Evaluating Companies

Earnings ÷ Outstanding shares = Earnings per share (EPS)

Current price ÷ EPS = Price-to-earnings ratio (P/E)

Total debt ÷ Value of outstanding shares = Debt-to-equity ratio

Evaluating a company means taking a close look at what that company makes or sells, how the company is managed, what it earns, the amount it owes, and how it performed during the ups and downs of the last full economic cycle. That information lets you evaluate its profitability, its growth potential, and its valuation.

Researching Research

A stock analyst’s job is to provide guidance on whether to buy a stock, sell it, or wait and see. Sell-side research, which is created for individual investors, is available from two sources. Brokerage firms provide their clients with in-house analysis at least in part to stimulate trading. Independent analysis comes from firms whose primary business is creating and selling research.

When an analyst is unambiguous, he or she advises you to buy, sell, or hold. One complication is that research reports don’t always use the same language. It’s easy to conclude that accumulate means buy. But does underweight mean sell some or sell all shares? Firms that provide consensus information, or a synthesis of what different analysts are saying, generally handle this issue by grouping all the ways to say buy or sell under a single term.

Keep in mind, though, that buy recommendations generally outnumber sell recommendations, even in weak markets. And while many analysts and the firms they work for are widely recognized and highly respected, that’s not always the case. You’ll want to evaluate the evidence used to support an analyst’s conclusions and his or her track record before acting on any recommendation.

IT’s all IN the numbers

One revealing statistic about any company is earnings per share (EPS), which is computed by dividing the company’s earnings during a specific period by the number of outstanding shares. Using a per-share calculation rather than the dollar value of the earnings makes it easier to compare the results of companies of different sizes. But, remember that acceptable profit margins vary widely by industry and sector.

Other important measures of profitability are return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC). The three also measure the efficiency with which capital is used. If a company’s ROE is higher than its ROA, it may be a sign that it’s using leverage, or debt, to increase profits and profit margins. The details should be included in the Form 10-K that it files with the SEC.

What’s the Potential?

A pattern of annual percentage increases in sales and earnings is a key indicator of a company’s potential success. Regular growth, especially when it’s the result of new products or marketing strategies, is generally a better signal than a one-time spike resulting from price increases or other market conditions without an accompanying growth in sales.

Remember, though, that growth potential varies for different-sized companies. Smaller, newer companies in an expanding industry may grow at a faster rate than larger companies in established industries.

WHAT’s ITS VALUE?

You can use various ratios, also called multiples, to measure a company’s valuation, or its stock price in relation to the company’s financial situation. One of the most widely cited multiples is the price-to-earnings ratio (P/E), which is computed by dividing the stock’s current price by EPS. P/E is a measure of how much investors are currently willing to pay for each dollar of a company’s earnings.

For example, a company with a P/E of 30 has a significantly higher multiple than a company with a P/E of 10. This may mean that investors believe that the company with the higher P/E is a promising investment whose price will continue to climb. But it may also mean that the stock is overvalued, or costs more than future earnings may justify.

Similarly, it’s possible that the company with the lower P/E is undervalued, and actually worth more than investors are currently willing to pay for it. But it could also mean that the company has serious problems that investors believe may limit its future success.

Say Ahhh!

A company’s financial health is affected by how much debt it carries. A company that’s taken on substantial debt and is not managing it well may find that its earnings potential is limited by its liabilities. In severe cases, heavy debt may even indicate that the company is veering toward insolvency.

One ratio commonly used to gauge financial strength is debt-to-equity, which divides total debt by the company’s market capitalization, or the value of outstanding shares. The higher the resulting percentage, the greater the company’s debt level.

For companies in financial difficulty, another key measure is current ratio, which compares liquid assets—cash on hand or assets easily converted to cash—to the liabilities due within the year.

How much debt is too much? The answer varies, depending on the type of business, the company’s ability to pay it back, how the debt is being used—to pay off other debts or to invest in new products or acquisitions—and the perspectives of the analysts who study the company.