How to analyze tech stocks
For mature tech companies that produce profits, the price-to-earnings ratio is a useful metric. Divide the stock price by per-share earnings and you get a multiple that tells you how richly the market values the company’s current earnings. The higher the multiple, the more value the market is placing on future earnings growth.
Many tech companies aren’t profitable; the price-to-earnings ratio is useless in those cases. Revenue growth matters more for these younger companies – if you’re investing in something unproven, you want to make sure it has solid growth prospects.
For unprofitable tech companies, it’s also important that the bottom line be moving from losses toward profits. As a company grows, it should become more efficient, especially when it comes to the sales and marketing spending necessary to close deals. If it’s not, or if spending is growing as a percentage of revenue, that could indicate that something is wrong.
Ultimately, a good tech stock is one that trades at a reasonable valuation given its growth prospects. Accurately figuring out those growth prospects is the hard part. If you expect earnings to skyrocket in the coming years, paying a premium for the stock can make sense. But if you’re wrong about those growth prospects, your investment may not work out.
Investing in tech stocks can be risky, but you can reduce your risk by investing only when you feel confident that their growth prospects justify their valuations.