How To Know When a Stock is a Worthwhile Investment

by | Aug 31, 2022 | Research

Have you ever wondered what makes a stock a worthwhile investment? In most cases, this distinction has little to do with a company’s products or services. Instead, it focuses on their financial position. To evaluate a stock, analysts use a variety of calculations to understand the finances of a particular company, forecast their potential growth, and determine whether the stock is undervalued or overvalued at its current price.

The assessments completed by professional analysts can be quite in-depth, but the average investor doesn’t need to know how to calculate these figures. That’s because most of these valuable ratios are readily available online. With these tools in hand, combined with the knowledge to use them, you can make determinations about whether a stock is a worthwhile investment.

What makes a stock a worthwhile investment?

You can make money from stocks in one of two ways – you can earn income from dividends, or you can make money when the stock price rises. Sometimes stocks provide both benefits.

A stock worthy of being included in your portfolio would be one that generates the most benefit, with the least amount of risk, but these stocks can be difficult to find. Because of this difficulty, investors often rely on certain widely accepted measures to evaluate a company’s strength and potential for future growth.

Common Ratios for Evaluating Stocks

The following metrics can help you compare similar stocks by demonstrating how a company performs relative to their competition. These metrics can also help you track a company’s financial position over time to determine if the company has improved or weakened. A company with better metrics than their peers, and whose measurements have improved over time, could generally be considered a worthwhile investment. Let’s explore some of the most widely used of these metrics:

Earnings Per Share [EPS]

Earnings Per Share [EPS] indicates how much profit a company makes for each share of stock they have issued. The higher a company’s EPS, the more profitable it is considered.

Investors typically gain the most insight by comparing a company’s EPS to the EPS of stocks in the same sector. A company with a higher EPS is generally considered more profitable than a competitor with a lower EPS. In addition, this figure can be helpful when comparing performance over time.

For example, if a company’s EPS has consistently grown over several years, you might assume that the company is expanding its profitability. While past growth isn’t a perfect indicator for future growth, most investors would agree that a company with a strong growth record is more likely to continue performing well than one that has seen earnings decline over several years.

While EPS can help investors make a quick determination about a company’s profitability, there are caveats that can skew results. One of these is stock buybacks. There are only a few ways for a company to increase its EPS – increase revenue, reduce expenses, or decrease the number of outstanding shares. Therefore, a stock buyback could give a false impression of an improving EPS when all other factors remain equal.

Price to Earnings [P/E] Ratio

The Price to Earnings [P/E] ratio is one of the most popular methods for determining a company’s strength as an investment. This ratio compares a company’s current stock price to its EPS to determine how much value investors place on each dollar of earnings.

If a company has a high P/E ratio relative to its peers, it generally indicates that investors place a higher value on the company’s stock. This could indicate that investors anticipate significant growth in the future and are willing to pay more for the stock in anticipation of higher returns later. On the other hand, a high P/E ratio compared to similar stocks could indicate that a company is overvalued. Therefore, when using the P/E ratio to evaluate stocks, it is important to do additional research about a company’s current profitability and anticipated growth.  

Debt to Equity [D/E] Ratio

The Debt to Equity [D/E] ratio compares a company’s total liabilities to its total shareholder equity. This ratio measures default risk for a particular company. As such, a high D/E ratio often signals a higher risk of the company defaulting on their debt – which can have serious consequences for the company and its stock price.

While high debt can signal higher risk, it can also indicate growth on the horizon. That’s why it’s important to uncover what a company is funding with its debt. A new company could have significant debt at inception to finance the beginning of operations, while an older company could use debt to finance a new location, new product, or new technique that could propel future growth. Both cases could result in a high D/E ratio but could lead to expansion in the future which could translate to positive stock performance despite the risk. This means a high D/E is not always a bad situation, but it’s definitely a red flag that you should evaluate before investing in a particular company.

Return on Equity [ROE]

The Return on Equity [ROE] measurement compares a company’s net income to shareholder’s equity. Since shareholder’s equity equals a company’s assets minus its debts, ROE can be used to gauge how efficiently a company generates profits using their assets. A higher ROE typically signals higher efficiency because a company generates more revenue per dollar of net assets.

Investors typically prefer companies with high ROEs compared to their peers. However, an extremely high ROE can signal issues like inconsistent profits, excessive debt compared to assets, or rapidly declining equity.

Alone, each of the ratios covered above provides valuable information but an incomplete picture of a company’s financial position and stock price. When reviewed together, these metrics can help you determine a company’s profitability, efficiency, and risk compared to its peers.

How to Use Financial Ratios to Choose Worthwhile Investments

In a perfect world, you would find a company that fits your investment needs, has proven earnings growth, whose stock price is undervalued with a relatively low default risk, and reports high revenue compared to assets. It would be very rare to find a company with all these traits, and that’s why effective investing requires lots of painstaking work.

Luckily, investors who do not have the time or inclination to analyze thousands of stocks can seek the help of a professional. By partnering with an experienced financial advisor, you can bring ideas to the table and then trust your wealth manager to do the intense work that is needed to secure your financial future.

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At DreamWork Financial Group, your advisor is your portfolio manager, so you have direct access to the person who chooses your investments. This unique structure allows you to propose investment ideas, discuss your own research, and have input into the stocks that are included in your portfolio. Historically, these services were only available to the very wealthy, but with DreamWork Financial Group, You Don’t Have to Be Wealthy to Have Wealth Management®.

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Article Topics: Investments | Stocks