Identifying Bargains!
Here are some of the fundamental ways to size up a
stock.
How did legendary investor Warren Buffett make his
money? Charles Munger, vice chairman of Buffett's company
Berkshire Hathaway and a four-decade confidant, offers the
following clue: "The way to win is to work, work, work, work
and hope to have a few insights. How many insights do you
need? Well, I'd argue that you don't need many in a lifetime.
If you look at Berkshire Hathaway and all of its accumulated
billions, the top ten insights account for most of it."
This course can't offer Buffett-style insights, naturally; those
you need to come up with on your own. But we can describe
some of the basic ways that investors analyze stocks to
determine whether or not they are good buys. What follows is
an overview of some of the most common methods; we'll
have more to say about several of these in future Money 101
lessons.
Broadly speaking, there are two ways to approach stock
analysis: you can either look at the technical indicators for a
company, or at its fundamentals. We can't cover technical
analysis in detail here -- it deserves a lesson unto itself --
but in essence, it's a highly mathematical way of evaluating
investments. A technical investor might compare the
performance of a number of stocks over the past year or so,
for example, in order to find ones that appeared to be
breaking out of their recent trading ranges, and then buy
those issues in what amounts to a momentum play (see
"Different strokes"). Or she might construct a computer model
of the overall market and its relation to other economic
factors, such as industrial capacity utilization, currency
values or interest rates. The model would be set up to yield
"buy" or "sell" signals for the market as a whole or for
individual groups of stocks.
Properly used, technical analysis can be a very powerful tool
-- especially so for determining when to buy or sell. The
alternative approach, fundamental analysis, is pretty good for
helping determine what to buy or sell. Here, the aim is to look
at the fundamentals of a company and its business outlook in
an effort to identify those stocks to which Mr. Market has
assigned an unreasonably low value. Here are some of the
factors that investors may examine:
Price/earnings ratio. A stock's price divided by its
earnings per share. The higher the P/E ratio, the higher
the expectation that earnings will continue to grow at a
rapid pace. Traditionally, investors have looked at P/Es
based on the previous 12 months' profits, known as
trailing earnings. Today, though, investors commonly
cite P/Es based on the consensus analysts' forecast of
the next 12 months' profits, or forward earnings. The
rationale for this change is that forward P/E is a better
reflection of a stock's future value -- and that, after
all, is what you're buying when you invest in stocks.
But take care: all projections involve guesswork and
analysts frequently err on the high side when making
such forecasts.
Profit margins. Income divided by revenues. Good
margins for a software company might be 25 percent,
while 2 percent is considered fabulous for a grocery
chain. So when gauging a company's profit margin, be
sure to compare it with that of other companies in the
same industry.
Debt-to-equity ratio. A company's debt divided by
shareholder's equity (or the value of its assets after all
liabilities have been subtracted out). This ratio is often
used as a measure of a company's health: the higher it
is, the more vulnerable a company's earnings may be to
industry changes and swings in the economy.
Return on equity. Net income divided by shareholder's
equity, or, literally, how much a company is earning on
its money. This ratio can be used to show how a
company's earnings measure up against those of the
competition, as well as how they compare with past
performance. A rising return on equity (ROE) is a good
sign in that case, and a falling ROE is often a warning.
Price-to-book value ratio. A stock's price divided by
its so-called book value, expressed on a per-share
basis. The book value is calculated by adding up the
worth of everything the company owns and then
subtracting its debt and other liabilities. The
price-to-book ratio compares the price that investors
are willing to pay for the company to the value they
would receive -- at least in theory -- if the company
were totally liquidated. A service business that has few
hard assets is likely to sport a high price-to-book ratio,
while an auto maker, which probably owns a huge
amount of expensive plants and equipment, is likely to
have a low one. As with all ratios, this one is most
useful when looked at in the context of a particular
industry and a company's own history.
PEG and PEGY ratio. The PEG, or
price/earnings/growth, ratio is calculated by taking the
P/E ratio based on forward earnings and dividing by the
projected growth rate. Stocks with a PEG ratio of less
than one (meaning that they are trading at less than
their projected growth rate) are generally said to be
cheap, while a PEG ratio of 1.5 or higher indicates a
stock that may be overpriced. For stocks that pay a
substantial dividend, the PEGY ratio -- which is the P/E
divided by the projected growth rate *and* the
dividend yield -- may be an even better measure than
PEG alone. Keep in mind, though, that both PEG and
PEGY are highly speculative measures, as they are
based on projections and no one can really foretell the
future.
You can find measures like these at virtually any online
investing site. In fact, thanks to a proliferation of financial
data on the Internet, the average person today can tap into
information that would have been available only to
investment professionals 10 years ago -- and much of it is
free. Popular sources include the Personal Finance section of
America Online, Yahoo! Finance, Quicken.com, Investor.com,
Money.com, Fortune Investor and many brokerage and mutual
fund sites.
You might use these measures as a gauge to check on a
company that you hear described as a good investment. You
can also use them to search for stocks directly, using a
screening tool like those offered at many sites (Fortune
Investor and Microsoft Investor among them). Either way,
taken together with the latest news on a company (as
opposed to rumors flying around Internet message boards),
measures like these can give a rough idea of whether a stock
is cheap, fairly priced or overpriced compared to others in its
class. |
