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Is This Stock Worth Buying?

Analysis can take some of the mystery out of investing in stocks.

Taking Some of the Mystery Out of Stocks

At first blush, buying stocks can seem a little overwhelming. You have a dizzying number of companies to choose from, their prices per share vary widely, and there's no guarantee what will happen to any stock's value over time.

Of course, you hope its value will increase and you'll one day sell at a profit. But how do you know which stocks will rise in value? 

So while it's easy to get lost in the highs and lows, there are proven ways to make wise choices. Let's have a look at some methods towards narrowing the field.

How To Analyze A Stock For Investing

It's impossible to know exactly what the future holds, which can make picking stocks tricky. There's no magic formula, and even experienced investors sometimes pick wrong—really wrong. But you can evaluate a stock carefully and make an educated guess about its future value.

The first method we'll break down is called a fundamental analysis. This approach uses key information such as company earnings and financial statements to gain insight into how the business is doing.

When you review these items, you'll want to ask:

  • Is the company making a profit?
  • Can it pay its debts?
  • Are revenues growing year-to-year?

Some key pieces of data can help you make these assessments. You can find them, and a host of others, on a stock's summary quote page.

EPS: Earnings per share refers to a company's profits divided by its number of shares; it's a basic measure of a company's profitability.

For example, if a company has annual profits of $1 billion, with 2 billion shares outstanding, the EPS is 50 cents.

Companies and analysts use different methods to measure EPS, so it can be hard to draw comparisons with other stocks. For that same reason, there is no single "good" EPS number a company "should" have, although a company that's losing money won't have one at all.

In general, a high EPS means that a company is capable of paying investors lucrative dividends. EPS is most useful in tracking trends—for example, if a company's EPS is growing every year, it's selling a product that customers value. Analysts often look at actual EPS against a company's forecasts for EPS, to see if expectations were met.

P/E ratio: Once you know a company's EPS, you can calculate another important number: The price-to-earnings ratio. This compares a company's market share price to its annual EPS.

For example, at the end of 2018, Apple shares were selling at $157.07, and the company had an EPS for the year of $12.16. Thus its P/E ratio was 12.92 ($157.07 divided by $12.16).

Historically, P/E ratios have averaged around 16, but the average fluctuates widely from year to year; there is no "normal" P/E.

That said, at a time when Microsoft's P/E was at 23.47, Apple's lower P/E reflected investor concerns about Chinese tariffs and lagging iPhone sales. That doesn't make Apple a bad stock buy; on the contrary, it could be viewed as a bargain, because Apple shares are comparitively cheaper than Microsoft's.

The higher the P/E ratio, the more investors are paying for each dollar of the company's earnings. That could mean that the stock is over­valued, or it could reflect optimism for the company's future.

Beta: This number represents a stock's volatility compared to the market. The market's beta is 1.0; a stock that moves up and down more than the market will have a beta higher than 1.0.

Generally, companies in established industries have low betas, while start­ups in new fields have higher betas. There's no definitive good or bad beta; the number is useful only as it relates to an investor's appetite for risk and reward. It's also most useful as a short-term indicator, since long-term volatility trends are harder to predict.

Knowing these details can help you determine the underlying health of a business, and compare it to both its competitors and its sector overall. Also, pay attention to the company's earnings and whether they fall short of their projections. Doing so repeatedly can be a red flag.

Understanding a Stock's Moving Average

The second way to evaluate stocks is called technical analysis, but don't let the name intimidate you. This method looks at how the stock itself performs. By studying a stock chart, technical analysts consider whether the stock price is moving up or down. And they're always looking for trends.

A technical analysis often relies on moving averages, which smooth out the stock price over a period of time.

You can run moving averages for various time frames: 30-day, 50-day, and 200-day are common figures. A shorter time frame reacts more quickly to price changes, while a longer time frame gives a broader view of performance over time.

Take a look at the chart above. With all the ups and downs, the data represented in blue is a little hard to follow. But by averaging that same data over 30 days -- the red line -- you get a much clearer sense of the stock's overall trend: relatively flat, followed by a gradual rise and a quicker decline.

The idea behind this method is that while history is not a perfect predictor of the future, it is likely to repeat itself. When you gather and analyze past performance data, you have a chance to see the various factors that have affected a stock's price swings over time. And once you understand the patterns that affect a stock's price, you'll get a sense of how prices may change in the future.

What's The Best Way To Analyze a Stock?

If you've read through these slides, you learned two different approaches to understanding a stock and analyzing its performance. You can probably guess which path will most clearly lead you to the best value: It's both.

You shouldn't ignore or discount the basic but critical details contained on the stock summary page or in an earnings report.

In addition, company executives often hold conference calls with analysts to answer more questions about fundamentals; these calls happen when companies report their earnings. They can produce valuable insight into management's strategy.

But you can also round that out with the information you gain from a technical analysis. Once you've analyzed a stock using these methods, you'll have some indications about whether it's a good investment.

After you've done your homework and picked your stocks, watching them grow can be extremely rewarding. Some people even invest in a single stock or two as a fulfilling hobby and a way to learn more about the market, or in the case of company stock, about their own employer.

Keep in mind that professional stock pickers look at many more complex factors. For the rest of us, stock picking should be recreational, and done with money we can afford to lose.

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