5 factors in evaluating stocks
Equities, stocks, shares – these are different terms for the same thing. When you buy them, you are effectively investing in a business. So, it’s much like investing money in, say, your friend’s restaurant business. If your friend’s restaurant business does well, you share in the profits through dividend payments to shareholders and through gains in the capital value of the business. If it fails, you could lose part or all your money.
But the advantage of buying small blocks of shares in a big company (versus a large share of a small restaurant) is the ability to sell on an open market. So, stocks are so-called “liquid assets”. A private business like a restaurant is a relatively “illiquid asset”.
Why are stocks so popular?
Despite the risks, stocks are arguably the most popular investment asset class in the world. And the biggest reasons are 1) that “liquidity” and 2) over the long-term, stocks are the most profitable major investment asset in the world, particularly in the so-called “developed markets”.
Over the period 1926 to 2016, US stocks registered compound annual returns of between 10% (for large companies) to 12% (for small companies). US Treasury bills earned only 3.4% per year. Inflation, on the other hand, eroded the real spending power of money by 2.9% a year.
Taking a shorter time frame, between 1998 and 2017, US$1 invested in US stocks would have registered compound annual returns of between 7% (for large companies) and 10% (small companies). US Treasury bills, returned only 1.9% a year. That is, their returns fell behind the inflation rate of 2.1% a year.
So, if you want to participate in what had historically been the most profitable asset class, here is a starting point to help you evaluate which stocks to buy:
1. Does the company have a good business model?
Are the products or the services offered by the company attractive? You would want to invest in a company whose products or services are in demand, have potential for growth, and can be delivered/provided in a profitable manner.
2. Is there a simple indicator of the strength of the business model?
A thorough understanding of the business is always better – that is, it is always better to understand factors such as the company’s product/service, the competition, barriers against competitors, the regulatory environment, and the management’s ability.
But one indicator of the strength of the business is the returns on equity or “ROE”. That is the net profit of the business divided by the business’ shareholders equity. This measures how much profit your capital is earning per year in the business.
The long-term average ROE for US stocks is around10%. But ROE can fluctuate very widely, depending on 1) the stage of the market cycle, 2) the industry sector, 3) the country/market.
So, in looking at the ROE, do compare that against the industry/sector average in that particular country/market. But there is a rough rule of thumb that the ROE should be higher than the “WACC” or “weighted average cost of capital”. WACC is the average percentage cost of debt and capital combined.
3. Does it have a healthy balance sheet?
A strong – or at least a healthy – balance sheet is important to help companies survive short-term challenges and adversities.
Look at indicators such as the debt to equity ratio (equity on the balance sheet is defined as total assets minus total external liabilities) and the current ratio.
Although debt to equity ratios vary depending on the industry, a rough rule of thumb is you should be a bit wary if it is over 1.5 and you would want to ask some hard questions if a company has a debt to equity ratio over 2. The current ratio is the current assets divided by current liabilities. Anything below 1 warrants a very careful investigation. The higher the figure above 1, the more comfortable the company will be in meeting short-term liabilities.
4. Is the stock reasonably valued, undervalued or overvalued?
Compare valuation ratios with similar companies in its industry. The two most commonly used valuation ratios are the Price to Earnings Ratio (PE Ratio) and the Price to Book (PB Ratio). These are known as “relative valuation” ratios.
The PE ratio is the price of a stock divided by either the forecast coming year earnings per share (prospective PE) or the immediate past year’s earnings per share (historic PE). So, if you’re using the price to historic earnings, then compare the company’s historic PE with those of similar companies in the same industry. Generally, the lower the better.
The Price to Book ratio (PB Ratio) is the price of the stock divided by the company’s book value per share. The book value is the net asset value of the company.
Again, the PB ratio investors should pay is relative. It is relative to the industry and comparable companies. It is easy and common to say “lower is better”. But sometimes when both PE ratios and PB ratios are very low, you should go back and look at the business model and the balance sheet. Are valuations low because of cyclical factors? Or are they low for structural reasons? Cyclical reasons will likely pass. Structural problems in the company – such as an out-dated product or service or bad management – could result in long-term poor performance of the share price or even corporate failure.
5. What are the stock’s earnings growth prospects?
Even if a stock appears expensive on its current PE ratio, a high and sustainable earnings growth rate can make the stock look cheap in a few years. That is, the PE ratio that you bought at would be reduced by the growth in the denominator “E” or earnings.
That is why often when investors look at the PE ratio, they also look at the earnings growth rate, “G”. Hence a commonly used ratio called “PEG”, or PE/Earnings growth. And a common benchmark is “1”. PEG ratios of below one are regarded as attractive and the more they go above “1”, the less attractive they appear.
How do ordinary investors get information to evaluate stocks?
If you are trading online, the trading platform should offer clients access to stock research.
DBS Bank, for example, offers access to research through various platforms such as DBS Vickers Online and through the bank’s various websites.
Through DBS Vickers Online you can obtain company specific information such as the stock’s PE Ratio, its earnings per share, dividend yield, balance sheet, profit trend, cash flow information, and in-house research by searching for the stock under the “Markets, News and Research” tab. As with other trading platforms, you need to have an account to access this information.
If you do not have an account, you can stay updated on major developments in Asia’s economic activity, policy, equity, and other areas through DBS Research.
In addition to these resources, the SGX website also provides information about companies under its StockFacts page.
For example, a search for Singapore Telecommunications Limited will lead you to a page which provides useful information on valuation ratios such as Price to Book and Price to Earnings; dividend yields; and balance sheet information including the ratios discussed above.
Lastly, don’t miss out on the classes and seminars that you can attend to learn more about investing. Do check out the new initiative FLY (Financial Literacy for You), a collaboration between DBS and SGX, that puts financial education and resources at your fingertips.
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