How to Evaluate a Stock before you Buy

3 basic things an investor needs to evaluate about the fundamentals of a company before deciding to buy are the company’s earnings, P/E ratio, and PEG.

1.) EARNINGS: No one will argue that the most important information in evaluating a stock is it’s earnings. How much money a company makes determines how valuable that company is, which in turn determines the price of that company’s stock. This is a simple concept. Things get more complex in real life, because earnings are not static.

Stock prices are based on the future. More specifically, prices are based on predicted future earnings. How can they be based on something that has not happen yet? That’s where all those high paid Wall Street analysts come in. Analysts are professionals who evaluate companies based on all available information, and determine future business prospects. For instance, if you go to the Yahoo Finance website and look up any ticker symbol, you can locate what the general concensus among analysts is for a company’s future earnings. An example would be to look at Bank of America’s estimates. For their fiscal year ending Dec 2008, the analyst estimate for earnings is $3.99/share.

The value of Bank of America’s shares are based on this information. But because there is always new information or news coming out, the earnings estimates can fluctuate along with the share price. Are analysts always right? Of course not. And they can be very wrong at times too. There’s also many times that different analysts covering the same company can have totally different views on a company’s future. So should we simply buy whatever company has better earnings? No. We need to evaluate how much we are paying for these earnings; in other words, the price we are paying.

2.) PRICE/EARNINGS RATIO: This is the bread and butter of evaluating stocks. It tells you whether company A is cheaper or more expensive than company B. Google may trade at $500 vs Yahoo’s $28, but if Google has a P/E of 30 vs Yahoo’s P/E of 45, then Google is actually the cheaper stock. This is because in this example, an investor is paying $30 for every $1 of Google’s earnings, but paying $45 for every $1 of Yahoo’s earnings.

P/E ratio is mainly useful in comparing companies in the same sector. In the example above, because Google and Yahoo are in the same business (web portals), it is a fair comparison. But comparing Google’s P/E of 30 and Bank of America’s P/E of 10 is not fair. Different sectors trade at different P/E’s for many reasons, including the general growth prospects of that sector. If the internet is growing at theoretical rate of 30% per year, and money center banks are growing at a theoretical rate of 10% a year, then it is only reasonable that Google trades at a higher P/E. This is because Google has higher predicted earnings growth, and leads us to the next tool in evaluating stocks.

3.) PEG: This is simply a company’s P/E ratio divided by it’s predicted earnings growth rate. In the above example, Google’s P/E is 30, and its predicted earnings growth rate is 30% per year, so it’s PEG is 1. Bank of America’s P/E is 10 and it’s predicted earnings growth rate is 10%, so it’s PEG is also 1. Based on a comparison of their PEG’s, these stocks are equivalently priced.

PEG is useful because Wall Street tends to be willing to pay a higher multiple (P/E multiple) for a company growing at a faster rate. This makes sense to us, because if their earnings are growing more, they should be worth more. PEG is also more useful comparing stocks in different sectors than simply P/E, because it takes into account the growth rates for the different industries.