There is no doubt that investors want their stocks to rise in value, potentially padding their bank accounts and affirming their skills as investors. On more than one occasion, however, most investors will perceive a certain stock price to be inscrutable, particularly if the current market price is less than the investor thinks it ought to be.
One method that an investor may use to understand how that stock price does indeed reflect market expectations regarding its current and likely performance is to do a stock comparison to the S&P 500, that is, compare its returns to that of the companies of the S&P 500 for a period.
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Select the Time Period
To fairly evaluate a stock, you must view its price and return in the context of the appropriate period. To do so, consider a stock's total dividend and interest payments as well its increase in price for a certain time.
In the process, assume your investment occurred on the first day of the period under consideration, such as year to date, a period that begins on January 1 and ends of December 31, or the company's fiscal year, the one-year period the company chooses to report its financial information.
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Check the Average Annual Return
Once you've selected an appropriate performance period, take a look at the stock's average annual return, or the rate at which a stock price grows during a five- or 10-year period. Also important is the total return on the stock, such as the regular cash payments an investor receives from the investment, such as dividends.
Consider the S&P 500 Context
Whether evaluating the performance of automobiles, space rovers or company stocks, context matters. That's where a benchmark for large-cap stocks, such as the Standard and Poor's 500 stock market index (S&P 500), comes in. The S&P measures the stock performance of 500 large companies, which are listed on United States stock exchanges. Consequently, the index provides insights as to the comparative performance of a stock to the market at large.
To accurately gauge a stock's performance, review it against the S&P 500. For instance, you should know if your stock generated a 6 percent return in 2020 versus that of the S&P 500, which gained 16.26 percent for the same year. You might also compare a stock's performance to other market indexes, such as the NASDAQ Composite or the Dow Jones Industrial Average.
When you use the S&P 500 as a benchmark, remember that you can't assume the market is correct as to any stock's valuation, just that it contains information an investor can use.
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Evaluate the Industry Performance
Once you're convinced a stock has performed well relative to the S&P 500, consider the status of other companies in its industry. Just because a stock might keep pace with or outperform companies of a market index, it may lag the financial performance of its primary industry competitors.
When making the performance comparison, however, be sure to compare apples to apples. It's of little use to compare a small pharmaceutical company to Pfizer or Abbott. While all three companies might produce and market a pain relief product, Pfizer and Abbott also produce other pharmaceuticals and consumer brands and they operate in global markets. So, limit your comparisons to companies of the same approximate size and that are in the same phase of the business life cycle, such as the growth or maturity stage.
While monitoring changes in a stock price or stock dividends is informative, they're but two data points you can use to evaluate a stock's performance and your possible stock market return. It's best to also consider a company's returns relative to the market and its major competitors as well as the environment in which a company operates.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.