How To Evaluate Stocks
Stock picking is akin to weather prediction - no one can predict with certainty five hours from now if the price will rise or fall, much less five years from now.
Nevertheless, there are indicators that help to reduce the risk and increase the odds of profiting over the long term. After all, historically stocks have returned over 10%, as measured by the growth of the S&P 500.
The first step is to get educated. Learn not only about dividends yields and earnings per share, but also some basic accounting. Reported figures have an air of authority but the sad fact remains that those numbers are arrived at, in part, by accounting methods which are not cut and dried.
The Enron case (case in which the executives of Enron manipulated their earnings figures to appear to be much more
successful than they were) is extreme, but even ordinary procedures involve judgment calls on the part of financial officers and auditors.
Next, commit to continuing research about stocks both inside and outside your intended portfolio, and update it as you buy and sell. There’s a broad spectrum between exact prediction and throwing darts blindly. In the long run, those who do their homework do far better and almost all day traders lose money.
Research both prospective buys and intended sells. Many investors put considerable time and effort into analyzing a buy, but then only watch for some price to be reached in order to sell. Knowing when to sell is just as important, and a target should be selected before the stock is bought.
RESEARCHING BUYS
Obtain the latest, and some historical, financial statements. The SEC provides these free (www.sec.gov) in their EDGAR database, but other exchanges have similar arrangements.
Analyze the quarterly statements covering two to three years, looking for EPS (earnings per share) and revenue trends. Calculate dividend yields, if the company pays dividends.
Compare the company’s P/E (Price to Earnings) ratio to others in the same economic sector. Look at P/S (Price to Sales) ratios, too. Sales growth is easier to predict than earnings and less volatile than P/E ratios.
Examine general economic factors. Interest rates affect stock prices as well as bonds (though less directly), since almost every company borrows money. Even when they don’t, their competitors, suppliers, and customers do. Interest charges reduce profits for all but the lenders, for whom it’s income.
Even when researching a bank, though, high interest rates increase short-term profits, but can reduce the number of loans and cause certain current ones to be repaid early. High interest rates aren’t necessarily good for banks either, therefore.
Use some of the more common technical indicators, such as MA (moving averages) and RSI (Relative Strength Index, which compares the number of days a stock finishes up versus down). An RSI of 70, or above, for example, does tend to indicate a stock which is overbought and due for a fall in price.
RESEARCHING SELLS
Pick a target price, which amounts to deciding how much profit (in dollars or percentage terms) you seek then sell at that price, unless your continuing research has turned up significant new information.
Consider selling if the price has dropped substantially or remained unchanged for several months. Losses are hard to bear, but consider that you can’t always pick winners and while you’re invested in one stock, you’re forgoing potential profit from another. That profit could help reduce or more than make up for the loss from the sale.
Continue to monitor the company’s fundamentals by obtaining updated filings. Re-evaluate them by updating earnings trend calculations, significant management or general economic changes.
You can ease the difficulty of performing calculations (which is a useful exercise at least once) by finding Internet sites that provide objective data and go easy on the “here’s how to pick winners” sales talk.
And remember, ‘on the street’ opinions are a dime a dozen - including mine.