Successful investment requires research. No two shares of stock are the same, and for this reason, you’ll want to evaluate the financial strength of each corporation. You don’t need to be a financial expert to do this research because there a number of things that even a novice investor can look for when buying stocks that may help you avoid making bad investment decisions.
Evaluating Corporate Earnings
Since the daily fluctuations in stock prices can reflect investor confidence more than the stock’s actual value, you’ll want to avoid overpaying for a stock. A common way to assess a company’s value is through the earnings it generates for shareholders. Investors frequently use the price-to-earnings ratio, commonly referred to as the PE ratio, as a tool for making the assessment. The PE ratio is calculated by dividing the stock price by its earnings per share. Earnings per share, or EPS, is equal to the net income reported on a corporation’s income statement divided by the number of outstanding shares. However, it’s important to remember that the PE ratio by itself provides limited insight into the value of a corporation’s stock. For better results, you should calculate the PE ratio for other companies within the same industry and compare all results. A higher PE ratio means that the market is paying a premium for a company's earnings relative to its peers in the industry. This could be because the company's growth prospects are strong, or it could be because the company's earnings are relatively weak. A lower-than-average PE indicates that the market currently values the company less than its peers. This could be because the company suffers from some underlying problem, such as a weakening market for its goods or a poor financial position. Or it could simply mean that the stock is currently undervalued.
Corporate Credit Ratings
A number of agencies, such as Moody’s, regularly evaluate the creditworthiness of corporations and assign credit rating scores to them. Despite the fact that you aren’t lending money to the corporation, these credit scores are useful since they’re the result of professional analysis of the same factors you’d want to evaluate when you decide which stocks present the best investment opportunities. These factors can include a company’s history of defaulting on its debt, its earnings history, its growth potential and a wide range of other financial data. When evaluating corporate credit ratings, you’ll need to understand the ratings system used. A company with a AAA rating has the highest credit rating possible, whereas a rating of BB and below generally indicates that a company has some undesirable credit issues that makes it a riskier investment.
If your investment goals place more importance on receiving streams of income rather than increases in a stock’s value, you may want to look for companies that consistently declare dividend payments to shareholders. A long track record of dividend payments -- particularly rising dividend payments -- is typically an indication of a company's consistent profitability.
Every company whose shares trade on a public stock exchange must issue annual financial statements that are open to public perusal. Most corporations will make their financial statements available in the “investor relations” section, or its equivalent, on their corporate websites. You should focus on the company’s balance sheet and income statement. The balance sheet will report the value of assets a company owns, the amount of debt it’s carrying and the cash it has available to pay its operating expenses. The more cash and assets a company has relative to its liabilities, the healthier it is financially. Income statements, on the other hand, provide information on a company’s earnings and the expenses it incurs to achieve those earnings and usually reports some historical data that can help you identify whether the company’s earnings are consistent. Also useful are the “management discussion and analysis” sections, which typically include information such as the opportunities the company is working on, potential problems it’s facing and its competitive position in the market.
Take as many factors as possible into consideration to evaluate a company's financial health and performance. This will help you minimize the effects of skewed data and reporting. For example, a company may be able to inflate its reporting of profits by puffing its numbers with short-term asset sales or by juggling numbers among accounting quarters. This may boost its PE ratio. But a look at the income statement and a look back through some balance sheets might tell you whether the company is amassing cash -- a sure sign of real profits -- or whether its financial situation is actually slipping.