Investing in stocks is all about the numbers. You must be able to analyze and understand many different statistics and ratios that clue you in to a company’s past performance and future potential. You don’t necessarily need to be an accountant or a math major in order to make sense of the numbers, though. (Go ahead an breathe that sigh of relief now.)
P.E. and We Don’t Mean Gym Class
One of the most important statistics is a stock’s P/E Ratio. "P" stands for Price, while "E" stands for Earnings, so you can calculate the P/E Ratio by dividing the stock’s current share price by its earnings per share. (Usually, the earnings from the prior four quarters are used, which is known as the company’s "trailing earnings.") By itself, the P/E Ratio might not tell you much about a company. But when you compare a stock’s P/E Ratio to other similar companies, or to the industry average P/E Ratio, or to the company’s historical P/E Ratios, you can get a hint about whether that stock is presently over- or under-valued.
Another way to use the P/E Ratio is to compare a stock’s P/E to its projected EPS growth rate. This is known as the PEG or P/E to Growth Ratio, determined by dividing the P/E Ratio of a stock by its EPS growth rate. The rule of thumb is that a stock with a PEG of less than 1 may be undervalued, while a PEG greater than 1 may mean the stock is overvalued.
P.S. Don’t forget About P/S Ratio
The Price/Sales Ratio is similar to the P/E Ratio, but uses sales per share instead of earnings. If a company’s P/S Ratio is lower than its historical trends, or when compared to competitors, then the stock might be undervalued.
Companies that have too much debt can run into trouble during general economic downturns or if the company starts running into financial difficulties and can’t make their interest payments on the debt. You can measure the relative amount of debt by considering the stock’s Debt/Equity Ratio. The Debt/Equity Ratio varies for companies in different industries, but investors often start paying close attention when it’s greater than 0.5. Of course, companies with no or very low debt don’t have much to worry about.
Interest Coverage is another way of looking at a company’s financial stability. It’s the number of times that a company can make its required interest payments out of its income. If the interest coverage is approaching one, the stock may soon face problems; if the company’s interest coverage is 10 or 15, then the company is likely in strong financial shape.
It’s all About Profit
As a company gets bigger, it ought to be able to wring more profits out of each dollar of sales, from economies of scale and becoming more efficient. You can measure this by looking at the company’s Profit Margin, the percentage of total revenues that end up as profits. Profit margins vary by industry, but you can compare the profit margins of similar companies to find the strongest candidates. You can also compare the profit margins of a single company from quarter to quarter and year to year to see if a company is becoming more or less profitable as time goes by.
You can study dozens of ratios about a public company, each one a piece of the puzzle that combine to give you a total picture of the stock and its future prospects. These are just a few of the more common statistics used by investors, so get familiar with these as a starting point for your stock analysis.