Three Ways to Judge a Stock

As the market slowly slips into below 10,000 points, some would say this is a great time to buy. But how do we separate the duds from the winners; the ones with potential and the ones that will never go anywhere? We’ll spend some time breaking down three specific metrics to help judge future return: P/E ratio, EPS, and Dividend & Yield.

Let's go to Yahoo! Finance, a great, free resource that is mostly accurate. If you need some information quick-and-dirty, this is one of my favorite places to go.

P/E Ratio

This is the price-to-earnings ratio. Literally, we take the current stock price divided by the EPS, which we will discuss next. For many, this ratio contains very little meaning. But there are actually two ways to read this ratio

1. The ratio tells me how many years it will take for me to double my money; or
2. The ratio tells me how much more I have to pay for the stock versus how much money the company is actually bring in.

Possible interpretations:

High P/E:

• Investors believe the company is growing or has growth potential.
• This is an indication that the stock is over-priced.

Low P/E:

• Investors believe that the company is mature and unlikely to grow much in the future.
• This is an indication this is a stock the market is currently under-valuing and I may be able to pick up the stock at a discount.

Note: Companies that are not earning money do not have P/E ratios.

In a mature industry such as industrial goods or oil and gas, it is likely that the ratios will tend to be low. (See Chevron NYSE: CVX) That means that over time, the market has a range where the price closely reflects with the earning potential of the company.

During the tech boom, many companies had P/E ratios in the 100s. Investors believed that these companies would grow and thus invested heavily, driving the stock prices even higher.

As a good rule of thumb, P/E ratios below ten are considered a good value. Ratios between ten and 20 require a look at our next metric.

EPS

This is the earnings per share. That’s how much net income (taxes have already been taken out) divided by the total shares outstanding. (Sometimes this is fully diluted shares, but for our purposes, we won’t worry about it.) This tells you a little bit about how much money this company is making.

As noted above, a company will not have a P/E ratio if it has no earnings. Thus, in those cases, the EPS would not be noted or they will display the loss.

In general, we would like the companies we invest our hard-earned money in, to be making money themselves. Of course, in cases like TiVo, a brand name that has entered the English language as a verb (i.e., I TiVo-ed it!), the company has lost money for years but somehow finds investors to keep it running. Those interested in long-term investments, may wish to find companies that have turned a profit regularly.

Check historical EPS. As investors we should know whether a company is continually operating at a loss, or if this year was just a bad year. Information can be found in the filings at the SEC and may be found in annual reports on the company’s website.

Finally, for those interested in an income stream, we should talk about our last point.

Dividend & Yield

Not all companies give dividends. In fact, as you search through the web, you’ll find many companies don’t give dividends. Why is that?

Companies that give dividends to its shareholders tend to be those that are mature and confident of steady net profit. Companies such as Caterpillar (NYSE: CAT) and Dow Chemical (NYSE: DOW) all give dividends.

Income is great, but how do we judge? That’s when we look at the yield. Think of the yield like the interest in your savings account. The difference is, you’ll likely get this interest quarterly (some are semi-annual or annual) and your investment is not backed by the FDIC, meaning there’s risk involved.

To reward you for the risk in investment, yields from some companies may be higher than what you’re getting on a money-market account at your local bank. Usually if you can invest the same amount in the stock as you put into your bank account, it’ll be more profitable in the market. The thing is, most folks would be uncomfortable putting their eggs all in one basket.

Dividends like interest are taxable. Qualified dividends are currently taxed at 15 percent (though this will likely change in the near future).

Overview

Once we take all three metrics together, we can actually gain a measure of the health of a company and its state of profitability. Always do your research and read up on analysts’ reports to gauge the industry. Check out how the entire industry is doing and see if it is trending upwards or stagnant. In Yahoo! Finance, look at the left sidebar under “Company” and you can find information on both competitors and the industry as a whole.

Finally, take a tip from Warren Buffet – invest in what you know. The more you research an industry, the more you know, and the more likely you’ll be able to pick out a diamond among all the rocks!