Stock refers to the shares into which the ownership of the company is divided. One share represents a fraction of ownership in proportion to the total number of shares. The shareholder is entitled to that fraction of the company’s earnings, voting power or proceeds in case of liquidation. Some shares don’t have voting rights, others have enhanced voting rights and others have priority in receiving profits or liquidation proceeds.
Stock can be bought and sold privately or on stock exchanges. Issue of new shares dilutes ownership and rights of existing shareholders. Companies can also issue stock options as employee compensation, though they do not represent ownership, they represent the right to buy ownership at a future time at a specified price. Companies can also buy back stock, which often lets investors recoup the initial investment plus capital gains from subsequent rises in stock price.
Some of the factors to consider when buying stock are listed below.
- 1. Price/Earnings Ratio (P/E)
- 2. Earnings Per Share (EPS)
- 3. Debt-to-Equity ratio
- 4. Market capitalization
- 5. Cash Flow Per Share (CPS)
- 6. Beta
- 7. The 52 week range
- 8. Dividends
- 9. Earnings growth
- 10. Volume
- 11. Management
- 12. Stability
- 13. Relative strength in the industry
- 14. News
- 15. Insider trading
- 16. Open interest in option chains
1. Price/Earnings Ratio (P/E)
The PE ratio gives an insight on whether a stock is overvalued or undervalued. The formula for finding the ratio is: Price per share/Earnings per share. A company is overvalued (stock is overpriced) if the PE ratio is high, meaning that the price per share is more than the earnings per share. While the opposite is true for an undervalued company (stock is underpriced), if the PE ratio is low, meaning that the price per share is less than the earnings per share. When selecting the stock to buy, go for one with a low PE ratio (ranging between 1.0x and 10.0x), since they have a greater potential of growing. If the market performs better, this can increase to around 10.0x and 20.0x. The PE ratio for a negative earnings per share will not be listed.
Earnings per share (EPS) is the portion of a company’s profit allocated to each share of common stock. EPS serve as an indicator of a company’s profitability. When selecting the stock to invest in always go for one with a positive EPS and with consecutive growth over the period. If EPS of the company keeps decreasing or fails to meet the expectations, the stock price will also tank. To get EPS, use this formula: (Net Income – Dividends on Preferred Stock)/Average Number of Shares Outstanding.
3. Debt-to-Equity ratio
All companies have liabilities, and precisely they carry debt on the balance sheet. For a company to claim soundness, it must have more assets than liabilities. Be wary of companies that have high amounts of debt. When making your stock selection, look at the company’s balance sheet, and compare the debt-to-equity ratio. It’s advisable to go with the company with a debt-to-equity ratio of 0.30 or below, in a nutshell, that one that presents lower risk. But in case you are a risk tolerable person, then you can look into companies that have higher ratios, or if a higher ratio is acceptable in the industry (for instance; construction companies, which are known for higher ratios, since they use a lot of debt funding).
4. Market capitalization
Market capitalization is the market value of a publicly traded company’s outstanding shares. That is, the share price multiplied by the number of shares outstanding. The market cap is used to classify the size of the company into one of the following categories: nano, micro, small, mid, large, and mega caps. The larger the company the more stable and safer it is, they can withstand any market disturbance. The small companies have high risk of failing in case the market crashes or bankruptcy. When selecting which stock to buy, assess your risk tolerance and match it with the market cap. Large companies have matured and present little or stagnant growth, whereas small companies, though with high risk, have potential for extreme growth. Market cap is determined using this formula: Number of Shares Outstanding x Price per share.
Cash flow per share (CPS) represents the net cash a firm produces on a per-share basis. CPS indicates the amount of cash the company has at hand in relation to one single share. This information is crucial when picking stock to invest in because it will give you an insight if the company has enough cash to pay off debt and if it’s in a position to pursue operations or projects that will contribute to stock price increases. CPS can be calculated by dividing cash flow earned in a given reporting period (usually quarterly or annually) by the total number of shares outstanding during the same term. Because the number of shares outstanding can fluctuate, a weighted average is typically used. When choosing which stock to buy always go for one with positive CPS.
Beta indicates whether the stock is more or less volatile than the market as a whole. It will help in assessing the risk arising from exposure to general market movements as opposed to idiosyncratic factors. A beta greater than 1 generally means that the asset both is volatile and tends to move up and down with the market. A beta below 1 can indicate either an investment with lower volatility than the market, or a volatile investment whose price movements are not highly correlated with the market. Negative beta, means the stock moves inversely or opposite of the market. Large blue-chip companies have the lowest betas as compared to businesses like casinos which have the highest betas. High beta can give you the most significant gains helping you make the quickest cash, but if the market is under-performing, you could lose the most. Low beta comes with lower volatility. Select a stock with beta that matches your risk tolerance.
7. The 52 week range
The 52 week range shows the lowest and highest price at which a stock has traded at in the previous 52 weeks. It provides information on how volatile a stock is. If a stock is trading at its near 52 week low, then it is considered a good value. Stock can either go high or low, regardless of its low point. When buying stock, ensure that the stock is on a rebound if it’s near the low. Avoid stocks that are constantly dropping, since they can create new lows. Also, avoid stocks trading at their 52 week high as they are likely to hit their resistance level and start dropping.
Dividends are payments that a company makes to its shareholders for holding their stock, usually as a distribution of profits. When selecting which company to invest in, ascertain if the company is currently paying dividends, as this means that the company has money and is experiencing a steady growth.
9. Earnings growth
Consider the net gain in income that a company has over time, when shopping for stock. Look at the trends and gauge if the earnings growth is generally increasing. When making your selection, go for a company that has steady and consistent earnings growth over time, and promises that into the foreseeable future.
Volume implies to the number of shares traded (bought and sold) in a single day. When the volume is low, it means that there are few or no buyers and sellers. Thus, low liquidity, making it hard to buy and sell, as this involves trading of penny stocks. Go with a stock that is trading with a volume of over 50,000, to avoid unnecessary volatility.
Take a keen look at how the company is being managed. Management plays a very vital role in the growth and stability of the company. Look at the management culture, innovativeness and competence before you make the decision. Avoid buying stock whose company is riddled with scandals that may have a negative impact to the value of the company, not only in the short term but also in the long term. Some companies may recover from setbacks, while others may not. So be very careful on the stock you are buying.
During economic difficulty and market upheaval times, stocks often lose value. When selecting a stock to buy, look at the overall stability in relation to the economic conditions. If a stock only drops when the rest of the market is in difficulty, then you might consider it. Avoid stocks that generally fluctuate.
13. Relative strength in the industry
Look at the overall industry and gauge the strength of the stock and its promise in the future. What’s the position of the company when compared to the competitors? Select a stock that shows optimal strength in the industry.
Positive and negative news about a company have an impact on its stock and other securities. The news can either in a positive or negative way affect the decisions and expectations by the public trading in its stock, thus affecting the stock prices. When making a decision to invest in a company’s stock, be on the lookout on the press coverage of the company. Take for instance, if a company is involved in a scandal; the stock prices will tank, investors will start disposing their stocks and the overall value of the company will drop in the near future. Investing is such a company, means you will lose your money.
15. Insider trading
Insider trading refers to trading of a publicly listed company’s stock or other securities by individuals inside the company, that have access to non-public information about the company. Such activities can be very crucial when you want to buy stock. If the staff are buying high stock of the company, then you can buy the stock. But, if they are dumping their stock, the avoid buying it. Often, insiders has more information about the company’s stock than outsiders even analysts.
16. Open interest in option chains
Stocks often offer options contracts for buying and selling in the future. This will give you an opinion on the future performance of the stock. Go for stocks where the bullish are more, people in the left open interest column (call side), than the bearish, people in the column on the right (put side). The bullish think the stock price is going up, while the bearish think the stock is going down. This shows that more people are interested in buying the stock in the future than selling it, a clear indicated that the stock is performing well or is likely to perform better in the near future.