The single biggest trick to picking the right stocks is doing so when they’re trading at a discount to the sum total of their worth based on earnings, dividends, equity and debt – aka intrinsic value (IV).
Admittedly, avoiding paying too much for a stock is easier said than done. After all, unlike brokers and fund managers, you don’t have the resources to analyse companies across key criteria like growth, value, quality and timing.
Nevertheless, by understanding a handful of financial ratios and other key indicators, Romano Sala Tenna – co-investment manager of ASX-listed Katana Capital Limited – claims you can majorly improve your ability to buy the right stocks at the right price.
While no single piece of data should be looked in isolation, here’s a handful of criteria to give you a much better snapshot of any stock’s overall health. First the financial ratios.
- Price-to-Earnings Growth Ratio (PEG): A combination of the price-to-earnings (PE), divided by the prospective earnings-per-share (EPS) growth rate gives the PEG Ratio which measures the price of earnings growth. Ideally you should be looking for PEG less than one, Mr Sala Tenna says. “The lower the PEG ratio, the more a stock may be undervalued relative to its future earnings expectations.”
- Price to earnings (PE): Contrary to popular belief, it’s not a measure of absolute value, often raises more questions than it answers, and as such, Mr Sala Tenna adds, is commonly misunderstood by stock-pickers. However, a stock’s PE – current share price divided by EPS – provides a playing field for comparing different stocks within like or similar sectors. “More money is lost using a PE ratio than won,” he says. “What needs to be understood is why a PE is low, and the outlook for the next 12 months, otherwise you could end up buying value traps.”
- Payout ratio: As a percentage of net profit paid out as dividends, the payout ratio is an important indication of the sustainability of a company’s dividend, while providing clues into future growth upside. Ideally, Mr Sala Tenna wants to see a payout ratio less than 50 per cent, so that there’s surplus cash to grow the business.
- Return on equity (ROE): A key measure of how well management uses its equity, ROE is earnings (revenue minus expenses, taxes and depreciation) divided by equity. As long as debt remains modest, Roger Montgomery, the founder and CIO of Montgomery Investment Management, says there’s no better indicator of business performance. “It’s a way of determining whether or not every $1 used in financial growth is able to convert into $1 of market value,” Mr Montgomery says.
- Return on investment capital (ROIC): Measures the cash rate of return on capital a company has invested. In some cases, it’s modified by replacing earnings with earnings plus the interest on long-term debt. In this case, comparison with return on equity (ROE) determines whether the company benefited from the extra debt. So if return on equity (ROE) is higher than ROIC, adds Montgomery, the debt has succeeded in adding value to the business.
- Earnings per share (EPS) growth rate: Within normal markets, share prices typically increase if EPS increases. And the faster a company grows its EPS, the higher those earnings tend to be valued.
Now the more qualitative stuff
It’s important to overlay key financial ratios, Mr Sala Tenna adds, with some important measures of growth and value, and digging around in the annual report can provide valuable insights into:
- Management’s track record and their industry knowledge.
- Evidence of a sustainable competitive advantage. Without it, Mr Sala Tenna says, a company can’t generate long-term, above-market returns.
- Sales activity: How has the company’s revenue tracked over the long term?
- CAPEX, staff numbers and R&D: Is the company investing in future growth?
- Structural growth: Unlike cyclical growth, which is vulnerable to the economic cycle, you want to find out how much structural growth is being driven by what’s happening inside the business.