Thoughts on How to Value Stocks

If you have decided to trade stocks, it is very important to arm yourself with enough knowledge to make informed, intelligent decisions.  How much money you want to commit to the stock market is a function of your total wealth, your investment time horizon, and your willingness to deal with risk (both financially and emotionally).  But once you make the determination of how much to put at risk in the hopes of gain, your odds of success in selecting stocks that appreciate in value is related to how much you know about how the market values companies.

The value of a company's stock is usually determined by a number of factors: earnings, revenues, cash flow, equity, dividends, and not least importantly, growth rates.  Most valuation experts look particularly hard at earnings and assets, and how fast the earning are growing or are expected to grow.  A good indication of a quality pick is the price/earnings (P/E) ratio. This shows the relationship between the market capitalization (shown on a per share basis by the stock price) and the earnings of the company (also often shown on a per share basis).

The P/E ratio is often a useful measure of whether any stock is overpriced, fairly priced, or underpriced relative to a company's money-making potential.  As a rule of thumb, the P/E ratio of any company that's fairly priced will equal its growth rate of earnings.  In general, a P/E ratio that's half the growth rate can be very positive, and one that's twice the growth rate can be very negative.  You can check a company's historical record on P/E's, check S&P reports. Track several years to get a feel for normal P/E levels, but keep in mind that past performance does not necessarily guarantee future results.  And these rules of thumb for P/E ratios apply well to stable companies with a long history of earnings.

Cash flow and equity are next to evaluate.  Check out the company's balance sheet.  A typical balance sheet shows 75 percent equity and 25 percent debt.  A higher equity and lower debt percentage may indicate a stronger company (certainly a more conservative one), while a lower equity and a higher debt percentage might be cause for concern, or at least further analysis.

For the extra income, stocks which provide dividends are often preferred over non-dividend paying ones.  Electric utilities and telephone utilities are the major dividend payers.  However, Lynch suggests the real issue should be analyzing how the dividend, or the lack of a dividend, affects the value of a company and the price of its stock over time.  Milton Freidman, Nobel prize-winning economist and founder of the Chicago School of Economics, proved mathematically that over the long term, there is no difference in value between stocks that pay dividends and those that don't.  So you can think of a dividend as taking your growth up front.

You may have your own set of criteria to determine what stocks you'll select.  By all means, use any and all tools necessary to make a conscientious, well-planned, well-researched decision.  Watch the markets on a daily basis.  Watch your stock selections in particular.  Read as much as you can about the company.

Consider the planning time before you purchase stock as part of your overall investment. After all, it's your money.