Evaluating stock performance is very individual to each investor. Just as every person has different appetites for risk, plans for diversification, and investing strategies, so too does every investor have different standards for evaluating stock performance. One investor may expect an average annual return of 10% or more, while another may look to add to his portfolio with a stock that is not correlated with the stock market as a whole.
Whatever you look for in a stock’s performance, there are a few variables to consider to help you evaluate whether that stock is a good investment for you.
- Evaluating the performance of a stock requires more than simply looking at the change in price over time.
- If the stock pays dividends, for instance, those cash flows must be added to the total return of the investment.
- Returns can only be properly compared against an appropriate benchmark that reflects the investment style and risk level of the stock you're looking at.
Consider Total Returns Over the Right Period
A stock’s performance needs to be placed in the right context to understand it properly. On the surface, it looks great to see that a stock has returned 20% since the beginning of the year when viewing the starting price versus the ending price, but you need to look a little deeper. Was the stock abnormally depressed on the first day? If so, it could throw the numbers off.
To counter this, most investors look at the stock’s total returns that include all dividend or interest payments in addition to the price return. Consider the actual performance of the stock over a period, as though you had invested in it on that first day of the period. Additionally, look at how the stock has done year to date (YTD), as well as over the past 52 weeks. Finally, consider the stock’s average annual return. Look at the five-year average annual return but also look at the 10-year average annual return if you are considering a longer-term investment.
Put It in Perspective
To evaluate a stock, review its performance against a benchmark. You may be satisfied with a stock that generated an 8% return over the past year, but what if the rest of the market is returning a few times that amount? Take the time to compare the stock’s performance with different market indexes, such as the Dow Jones Industrial Average, the S&P 500, or the NASDAQ Composite. These indexes can act as the benchmark against which to compare your own investments' performance.
Be sure to choose an appropriate benchmark. If you invest in small speculative penny stocks, the S&P 500 will not be the right yardstick, as that contains only large-cap stocks listed on major stock exchanges.
You may also want to look at how the economy has done during the same period, how inflation has risen, and other broader economic considerations.
Look at Competitors
Of course, even if a company has done well compared to the broader market, there is still the question of how its industry is doing. It could happen that a stock is outperforming the market but is nevertheless underperforming its own industry, so make sure to consider the stock’s performance relative to its primary competitors as well as companies of similar size in its industry.
For example, if you are evaluating a small semiconductor company, it may not be fair to compare a startup business directly with a well-established company such as Intel, even if the two companies' products may compete against one another in some arenas. While it helps to see how that smaller-cap company may be doing relative to its larger competitors, it gives you greater perspective to also consider competitors in similar stages of their business life cycles.
The Bottom Line
Looking at the change in a stock's price by itself is a naive way to evaluate the performance of a stock. Everything is relative, and so that return must be compared to make a proper evaluation. In addition to looking at a company’s total returns, comparing them to the market and weighing them relative to competitors within the company's industry, there are several other factors to consider in evaluating a stock’s performance.
For one, you should look at whether the company pays dividends and how reinvesting those dividends may improve its total returns. Also, be sure to factor in inflation in calculating returns, especially as you consider long-time horizons for your investments. This is called a real return and can be done simply by subtracting inflation from the annual return of your investment.