a stock before buying?

The short answer is yes. Stock trading doesn’t necessarily benefit from a passive “set it and forget it” strategy. It’s important to assess your tolerance for risk before investing and checking in on it periodically. Additionally, make time to review your stocks’ performance and watch the market regularly.

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