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Basic Stock Evaluation

Friday, September 21, 2007

Basic Stock Evaluation

How to do a Basic Stock Evaluation

There are a few common variables to assess when evaluating a stock:

1) Profitability: Does the company make a lot of money?
2) Growth: past, present, future—major driver of stock price
3) Financial Health: Strong Balance Sheet—the company can weather a storm.
4) Value: the stock is available at a discount (on sale) compared to its historical value, compared to its competitors, compared to its intrinsic value.

1) Profitability: (Return on Capital and Return on Equity) (ROC) & (ROE)

Return on Equity (ROE)
(ROE) Low numbers (> 12%), especially if declining, (Look elsewhere)
Steadily increasing ROE speaks well of company management.

Measure of profitability
Also indicates internal growth potential (ability to self-finance growth without borrowing money or issuing new common shares)

2) Growth:
Earnings and Sales Per Share (EPS)
Primary determinant of share price movement
Rapid and consistent growth is highly desired
(harder to manipulate through accounting practices than earnings)
Look at Value Line Charts (visual of cash flow growth)
issue of more common stock (dilutes EPS)

Dividend Growth
Some companies pay out too much in a good year and then reduce them in a bad year (can hammer stock)

3) Financial Strength
Capital Structure: Excessive debt? Shareholder risk increases with the proportion of debt in a company’s capitalization
A company with zero debt can’t go bankrupt!
(Free Cash Flow Per Share): Cash Flow – (dividends + Capital spending): Capital Spending requirements that deplete CF over long haul is bad, Short term good.

Long Term Debt:
Examine long-term debt load in terms of absolute numbers and its trendàstable or declining trend suggests good financial health

Current Position
To asses solvency: pay attention to cash and marketable securities; monitor receivables closely. Receivables increasing at rate faster than sales (perhaps some money owed to company is not being collected)
Inventories: should not grow faster than sales (Red Flag)

4) Value:
The valuation of a stock relative to its own history: P/E, Price/Cash Flow, Price/Sales, Price/Book Value compare past 5 years (Watch out for cyclical companies)
The valuation of a stock relative to others in its peer group: compare to see if stock is above of below where it traditionally sites in terms of the entire market of stocks
Quickest way to evaluateà compare cash flow line (the value line) or earnings line to see if company is above or below the line (stocks at or near line may be undervalued)

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