Evaluating Stocks: The Basics

I hear a lot of beginner investors say that they want to buy a company’s stock because it’s “cheap” or that they won’t buy a company’s stock because it’s “expensive”.  Unfortunately a lot of beginners are evaluating a stock based on its market price.  Don’t!

The market price alone is useless in determining value because it depends on the number of shares out there.  A company can manipulate its stock price just by doing a split or reverse split.  When determining if a stock is cheap or expensive, ignore the stock’s market price and instead look at these two things: earnings per share (EPS) and price-to-earnings (P/E Ratio).

Earnings Per Share

As the name implies, EPS is simply the company’s earnings divided by the number of shares outstanding.  This tells you how much of the company’s earnings are represented by each share.  The more, the merrier.  However, EPS by itself does not tell you if the stock is cheap or expensive, but it’s used in the P/E ratio, which does just that!

Price-to-Earnings

The P/E ratio is calculated by dividing the current market price by the EPS.  I think that it’s the singe most important number to look at when evaluating if a stock is cheap or expensive.  This is basically how much you’re paying for the company’s earnings.  The lower the number, the better bang for your buck!  However, don’t buy a company that looks like a sinking ship just because it has a low P/E ratio.  (Only the future earnings count!)  Similarly, many technology companies have really high P/E ratios because the street believes that these companies are really onto something and that their earnings will continue to increase.  Unfortunately, this is also how bubbles occur.  When there’s a lot of hype, like there was around technology stocks in 2000, a crash can occur when the street finally realizes that their expectations are way too high and the company’s will never be able to generate the expected earnings.

A couple examples ...

Lets start with Apple (AAPL).  The market price is currently $633.68, which is just about its all-time high.  I know that price is tough to swallow but in my opinion, this stock is actually cheap!  The high market price just means that you won’t be able to buy a lot of shares but that’s OK.  All that matters is the return you get on your investment.

In the case of Apple, I bought the stock at $200 because I believed that iPhone sales would go through the roof and the iPad would sell like crazy (even though it’s just a big iPhone that can’t make phone calls).  So, is it still a good buy today?  Lets look at the fundamentals.  The EPS is 35 and the P/E is $18.  When you compare that to the P/E of the S&P 500, which is currently $13, you see that it’s priced at a premium.  But there’s a good reason.  Apple is on fire!  Every device they make, even if it’s only slightly different from the previous model, it sells like crazy, so the street believes that earnings will keep increasing.  Most importantly, a P/E of $18 is not high when you look at Apple’s historic P/E.  How do you see the historic P/E?  Big Charts by Market Watch.  When you do an advanced chart, click on “Lower Indicator” and then click “P/E Ratio”.  Set the time to 5 years.  Here’s what you get:

As you can see, despite tremendous appreciation in the stock’s price, the P/E ratio has remained stable, between $15 and $20, because Apple’s earnings keep increasing each quarter, which justifies the appreciation.  So, based on Apple’s historic P/E ratio, one could argue that Apple is actually still “cheap”, despite costing almost $700/share. Plus, Apple recently announced that it will begin paying a dividend which yields about 1.5% at the current price, which adds to the value.  Need I say more?  Apple is the real deal!

Amazon (AMZN) is currently trading at $194.39 with EPS of $1.37 and a P/E ratio of $142.  Amazon is 21% below its high of $246.71.  The P/E ratio of Amazon.com and other online retailers has always been high because the street believes that online purchases will continue to increase.

But how does the current P/E ratio compare to Amazon’s historic P/E?

As you can see, Amazon’s P/E ratio is higher than ever, which may explain the recent pull-back in its market price.  However, Amazon is currently shifting its business model to revolve around its e-readers and tablets which it basicaly sells at cost (or below) because the company hopes for recurring profits to come from the digital purchases made on its devices.  (Think about razors …  The razors are always cheap because the company makes its money from its over-priced high-margin razors!)  If you think this strategy will work, buying Amazon at such a high price may not be so crazy.  A couple good earning releases and this stock is over $300.  Then again, Amazon is under pressure from the traditional competitors companies like Wal-Mart and the not-so-traditional competitors like Google, which just introduced its “Play” store and plans to release new devices that will compete with Amazon’s “Fire” tablet.

I hope you now have a better understanding of how to evaluate a company’s stock.  I can’t say enough about how important a company’s P/E ratio is but remember that it isn’t everything.  I’m just scratching the surface when it comes to evaluating stocks.  There’s several other very important ratios to consider as well as the company’s financial reports.

Disclosure: I am long AAPL and AMZN.

Categories Money

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