How to evaluate a Stock before Investing

 There exist a multitude of perspectives and approaches reliant on diverse variables and various ideologies, ranging from acquiring undervalued stocks to investing in growth-oriented equities, all the way to aligning investments with global developments. How can one possibly assimilate the full spectrum of market dynamics, spanning shifts in individual stock performance to seismic changes in the global economy, from trends in commodity markets to fluctuations in currency values?

How to evaluate a Stock before Investing

The intrinsic worth of a stock, deeply rooted in its fundamental business attributes, frequently diverges from its prevailing market price—despite certain contrary beliefs. A stock's value is an intricate interplay of numerous factors, encompassing the company's sustained profitability potential, its customer base, its financial underpinnings, the broader economic context, political and cultural trends, and its relative positioning within the industry. Grasping this concept constitutes a pivotal step in your journey to crafting a well-rounded stock portfolio.

To this end, three primary methodologies come into play: Net Asset Valuation, comparative valuation utilizing multiples, and the Discounted Cash Flow (DCF) valuation approach, widely regarded as the most dependable of the three.

Current Valuation Analysis

Enterprise Value serves as a practical gauge for assessing a company's present market worth. Its primary application lies in the evaluation of acquisition or merger pricing for a corporation. In contrast to Market Capitalization, this metric offers a more comprehensive perspective by factoring in the entirety of liquid assets, outstanding debt obligations, and complex equity instruments present on the company's balance sheet. In the event of an acquisition, the acquiring company assumes the target company's liabilities while gaining control of all available cash and cash equivalents.

Enterprise Value = Market Cap + Debt - Cash

Probability Of Bankruptcy

The Probability of Bankruptcy is a metric employed to assess the likelihood of a company facing financial turmoil in the upcoming two years, given existing economic and market conditions. This probability is calculated by adjusting and interpolating the Altman Z Score, accounting for off-balance-sheet items and any missing or unreported public information. All data used in this analysis is extracted from Editas' balance sheet, as well as their cash flow and income statements, as per the most recent filings.

This metric provides a relative indication of the company's susceptibility to financial distress. In the context of stocks, it represents the normalized Z-Score value, while for funds and ETFs, it's derived from a multi-factor model developed by Macroaxis. The score is utilized to forecast the likelihood of a company or fund encountering financial difficulties within the following 24 months. Unlike the Z-Score, the Probability of Bankruptcy falls within a range of 0 to 100, reflecting the actual probability that the firm will face financial distress in the next two fiscal years.

Probability Of Bankruptcy = Normalized Z-Score

Z Score

The Altman Z Score stands as one of the most straightforward foundational models for assessing a company's vulnerability to financial failure. This score serves the purpose of predicting the likelihood of a company entering bankruptcy within the subsequent 24 months or two fiscal years, commencing from the date specified in the financial statements used for its computation. Professor Edward Altman devised this model in the late 1960s at New York University, incorporating five essential business ratios, each weighted according to his algorithm.

Calculating the Z-Score necessitates knowledge of the company's current working capital, total assets, total liabilities, the most recent retained earnings figure, as well as earnings before interest and taxes (EBIT). Companies boasting Z-Scores exceeding 3.1 are generally regarded as stable and robust, with a low probability of bankruptcy. Scores falling within the range of 1.8 to 3.1 are situated within a "grey area," while scores less than 1 indicate a high probability of financial distress. The Z Score finds widespread utility among financial auditors, accountants, asset managers, loan processors, wealth advisors, and day traders. Over the past quarter-century, numerous financial models employing the Z Score have demonstrated their efficacy in predicting corporate bankruptcies.

Z Score = Sum Of 5 Factors

Book Value Per Share

A straightforward method for assessing Book Value per Share involves comparing it to the current stock price. If the Book Value per Share exceeds the prevailing market value of the stock, it suggests that the company may be undervalued. However, it's crucial for investors to recognize that the traditional calculation of Book Value excludes intangible assets like goodwill, intellectual property, trademarks, or brands, making it an incomplete measure for many businesses.

To compute Book Value per Share (B/S), one subtracts the company's liabilities from its assets and then divides the result by the total number of outstanding shares. This figure signifies the degree of security associated with each common share after accounting for liabilities. In essence, shareholders can employ this ratio to estimate the potential proceeds from selling their stake in the company in the event of liquidation.

Book Value Per Share = Common Equity/Average Shares

The Book Value per Share offers valuable insights to shareholders by indicating the worth of their shares in the event of the company's closure and asset liquidation, satisfying any outstanding obligations. This information is particularly crucial when investing in potentially unstable or speculative companies, providing a sense of what one might recover if the company faces insolvency. While investing heavily in such situations is generally ill-advised, there are specific circumstances where it may prove advantageous.

Furthermore, Book Value per Share can serve as a tool to gauge potential risks. If the calculated book value stands at $10, and the stock is trading above this book value, it can be used as a reference point for setting a stop-loss level. Prudent risk assessment is a cornerstone of effective portfolio management, as while profits are enticing, safeguarding against risks is equally vital.

What is considered to be a high beta?

Beta is a metric that quantifies how a stock's price tends to move in relation to a chosen benchmark. Typically, this benchmark is the broader stock market, often represented by the S&P 500, although it can also be an industry-specific index or a collection of companies of similar size. A beta value of less than 1 suggests that the stock exhibits lower volatility than its benchmark, while a value greater than 1 indicates higher volatility, amplifying the benchmark's fluctuations. Conversely, a stock with a negative beta tends to move in the opposite direction of its chosen benchmark.

For instance, consider a stock with a beta of 1.3. On average, it moves 1.3 times the magnitude of each movement in the S&P 500. If the S&P 500 rises by 10%, the stock with a beta of 1.3 would typically increase by 13%. Conversely, if the S&P 500 falls by 10%, the stock would decline by 13%. This implies that the stock is characterized by a higher degree of risk and potential reward. In a declining market, the stock tends to suffer more significant losses, but in a rising market, it has the potential to outperform. Calculating beta is a straightforward process, and numerous websites, including Yahoo Finance, provide this information.

High beta values are commonly associated with smaller, more speculative companies, such as biotech firms developing innovative treatments or small tech companies with cutting-edge technologies and significant growth potential but limited market share.

While beta can be a valuable tool when used in conjunction with other metrics, it's essential to remember that it solely reflects past volatility in relation to an index and does not gauge the safety of an investment. When researching any stock, a comprehensive analysis of the entire business is crucial, focusing on identifying enduring competitive advantages.

Financial ratios to help with stock evaluation

Ratios provide valuable insights into a company's financial well-being, enabling meaningful comparisons with other firms in the same industry or in relation to the broader market.

What is a good Earnings Per Share (EPS)?

Earnings per share (EPS) serve as a metric that informs investors about the portion of earnings allocated to each shareholder if the company were to be immediately liquidated. Earnings typically form the foundation for a company's valuation, and investors are inclined to favor increasing earnings. A rising EPS suggests that the company may have more resources available for distribution to shareholders or for reinvestment in its operations.

Earnings, also known as net income or net profit, represent the funds remaining after a company settles all its financial obligations. To calculate earnings per share, one simply divides the company's reported earnings by the number of outstanding shares. For instance, if XYZ Corp. has 1 million shares outstanding and has earned $1 million over the past 12 months, its trailing EPS is $1.

Earnings per Share = (Net Income-Preferred Dividends)/(End-of-Period Common Shares Outstanding)

However, the EPS figure on its own lacks context and significance. To assess a company's earnings in relation to its stock price, most investors utilize the price/earnings (P/E) ratio.

What is a Good Price-to-Earnings (P/E) ratio?

This formula serves as a tool for assessing the relative valuation of one company's stock compared to another. The price-to-earnings (P/E) ratio is a straightforward metric that divides a company's stock market price by its earnings per share (EPS). This ratio offers insights into how many years it would take for a company to generate sufficient earnings to buy back its own stock.

PE ratio = Current share price / Earnings per share

The P/E ratio considers the stock price and divides it by the earnings over the past four quarters. For instance, if XYZ Corp., as mentioned earlier, is currently trading at $15 per share, its P/E ratio would be 15.

Often referred to as a "multiple," the P/E ratio is frequently compared to the current growth rate of EPS. Returning to our XYZ Corp. example, if we discover that the company achieved a 13% growth in EPS over the past year, a P/E of 15 would indicate that the company is reasonably valued.

Furthermore, the P/E ratio can offer insights into the market's expectations for a company's future profit growth. A small, rapidly-growing company may have a high P/E ratio because it generates limited earnings but commands a high stock price. Investors purchasing stocks with high P/E ratios typically anticipate future earnings growth. If the company can sustain robust growth and rapidly increase its earnings, a stock that appears expensive based on P/E can transform into a bargain. Conversely, a low P/E ratio may suggest good value for investors, but it can also indicate skepticism about the company's future performance.

Smart investors assess companies based on their future prospects rather than past performance. Stocks with low P/E ratios may signal potential issues on the horizon. If a company has incurred losses in the past year or experienced a decline in EPS, the P/E ratio becomes less reliable, and alternative valuation methods should be considered.

One commonly used derivative of the P/E ratio is the P/E and growth ratio (PEG). The PEG ratio, which factors in growth, offers a more comprehensive assessment of a company's price relative to its future earnings growth potential, making it a valuable measure of value.

What is a good PEG ratio?

The Price/Earnings-to-Growth ratio, commonly referred to as the PEG ratio, is a metric that aids investors in assessing a stock's value by considering factors such as the company's market price, earnings, and future growth prospects. Relying solely on a trailing Price/Earnings (P/E) ratio is akin to driving while fixating on the rearview mirror; the PEG ratio offers a more comprehensive view of whether a stock is overvalued or undervalued.

In essence, the PEG ratio provides a quick and effective means to gauge how a company's current stock price relates to both its earnings and its anticipated growth rate. One of its notable advantages is its ability to facilitate comparisons between companies in different industries without delving into the intricacies of their P/E ratios.

The PEG ratio extends beyond the trailing P/E ratio by factoring in the furthest estimated rate of growth and then comparing it to the trailing P/E ratio. A company expected to experience significant growth in revenue, earnings, and cash flow is inherently more valuable, assuming all other factors remain equal. Consequently, growth-oriented companies tend to command higher P/E ratios, as investors are willing to pay a premium for the potential for future growth.

The PEG Ratio is computed as follows:

PEG ratio = PE ratio/EPS Growth

For instance, if a company is projected to grow at a rate of 10% annually over the next two years and currently boasts a P/E ratio of 20, its PEG ratio would be 2 (20 trailing P/E / 10% projected EPS growth rate = 2.0 PEG). To calculate the PEG ratio, you need three essential pieces of information: the stock price, earnings per share, and the expected growth rate.

Many analysts and investors prefer the PEG ratio over the P/E ratio because it incorporates a firm's future growth prospects. A lower PEG ratio typically suggests that a company is undervalued or fairly priced, with a PEG ratio of 1.0 or lower indicating that a stock is reasonably priced or potentially undervalued. Conversely, a PEG ratio exceeding 1.0 implies that a stock is overvalued. For instance, a company labeled A with a PEG ratio of 1.2 would be considered more "expensive" than company B with a PEG ratio of 1.0. Company C, with a PEG ratio of 0.8, would be considered "fairer" than company B. In essence, investors relying on the PEG ratio seek stocks with a P/E ratio equal to or exceeding the company's expected growth rate.

When employing the PEG ratio, the goal is to assess the stock's value while considering earnings growth. Unlike its close relative, the P/E ratio, which is primarily used to determine if a stock is overvalued or undervalued, a lower PEG ratio could indicate potential growth issues.

The PEG ratio is especially useful for evaluating companies with growth potential. However, for larger and more established companies, the Year-Ahead P/E and Growth ratio (YPEG) is often preferred. The YPEG employs similar assumptions to the PEG but uses forward earnings estimates instead of trailing earnings. It also considers estimated five-year growth rates, readily available from various financial sources. For example, if a company has a forward P/E ratio of 10, and analysts anticipate a 20% growth rate over the next five years, the YPEG would be 0.5.

Price-to-sales ratio (P/S)

The price-to-sales ratio, calculated by dividing a company's market capitalization by its revenue, focuses solely on revenue and does not take into account profits. This metric proves beneficial for evaluating companies that have yet to turn a profit or have minimal profitability. Ideally, the P/S ratio should approximate one. If it falls below one, it is typically considered an excellent indicator.

Price to Book (P/B)

The Price to Book (P/B) ratio serves as a metric for comparing a company's market value to its book value. A high P/B ratio suggests that investors anticipate higher returns on their investments from the company's existing set of assets. The book value, in this context, represents the accounting value of assets minus liabilities.

P/B = MV Per Share/BV Per Share

The Price to Book ratio finds extensive application in the financial services sector, where assets and liabilities are typically quantified in monetary terms. While a low P/B ratio generally signals that the company may be undervalued, it can also be an indicator that the firm might be facing financial or managerial challenges, necessitating more thorough investigation.

Return on equity (ROE)

Return on Equity (ROE) stands as a pivotal metric for investors, offering insights into a company's profit growth. To calculate ROE, one divides the company's net income by its shareholders' equity and then multiplies the result by 100. This ratio essentially quantifies the value shareholders would receive if the company were to liquidate its assets instantly. For certain investors, a desirable ROE trend entails annual growth of 10 percent or more, mirroring the performance of the S&P 500.

Debt-to-equity ratio (D/E)

The debt-to-equity ratio is a financial metric obtained by dividing a company's total liabilities by its total shareholder equity. This ratio provides investors with insights into the extent to which the company relies on debt to finance its operations. A high debt-to-equity ratio signifies a company that heavily relies on borrowing. Whether this ratio is considered excessive or not depends on its comparison to other companies within the same industry. For instance, businesses in the technology sector typically maintain a debt-to-equity ratio of approximately 2, while companies in the financial sector may exhibit much higher ratios, reaching up to 10 or more.

Debt-to-asset ratio (D/A)

Comparing a company's debt level to its assets through the debt-to-asset ratio provides valuable insights when assessing its financial health relative to others in the same industry. This comparison enables potential investors to gain a clearer understanding of the investment's risk profile. Excessive debt can serve as a cautionary signal for investors.

Current Ratio

In general, short-term creditors tend to favor a higher current ratio as it lowers their overall risk exposure. However, from an investor's perspective, a lower current ratio may be preferred because the focus is often on utilizing the company's assets to fuel business growth. While acceptable current ratios can vary across different industries, the widely accepted standard is to have current assets at least twice the value of current liabilities, resulting in a Current Ratio of 2 to 1.

Current Ratio = Current Asset/Current Liabilities

The Current Ratio is calculated by dividing a company's Current Assets by its Current Liabilities, serving as an indicator of whether the company possesses sufficient cash or liquid assets to cover its short-term obligations in the coming fiscal year. This ratio is commonly used as a measure of a company's liquidity.


In conclusion, financial ratios are essential tools for investors, creditors, and analysts alike. They offer valuable insights into a company's financial health, performance, and risk profile. Whether you're assessing a company's profitability, evaluating its ability to meet short-term obligations, or comparing its valuation to industry peers, these ratios provide a quantitative framework for making informed decisions. It's important to remember that the interpretation of these ratios can vary across industries, and it's often best to consider them in conjunction with other qualitative and quantitative factors. By harnessing the power of financial ratios, investors and stakeholders can navigate the complex world of finance with greater confidence and precision.

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