3 ways to evaluate companies
While a company’s stock price is often the first thing investors notice, there are other metrics you can use to estimate the value of a business.
You’ll need to consider both financial and non-financial factors. Financial ratios can help you understand if a company is profitable or losing money, if the stock price is over- or undervalued, and how their financial performance compares to that of their competitors. Non-financial factors—such as a company’s management team—can provide insights into the company’s structure and how well they may respond to opportunities and risks.
3 factors to consider when evaluating a company:
1. Company metrics
There are many financial indicators to consider when looking at a company, including the price-to-earnings ratio (P/E ratio). This ratio divides the company’s share price by its earnings per share. Investors and analysts look to the P/E ratio for several reasons.
First, it provides a basic measure of how much an investor is paying for a company’s earnings. If a company has a high P/E ratio, the company’s stock may be overvalued or too expensive. Conversely, a low P/E ratio can indicate that a stock is undervalued. Generally, investors consider a P/E ratio under 10 to be a sign of value, but this benchmark varies by industry.
The P/E ratio is also helpful for comparing one company to another. When making this comparison, remember to research typical P/E ratios for a given industry as averages can differ drastically across sectors. For example, P/E ratios in the banking industry rest on average around 10, while the average for pharmaceutical companies is over 100.
Other popular ratios to consider are the dividend yield, price-to-book value ratio (P/B), and price-to-sales ratio (P/S).
2. Examine the industry
The business cycle, risks, and challenges are different for each industry.
By researching the industry, you can better understand how a company is performing relative to its competitors. For example, while all companies in an industry may face the same risks, successful companies can better manage challenging economic situations and take advantage of potential opportunities.
3. Understand the business
Before you invest in a company, make sure you understand the business that the company is in. Even the most sophisticated investors can struggle with this when investing in a sector or industry they are not familiar with. If you have a hard time explaining what the business produces or how it makes its money, you may find it hard to understand the risks that could affect its performance.
There are risks with any investment. You can make an informed decision by better understanding the company and its business environment.
Take action:
- Understand the risks of investing in stocks
- Brush up on the basics
- Learn some of the factors that can affect stock performance
- Track your portfolio’s performance
- Review the company’s financial statementsFinancial statements Reports that sum up a company’s financial data and tell you how it is doing. The four basic statements are: the statement of financial position (balance sheet, statement of profit or loss (income statement), cash flow statement, and statement of changes in equity.+ read full definition