Picking stocks in details

In post http://gtdinvest.blogspot.com/2007/10/picking-stocks.html I stated what should an investor look for. First of all an investor should make an investment plan, specifying how much he is going to invest per year, how long will he will invest and what return rate he expects. With these parameters, an investor should make an outline of his portfolio specifying industries to invest in. An investor could be a little emotional with this by excluding certain industries, but he mustn't be to emotional and exclude all but one (or two) industries. Also, an investor should have at least 30 different assets in his portfolio. The rationale for this is the reduction of risk. If one asset goes to zero (which is very unlikely), than an investor still have the remaining 97% of his investment. This means that in process of picking stocks an investor should first look at his portfolio and investment plan, and then to select a certain industry to invest in.

When a certain industry is selected, then an investor should select different stocks (the more of them the better) and to compare them one by one. In that process, favorites will emerge. How could we compare two different companies? There are a lot of parameters that one could take into account: EPS, P/E, PEG, P/S, P/B, Dividend Payout Ratio, Dividend Yield, Book Value, Return on Equity. The history of these parameters are also very interesting. Let's discus each one of them.


Earnings

Earnings is the after tax net income that company produces during a certain period (usually a quarter which is three months, or a year). This is a widely used indicator. Usually is compared to the prognosis of the management and independent analysts. Surpassing the prognosis significantly usually drives price up and vice versa. To summarize, earnings should be compared to the estimates of the management and the independent analysts. Comparing earnings with earnings of some other company doesn't mean anything. Big companies will have large earnings while small companies will have small earnings.

EPS - Earnings per Share

In order to somehow relate one company with another EPS is devised and is calculated as Net Earnings/Number of shares outstanding. Now we can see how much money each share generates. Greater EPS is better. EPS can be observed for different period of time, previous year, current year and the following year. In the first case, it is the actual data, while in other two cases it is a prognosis. The problem with EPS is in the fact that a company could generate the same amount of money with much less capital being more efficient and a better opportunity for buying. A good indicator for possible buying is the raising of EPS. An investor should be careful with earnings because that parameter could be "tuned up". As number of shares outstanding can differ from time to time, the weighted average number of shares could be used. For example if there were 1000 shares for the first nine months, and 2000 shares for the remaining three, average number of shares can be calculated as 1000x(9/12)+2000x(3/12) and that yields average number of shares 1250.


P/E - Price to Earnings Ratio

As mentioned above two companies cannot be compared neither using Earnings nor Earnings per Share. Let's say that the companies A and B have the same value 10,000$ and the same earnings 1,000$ and that company A has 10 shares and company B has 100 shares. That would give that EPS for the company A is equal 100 and for the company Bis equal to 10. We can see that although companies have the same value, EPS can differ a lot. That is the reason for introducing the Price to Earnings ratio as (Price per share)/(Earnings per share). Price to earnings ratio is usually labeled with P/E, and sometimes is called "earnings multiple" or just "multiple". The meaning of this parameter is how much do you pay for a single dollar of earning.

Let's look at the previous example. Company A has P/E = 1000/100 = 10. Company B has P/E = 100/10 = 10. That would mean that both companies have the same P/E ratio and that it takes 10$ to buy 1$ of earnings. Suppose that there will be the same earnings each year then it would take 10 years to return investment completely. Thus if we want to compare two companies having other important parameters equal we would chose the one with smaller P/E ratio i.e. the one that would return investment sooner.

Average P/E ratios for different industries can differ significantly, making comparison of two companies from different industries difficult. That is not a real problem because if we wish to maintain a portfolio, we are looking for appropriate investment in a certain industry. Average P/E ratio in the last century for the US equity is around 15. If there is unusual activity, it is possible to calculate P/E ratio that would take into account previous years.

What does it mean if a certain company has small P/E ratio (let's say 8)? It could mean several things: company is undervalued at this moment (consequently a good buy), or company is experiencing a great increase in earnings in that period. Also, it is possible that the price of stock is declining.

What does it mean if a certain company has high P/E ratio (let's say 30)? It could mean that the company is overvalued or company is experiencing a great decrease in earnings or that the price of stock is growing expecting increase in future earnings (that could be for example pharmaceutical or mining company).

PEG - Projected Earning Growth

This ratio is calculated as PEG = (Price to Earnings ratio)/(projected growth in earnings). PEG is based on projection, and therefore is a little bit subjective. Being based on P/E, PEGs for companies from different industries are different. Greater the projected growth in earnings, smaller the PEG, meaning "the smaller PEG the better".

P/S - Price to Sales

Price to sales ratio is calculated as P/S=(Share price)/(Revenue per share). Instead of P/S, abbreviation PSR is also used (Price to Sales Ratio). P/S gives us the information how much revenue generates each dollar. For example a Share price could be 100$ and Revenue per share could be 100$ yielding P/S = 1. Usually, the smaller P/S the better (one dollar of investment generates more revenue). P/S can differ for different industries. It is important to note that information about profitability of production of a certain company is not included in this ratio. A company could have small P/S but could be also unprofitable.

Book Value

Book value is the net value of a company (assets minus liabilities). Book value for itself doesn't mean a lot.

P/B - Price to Book

Price to Book ratio is calculated as P/B=(stocks capitalization)/(book value). Usually the lower P/B the better. This ratio is also dependent on industries. For example P/B for consulting firms is different then P/B for manufacture firms.

Dividend Payout Ratio

Dividend Payout Ratio is calculated as DPR = Dividends/(Net income). This ratio is the percentage of earnings paid to shareholders in dividends. Dividend Payout Ratio is usually used for estimation a good cash flow management.

Dividend Yield

Dividend Yield is calculated as DY = (Dividend per share)/(Share price). The greater the Dividend Yield the better. It should be noted that a profitable firm could decide not to payout dividends and to use profits for development. In that case Dividend yield is 0, but firm is still profitable.

ROE - Return on Equity

The Return on Equity is calculated as ROE = (Net income)/(Shareholder's equity). As other ratios ROE is also industry dependent but is useful to compare companies within the same industry. Usually the greater the ROE the better.

This is only a list of the most important ratios. An investor should do his homework and to check all parameters available before any investment made.