How to Evaluate Company Stock During a Recession

With a recession approaching, businesses are scaling back, people are losing their jobs and confidence in the market is diminishing. But despite the many unknowns, the bear market presents a rare buying opportunity.

When there is a great movement in the markets, there can be big profits. One advantage of a bear market is finding reasonably valued stocks that are traditionally very expensive.

“Buying in a bear market is a great thing if you can withstand the volatility. As Warren Buffett has said, ‘The time to buy is when everyone is fearful, and the time to sell is when everyone has no fear’,” says Derek Horstmeyer, a professor at George Mason University School of Business.

Wealth is about owning more shares when stock prices go up, and these market dislocations are opportunities to do just that.

“If you are a value investor, now is a great time to jump in the market because there are plenty of traditional growth stocks that are a great opportunity to buy on the cheap now,” Horstmeyer adds.

That means investors should take a second glance at tech stocks with high price-earnings ratios, he says.

Buying During a Bear Market

Markets continue to show weakness and no one can predict when a recovery will happen, but the biggest mistake is selling your investment into a market that may be about to go up and miss out in big gains.

Keep in mind that the market is always bullish over time and every bear market in history has ended usually in a period of months. So being well-positioned for success when a recession ends is an effort worth taking to benefit your finances in the long run.

If you want to take advantage of this bear stock market, here are some tips on evaluating stocks and where to gear your attention when looking into companies in which to invest during a recession.

[7 Best Value Stocks to Buy in 2020]

How to Value a Stock

Many components go into stock valuation, but there are basic metrics and methods to review when considering putting your stake in a company.

To determine the value of a stock, it’s suggested to do a fundamental analysis first and look at a company’s earnings per share and P/E ratio. These metrics are key components that go into pricing a stock.

The P/E ratio compares a stock’s price to its profit. Looking at a company’s P/E ratio is a good relative valuation technique to see how your prospective company fares in regard to other similar businesses and can determine if the stock is undervalued or overvalued.

“A low P/E ratio may suggest a company is undervalued. Most companies have low P/Es in response to negative market conditions or points to inherent problems the company may have,” says George Calhoun, a professor at the Stevens Institute of Technology in New Jersey. “If you use [these] low metrics to guide you, you can find opportunities for investing in undervalued companies.”

It can take a while for that correction to take place — more than one to three years — so if you buy a company today that looks attractively undervalued, you have to be prepared to wait several years to see if you’re correct, Calhoun says.

Another central element in stock valuation is earnings per share, or EPS, which is calculated by dividing the company’s profits by the number of shares outstanding. The higher the number, the more profitable the company is said to be. Track the EPS year over year: If it’s growing, then this means the company is selling a product or offering a service that customers value.

[7 Stocks That Soar in a Recession.]

In addition, searching for a company’s rate of return on invested capital, or ROIC, is another important metric, according to David Souccar, a portfolio manager at Vontobel Asset Management in New York.

“ROIC is equivalent to a car’s maximum speed. If you try to drive the car faster than the engine’s specification, the engine will blow up. A company trying to grow its business at a faster rate than the ROIC will need to use leverage to complement the growth up to a point where it becomes unsustainable. Or alternatively, a company will have to issue equity to the point that existing shareholders will be diluted and EPS growth will be muted,” Souccar says.

Souccar adds that companies do not achieve a high ROIC by accident.

If a business has a high ROIC, the competition will try to come in by charging a lower price. So another element to look for is a moat, a competitive advantage that makes it difficult for others to copy.

The moat comes in different forms, such as a brand, patent, low-cost position or distribution, to name a few.

Technical analysis, which consists of looking at the moving averages of a company’s stock price over a period of time on a stock chart, is a critical valuation strategy. Analyzing the stock’s past movements can give you a good idea of what factors have influenced a stock’s price over time.

But given the unprecedented, exogenous shock currently roiling markets, Michael Treidl, director at Miracle Mile Advisors in Los Angeles, recommends that investors stay focused on the endgame.

He says to study the “qualitative factors that will play an important part in determining a stock’s value, such as quality of management, industry growth trends, competitive advantage and an ability to scale quickly when the economy recovers.”

[See: 7 Stocks Poised to Profit From Coronavirus]

What to Look for in a Company to Buy Now?

The current market has a lot of uncertainty, which is unlikely to go away anytime soon. As you work toward being a selective buyer in this volatile environment, look for companies that have strong business models, healthy cash flows and very robust balance sheets.

“In a crisis, liquidity is king. Companies need to be able to survive, which means they need to have enough cash to get through the trough,” says Sudhir Roc-Sennett, head of thought leadership at Vontobel Asset Management in New York.

When you think about investing in companies now, consider the quality, stable competitive advantages and continued demand in their business. High-quality companies will perform better and recover faster. This will put them in good shape among market crisis victims with continued ability to produce and thrive during challenging times.

Calhoun provides this suggestion on how to identify quality companies, “The balance sheet reflects the old industrial view of what assets are, but the new age of assets that drive the economy today like brand, data, technology and customer equity do not show up. What’s more important are the operating margins in the income statement, how profitable is the company relative to other companies in that sector.”

According to Calhoun, free cash flow is a concept that explains not all of the cash from selling is free — some of it has to be recommitted back to the business. As a general rule, companies with stronger free cash flow over a reasonable period are going to be more valuable.

It should be mentioned that free cash flow is a relatively new concept and is not yet standard, but it is of considerable interest to investors because they now feel it ought to be an important indicator of traditional measures of earnings, according to Calhoun.

Evaluating a company’s corporate earnings tells you a whole lot about its competence as an organization. If you find these financial statements comprehensive and efficient, it can bring more confidence to you as an investor.

Ultimately, to prepare for future gains, it’s important to continue investing in company stocks. When going to purchase shares in a company during a recession, it’s vital to perform stock valuation techniques. When thorough research is performed, it’s easy to understand the overall health of a company in a recession.

More from U.S. News

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How to Evaluate Company Stock During a Recession originally appeared on usnews.com

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