Chapter 13. Evaluating Stocks' Prospects

In This Chapter

  • Measuring the potential risk and return of a stock

  • Valuing a stock using a discounted cash flow analysis

  • Determining the valuation of a stock, including price-to-earnings ratios

  • Using online stock selection tools to study investments

  • Comparing a company to its peers and industry

When investors say they bought a stock because "it's a good company," you should automatically become skeptical. As you find out in this chapter, one of the biggest mistakes investors make is confusing a company and its stock. They're not the same thing.

A company is a business that sells things to customers and tries to make a profit. A company's success is measured by its revenue and earnings growth, things that are discussed in Chapter 11. But a stock is a different animal. Stocks are essentially pieces of ownership in a company. Stock prices are determined by how much investors are willing to pay to own a piece of a company. If too many people think a company is good, they might pay top dollar for the stock and drive up its valuation. And when a valuation rises, your potential return decreases. Valuations are the root of one of the most perverse realities in investing: Good companies can be bad stocks. If you overpay for a stock, even if the company delivers great earnings growth, you can still lose money. Savvy investors know the price they pay for a stock is one of the biggest factors that determines how much they'll profit.

This chapter shows you how ...

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