Picking an investment: How to approach analyzing a stock

Deciding how to invest is a lot like shopping for a car, but a lot more consequential. You can start by understanding your personal needs and style. Then you can consider different models, comparing choices based on their price and potential performance. Investment decisions deserve a similar but even more robust analysis. For many, evaluating investments might not feel as natural as shopping on a car lot, especially if you’re doing it for the first time. But, by learning the basics, you can figure out what to look for, and what to potentially avoid.

Whether you’re buying a single stock or building a diversified portfolio, smart shopping can have an impact on your portfolio’s performance. So how do you tell a reasonable investment from a total lemon? Well, there are no guarantees, but there are some ways to increase your chances of making an investment that supports your goals. Here are four steps to consider when analyzing a potential stock investment:

Just as you choose a car to fit your lifestyle, investments should support your goals. Your plans will inform how long you want to keep an investment, and how much risk you’re willing to take on. Certain investment goals may remove some more volatile investments from your consideration. For instance, if you need money in the short-term (e.g., to pay off credit cards or pay tuition), investing in volatile assets might put that money at too much risk for your comfort. Stock prices can fall quickly, taking your plans for the money along with them. That said, (while past performance is no guarantee) stocks have also been one of the better opportunities to achieve growth over the long haul. Holding stocks for longer periods of time (10-plus years) generally reduces the risk of loss, which can make them helpful to hold to support long-term goals, such as a home purchase, a child’s education, caring for parents, or retirement. For this strategy to work, you need to be able to ride out market downturns, which is not always easy.

As you decide how much risk you can handle, you might consider how your investments are balanced. In other words, what percentage of your portfolio is allocated to each type of investment? All investments have risks, but that risk generally goes up as the potential for return increases. That’s why some investors make room in their portfolios for a portion of typically lower-return investments, such as bonds, to help balance out higher-risk, potentially higher-return investments like stocks.

Just like the various vehicles at a dealership, every stock is different. They can vary in size, purpose, and of course, price. It’s up to you whether you want a soccer mom van or a sports car—or something in between. When you look at a stock, you might consider its market cap, the sector it belongs to, and where it could fit into your portfolio. You can also consider what makes it attractive. Does the company pay dividends? Does it look poised to grow?

Here are some key filters that can help you categorize stocks and size up their potential:

Size: When you go car shopping, you might think about whether you want a SUV or a sedan. Likewise, many investors think about a company’s size. One common measure of a company’s size is its market capitalization (aka “market cap”). This is the value of the company if you multiply the total number of outstanding shares by the company’s current share price. For example, if there were 30 shares in Eric’s Electronics and the market price was $4, the company would have a market cap of $120 (30 shares x $4 per share = $120 market cap).

Small-cap companies are generally valued between $250 million and $2 billion, and mid-caps are valued between $2 billion and $10 billion. Large-cap companies are those valued at $10 billion or above. Sometimes though, market cap is based more on perception than a company’s fundamentals. That’s because some investors value stocks based on their intrinsic value, while others approach them based on their apparent popularity, or market sentiment. With that in mind, companies frequently share certain similarities at different stages of growth. Small-cap companies are often unproven – Many show potential or could be acquisition targets, but they also face growing pains. For instance, can they expand beyond their existing customer base? Are they under pressure from incumbents or regulation? Small-cap companies could eventually become mid-cap or large-cap companies, but they could also fail. It’s also fully possible that a small-cap company could remain a small-cap company. By contrast, large-cap companies tend to be more stable, with management experience and cash on hand – Both can help weather the challenges that arise from competitors and sustain performance. As a whole, large-cap companies are more likely to pay dividends (more on that below). You can find many large-cap stocks in the S&P 500 Index, a collection of some of the largest publicly-traded companies in the US.

Sector: If you divide all businesses by the type of industry they fall into, you have sectors. For example, banks are part of the financial sector, internet companies are considered information technology or communication services, drug makers fall under the healthcare sector, diaper-makers are an example of consumer staples, and so on. There are different ways of slicing it, but as a general standard, there are 11 sectors in the stock market, as defined by the Global Industry Classification Standard, a common tool used in the financial world. When evaluating a potential stock investment, it often helps to compare it to others in the same sector. Investing in many different sectors can help you diversify your portfolio, lessening the blow of weak performance in one sector with strong performance in another sector.

Style: Do you want to buy a hot, new car? Or are you happy to hunt for a ride that’s been overlooked? Style is not as much about the company, as it is about how an investor categorizes their investment. “Growth investors” might look for companies that are expanding rapidly. Oftentimes, these are companies that receive extensive media coverage and get labeled as disruptors. Meanwhile, “value investors” might look for companies they consider underpriced. Both investment styles have their benefits and risks, which is why many investors own a mix of value and growth stocks.

Dividends (or not): As a stockholder, your investment might pay off in two ways—1) The company’s stock price, so you can sell an investment for more than you paid, or 2) you collect dividends, a portion of profits which a company might pay to its shareholders. Not all companies pay dividends, but those that do typically do so on a periodic basis, often quarterly (i.e., roughly once every three months). While they’re not guaranteed and can be eliminated or reduced without notice, dividends can provide investors with another source of income.

If you’ve ever seen the term “dividend yield,” that refers to how much a company paid in dividends during its last fiscal year, divided by the company’s share price. This metric can help investors understand a company’s stage of growth. Oftentimes, early-stage companies don’t pay dividends to investors at all, preferring to continue building their business and developing new products. By comparison, more mature companies are more likely to offer investors a higher dividend yield. High dividend yields also tend to be associated with companies that offer staple items or services, such as consumer packaged goods businesses.

As an investor, you might face a choice of what to do with dividends you receive. Some investors choose to use their dividends to buy additional stock or fractional shares of that company, which is known as using a Dividend Reinvestment Plan, or a DRIP. These plans are often offered by brokerage firms, and are sometimes also offered directly by a company to its shareholders.

Individual issue or fund: If you’re concerned by the pressure of picking a stock, you don’t have to pick just one. If you want, you can purchase a collection of stocks through an exchange traded fund (ETF) or mutual fund. These allow you to own many stocks at once. This can help reduce the risk of picking just one stock, providing you with some diversification. With ETFs and mutual funds, you can also find funds focused on specific sectors or risk levels.

Whether you’re investing in individual stocks or pre-packaged funds, a tool called a stock screener, can help you sort through investment choices, according to size, sector, price, and other measures. Alternatively, some investors start by analyzing companies they know well and comparing them to others in their category.

Buying a stock means becoming a partial owner in that company. As a shopper, you’re generally looking for one that is well-managed and profitable—and you want to pay a reasonable price. To find that information, turn to the company’s financials. Companies with publicly traded stocks make their financial information available to the Securities and Exchange Commission (SEC) and the public. This information, which you can typically find on the SEC’s EDGAR site or companies’ investor relations pages, includes annual 10-K filings, quarterly earnings reports, and other statements filed to regulators. You can usually find this information on the SEC’s EDGAR site and the company’s website (typically on an “investor relations” page). It’s also often included in stock profiles on brokerage platforms like Robinhood. Here are a few ways to interpret what’s in them.

Is the company growing? Check its revenue.

Revenue is the total amount of money a company generates from sales of goods and services. If it increases from one year to the next, that’s generally a sign of growth. An even better sign can be increasing net income, which is a company’s total income minus its expenses.

How much is the company earning? Measure the earnings per share.

Earnings per share (EPS) is the company’s earnings divided by the total number of shares it has on the market. A high EPS (or an EPS that is trending up) can be a sign that the stock is healthy and a potential opportunity for investors. Be wary though, EPS can also jump for less savory reasons, such as reverse stock splits.

Is the stock ‘fairly priced’? Examine its P/E ratio and the P/S ratio.

If you’re comparing two stocks, the price-to-earnings ratio (P/E) tells you what investors are paying for the stock in relation to a company’s earnings. (This metric is often described as how much you, as an investor in that company, are paying for a dollar of earnings.) Meanwhile the price-to-sales ratio (P/S) compares a company’s stock price to its revenues, aka, sales.

The P/E ratio is the stock’s current price divided by earnings per share. For example, a P/E ratio of 20 to 25 means investors will pay $20 to $25 for every $1 of earnings. A high P/E ratio usually means investors expect higher earnings, but it can also be a sign the stock is overpriced. A low P/E may indicate that a stock is underpriced lower, or it might be an accurate reflection of a company with limited prospects.

Some investors divide the P/E ratio by a company’s expected growth rate in the coming year. This provides a price/earnings-to-growth (PEG) ratio, and it can help you determine if a stock is potentially overpriced or undervalued. A PEG of one is thought to be fair value, while a PEG greater than one might start to look expensive, and a PEG less than one could look like a bargain.

Meanwhile, the price-to-sales (P/S) ratio, aka the “sales multiple” or “revenue multiple,” can be found by dividing the company’s market capitalization by its revenue, or total sales, over a specific period, like a year. You can also calculate the P/S ratio by dividing a company’s share price by the company’s sales per share. Comparing P/S ratios for companies in the same industry can help give you a sense of which ones might be undervalued or overvalued. For example, say you’re comparing three large tech companies, and the first has a P/S ratio of 6 while the others have P/S ratios of 4 and 2. The company with the lowest P/S ratio in this example may be undervalued, as its sales are high relative to its share price. (You may also come across a P/S ratio that is based on forecasted sales for the current year, which is known as a “forward ratio.”)

What about red flags? Watch the debt-to-equity ratio.

Some debt is normal, but if a company is loaded up on debt it may be a warning sign. The debt-to-equity (D/E) ratio can help you compare stocks. It’s measured by taking a company’s total liabilities or debt and dividing it by shareholder value. A D/E ratio of one or lower generally suggests that a company can cover debts if it has a bad year. A high D/E ratio may be a sign the company is in over its head. All of these ratios and metrics can be useful, but keep in mind that relying on any single metric in isolation can lead to poor analysis or investment decisions. Also, be wary that companies can perform well in the short-term according to certain metrics, but don’t always sustain that performance – Over limited time frames, investments can look better than they really are.

How volatile is the stock?

Before picking a stock, it can be helpful to get a sense of how volatile it tends to be, in order to give yourself a better chance of knowing what you’re signing up for. A metric called beta is a numerical rating of stock’s volatility. Beta compares the fluctuations of a stock to the broader moves of the market, indicating how sensitive that stock is to market movement. The more volatile a stock or other traded investment is, the higher its beta tends to be – The less volatile, the lower the beta tends to be. While investments with lower betas are generally considered to be less risky, lower betas can also signal less opportunity for reward.

Is it a good deal? Return on Equity can help

Everyone wants to know if they’re snagging a deal, or getting jipped. Return on equity (ROE), a measure of how well a company is turning equity into a profit, can help you figure that out. It’s sort of like a way for an investor to measure the bang they’re getting for their buck. The return on equity ratio is net income divided by shareholders’ equity. It tells you how much bottom-line profit a company earns per dollar of value that the shareholders have invested in the company. When evaluating a company’s ROE, it’s essential to compare it to similar companies, that is, companies in the same industry and of comparable size. It can also be useful to compare a company’s most recent ROE to its ROE in previous years to see if profitability is improving or getting worse.

As an example, let’s say a bank called Earnest Pig had a return on equity of 10% last year, and was able to generate 10 cents of profit for every dollar of its shareholders’ ownership. To help understand if that’s good or bad, you can compare its ROE to other big banks, as well as to Earnest Pig’s ROE in prior years.

How does it compare to the competition? Explore analyst research.

Analyst reports can help add quantitative, as well as qualitative, information to your research, such as assessing a company’s competitive strengths and weaknesses, new products, and important consumer trends. Analysts also regularly look at management, including stability, track record, and the costs of operating the business.

If you’re investing in an ETF or mutual fund, you may choose to do some of the same research on the fund’s biggest investments, known as holdings. You can also compare the fund to an index of stocks with similar holdings, known as a benchmark. The S&P 500 Index, for example, is a benchmark for large-cap stocks. If you are investing in an actively managed mutual fund, the long-term performance and track record of the fund manager can help you evaluate the fund’s success over time. You should also pay attention to the fees associated with investing in a fund. An expense ratio is one measurement of the costs associated with investing in a fund. These costs include, for example, payments to the fund manager, transaction fees, taxes, and other administrative costs, and are deducted from your returns in the fund as a percentage of your overall investment.

One great way to evaluate a stock is to watch and follow it for a period of time before becoming an investor. Data on past performance can help provide some context around the stock’s behavior, but putting yourself in the shareholder’s seat can sometimes give you a better feel for how you might handle what could be a bumpy ride. Even with taking great care to incorporate these and other considerations, you may find yourself with investment losses. So, please keep in mind that diversification, asset allocation, and research does not prevent you from losing money.