Stock Basics: Check These Key Numbers
Book value, return on equity, total return and other indicators can help you zero in on quality stocks.
Do you own stocks or stock funds? If the answer is yes, this tutorial can help you develop a portfolio that makes sense for you. If the answer is no, this planning center has the information and advice you need to confidently place your first buy order.
Here is a review of some of the important figures you'll need to understand when investing in stocks.
How does the price relate to book value?
Simply put, a company's book value is the difference between its assets and its liabilities — what it owns and what is owed to it, minus what it owes to others.
This is sometimes referred to as shareholder's equity.
Dividing book value by the number of outstanding shares gives you the book value per share.
Theoretically, book value represents the amount stockholders would receive for each share they own if the company were to shut down, sell all its assets, pay all its debts and go out of business. (Few companies whose shares are widely traded ever shut down, but the list of bankruptcies that dot the history of American business makes the point: Stuff happens.)
Stocks may be recommended as cheap because they are selling below book value or very little above.
Such stocks sometimes become takeover candidates, attracting the attention of other companies, which see a chance to buy them up on the cheap — and that can drive up the price of the shares and thus reward investors who spotted the bargain sooner.
However, it's possible that a company's stock is selling below book value not because it is an undiscovered bargain but because that company or its industry has fallen on hard times.
You should have more information to go on before you start buying.
What's the return on equity?
A company's total annual net (after-tax) income, expressed as a percentage of total book value, measures how much the company earns on the stockholders' stake in the enterprise.
Return on book value, also called return on equity, varies from company to company and from industry to industry, and it fluctuates with economic conditions.
One year's return on equity means little, but by comparing several years' results for the company and its industry, you can spot trends and get an idea of how well the company manages its assets.
What's the total return?
Investors tend to think of their gains and losses in terms of price changes and forget about dividends . But both price changes and current income should be taken into account to evaluate investment performance.
Together they show your total return, which is the only fair way to compare stocks that pay dividends with stocks that don't, and to compare results from stocks with results from bonds, Treasury bills and other alternatives.
How much debt does the company carry?
A company's debt-equity ratio, which is its book value divided by its debts, is a pretty good measure of its fiscal health because the more it pays out to debt service — as interest on bonds, for instance, or on lines of credit with banks — the less it has available to pay dividends, invest in the future or set aside as a cushion for business downturns.
Most companies do carry some debt, and what's acceptable in one industry may not be acceptable in another. Always be sure to compare debt-equity ratios of similar companies. Other things being equal, the lower the debt the better.
How volatile is the stock?
A stock's past volatility, which can be measured with some precision, is as good a gauge of its future risk as you're going to get. At the least, knowing a stock's volatility gives you some idea of the kind of behavior you can expect from it in relation to the market.
Some stocks' prices move slowly and within a relatively narrow range; others bounce up and down a lot. Analysts have developed several measures of price volatility. Perhaps the most easily understood is the beta, which tells you how much a stock characteristically moves in relation to a change in a stock-market index, usually the Standard & Poor’s 500.
A stock with a beta of 1.0 moves in step with the index. A stock with a beta of 1.1 historically rises or falls 10% more than the index. A stock with a beta of 0.9 is less volatile than the index; it would be expected to go up 9% if the market rose 10% or down by 9% if the index fell 10%.
Once thought to be an arcane measure best left to the green-eyeshade crowd, betas are now commonly reported.
Getting a little technical
The concepts described so far — P/E ratios, book value and so forth — are derived from a company's fundamental financial strengths and weaknesses, and using them as tools to spot stock values is called fundamental analysis.
From time to time you may come across buy or sell recommendations that reflect what is known as technical analysis.
Technicians examine the whole market or individual stocks and try to forecast price movements by examining previous price changes, the ratio of advancing to declining stocks, and a wide and sometimes bewildering range of other statistical data.
To technicians these factors, often plotted on charts, reveal the basic forces that they believe influence prices of individual stocks and the market as a whole.
Technicians speak their own language, particularly when referring to chart patterns they feel have special significance: heads and shoulders, channels, saucers, wedges, pennants, double bottoms.
Many investors have no faith in such patterns, and most don't understand them, but technical analysis does command respect in the investment business, and committed adherents of fundamental analysis often check a stock's technical position before acting.
You should know a little technical analysis, but unless you plan to make a lengthy study of its methods, don't go nuts trying to decipher it.