Use the Right Tools to Evaluate Stocks

Physician's Money DigestJune15 2003
Volume 10
Issue 11

Wall Street Journal

Short of looking into a crystalball, no one has the luxury ofknowing for certain if a particularstock pick will bear fruit orturn sour. A recent article in theoffers the followingreliable tools to help evaluate astock and make a more informedinvestment decision:

•Price-to-earnings ratio (P/E).A stock's P/E ratio indicates if astock is undervalued (ie, low P/E)or overpriced (ie, high P/E). It alsoindicates if the market expects earningsgrowth to be strong (ie, highP/E) or weak (ie, low P/E). It's calculatedby taking the stock's currentprice and dividing it by its earningsper share for the most recent 12months. A stock with no earningshas no P/E. Typically, lower P/Eratios are favored by conservativeinvestors. High P/E ratios oftenattract investors who have loftyexpectations for the stock and cantolerate more risk. It is equallyimportant to compare a stock's P/Eratio to the P/Es of other companiesin the same industry.

•Price-to-sales ratio (P/S).The P/S ratio is the company's currentstock price divided by its salesper share. A low P/S ratio can meanthe stock is undervalued—a potentialbargain for investors. A high P/Smay mean it's overpriced.

The P/S ratio is useful for analyzingstartup companies with noearnings, as well as confirming thevalue of a stock that does have earnings—the P/E ratio and the P/Sratio should agree (both high orboth low).This tool can also help toexamine a company that isn't makingmoney because of a sluggisheconomy. For example, the companymay have no P/E ratio, but stillhave an attractive P/S ratio.


Stock tip for conservative


•Beta. The beta measures astock's volatility compared to thebroad market. However, the betadoes not predict performance. Ifthe S&P 500 is up or down 1%, thearticle explains, a stockwith a beta of 0.8 should be up ordown 0.8%. A low beta is associatedwith low risk. In addition to limitingyour losses, however, a lowbeta may also limit your gains.

•Return on equity (ROE).ROE tells you how well a company ismaking shareholder equity work forthem. If a company makes $1 millionand has shareholder equity of $10million, its ROE is 10%. Look forcompanies with an ROE of 20% to30%. Such companies can make bigprofits with little capital investment.

•Institutional ownership. Thisis the percentage of a company'sstock that is owned by mutual fundsand pension funds. Institutionalinvestors buy and sell blocks ofshares large enough to influence thestock price. Pick a stock that is indemand with these types of investors.Before adding it to your portfolio,however, find out if the stock isowned by top-performing funds.

•50-day moving average. Themoving average is a line on whicheach point denotes the average ofthe closing stock prices for the previous50 trading days. It's an evenbetter indicator of whether a stockis moving higher or lower than astock's daily closing price. Look fora stock trading above its movingaverage.

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