Topic: How To Invest

Here is some time-tested advice on how to evaluate a stock before buying so you can maximize your gains

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Learn how to evaluate a stock before buying so you make picks that you can feel confident in as part of a sound long-term portfolio. Here’s what you need to know

Do you know how to evaluate a stock before buying? Consider earnings, dividends and other key factors to make your decisions. They matter far more than short-term stock-price trends. Stock prices rise and fall. But strong dividend stocks like to ratchet their dividends upward. Even during market downturns, the last thing a well-established company is likely to do is lower its dividend. When times are good, strong companies will raise their dividends.

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These four ratios will help you understand how to evaluate a stock before buying

Price-earnings ratios (or p/e ratios): The p/e is the ratio of a stock’s market price to its per-share earnings. As a general rule, the lower the p/e, the better, and generally a p/e of less than 10 represents value.

Price-to-book-value ratios: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share gives you a rough idea of the stock’s asset value.

Price-cash flow ratios: Simply put, this is earnings without taking into account non-cash charges such as depreciation, depletion and the write-off of intangible assets over time. It’s actually a better measure of a company’s performance than earnings.

Debt-to-equity: When a company loses money, it still has to pay the interest and eventually repay the debt. Generally it does so by dipping into shareholders’ equity. A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump. 

Go beyond ratios in investment portfolio analysis 

Once we’ve found a company that looks attractive using the financial ratios detailed above, we look deeper to determine that it has a solid business in an attractive industry, with a history of rising sales and earnings, if not dividends. Even a stock whose financial ratios look good can stagnate if the company or its industry is in a difficult period. But if it’s a high-quality company, it’s likely to hold up better than other alternatives. Better still, it may be first to move up when conditions improve.

Look for these financial factors to find stocks with investment value and growth potential

  • 5 to 10 year history of profit. Companies that make money regularly are safer than chronic or even occasional money losers.
  • 5 to 10 years of dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
  • Manageable debt. When bad times hit, debt-heavy companies go broke first.
  • Freedom from business cycles. That’s why you need to diversify. Invest in utility, finance and consumer stocks, along with resources and manufacturers.
  • Ability to profit from secular trends: These trends outlast ordinary business booms and busts, because they reflect ongoing social change. Free trade and rising environmentalism are just two examples of secular trends.
  • Ownership of strong brand names and an impeccable reputation. Customers keep coming back to these businesses, and will try their new products.

Be cautious of companies that only grow by acquisitions when considering how to evaluate a stock before buying

Growth by acquisition is riskier than internal growth. That’s because the seller of corporate assets almost always knows more about the assets than the prospective buyer. If you make enough acquisitions, you are bound to buy something with hidden problems. Eventually, these problems come out in the open and hurt the acquirer’s earnings.

Growth by acquisition can also warp the thinking of company managers. After all, their pay varies, up to a point, with the value of the assets they manage. This introduces an obvious conflict of interest.

Growth by acquisition also creates profit opportunities for banks and brokers. They collect fees for pre-acquisition research and consulting, and for merger financing. This income can influence the advice they give to their clients.

It’s true that acquisitions may also expand earnings and dividends for the company’s shareholders. Here, though, the gains are less dependable.

In extreme cases, growth by acquisition can work brilliantly for years, then suddenly erupt into a situation like the one that Valeant Pharmaceuticals found itself in a few years ago, when it plunged from $350 to $17. Of course, growth by acquisition was just one of several factors that brought on Valeant’s downfall. 

Use our three-part Successful Investor approach to understand how to evaluate a stock before buying 

  1. Invest mainly in well-established, dividend-paying companies;
  2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
  3. Downplay or avoid stocks in the broker/media limelight. 

Do you pay more attention to a stock’s historical performance or its current price when you consider buying?

What do you consider to be the single most important factor in evaluating a stock?

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