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A Primer on Stock Investing (Part 1)
The objective of this article is to summarize some key metrics of stock investments and valuation; and help investors make informed decisions using a relatively simple framework.
There has been a plethora of information on stock investing, regularly bombarded on investors by financial media. This flood of information is disseminated by multiple media channels. Some of these industry resources provide valuable information, yet these reports may not help in making informed decisions. Studies have shown that Value line, with its highly sophisticated analysis, can hardly compete with the Market index. Research has demonstrated that beating the Market index needs “superior” analysis and right timed execution. The term used for this unique skill is Alpha; and some examples of Alpha seeking Gurus are Warren Buffet, George Soros, Peter Lynch and others.
Before delving into a more pragmatic framework of stocks, it is important to define different categories of stock investing. Stocks are broadly categorized as either common stocks or preferred stocks. The key difference between the two is characterized by the following. First, preferred stocks are preferred, as the name implies, over common stocks in terms of claim by the shareholders in case of default by the company. Second, preferred stocks are purchased to get dividends (income) with less potential for appreciation; while common stocks may be used for both dividends as well as capital appreciation, with focus on the latter. Third, preferred stocks behave like bonds in some cases, as interest rates go up the price of preferred would typically go down. Interest rate variation has some degree of correlation with stock market as a whole because as interest rates go up the stock market gets hit. For individual common stocks, interest rate variation effects will depend on a number of factors, in particular the capital (or debt) structure of the firm.
Other categories of common stocks include: First blue chip stocks of well reputed Dow Jones companies with established history of dividends payments to investors. Second, value stocks are under-valued gems, likely to grow in the long run. Third, growth stocks as the name implies are growth oriented stocks which are priced higher because of their perception of appreciation in future. Fourth, cyclical stocks which are sensitive to swings in the business cycles. And fifth, stocks which stay calm during market swings such as Utilities.
The key metrics of stock investing are summarized below:
1-52 Weeks High-Low: Find out the price of the stocks prevailing in the stock market and compare the current price to past 52 weeks of high and low prices of the same stock. The idea is simple: stocks having lower price range in the rising markets have greater upward potential than stocks which have already reached high 52 week mark.
2-Market Capitalization: This metric reflects how big the company is. Market capitalization is obtained by multiplying the number of shares outstanding of the company by the prevailing market price. Typically stocks are classified as large cap, mid-cap and small cap stocks. Large cap stocks, like Exxon, generally do not have a great upward potential of price increase as compared to some gems in the category of mid-cap and small-cap stocks. The latter category of mid-cap and small-cap stocks has the highest probability of representing emerging star investments, which typically multiply and grow ten-fold in a certain time period.
3-Volume: This metric tells us how much dollars are being traded on a single day. Volume is computed by multiplying number of stocks in trading on a particular day by the average price. Blue chip stocks like Exxon, Microsoft and Apple have larger volume. In contrast, small and mid-cap stocks have smaller volume, thereby creating some liquidity risk.
4-Earnings growth (past and future): This is a key metric which determines the price of stocks. Earnings per share (EPS) is computed by dividing the earnings of the company by the number of shares outstanding. Earnings growth (year over year YOY) is important from two angles: whether earnings have grown in the past five years; and whether actual earnings have exceeded the predicted earnings in the current year. The performance of growth companies particularly is judged by the corresponding growth of earnings. Interestingly earnings per share is diluted by the issuance of more shares; or conversion of fixed income securities onto common stocks. This action would decrease the value of EPS. In contrast, if a company buys back its shares, the earnings per share would increase proportionately. For example, if a company, abundant in cash reserves, buys back half of its shares, the EPS would arithmetically double, making it more attractive to the stock investors. Remember EPS is strongly correlated to the price of stock. Consequently, buying back stocks and assuming that the external factors do not change can eventually lead to increase in the price of stocks.
5-Price to earnings (P/E) ratio: Despite the fact that this ratio has some caveats, P/E is the most popular ratio in the world of stock investing. P/E ratio is simply the current price of stock divided by the 12 months trailing earnings (although analysts sometimes use 12 months of forecasted earnings as well). Growth investors would like growth in earnings regardless of the direction of the price of stock. Conversely, the value investors want to see declining P/E ratio in order to hunt for the undervalued gems. Value investors typically go after companies whose earnings growth rate is higher than the P/E ratio. The second metric admired by the value investors is the existence of the current P/E ratio falling below the past five year average.
6-Price to Sales (P/S): There is general perception that sometimes companies would twist accounting methods in order to manipulate earnings. It is rather difficult to apply such manipulation to the sales numbers. This metric throws light on how much money you are willing to pay for the sales generated by the company. For growth companies, this number should continue to be smaller. However growth investors will not care much about this ratio as compared to value investors. The value investors would like to see this ratio lower.
7-Price to Book ratio (P/B): The book value means how much a company is worth if it was liquidated today. The price to book ratio is a simple comparison of stock’s price to net asset value of the company. The main caveat is that this metric focuses on tangible assets of the company. Investment research has revealed that intangibles also play a very significant role in the value creation for the shareholders. It is for this reason that P/B ratio is not a comprehensive metric.
8-Value creation and growth metrics: Most stock analysts typically focus on EPS (Earnings per share) metric for the past five years. Although earnings and sales are like life bloodline of a company, yet basing stock investing decisions on earnings (and sales) standalone can be misleading. More specifically, the analyst should undertake more detailed analysis of the following three key areas that determine the earnings (sales) of the company eventually:
a-The quality of revenue earned by the company and transparency (compliance standards) of revenue recognition. What are the growth prospects of the company?
b-The net profit margin or quality of earnings: what is the strategy of a company to optimize costs and increase return on investments? Of course, management plays a critical to enhance the size and quality of earnings.
c-What is the position of cash flows? It is important to purchase stocks of companies with positive cash flows.
9-Dividend Yield: This metric is generally relevant for large blue chip companies, such as those constituting the Dow Jones Industrial average. It is less relevant for small and high growth companies, because these companies hardly declare any dividends. Some investors, depending on their risk profile and investment goals will prefer large companies churning dividends consistently.
10-Relative Price Strength: This metric compares last year price performance of stocks within a congruent group. Similar comparison between stock siblings is made for Earnings per share. This type of analysis is typically done by Investor’s Business Daily.
11-Return on Equity (ROE): is an important metric, which explains how much money the company is making at the behest of the shareholders’ equity. In simple terms, it elucidates whether the company is efficiently utilizing resources at its disposal and is making profit. This metric is particularly relevant for growth investors. Growth companies should keep track of Return on Equity (ROE) to ensure that the growth projects are generating positive net present value (NPV). The ROE metric clearly speaks of the depth and competency of the management.
12-Insider Ownership: It is generally argued that the larger size of the insider ownership is a better indicator of the success of a company. This proposition makes sense because when owners are stakeholders, they would work hard to push the company to success. However this metric standalone cannot indicate the strength of a company. There could be periods when stakeholders would sell stocks to generate money from their changing personal and business needs.
13-Forecast on Company’s performance: Value of a company is not based on its past performance. This is because past performance is only relevant to the extent that it can help analysts make some predictions about future trends and growth. However, there is no guarantee that the external environment would stay the same and that the company would repeat its past performance. Equally difficult is the forecast (predictions) about future earnings and revenues of the company. Investors should complete their own due diligence to analyze the possibility of meeting actual earnings and revenue goals.
14-Integrity and Depth of Management: This is perhaps the most important metric to make an assessment about the future performance and direction of any company. Performance is a relative term; and will vary depending on the nature of company. For example, from the viewpoint of growth companies, performance is defined by year over year (YOY) growth while maintaining positive return on equity (ROE). For technology companies, performance is underpinned by successful launch of innovation in the guise of new product introductions. The caveat is that innovation is difficult to measure because of its rolling into both tangible and intangible domains. How can you, for example, measure the success or long term value of Apple iphones? The ubiquitous existence of disruptive technologies makes this task even harder. Overall, the depth, maturity and commitment of management is the most important metric to judge the future performance of a company.
15-Volatility of Stocks: This metric is absolutely critical in making decisions about the Risk-Return profile of the investor. Put simply, volatility is a measure of how much returns deviate from the average value in a given period of time. Greater volatility implies greater risk. Volatility tends to be higher in the short run and would smooth out to some extent in the long run. Of course, volatility depends on the correlation of stock price to market swings (called as Beta).
To conclude, the above framework must be analyzed in a holistic manner. Again these metrics, when combined together, will be viewed differently by the value and growth investors. The value investor would be focused on long term competitive advantage, reputation of brand and relative current valuation of the company. On the other hand, the growth investor will care about past and future growth patterns regardless of 52 week price fluctuations and growth potential (revenue generation) of the company.
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