If you search “good stocks to buy” on Google, you’re going to end up with more than 227,000,000 hits.
That is madness. There is an endless supply of stock recommendations scattered across the internet for you to sift through, most of which are total garbage.
I was reading an article just recently that listed more than 30 companies, all of which were “100% buy right now!”
What does that even mean? We’re talking about the stock market here, and that article is swinging around words like “guarantee” and “100%” as if they actually mean something. The only thing that is a 100% buy is the amount of food you need to eat, the amount of water you need to survive, and some type of shelter to keep you warm at night.
Everything else, is, at best, an educated guess.
So in order to equip you, our cunning Dynalect Readers, with the tools and skills necessary to sniff out the good from the bad when it comes to investing advice, I’ve decided to spend this week highlighting a few of the key metrics I use when evaluating stocks myself.
Before we get into the actual metrics though, allow me to say a few words about qualitative reasoning.
It’s always important to have a qualitative understanding of a company well before you dive into the actual numbers of the business. As Warren Buffett says:
“Never Invest in a business you cannot understand.”
So take some time to figure out a few key things about a company you’re interested in:
- How does this company make money? What is their revenue model? What is the prospect of growth over the short and medium term?
- Who runs the company? Is it a new CEO? If so, where did she/he work before? Was she/he successful? Does this company have a pattern of hiring new CEOs often?
- Where is this company headed in the future? Are there long term investments being made? If so, what are they and how will they impact earnings?
- Who are the relevant competitors? Are they better investments than the company I’m looking at? Or could I invest in several similar companies in order to gain diverse exposure to particular sector/industry?
- Does this company have a respectable brand? Do they treat their employees well? (You can always call the investor relations department and ask!) Have they had any recent customer service gaffs?
Great! Once those questions are answered, you’re ready to move on to quantitative metrics.
But before we do that, let’s take a moment to process what we’ve learned and breathe before getting in to more nitty gritty investing insight.
Here’s some light mid-article humor:
Number 1: P/E Ratio
One of of the first things that we look at here at Dynalect when evaluating a company is the price to earnings ratio (P/E). When you hear someone say something like “Oh that company is trading at 15x earnings” or “Their P/E is a lot higher than the industry average,” they’re talking about the price to earnings ratio.
So what is it?
Put simply, the price to earnings ratio is the amount you have to spend to own $1 of earnings in a particular company. Take Ford Motor Company (NYSE: F) as an example, which has a P/E of 12.18. That means that investors are currently willing to spend $12.18 per $1 of earnings to own Ford.
We use the P/E ratio to get a sense of the value of a company, relative to similar companies within the same industry. Consider Microsoft and Apple as an example. Microsoft’s P/E ratio is slightly over 30, whereas Apple’s is only 18. This tells us that Apple is a relatively better value investment than Microsoft right now, given the fact that they are similar companies. Each single dollar of Apple’s earnings is almost half the price of a dollar of Microsoft’s!
Be wary of over-using P/E ratio across the board. For example, don’t try to compare the P/E of two completely different companies! It’s much better to try to compare to an industry average so that you can get a sense of how the company performs relative to some of it’s competitors.
Number 2: Market Capitalization
Market Capitalization or “Market Cap” is the value of a company in the eyes of it’s share holders. On a basic level, it’s calculated by multiplying the shares outstanding by the current price of each share. If Dynalect Analytics was trading for $15/share, and we had 1 million shares outstanding, our market cap would be $15 mil.
Companies are broken down into categories according to “cap size.” You have:
- Mega Cap (Apple, Amazon, Microsoft, etc…) These companies generally have market caps above $200 billion. Apple has a market cap of over $800 billion!
- Large Cap (Tesla, GE, Boeing, etc…) Anything between $10 billion and $200 billion is considered large cap.
- Mid Cap (Tractor Supply, Royal Gold, First Solar, etc…). Anything between $2 billion and $10 billion.
- Small Cap (Silver Standard, Bankrate, etc…) Anything less than $2 billion.
- Micro Cap Anything between $50 million and $2 billion.
- Nano Cap Anything less than $50 million.
Generally speaking, the larger a company’s capitalization is, the lower risk the investment carries. “Blue chip stocks,” which are widely regarded as safe investments, are almost exclusively large and mega cap stocks!
With that said, smaller cap stocks typically have a lot more upside potential, so it’s good to balance your portfolio with a bit of a mix of everything!
Number 3: Earnings Per Share (EPS)
This metric is useful to give you a sense of how much the company earns relative to their shares outstanding. It is an excellent figure to use to compare two similar companies to see which might be the better investment.
Going back to the Microsoft vs. Apple example, Microsoft has an EPS of $2.26, and Apple has an EPS of $8.55. This tells us that Apple is able to earn more money per share than Microsoft, which makes each one of their shares relatively more valuable!
Again, along the same lines of P/E, EPS should not be used across industries. Companies in different sectors might have very different EPS standards, so try to compare your company to an industry average or a similar competitor!
Number 4: Sales/Revenue Growth
The mark of any good investment opportunity is the fact that the company is growing! And the only way to figure out whether or not that is true is by looking at the sales/revenue figures for the past several years to see whether or not the company has been able to grow their business.
The Dynalect team prefers looking at sales/revenue data for signs of growth over other metrics such as net income because it provides a raw look at the total amount of money filtering through a company before all of the expenses and investments are accounted for. For example, if a company makes a big investment into research or new machines, the net income for that particular year might show a big decline despite the fact that the company actually had more revenue than the previous year!
This information can be found the income statement of the company, which is typically available on a quarterly basis through the earnings releases, or alternatively on an annual basis on the shareholder report.
You can also sign up for a service like the Wall Street Journal, where all of the data is presented in one place. This is what Dynalect uses to conduct a lot of our quantitative research!
Number 5: Debt to Equity
One of the last things to look for as you begin to evaluate an investment opportunity is the debt to equity ratio. Knowing how much debt a company holds relative to its internal equity can tell you a lot about how well the company is managed from a financial point of view.
With that said, it should be expected that larger companies are going to hold a considerable amount of debt relative to their equity, which is not necessarily a bad thing; Apple’s debt to equity ratio is 67.86, which means the value of their debt is 67.86x that of their held equity!
When evaluating a company based on their debt to equity ratio, it is important to compare companies within a similar industry. If the company you’re looking at has a significantly higher debt to equity ratio than some of its big competitors, it might be a good idea to consider sending your money elsewhere!
So next time you come across a site that is recommending a certain stock to you, make sure you take some time to evaluate that stock yourself! You never know what kind of garbage is coming your way on the internet.
Until next week…