Comparing stocks is a very critical aspect of stock investing, and this is because deciding which stock to pick can sometimes determine whether you’ll be making a profit or a loss. What’s even more interesting is that, with multiple stocks options available to pick from, there are metrics to consider when picking a stock. So how do you narrow your options, decide which stock to pick, and take timely investment actions?
How To Compare Stocks
Perhaps the first thing to bear in mind when comparing stocks is to make sure that the stocks you want to compare are players in the same industry or have some relationship. The last thing you want to do is compare an oil company with a burgeoning tech stock.
Comparing stocks within the same industry gives you a good idea of whether a stock is valued properly or whether a company is faring better or worse than its peers in the industry.
There are so many metrics that can be used to compare stocks. However, you don’t need to apply all of them. Essentially, the key is to choose a few relevant metrics in that industry and apply them.
Some key metrics to bear in mind are; the company’s revenue, profits, market capitalization, price to earnings ratio, and price to sales ratio. To a layperson, these concepts may seem complex, but once you understand them, they’re pretty easy to apply.
Revenue – How To Compare Stocks Based on Revenue
Revenue is the money a company generates from selling goods or providing services. Revenue can be calculated by multiplying the prices of the items sold and the number sold.
For example, if a company sells a bag of cement for $2 and in a year, the company sells 10million bags, then the company’s revenue will be $2 x 10million giving a $20million figure.
Generally, a company with a track record of steady revenue growth is preferred.
However, revenue alone may not always be the best measure of a company’s value because companies can have impressive revenues and still record losses when their costs exceed their revenues. Therefore, consider other key metrics like costs and profits.
Suppose Company A has a higher revenue but consistently records losses. In that case, it might be a sign that the company cannot make enough money to cover its costs, which invariably means that the business may not be sustainable in the future.
On the other side, if Company B has lesser revenue but consistently records profits, then Company B is making enough to cover its costs and even more. In this scenario, Company B will be a better investment option even though it records lesser revenues than Company A.
Market Capitalization – How To Compare Stocks Based on Market Capitalization
Market capitalization is simply the market value of a company’s outstanding shares.
Market capitalization is obtained by multiplying the number of outstanding shares and the market price of one company share.
If Apple, for example, has 100million shares outstanding and the price of one Apple stock is $200, then Apple's market capitalization will be 100million x $200, which is $20billion.
Market capitalization is usually considered a good measure of the value and the size of a company.
Companies with small market capitalization are usually referred to as small-cap stocks, while companies with large market capitalization are usually referred to as large-cap stocks. Usually, large-cap stocks are characterized by relatively mature and stable companies with a track record of paying dividends.
On the other hand, small-cap stocks are characterized by small businesses with more growth potential. If you are risk-averse, large-cap stocks will be your preferred option because they are considered less risky given the consistency of dividend payments and the stability of the companies.
However, if you have a strong risk appetite, you may be more tilted towards small-cap stocks since they are more affordable and have higher growth potential.
Profit – How To Compare Stocks Based on Profit
When a company’s revenue exceeds the total cost of its production and business operations during a specific period, it has made a profit.
Furthermore, profit is the benefit a company realizes when the money generated from sales exceeds the total expenses incurred that period. A company’s profit is calculated by subtracting its total expenses from its total revenues.
One of the rationales behind investing in a company’s stock is the expectation that the company will reinvest some or all of its profits to grow the business and generate more profit.
The common measure of profitability for companies is the profit margin. Profit margin reflects how much profit a company has generated compared to its revenue. To determine a company’s profit, the profit is usually divided by revenue.
For instance, if a company records a revenue of $1billion and a profit of $20million in a year, the profit margin will be calculated as $20million/$1billion, which is 0.02 or 2%.
When comparing stocks, it is best to understand what obtains in the industry where the company operates. If, on average, companies within the industry have a profit margin of around 5% and the company you’re targeting has a profit margin of 2%, it could be a sign that the company is not generating enough to cover its expenses.
Companies that consistently grow their profit margins will usually record an increase in their share prices over time because the higher a company’s profits, the more valuable the company becomes. As a result, companies with higher profit margins are generally preferred.
Price to Earnings Ratio – How To Compare Stocks Using Price to Earnings Ratio
The Price to Earnings ratio is commonly referred to as the P/E ratio. A company’s P/E ratio shows the relationship between its stock price and earnings per share (EPS).
Therefore, to calculate a company’s P/E ratio, the company’s EPS must first be ascertained.
What exactly is Earnings Per Share (EPS)?
Earnings Per Share or EPS is used to calculate a company’s P/E ratio and reflect how much money a company makes relative to its number of outstanding shares. To calculate a company’s EPS, you need to divide its profit by its number of shares outstanding.
If a company makes $20million in profits and has 1million shares outstanding, then the company’s EPS is $20million/1million, which gives $20.
The formula to calculate a company's P/E ratio is its stock price divided by its EPS
After calculating a company’s EPS, it is easier to calculate the P/E ratio.
In the above example, the company's EPS was $20. If the company’s stock price is $40, then the P/E ratio will be calculated as $40/$20, which gives a P/E ratio of 2.
Therefore, for every $1 the company earns, investors are willing to pay $2.
When comparing the P/E ratio of two stocks in the same industry, a stock with a high P/E ratio relative to its peers may be considered overvalued. In contrast, a stock with a lower P/E ratio relative to its peers may be considered undervalued.
On the other hand, a higher P/E ratio could signify that the stock is attractive and investors are happy to pay more because they believe the company has a better chance to grow in the future.
Conversely, a low P/E ratio may be considered unattractive as it could mean that investors do not see future growth prospects in that company and are not willing to bet on it.
Additionally, when a company doesn’t make any profits, it would be inappropriate to analyze the company using the P/E ratio. The Price to Sales Ratio may be more appropriate in such cases, which we will discuss next.
Price to Sales Ratio – How To Compare Stocks Using Price to Sales Ratio
The Price to Sales ratio also referred to as the P/S ratio, is used to value companies that have yet to rake in profits or record losses due to some setback.
A company’s P/S ratio shows the relationship between its market capitalization and revenue. As mentioned earlier, market capitalization is the total market value of a company’s outstanding shares, while revenue is the money generated by a company in the course of its business.
If a company has a market capitalization of $100million and records a revenue of $100million that year, the P/S ratio will be calculated at $100million/$100million = 1.
Therefore, the company will have a P/S ratio of 1. A stock with a lower P/S ratio relative to its peers in the same industry could be considered undervalued and may hold some growth potential.
Nevertheless, it is advisable not to consider the P/S ratio in isolation as other metrics like profit margins or debt levels should also be considered.
Finally, putting all your eggs in one basket is not a financial-wise decision when building a stock portfolio. The reason for this is simple – diversification.
Your portfolio should be diverse to reduce your risk properly, like a football team with different players – defenders, strikers, etc.
Essentially, the idea is to invest your money in different stocks across different industries. When considering what stocks to pick in an industry, it is also important to note that a stock shouldn’t be picked based on one metric alone. Other metrics and valuation methods should be considered to achieve the best results.