Tuesday, August 11, 2015

Stock Investing: Financials, Part II


When I left off discussing the numbers of a company you’re interested in adding to your portfolio, almost a month ago (sorry), I told you about some broad checks I do to ensure the company is in good shape, like Return on Equity, PEG Ratio, Total Debt, and 52-week Price Change. Now let’s drill a little deeper. Like in my previous Financials post, this information is all available and free for the taking, in Yahoo Finance.

First let’s look at the Current Share Price. This is not meaningful in and of itself--- a share can cost $10 or $200 or, in the case or Berkshire Hathaway A shares, over $215,000 apiece. Share price is not an indicator of value, though obviously there are few among us who have the cash to pay for a Berkshire A share. The only thing we care about the price of a stock is whether it’s not too inexpensive; we want to avoid “penny” stocks, which naturally are those under $1 per share, and anything too close to that level.

Penny stocks often are that price for a very good reason. And while there are those who like to dabble in stocks with tiny prices (5,000 shares for under $1500!? What a deal!) the truth is usually that something terrible has happened to the company and it is in danger of not only bankruptcy, if it’s not there already, but of being dropped, —delisted— from the major trading houses. Which means it becomes very hard to sell, even if the prices rises some. And more often than not, the prices stays down and even becomes worthless. Have you heard of Pets.com or Toys.com?

I like to find companies whose shares trade above about $7, which is most of the companies we’re talking about anyway. Less than that is just too close to the line for me and in those cases I frequently cannot get enough reliable information about the company, so I can’t make an accurate assessment of its market chances.

Market cap
Next up is Market Cap, or Market Capitalization. This is simply the total value of all currently outstanding shares in the company. Unless you know a founder or you’re in some other way personally very familiar with a particular company, I would urge you to keep your investments in companies with a market cap of at least $2 billion. Again, like share price, it is merely an indicator that the company has been around long enough, and available in the public markets long enough, that you—like any analyst or journalist or curious customer—can easily locate solid information.

Insider Holdings is a very useful metric, available of the Yahoo Finance Major Holders page. It tells you what percentage of the outstanding stock is held by founders or executives of the company. The higher this number the better. We want to invest in businesses whose leaders ride in the same boat we do and so are generally motivated by the things that we are. In most cases an executive with ownership of 1% or more will be incentivized more by his or her share ownership than a pay package when making key decisions which affect that business. Not to mention someone who owns that much of a big, publicly traded company likely has a passion for that business and will work extremely hard to see it succeed. Precisely what a passive shareholder wants to see.

Revenue Growth and Earnings Growth:
(For these you will, unfortunately, need to start calculating. This is where that Excel spreadsheet comes in handy. I just copy-paste a company's Balance Sheet, Income Statement, and Cash Flow Statements right off the web and onto a worksheet, then I can build formulas to track my metrics.)

What we want to know here is how quickly Revenue and Earnings— profits— are growing on an annualized basis. And I weight my figures so that last year and this year are getting more say in the rate calculation than 2 years ago. Here’s the formula for Revenue Growth:

      This Year Revenues                          This Year Revenues
      ------------------------------  x .65      +     -------------------------------   x .35   - 1
      Last Year Revenues                          2-years ago Revenues


and for Earnings Growth:

       This Year Earnings                           This Year Earnings
       -------------------------  x .65      +        ----------------------------   x .35     - 1
       Last Year Earnings                           2-years ago Earnings


Ideally, we want a business where revenues are rising at least 10%/year, and earnings are growing even faster than that, preferably more than 20%/year. Of course, there are some outstanding exceptions: Amazon, for example, has astounding revenue growth and virtually no earnings at all most of the time, as nearly everything is reinvested into the business to maintain massive growth… it’s a choice which, as a growth stock investor, I’m totally happy with. 

Relative Strength is a measure of how much the stock’s share price has risen in the last 6 or 12 months relative to a given set of other stocks—in other words, how much faster a particular stock is rising compared to others. The idea is that this is an indication of management skill or profit margins or manufacturer efficiency. The reality is that while it could indicate any of those things, likely as not it’s more a measure of what we now call “trending,” or the level of investor interest in a given company. A business that is hot in the market lately will likely have seen a greater price increase relative to its peers than another business. In any of these cases, we like fast price appreciation and we look for it.

It is an impossible number to calculate, as you need to determine the price increase rates of a whole pile of other stocks and then compare to the one you’re researching. Best bet: search for it online. Use the ticker symbol (AAPL for Apple, NKE for Nike, etc.) and then look for Relative strength. Often you can find some analyst’s take on the first try.

Finally, Cash Relative to Total Debt is just what it sounds like: how much cash and other liquid assets the company has on hand compared to all their debt. We want cash on hand to be the larger number—preferably 1.5 times bigger. To be fair, this pretty much rules out a lot of manufacturers and other capital-intensive businesses, such as airlines and shippers and so on. But you want to know regardless: can the company pay off debt anytime should a need arise?

Of course, there are many more ratios and calculations you can perform to help you determine your company’s strength, cash flow habits, financial priorities, growth rates and profitability. I urge you to play around on a couple of websites in addition to Yahoo Finance that are great for this sort of exploration:

The Motley Fool offers a wealth of information just by typing in a company ticker to the top-right corner search field of their home page, including common ratios (most of those listed on my blog), charts and graphs, and some comparison tools as well.

Nasdaq provides data about just about any stock traded in the U.S., both in and out of the Nasdaq trading exchange. Their home page has a search bar to enter any ticker you want and get, on the left margin, a page called Guru Analysis which will rate a particular investment opportunity filtered through the philosophy of a number of renowned investors, such as Benjamin Graham and Peter Lynch. And you’ll find a quick and easy visual guide to their own analysts’ take under Analyst Report.

Drifting to Fifty | Random unrelated nugget of the week
Short-term thinking— a need for instant gratification— is the source of a great number of our problems. If instead one approaches a consequential decision from the perspective of how her or she will feel about that choice a year from now, or 10 years from now, one will likely find greater satisfaction.

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