If you want to get rich from investing, here’s the ultimate stock tip: Do your homework.
Buying stocks is an excellent way to accumulate wealth—if you choose the right stocks. While investing always involves risk, you can boost your odds of making money by thoroughly researching stocks before buying. The key is knowing which factors to examine.
Where do you start? Let me walk you through the most important criteria to analyze when picking stocks and deciding which companies are worth your investment dollars.
Anybody can be successful in stock investing as long as they take the time to choose stocks through facts and analysis rather than hunches.
How to Analyze a Potential Stock: 9 Investing Criteria to Examine
No single stock metric or other piece of information is enough for you to determine whether you should buy a company’s shares. Instead, good stock pickers consider several criteria to put together a holistic view of any stock.
1. Your Own Investment Goals
What’s your goal as an investor? Do you want to aggressively build your wealth for the future? Do you want to protect the assets you have? Do you want to generate income that you can live on over the long haul?
The answers to these questions can help you determine your own investment strategy and narrow down your stock search.
While there are many types of investment strategies, let’s look at a few of the broadest, most basic strategies to show you how they can affect what you might look for in a stock.
- Growth Investing: Growth stocks are shares in companies that are most focused on expanding their existing business. They typically reinvest most, if not all, of their earnings back into the company to help it grow faster. Unsurprisingly, shares of these companies have the potential to rise rapidly—and the higher the price goes, the better the price you’re getting whenever you decide to sell.
- Value Investing: Value stocks are shares in companies that are considered underappreciated by the market. We’ll go over numerous metrics that investors use to determine value, but the general idea is, an undervalued stock will eventually rise in price when more investors realize that the company should be worth more and start buying shares themselves. (WealthUp Tip: Growth-focused companies can be undervalued, too!)
- Dividend/Income Investing: Typically, investors think of their returns in terms of their stock and fund prices going higher or lower. But some companies deliver an additional source of returns: dividends. A dividend is a cash payment a company makes to its shareholders—consider it a reward for continuing to hold the stock. Many investors choose to reinvest those dividends, which produces compound growth over time. However, in retirement, many people actually use those dividends as a source of passive income that they use to pay for everyday expenses. (WealthUp Tip: You’ll more commonly receive dividends from value stocks than growth stocks.)
2. Market Capitalization
Market capitalization, also referred to as “market cap” or even “market value,” is a popular way of measuring a company’s size. To calculate a company’s market cap, you simply multiply the total number of shares outstanding by the stock’s current market price. So, if a company trades at $50 per share, and they have 1 million shares outstanding, the company would be worth $50 million by market cap.
Here are the most common categorizations of market capitalization:
- Mega-cap (> $200 billion)
- Large-cap ($10 billion-$200 billion)
- Mid-cap ($2 billion-$10 billion)
- Small-cap ($300 million-$2 billion)
- Micro-cap ($50 million-$300 million)
- Nano-cap (< $50 million)
Why is a company’s size important? Very broadly speaking, the larger the company, the less risky the investment. A larger company is more likely to have more lines of business (and thus more diversified revenue streams), more cash in the bank, easier access to capital, more institutional stock holders, and more stock stability.
The smaller the company, the less of these advantages they’re likely to have. But conversely, they have much larger growth potential—after all, as the saying goes, it’s easier to double revenues from $1 million than it is to double revenues from $1 billion.
So, if you care more about stable growth, even if it’s a little more muted, you might tend to hold more large companies than small companies. If you’re pretty risk-tolerant and want aggressive growth, you might hold more small companies than large companies.
3. Valuation Metrics
Picture this: You’re in the grocery store, and a 20-ounce box of cereal is $5, a 40-ounce box is $10, and a 60-ounce box is also $10. Well, that 60-ounce box looks like one heckuva value compared to your other options—and you’ll be more likely to buy it as a result.
The same principles apply when shopping for stocks. Many investors want to know which stocks are overpriced, and which ones might be relative bargains—and to determine that, they’ll typically use one or more of several valuation metrics.
To determine stock valuation, here are a few popular metrics:
Price-to-earnings (P/E) ratio
One of the most basic valuation metrics is the price-to-earnings (P/E) ratio. To get this figure, you simply divide a company’s stock price by the company’s earnings per share:
Price/share ÷ earnings/share = P/E
Example: A stock trades for $50 per share, and its underlying company earned $5 per share over the past 12 months. Its P/E ratio would be 10.
$50/share ÷ $5/share = P/E of 10
In general, the higher the price-to-earnings ratio, the more highly valued the stock is considered, and vice versa. But whether the number is 10 or 100, it’s pretty meaningless on its own; you typically need to compare it to another P/E.
For instance, you might compare your stock’s P/E to the P/E of one or more stocks in the same industry. Or you might even compare it to a major index, like the S&P 500. If the P/E is lower than its industry rivals or the stock market, you could say a stock is relatively undervalued.
Forward P/E vs. trailing P/E
The example of P/E I gave above, using the past 12 months’ worth of earnings, gives you the trailing P/E (short for trailing 12 months’ P/E, or just TTM P/E). It’s a very common metric, but it’s also merely a snapshot of what the company has done in the past. On the one hand, it’s an objective figure. But on the other hand, the stock market is considered “forward-looking” (e.g., investors make decisions based on where stocks are expected to go, not based on what they’ve already done), so some investors prefer not to use trailing P/E.
Instead, they prefer to use forward P/E, which uses guidance for future earnings gleaned from company and analyst forecasts. This figure needs to be taken with a grain of salt because it’s based on estimates. But it’s forward-looking, which can be a better indicator of a company’s value to investors making decisions about the future.
Example: A company trades at $100 per share. It made $100 per share over the trailing 12 months. It has a trailing P/E of 1, which is much lower than its competitors. However, the company just lost a patent battle and won’t be able to sell its main product anymore. It’s expected to make just $1 per share in the coming year. It has a forward P/E of 100—much more expensive than its competitors—as a result. Which P/E would be more important to you?
Like with trailing P/E, though, forward P/E is most useful when compared with other forward P/Es, whether it’s the valuations of other companies or a broader index.
My favorite valuation metric is the price/earnings-to-growth (PEG) ratio.
P/E and forward P/E only account for some snapshot of earnings, whether that’s a period in the past or the future. But PEG actually accounts for a rate of (expected) earnings growth over a certain amount of time, which is both more informative, and produces a metric that’s useful even without comparing it to something else.
PEG basically takes the trailing P/E and divides that by the expected annual rate of earnings growth over a period of time (usually the next three or five years):
(Price/share ÷ TTM earnings/share) ÷ annual EPS growth rate = PEG
For example, a stock trades at $100 per share and earned $10 per share over the trailing 12 months. It has a P/E of 10. It is expected to grow earnings by 10% annually.
($100/share ÷ $10/share) ÷ 10 = PEG of 1.0
What’s interesting about PEG is that it’s based around the number 1:
- A PEG ratio of 1.0 implies the stock is fairly valued.
- A PEG ratio under 1.0 implies the stock is undervalued.
- A PEG ratio over 1.0 implies the stock is overvalued.
Importantly, this means that you don’t have to compare a stock’s PEG with anything else to glean something from it because expected growth is already factored in. If a high-growth tech company has a PEG of 1.0, it’s fairly valued. If a slow-growth utility has a PEG of 1.0, it’s fairly valued.
You can still compare PEGs. Sometimes, the entire stock market is overvalued—let’s say the S&P 500 has a PEG of 2.0, and a stock you’re looking at has a PEG of 1.5, well … the stock might be overvalued, but still undervalued relative to the market.
Other valuation metrics
Investors use plenty of other valuation metrics—sometimes based on preference, and sometimes because certain metrics are more useful in some situations than others. Three others worth noting include:
- Price-to-sales (P/S): This ratio is calculated by taking the share price and dividing it by the sales (revenues) per share. Like many valuation metrics, you want to compare a company’s P/S to similar stocks, the company’s sector, or the broader market. P/S is a great way to value companies that haven’t yet begun to generate steady (or any) profits.
- Price-to-free-cash-flow (P/FCF): Free cash flow (FCF) is the true cash left over after a company makes critical expenditures to operate and grow the company. Cash can be used to fund dividends, stock buybacks, mergers, and more. Thus, many investors like using P/FCF, in which you divide the company’s share price by its free cash flow per share.
- Enterprise value/EBITDA (EV/EBITDA): Enterprise value (EV) is another way to measure the size of a company. It’s calculated by taking the market cap, adding debt, then subtracting cash and equivalents. EBITDA, meanwhile, is a measure of earnings that backs out interest, taxes, depreciation, and amortization. Some investors prefer the EV/EBITDA ratio, believing it values a company using a more accurate picture of a company’s financial performance.
WealthUp Tip: Many of the above valuations can be found on prominent stock-data sites. For instance, on Yahoo! Finance, you’ll find most of these metrics under the Statistics tab for any stock. Morningstar lists them on its Valuation tab.
4. Dividend Metrics
If you lean toward an income investing strategy, you’ll care a lot about a couple of dividend metrics.
The most basic income metric is a company’s dividend yield, which effectively tells you what percentage of a stock’s price you can expect to collect within a given year. This is calculated in a couple of ways depending on the asset you’re talking about.
U.S. stocks tend to have very regular, predictable dividend payments that remain level or increase over time. So, to calculate their yield, annualize their most recent payout, then divide by the share price.
Annualized dividend/share ÷ price/share = dividend yield
Example: A stock trades for $100 per share. It has a quarterly dividend of 25 cents. Annualized, the stock should pay out $1 per share. Its dividend yield is 1%.
WealthUp Tip: U.S.-based stock funds, as well as individual international stocks, pay dividends that vary more across the year. To calculate their yields, don’t annualize the most recent payment—instead, use the trailing 12 months’ worth of payments.
What’s a good dividend yield? There’s no hard-and-fast number. The higher the yield, the better your return—but because yields are calculated using share prices, high yields can also reflect a declining stock, which itself reflects a troubled company that could struggle to continue paying the dividend at current levels.
So, one other metric you should be aware of is payout ratio, which is the percentage of earnings that go toward paying the dividend. To calculate this, merely take the annualized dividend per share and divide by the company’s annual earnings per share (like with P/E, you can use TTM earnings, or future estimated earnings).
Annualized dividend/share ÷ earnings/share = payout ratio
Example: A stock pays $1 per share in dividends each year. It is expected to earn $4 per share in the coming year. It has a 25% dividend payout ratio.
$1/share ÷ $4/share = 0.25, or a 25% payout ratio
Like with yield, there’s no hard-and-fast “good” or “bad” earnings payout ratio. But as a broad guideline, a payout ratio below 33% indicates a highly-covered dividend with plenty of room for dividend growth, a ratio between 33% and 66% indicates a decently covered dividend with some room to grow, and a ratio above 66% indicates potentially tight coverage with not much room to grow. Anything above 100% implies a threat to the dividend and warrants a deeper look.
5. Beta (Volatility)
When any asset makes frequent, drastic moves in either direction, they’re considered to be “volatile.” Thus, volatility can be bad or good, depending on the direction the asset is moving.
Still, some investors would prefer not to have a volatile portfolio—even if it means sacrificing some performance along the way.
A good way of observing volatility is a stock’s beta. Beta is a measure of volatility compared to a pertinent benchmark; a stock’s beta, then, typically refers to its volatility versus the overall market, represented by the S&P 500.
The benchmark is always considered to have a beta of 1.0. So if the stock you’re considering has a beta of higher than 1, it’s considered more volatile than the market. If it’s less than 1, it’s considered less volatile.
Calculating beta is, to be frank, a pain. If you want to know the formula, it’s:
Covariance (stock returns, index returns) ÷ variance (index returns) = β (beta)
But you’re much better off simply looking up a stock’s beta on an investing research or stock analysis site.
To be clear: Beta doesn’t indicate whether a stock will go higher or lower. It’s a backward-looking metric that merely tells you how volatile the stock has been. Still, many investors believe beta is an important consideration when constructing their portfolios.
6. Capital Structure (Debt-to-Equity Ratio)
Capital structure is the distribution of debt and equity a company uses to finance its operations. The debt may be from loans or bonds they have issued. A company’s equity is the ownership rights in the company, which can come in the form of common stock, preferred stock (which provides a higher claim to dividends), or retained earnings.
To determine how risky a company’s capital structure is, you calculate its debt-to-equity ratio, which is simply calculated as
Total debt ÷ total shareholders’ equity = debt-to-equity ratio
(The numbers you need for this calculation are found on the company’s balance sheet.)
Debt in and of itself is not necessarily a red flag—some businesses use debt in a strategic way to grow the company more quickly than they could with cash on hand.
Still, an unhealthily high debt-to-equity ratio could indicate difficulty servicing debt either now or down the road, which speaks to the company’s ability (or lack thereof) to survive.
There’s no hard “good” debt-to-equity ratio, but a ratio of 1.5 or below is considered pretty safe. Some industries naturally have higher debt-to-equity ratios, so if you’re evaluating a company’s debt-to-equity, you’ll want to look at its competitors.
7. Technical Analysis (Stock Charts)
You’ll frequently hear the phrase “past performance does not guarantee future results.” That’s true. However, past price performance can be helpful in mapping trends that some people use to determine how a stock might perform going forward.
As opposed to fundamental analysis, which is the study of company fundamentals (like the criteria above), technical analysis is the study of price trends and patterns that form on stock charts over time. Technical analysts (TAs) believe that these trends and patterns can help determine how a stock might move in the future.
Technical analysis is a particularly difficult skill that we won’t cover in depth here, but a few examples of important chart indicators include:
- Moving averages: A moving average is the average of a stock’s price across a certain period of time. TAs often use 20-day (short-term), 50-day (intermediate-term), and 200-day (long-term) moving averages. Among other things, moving averages can act as resistance (keeps a stock from advancing) or support (keeps a stock from declining).
- Relative Strength Index (RSI): This indicator measures momentum—both the speed and change of price movements. RSI is measured on a scale of 1-100; any reading below 30 indicates a stock is oversold, and any reading above 70 indicates a stock is overbought.
- Bollinger Bands: This is a set of lines that represent a stock’s volatility. The outer lines represent two standard deviations (one positive, one negative), away from a simple moving average of a stock’s price, and the middle band is the moving average. A stock’s price is expected to remain within the bands about 90% of the time. This indicator can also help you determine when a stock is overbought or oversold.
8. The Business
As Albert Einstein once said, “If you can’t explain it to a 6-year-old, you don’t understand it yourself.” So as a general guideline, it’s helpful to have some understanding of what a business does before you buy its stock.
What is the business model? What products or services does the company provide? What’s known about management?
This isn’t to say you need to become an expert on the company. But if you have no idea what a company even does, it’s difficult to make an informed decision on whether to invest in it.
9. The “Story”
While a company’s business represents where it is and what it has done, a company’s “story” is moreso about its future.
What products or services is the company working on to remain relevant? Where does the company have room for growth? Is the company disrupting an industry? Is it being disrupted? What moves—mergers, acquisitions, spinoffs—has the company made recently that are expected to meaningfully impact its financial situation in the coming months or years?
The “story” is perhaps the least tangible criterion on this list, but it’s vital nonetheless. A good story could include an eventual catalyst for breakneck growth. A bad story might be the reason why an undervalued stock remains undervalued.
Unlike most of the above criteria, you typically won’t learn the story on a stock-data site—instead, this comes from reading news and analyst coverage of a company.
Great Places to Go for Information
Now that you know what to look for, the question becomes, “Where do I find it?”
This isn’t a comprehensive list, but you can typically find everything you need across the following information sources:
- Investor relations pages
- SEC filings / financial statements
- Quarterly earnings releases
- Conference call transcripts
- Investor presentations
- Press releases
- Stock news websites
- Stock research apps
- Brokerage/IRA portals
How Can I Start Investing Using These Stock Selection Criteria?
In short: You’ll need some sort of investment account. While there are many to choose from, the best types that allow you to invest in individual stocks include:
Whichever of these accounts you choose, you’ll want to make sure it’s self-directed—in other words, you choose the investments. (Some accounts only allow you to select from pre-built portfolios, which are typically made up of one or more investment funds.)
You’ll initially fund your account with a lump-sum payment, though you can also set up recurring payments so you can keep investing more money over time.
Once your account is funded, you can begin buying stocks that you have vetted with the criteria explained earlier in this piece. If you buy a dividend stock, you can decide whether you want to reinvest the dividends, or just have them hit your account as cash.
Check in on your investments, and re-evaluate them regularly. Sometimes, a stock will become a better value, making it a good decision to buy more. Sometimes, a stock’s story will change for the worse, and you’ll need to consider selling. Even if you buy a stock to hold for the very long term, circumstances change—and one day, you might need to pivot.
Free (no monthly fees).
Commission-free trading. Robinhood Gold: Free 30-day trial, then $5/mo.
Stash Growth: $3/mo. Stash+: $9/mo.
A Final Word of Advice: Stock Picking Might Not Be for You
Being able to conduct investing research is a useful personal finance skill, but some people simply don’t have the time to pore over company reports and examine stock metrics. If this all sounds like too much work, or you worry you might be in over your head, you have other options:
- Consider owning one or more mutual funds or exchange-traded funds (ETFs). Mutual funds, ETFs, and other investment funds hold numerous stocks, bonds, and/or other assets; when you buy shares of these funds, you enjoy in the gains (or suffer in the losses) of those collective assets.
- Look into stock-picking services, such as those provided by Motley Fool, where a professional does the research, then recommends stocks for you to buy. (Note: Only use established stock-picking services that have a proven record of success.)
- Hire a financial advisor to do the heavy lifting for you.