I’ve had hundreds of conversations with thousands of people over the last twenty years about stocks and in what direction they are headed. Every week, I read the latest financial publications, speak to financial professionals, and I’ve even gone as far as signing up with a few stock-picking services to help diversify my holdings and find the latest growth stocks. The honest answer, stock picking is really difficult. If I had a £1 for every time I had met a stock-picking expert over the last twenty years, I would be a wealthy man.
Sadly, the reality is that the average person doesn’t have much chance. Across the world, there are thousands of professionals with some of the best technology studying worldwide stocks. The chances of you, someone that spends a few minutes a day looking at stocks, is going to find or see something that somebody else hasn’t already spotted, and is therefore not already in the price, is very, very slim.
Consequently, most investors and most investment advice are concentrated around investing in funds run by professionals or index EFT’s that offer broad exposure to a range of assets. Yet many of us, after building a diversified portfolio, still have an itch to invest in companies that we think will hit it big. The question is how to spot those stocks before their values skyrocket.
Over the years I have had some cracking investments, however I which I had invested in Amazon back in the early 2000’s. If you had bought Amazon.com in early 2006 when the stock traded for about $45 just after Amazon Prime launched, and had held on to until now where the stock is trading for about $3,500 per shares, you’d have made more than 6,000%.
How to Analyse a Stock?
To evaluate whether a stock price is attractive and therefore a good buy, you need to understand the company’s intrinsic value from the bottom up. This usually involves examining a company’s historical financial statements.
Across the world, all publicly traded companies are required to publish their financial results each quarter. This allows investors an excellent opportunity to review a company’s expectations versus its actual performance and then decide whether to buy, hold, or sell. Typically, there are three places to find a company’s financial information, on their website, on Financial Websites such as Bloomberg, or through your investment platform.
What to Look For?
Judging whether a company is growing starts with its liquidity and profitability ratios. These ratios only have value when they’re compared to a benchmark, either a company’s direct competitors or an industry average, so make sure to have those handy.
For example, Square has a PE ratio of 332, which seems abnormally high compared to the PE ratio of Exxon Mobile, which has a PE ratio of 25, however, when you factor in the PE ratio for other high-growth technology companies in the USA, it’s actually comparable.
Liquidity ratios are fundamental for working out a company’s financial stability and, more specifically, its ability to pay off current debt obligations without raising external capital. Typically, there are three ratios that you need to think about, Quick Ratio, Net profit Margin and Return on Assets.
- Quick Ratio – is an indicator of a company’s short-term liquidity position and indicates its ability to instantly use its near-cash assets (assets that can be converted quickly to cash) to pay down its current liabilities. To work it out, you divide the companies current Assets by its Current Liabilities. You’re looking for a ratio higher than 1, which means a company can pay its debt, although the higher the ratio result, the better its liquidity and financial health.
- Net Profit Margin – shows how much money a company earns from every pound of sales. Its worked out by dividing a company’s Net Income by its Revenue and is typically expressed as a percentage. The larger the percentage, the more profit a company is making from its sales, and while a low-profit margin isn’t necessarily a bad thing, you need to see this number growing over time. A decreasing Net Profit Margin is not what you want to see.
- Return on Assets (ROA) – is a measure of how profitable a company is relative to its total assets. It gives an investor an idea of how efficient a company is at using its assets to make money. Typically, ROA is displayed as a percentage. The higher the percentage, the better, however like all ratios, it’s fairly meaningless on its own but very useful when compared to companies in the same industry.
Valuation ratios compare a company’s financial results to its price in the market and put some context behind the numbers. Like all Ratio’s, the individual number often means very little, however, compared to their competitors, the number can provide real insight into the performance of a company. Below are four valuation ratios that you need to be aware of before you buy a stock.
- Earnings Per Share (EPS) – are the total earnings of the company, divided by the number of outstanding shares in the company. Theoretically, the higher the EPS, the more profitable a company is likely to be, but it is more beneficial to compare its EPS against its competitors.
- Price to earnings ratio (PE) – is a quick and easy way to compare one company with another. It worked out by dividing the current share price by the annual earnings per share (EPS). While it is a quick and easy way to compare a company with another, it doesn’t incorporate the balance sheet and doesn’t consider debt hence why it’s most useful in conjunction with other metrics.
- Price to Sales Ratio (PSR) – is the company’s total capital divided by its annual Gross Sales. Typically, you’re looking for a low price to sales ratio, as this means that you’re paying less for each pound of sales a company makes. It’s a good ratio for growth stocks that have not made a profit, however just because a company has a low PSR doesn’t mean it’s a company to invest into as it does not consider any debt.
- Enterprise Multiple – is one of the best valuation tools for understanding a company’s actual valuation. To work out a company Enterprise Multiple, you must first understand its Enterprise Value which is calculated by taking its Market capitalisation + value of debt, minority interest, and preferred shares MINUS value of cash and cash equivalents. Once you have a valuation, simply divide its valuation by its EBITDA to get its Enterprise Multiple. Typically EM is a better valuation tool than a company’s PE as it considers debt and cash on hand. A company with a low Enterprise Multiple is regarded as a better investment because it reflects a low price for the company’s value.
A company that pays a dividend is a good thing as it shows financial stability. If a company is increasing its dividend payout consistently each year over a long time, it is even better as it shows financial stability and financial growth. To view companies in the S&P500 that have continually increased their dividend payouts each year for the last 25 years, look at the list of Dividend Aristocrats in the US or the UK Dividend Aristocrats, which is the same, but with the slight difference that companies only have to increase their dividend for ten years.
What’s important is that you watch out for companies with a high dividend yield, as this can mean that a company is getting desperate or it’s not investing in itself and will have problems in the future. What’s also important is that you realise that a company that temporarily cuts its dividend to secure more liquidity during challenging economic times isn’t necessarily bad and shouldn’t worry investors who are in it for the long-term.
To Buy or Not to Buy
Making money on the stock market is about finding a great company priced below its fair value. If a company is considered to be cheap amongst its peers, the assumption is that market prices will correct over time to reflect its actual value. When this happens, you’ll make a profit on your investment.
Two points to remember, the stock market is forward-thinking. It’s not what a company is doing today that is important; it’s what they will be doing in six months. If a company reports impressive results but says that it’s likely to struggle going forwards, the stock price will fall. If a company reports poor earnings, but its expectations for the future include new product lines or shifting market conditions, the price is likely to increase.
It also depends on the overall market. It’s very difficult for a company’s share price to increase if the overall market is going down. If you look at the most recent market correction, the FTSE100 went from a high of 7,674 on the 17th of January 2020 to a low of 5,190 on the 20th of March. During these two months, not a single company within the FTSE100 increased in value. Even if you had invested in the most under-valued company within the FTSE100, you’d still have lost money.
Stock picking is very difficult. There is a good chance that you’re going to buy a bunch of duds and a few winners along the way. As a result, it’s a good idea not to let your losers overrun your portfolio and only invest a small percentage of your portfolio in your stock picking experiments.