Hello, Good Buy (Part 2)

So, you’ve got the narrative. You know the industry well enough to know that this company has room to grow, or you know the company well enough to know that it will shoot for the stars and be on target. Your gut says yes.

But objectively, how do you know this stock is a good buy?

Let’s start with the price.

To find a stock’s price, you can go to nearly any finance-related website. My favorite for straight-no-chaser information is Google Finance (http://finance.google.com), but Yahoo! Finance (http://finance.yahoo.com) is a formidable competitor. I’ll use Google Finance on this blog, just to stay consistent.

Most finance websites these days will let you type in the name of the company to pull up data, but you’ll want to know the company’s ticker symbol as well. It’s basically an abbreviation that identifies the company most quickly on a stock exchange.

When the company profile comes up, the first thing you’ll see is the price per share of the stock. Ask yourself how many shares you can afford at that price. Some brokerages have a required minimum number of shares in order for you to purchase with them (often 1 share is enough). However, ING’s Sharebuilder is unique in that, with the right plan, it will allow you to purchase fractions of a share of stock. There are downsides, though: (a) you can only purchase on a certain day -- typically Tuesdays, (b) you have no control over at what time of day -- and thus, at what price -- the stock is purchased, and (c) you'll wind up paying full commission for a smaller portion of stock. For simplicity’s sake, I’ll assume on this blog that you have a regular broker that will only allow you to purchase full shares of stock. Either way, you should always buy a number of shares whose proceeds will make the cost of commission worth it (see Post 2 for more information).

So, you’ve got money and you know how many shares you can afford – great! But hold on.

Take a look at the information available, particularly:

Range

52-week range
Market Cap
P/E
Dividend
EPS

Range – This is the lowest and highest prices the stock traded at in the past trading day. Basically, it represents a stock’s volatility, or how much the price fluctuated in the past day. Normally, this doesn’t move very much (maybe $1 or $2, or just a few cents), but if the whole stock market went up or down, you’ll see more variability here. You should equate volatility with risk – generally, the more volatile a stock is, the riskier it is. But with high risk comes high reward [in theory]. That said, don’t be afraid if a stock moves up and down more than $2 – Under Armour fluxed between $94 and $102 today, so it definitely happens.

52-week range – Similar to the day’s range, but, in my opinion, a lot more important. This gives the range of prices the stock has experienced in the past year. It’s an even better signal of volatility, especially if the highest price is waaaaaay more than the lowest (like, 3 or 4 times as much). Sometimes, you can look at a 52-week range to judge how “expensive” a stock is – if it’s at the top of the range, you’ll probably want to wait until the price goes down to buy; if it’s at the low end….well, that depends. It could be a signal that the stock is really cheap, but if the company is not doing well financially, it’s a sign of the worst.

Market Capitalization (Market Cap) – This basically tells you how large the company is, financially-speaking (and even more specifically, equity-speaking. I’ll get to debt later.). It is the total of the number of shares the company has available to investors multiplied by the price per share. Generally speaking, large-cap companies like Wal-Mart and McDonald’s tend to have less-risky stocks than small-caps like Basset Furniture.

P/E – P/E stands for price-to-earnings (or price-earnings) ratio. I would say that it’s the most commonly used ratio to decide if a stock is expensive or not, though that idea does not always hold. The P/E ratio can be found two ways: by dividing the company’s market cap by its net income or by dividing its current price by the amount it has earned per share in the past year. Either way, you’ll get the same answer.

Basically, it tells how much you’re going to pay per share for the amount of money the company earned. If the ratio is high (and “high” depends on the company’s industry), you’re paying too much for the stock; if it’s low, you’ve found a bargain. But as I said, this doesn’t always hold. Older, more established companies like GE tend to have lower PEs (GE’s is less than 16) whereas newer companies, such as Lululemon, tend to be higher (LULU’s is 58). This is because the PE can reflect investors’ expectations of a company’s growth. In this example, one would think GE has grown as large as its going to grow, but Lululemon has room to spread itself around.

Dividend – Sometimes, you get a tip from the company to thank you for investing in it. It’s called a dividend, and it’s a portion of the company’s bottom line earnings that it felt it should share with its shareholders. Why would a company do that? Well, they want you to keep investing in the stock and sometimes, they don’t want to keep too much cash on them and a dividend is a good way to get rid of it.

EPS – Stands for earnings per share; it’s a measure of how much the company earned in net income for each share of stock it has available to investors. The higher the better, but this figure can fluctuate wildly depending on what’s going on in the company, the industry, and the world. EPS is also a shadow – what’s happened in the past. There’s no guarantee that the same (for better or worse) will happen in the future, but it can give you an idea of what the company’s stock is capable of earning.

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Now, you’ve got the story and you’ve got the numbers. Next, we’ll put them together.