There is no single, silver bullet when it comes to weighing stocks as potential investment choices. A broad, multi-pronged approach is required. That means research, time, and trouble to dig, but by doing so you will lower the risk of making a bad or wrong choice when it comes to investing in a particular stock.
Where to look? Here is a list of subject areas that can be delved into to discover the strengths, weaknesses, opportunities, and threats to a public company, and the implications we can expect about future stock gains. The following are key steps for how to study a stock:
- Review the company’s financial statements
- Analyze the company’s business model and competitive position
- Research the company’s management team
- Evaluate the company’s industry and market outlook
- Consider valuation netrics (more on this later)
- Assess risk factors
Valuation Methods & Metrics
Valuation methods typically fall into two main categories: absolute valuation and relative valuation.Absolute Valuation models seek the intrinsic value of an investment based on fundamentals. Fundamentals means focusing on dividends, cash flow, and the growth rate for a specific company. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income model, and asset-based model (below we list some of these in more detail).
Relative Valuation models compare the company under study to other similar companies. These methods involve calculating multiples and ratios, such as the price-to-earnings (P/E) ratio, and comparing them to the multiples of similar companies. For example, if the P/E of a company is lower than the P/E of a comparable company, the original company might be undervalued. The relative valuation model is a lot easier to calculate than the absolute valuation model, so perhaps focus on this primarily. Besides P/E, ratios like price-to-book (P/B), and price-to-earnings growth (PEG) are useful to analyze relative value.
Below are a few of the methods you can use (an internet search will provide the formulas and steps you need to take for each calculation):
- Dividend Discount Model (DDM): This model estimates a stock’s intrinsic value based on expected future dividends (for companies that pay dividends).
- Discounted Cash Flow Model (DCF) What if the company doesn’t pay a dividend? In this case, use the DCF model. The DCF model uses a firm’s discounted future cash flows to value the business. To use the DCF model most effectively, the target company should have stable, positive, predictable free cash flows. Companies that have the ideal cash flows suited for the DCF model are typically mature firms long past their earlier growth stages.
- Price-to-Earnings (P/E) Ratio: The P/E ratio compares a company’s stock price to its earnings per share (EPS). A low P/E ratio suggests the stock may be undervalued.
Of these ratios, the P/E ratio is the most often used because it focuses on the earnings of the company, which is the primary driver of an investment’s value. We are limited to publicly traded companies since both the stock price and the earnings of the company are readily available for analysis. The company should be generating positive earnings because a comparison using a negative P/E multiple is meaningless. Lastly, the earnings quality should be strong, lacking high volatility, and company accounting practices used by management should not distort the earnings based upon generally accepted accounting principles.
Valuation Metrics Conclusion
No single valuation model fits every situation, but knowing the characteristics of the company, you can select a valuation model that best suits that specific situation. You are not limited to using one model. Several valuations to create a range of possible values or averages provide an overall company picture. When it comes to stock analysis, it’s not a question of the right tool for the job, but how many tools you employ to obtain varying insights from the numbers.What Are Stock Repurchases?
Share repurchases or buybacks are a decision by a company to buy back its own shares of stock from the marketplace. Management may feel their stock is undervalued and that purchasing these shares is a good investment strategy overall. Additionally, we discussed the P/E ratio above. As the number of shares outstanding decreases, the P/E ratio increases, making the stock more attractive to investors. Apple, for instance, is one of the biggest repurchasers of its own stock. With a large amount of cash on hand Apple recently announced a share buyback program. The company upped its cash dividend by 4 percent and is buying back $110 billion worth of stock. It’s the largest buyback in Apple’s history. Unsurprisingly, investors were thrilled and bid the price of Apple stock up significantly following their announcement.
Entire courses are available to delve deeply into the math and analytical aspects of stock price assessment and investing strategy. Whether you study these for your own personal investment portfolio or want to become a professional investment advisor as a career, the more you learn—and the more you practice—the better you hone your skills, for there are art and luck components involved here as well, there are no tools that will provide absolute certainty. Yet we can lower risk, and that alone takes us out of the realm of gambling and into the world of quality investing.
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