How to Determine Good Buys on Stocks

Both technical analysis and fundamental analysis are valuable in picking stocks.

Two schools of thought prevail regarding stock picking and investment analysis: technical analysis and fundamental analysis. Most good stock pickers use a combination of both. Technical analysis looks at trends in pricing and volume to make guesses about the direction of stock in the future. Fundamental analysis, however, looks at the intrinsic value of the stock compared with its market value. One popular stock-picking tool that bridges the gap between the worlds of technical and fundamental analysis is the P/E (price-to-earnings) ratio.

Things You'll Need

• Calculator or spreadsheet

Instructions

1. Identify an industry to focus on. Many investing experts, such as Peter Lynch, believe you should trade what you know; that is, you should pick stocks in an industry with which you are familiar. Think about the industry of your employer or an industry that supports your favorite hobby or sport.

2. Decide whether you want to invest in small, medium or large companies within the industry. You can determine size by looking at the number of employees, the number of locations (market footprint), or the number of shares outstanding for the company.

3. Look up the stock prices for at least five companies that meet your criteria. You can do this through an online broker or by using online investment tools. Quotes are usually the same, regardless of the source, unless they're in real time (less than a five-second delay).

4. Look up the earnings per share for these five companies. You can find earnings per share, calculated by dividing net income by the number of shares outstanding, on investment research sites or online brokerages. If you want to calculate them yourself, these numbers are on the income statement, which is in the company's annual report. The income statement starts with Revenues/Sales and ends with Net Income/Earnings Per Share.

5. Divide the current price by the earnings per share (EPS) to find the P/E ratio. For instance, if the stock price is $10 and the EPS is 2, then the P/E ratio is 5 (10/2).

6. Pick the stock with lowest P/E ratio. In general, stocks with a high P/E ratio (high market value for stock and/or low net income per share) are said to be overvalued in the market. Stocks with a low P/E ratio are said to be undervalued.

Tips & Warnings

• Most investment research sites will sort stocks within a particular industry by P/E ratio.

• Think about P/E ratio as a relative price tag for stocks. A stock with a high market value (price tag) should have high earnings (quality) to back it up (low P/E).

References

• Investopedia: Price Earnings Ratio
• TheDigeratiLife: The Peter Lynch Strategy