How To Check Out A Hot Stock Tip
Putting your money where someone else's mouth is is far more likely to be risky than rewarding - unless you follow the tip up with some research. Here's the right way to do just that.
If you're like many investors, your first instinct upon hearing a plausible argument for a stock is to bounce the idea off your broker the next morning. But to make the conversation a more intelligent one, head for your public library first. Specifically, look up the company in the Value Line Investment Survey or Standard & Poor's Stock Guide.
Pay particular attention to how the share price has fared lately. If the stock is in the news, it may be a good time to look at it, but it's probably the wrong time to buy it, since the news may already be reflected in the price. In any event, steer clear of shares trading at a new 52-week high; instead, wait three to six months to see whether the stock retreats to a more reasonable level.
What follows are five frequent stock pitches you may be tempted to swing at, plus some advice that will help to give you a better batting average.
The New Product Scenario
While everyone wants to get in on the next biotech or software star, buying the stock of a new cutting-edge company can be especially risky. Not only is the business or product likely to be difficult to understand, but standard stock analysis is complicated if, as is often the case, the company has yet to earn a dime.
Still, investors are far from helpless, but researching the product or technology is not the way to start. Whatever business it's in, you can determine the value of a development-stage company by comparing its total market value (the number of shares outstanding times the price) with how much it has spent on research and development over the past five years, information that can be gleaned from company financial reports.
Stick with firms sporting a market capitalization/R&D ratio of less than 10 to 1. If it's higher than that, the stock is overpriced.
The Bargain Stock Story
The textbook way to see whether a stock is undervalued is to examine its price/earnings or price/book ratio. Any stock trading at less than one times its book value per share - that is, the per-share worth of the company's assets minus liabilities - or below the market's P/E ratio is a potential bargain. Underline potential.
Above all, don't make the beginner's mistake of merely comparing the company's P/E to the market's and concluding that the shares are cheap or too high priced. Instead, check out the stock's annual relative P/E ratio, available in Value Line, to see whether the company usually trades at a discount or premium to the market.
Then too, go beyond P/E ratios in researching a supposed value stock. Zero in on the strength of the company's finances. Start by looking at Standard & Poor's investment quality or Value Line's financial strength ratings and think twice before investing in a company with less than a B+ grade from either source. Then see how much debt the company has, and stick with outfits where debt is no more than 40% of capital. If the balance sheet is solid, then an undervalued stock you hear about is worth considering.
The High-Dividend Dazzler
In truth, to wise investors an ultra-high yield can be a sign of financial trouble, and always merits further study. Compare the yield with other companies in the same industry. If it's two or three percentage points higher than the industry benchmark, figure that the dividend is ripe for pruning.
To find out whether the dividend will get the axe anytime soon, scrutinize the so-called payout ratio, or dividends as a percent of earnings. You can find it in Value Line or calculate it by dividing the annual dividend by the past 12-months' earnings per share. The lower the payout ratio, the more cushion the company has to maintain the dividend if earnings drop. For an industrial company, conservative investors should look for a ratio of 50% or less (70% is okay in the case of a utility). But if the dividend is more than earnings and profits are on a downtrend, there's a serious risk the dividend will be cut.
The earnings-Growth Grabber
Since stock prices tend to track prospects for earnings growth, everyone loves a company capable of 20% profit increases year after year. Two telltales can help you judge how profitable a business is: An above-average return on equity (ROE) - basically a look at what the company is earning on the shareholders' stake - and high, and expanding profit margins.
Coupled with low debt, a high ROE can predict above-average earnings, assuming the company reinvests profits in the business. An ROE above 12% merits your attention; above 15% suggests a solid grower; and 20% or more means you have a potential scorcher. But since an ROE is merely a snapshot of a company's profitability, look for signs that the company can sustain such a torrid return. Growing profit margins indicate that the concern maintains pricing flexibility or is reducing its costs. Either way, it's doing something right.
The Turnaround Tempter
Before swallowing the hook, search newspaper articles for reports of executive changes or consult the company's latest annual reports. Also look in Value Line to see whether cash flow (how much net cash the business generates) has moved into the plus column. Such a turnaround can be a sign that earnings will follow suit, and Wall Street simply loves positive earnings reversals. Then too, check whether company insiders are really optimistic about their firm. Look up insider buying behavior in Value Line. Just as more insider selling than buying over recent months could signal a problem, increased buying may be a sign that the stock is poised to take off.
However compelling a stock tip sounds, don't feel you have to swing at the first pitch. No matter how good the story, there's always time to check it out. And what's more, there's always going to be another good stock pitch come along!
* * * * *
If you're like many investors, your first instinct upon hearing a plausible argument for a stock is to bounce the idea off your broker the next morning. But to make the conversation a more intelligent one, head for your public library first. Specifically, look up the company in the Value Line Investment Survey or Standard & Poor's Stock Guide.
Pay particular attention to how the share price has fared lately. If the stock is in the news, it may be a good time to look at it, but it's probably the wrong time to buy it, since the news may already be reflected in the price. In any event, steer clear of shares trading at a new 52-week high; instead, wait three to six months to see whether the stock retreats to a more reasonable level.
What follows are five frequent stock pitches you may be tempted to swing at, plus some advice that will help to give you a better batting average.
The New Product Scenario
While everyone wants to get in on the next biotech or software star, buying the stock of a new cutting-edge company can be especially risky. Not only is the business or product likely to be difficult to understand, but standard stock analysis is complicated if, as is often the case, the company has yet to earn a dime.
Still, investors are far from helpless, but researching the product or technology is not the way to start. Whatever business it's in, you can determine the value of a development-stage company by comparing its total market value (the number of shares outstanding times the price) with how much it has spent on research and development over the past five years, information that can be gleaned from company financial reports.
Stick with firms sporting a market capitalization/R&D ratio of less than 10 to 1. If it's higher than that, the stock is overpriced.
The Bargain Stock Story
The textbook way to see whether a stock is undervalued is to examine its price/earnings or price/book ratio. Any stock trading at less than one times its book value per share - that is, the per-share worth of the company's assets minus liabilities - or below the market's P/E ratio is a potential bargain. Underline potential.
Above all, don't make the beginner's mistake of merely comparing the company's P/E to the market's and concluding that the shares are cheap or too high priced. Instead, check out the stock's annual relative P/E ratio, available in Value Line, to see whether the company usually trades at a discount or premium to the market.
Then too, go beyond P/E ratios in researching a supposed value stock. Zero in on the strength of the company's finances. Start by looking at Standard & Poor's investment quality or Value Line's financial strength ratings and think twice before investing in a company with less than a B+ grade from either source. Then see how much debt the company has, and stick with outfits where debt is no more than 40% of capital. If the balance sheet is solid, then an undervalued stock you hear about is worth considering.
The High-Dividend Dazzler
In truth, to wise investors an ultra-high yield can be a sign of financial trouble, and always merits further study. Compare the yield with other companies in the same industry. If it's two or three percentage points higher than the industry benchmark, figure that the dividend is ripe for pruning.
To find out whether the dividend will get the axe anytime soon, scrutinize the so-called payout ratio, or dividends as a percent of earnings. You can find it in Value Line or calculate it by dividing the annual dividend by the past 12-months' earnings per share. The lower the payout ratio, the more cushion the company has to maintain the dividend if earnings drop. For an industrial company, conservative investors should look for a ratio of 50% or less (70% is okay in the case of a utility). But if the dividend is more than earnings and profits are on a downtrend, there's a serious risk the dividend will be cut.
The earnings-Growth Grabber
Since stock prices tend to track prospects for earnings growth, everyone loves a company capable of 20% profit increases year after year. Two telltales can help you judge how profitable a business is: An above-average return on equity (ROE) - basically a look at what the company is earning on the shareholders' stake - and high, and expanding profit margins.
Coupled with low debt, a high ROE can predict above-average earnings, assuming the company reinvests profits in the business. An ROE above 12% merits your attention; above 15% suggests a solid grower; and 20% or more means you have a potential scorcher. But since an ROE is merely a snapshot of a company's profitability, look for signs that the company can sustain such a torrid return. Growing profit margins indicate that the concern maintains pricing flexibility or is reducing its costs. Either way, it's doing something right.
The Turnaround Tempter
Before swallowing the hook, search newspaper articles for reports of executive changes or consult the company's latest annual reports. Also look in Value Line to see whether cash flow (how much net cash the business generates) has moved into the plus column. Such a turnaround can be a sign that earnings will follow suit, and Wall Street simply loves positive earnings reversals. Then too, check whether company insiders are really optimistic about their firm. Look up insider buying behavior in Value Line. Just as more insider selling than buying over recent months could signal a problem, increased buying may be a sign that the stock is poised to take off.
However compelling a stock tip sounds, don't feel you have to swing at the first pitch. No matter how good the story, there's always time to check it out. And what's more, there's always going to be another good stock pitch come along!
* * * * *
posted by Bob Moser at
3:59 PM
0 Comments:
Post a Comment
<< Home