Five factors in evaluating stocks

Five factors in evaluating stocks

For all the risks involved, stocks are arguably the most popular and accessible asset class to invest in globally.

This boils down to:

  1. Liquidity – they are easy to buy and sell
  2. In the long-term, stocks haven proven to be the most profitable major investment asset in the world, particularly in developed markets.

Over the period 1930 to 2019, the S&P 500, a collection of the 500 largest stocks by market capitalisation on the New York Stock Exchange, registered a compound annual return of 11.84%. US Treasury bills earned only 3.4% per year. Inflation, on the other hand, eroded the real spending power of money by 3.04% a year.

Taking a shorter time frame, between 2000 and 2019, US$1 invested in S&P 500 stocks would have registered compound annual returns of 8.22%. Meanwhile, US Treasury Bills (T-Bills) only returned 1.61% a year. Taking inflation for the period into account, returns on T-Bills would be negative at -0.59% a year.

Five factors in evaluating stocks

Understanding stocks

Equities, stocks and shares essentially carry the same meaning; they represent an ownership in a company or a business. Simply put, it is similar to investing in your friend’s restaurant. If the business is thriving, you benefit through receiving a share of profits through dividend payments. You also gain from a higher capital value of the business. The restaurant is representative of a private company.

On the other hand, public companies are those that raise funds by selling its stock through a stock exchange like the Singapore Exchange or the New York Stock Exchange. DBS is one example of a public company.

Investors of public-listed companies can buy and sell shares of these firms through stockbrokers like DBS Vickers Securities, among others. Stock exchanges track the supply and demand of each company's stock and these mechanics ultimately determine a company’s stock price.

Given that stock prices fluctuate across each trading day, it may lead some to consider them as very high-risk investments. However, long-term investors often look over the near-term volatility of stock prices and focus on the growth prospects of a company.

That said, do remember that all investments come with risks. In extreme cases, companies can lose substantial value or go out of business completely. If this happens, you could lose a large amount or all of your investment. This is why it is important that you not put “all your eggs in one basket” and instead work toward spreading your risk through diversification.

But there is an advantage of buying small blocks of shares in a big company, instead of a large share in a single restaurant. Big companies or blue-chip firms are considered “liquid” assets to hold as they are more easily sold in the open market. A private business like a restaurant is relatively “illiquid” as it is harder to find buyers for your stake if you choose to sell.

Five factors in evaluating stocks

Factors to consider

As investors, learning how to evaluate a stock is very important. If you are keen to participate or build your exposure to what has historically been the most profitable asset class, here are 5 things to consider when evaluating which stocks to buy:

1. Does the company have a good business model?

As with all investments, one important question to ask yourself before investing is: Are the products or the services offered by the company attractive?

This simple question can go a long way to understanding whether a company makes a good investment or not. We all want to invest in a company who produces products or offers services that are:

  1. In demand
  2. Have potential for growth
  3. Can be delivered/provided in a profitable manner

Alternatively, you may be more interested in accumulating dividend income. Such companies or entities tend to have less volatile share or unit price movement, making them more “stable”. These companies often have less avenue for growth but are typically profitable and dole out regular dividend income to shareholders.

As with most things in life, having balance is key. As such, many investors prefer to have a blend of both. By owning higher growth companies (they usually have strong positive cash flows or earnings) in a portfolio, investors are able to capture above average growth rates compared to the overall economy.

On the other hand, balancing them with dividend plays in a portfolio allows investors to capture a constant stream of recurring income.

Barbell investment approach

With the current volatile investment climate, geopolitical uncertainties, the Covid-19 outbreak and low interest rates, adopting a barbell-type approach to building up one’s portfolio can be useful in boosting resilience in a challenging period.

This is a strategy advocated by DBS CIO Office and it positions investors to capture superior returns from long-term, irreversible growth trends on one hand, while generating stable income on the other hand to mitigate short-term market volatility.

A summary of the DBS Barbell Portfolio Strategy can be found here

 

2. Is there a simple indicator of the strength of the business model?

The more an investor understands a company’s business model and its strengths, the better. You should have a thorough understanding of these factors:

  1. The company’s product/service
  2. Its competition
  3. Barriers to entry for its industry
  4. Its management’s performance
  5. The regulatory environment 

Return-on-equity ratio

You can also make use of financial ratios to get a sense of the strength of a business such as the return-on-equity (ROE) ratio.

Simply put, ROE measures the level of profitability of a company in relation to the value of the shares (equity) owned by its shareholders.

Five factors in evaluating stocks

ROE is calculated by taking a company’s net income (or net profit) divided by its shareholders equity. Whereby,

Five factors in evaluating stocks

As such, ROE is also considered the return on net assets of a company and measures how much profit your capital is earning per year in the company.

The long-term average ROE for the S&P 500 is around 14%. Given that the figure is an average, ROEs can fluctuate widely among companies, and is dependent on these three factors:

  1. Stage of the market cycle
  2. Industry sector
  3. Country/market

You can gauge whether you deem a company’s ROE to be good or bad when comparing with its peers – companies of similar size operating in the same industry sector – and its industrial average.

It is important that you are aware of why different industries have different average ROE values.

For example, utilities and telecommunications companies have comparatively higher level of assets and debt in relation to their net income. As such, investors can expect ROE values for such sectors to be lower. In contrast, tech firms which usually have smaller balance sheet accounts relative to net income may have ROE levels north of 20%.

So, when looking at the ROE of a particular company that you are interested in, do compare that against the industry/sector average in that particular country/market. Doing so should give you a sense of whether a company is under- or over-valued compared to its peers.

A general rule of thumb is that ROE should be higher than the weighted average cost of capital (WACC).

Five factors in evaluating stocks

WACC is used to calculate a company’s cost of capital. In other words, WACC is the minimum a company must earn in order support its assets and satisfy its debt obligations.

While companies calculate their own WACC to assess their health, the figure is not usually found in financial statements. Instead, investors can look to analyst reports for an estimated WACC that has been calculated.

Five factors in evaluating stocks

3. Does it have a healthy balance sheet?

Having a basic understanding of a company’s balance sheet helps you to assess its financial health based on how much it owns, owes and the amount shareholders invested.

The balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity at a particular reporting period (e.g 3Q 2020 or FY2020).

A strong – or at least a healthy – balance sheet is important in informing investors of whether a company is likely to survive short-term challenges and adversities.

When evaluating a company, the balance sheet is used together with the Income Statement and Statement of Cash Flows to derive financial ratios for stock analysis.

Debt-to-equity ratio

A number of ratios can be derived from the balance sheet. The first of which is the debt-to-equity (D/E) ratio, which shows the extent to which a company is financing its operations through debt against shareholders’ equity. In other words, it measures a company’s leverage.

The D/E ratio is expressed as:

Five factors in evaluating stocks

The value of total liabilities and shareholders’ equity is easily found on a company’s balance sheet. You may have also noticed that the ROE and DE ratios share the same denominator in shareholders’ equity.

Here is a breakdown of what the value of DE ratios means:

Value of D/E Ratio

What it means

< 1 Most of a company’s assets are funded by equity
1 A company’s assets are equally funded by debt and equity
> 1 Most of a company’s assets are funded by debt

A company is less leveraged by debt (or more by equity) if its D/E ratio falls over each quarter or year. On the flipside, if a company’s D/E ratio is growing larger each reporting period, it is becoming more highly leveraged by debt.

From here, you can gather that a company with a higher D/E ratio is likely to be a riskier investment as it has been financing its growth aggressively through debt.

Like ROE, D/E ratios are dependent on industry sector. Overall, the rule of thumb is that you should be a bit wary if the D/E ratio is over 1.5. You might want to ask some hard questions if a company has a D/E ratio of over 2.

This might not apply if a highly leveraged company is able to post earnings increases by a greater amount than the cost of its debt because shareholders can expect to benefit in this case.

Current ratio

Another ratio to take note of is the current ratio, also known as the working capital ratio.

It is a liquidity ratio that measures a company’s ability to meet its short-term (usually due within a year) debt obligations. This ratio is often used by prospective lenders to decide whether they should lend to the company in the short term.

The current ratio is also an indication of a company’s ability to manufacture its products or provide services and turn them into cash.

It is expressed as:

Five factors in evaluating stocks

Both variables are easily found in a company’s balance sheet.

Here is a breakdown of what the value of current ratios means:

Value of Current Ratio

What it means

< 1 A company might have issues meeting its short-term debt obligations as current liabilities exceed current assets.
1 ≤ current ratio ≤ 3 A company is using its assets or financing efficiently while being able to meet short-term obligations. This is a healthy range.
> 3 If the value is too high, it might suggest a company might not be using its assets or financing efficiently.

Similar to the D/E ratio, acceptable current ratios vary from industry to industry. Generally, if a company’s current ratio is in line or in the region of the industry average, it is considered acceptable.

A current ratio that is lower than the industry average may indicate a higher risk of distress or default. Similarly, if a company has a very high current ratio compared to its peer group, it indicates that management may not be using its assets efficiently.

Lenders tend to prefer a company with a higher current ratio over one with a lower current ratio. This is because a higher current ratio indicates that the company is more likely to meet its short-term liabilities.

Five factors in evaluating stocks

4. Is the stock reasonably valued, undervalued or overvalued?

Another way you can compare companies is through using relative valuation ratios. By calculating such ratios, you can assess a company’s value by comparing its value relative to its peers (or competitors). There are two commonly used valuation ratios.

Price-to-earnings ratio

The best known of these two relative ratios is the Price-to-Earnings (P/E) ratio, which measures a company’s current share price to its earnings per share (EPS). This ratio is also known as the earnings multiple.

The P/E ratio can be calculated by:

Five factors in evaluating stocks

You can also use the ratio to compare a company against its previous valuations or to compare one market to another. The ease of application is one of the reasons why the P/E ratio is one of the most commonly used ratios in financial analysis.

Like the other ratios discussed previously, P/E ratios have different averages per industry sector and as such, an investor should use this metric to compare companies who ply their trade in the same sector.

A high P/E ratio might indicate a stock’s price is high relative to earnings and also suggests that a stock is overvalued. However, this might not make a stock a bad buy, especially if growth prospects of a company are huge.

The P/E ratio can be measured as a trailing (it considers recent EPS, usually in the past 12 months) or forward (based on forecasted EPS) ratio.

For example, if the shares of Company A are trading at $20 and EPS for the most recent 12-month period is $0.40, then the trailing P/E ratio of Stock A is 50. Assuming profits stay constant, it would take 50 years to regain its share price.

If you believe a company has reported its past financial performance accurately but not its future performance, a trailing P/E can be used. When using a trailing P/E, remember to compare a company’s trailing P/E with those of similar companies in the same industry.

That said, using trailing P/E has its fair share of limitations. This is because investors are often forward-looking and are committing their funds based on future prospects of a company, not past performance. Furthermore, share prices fluctuate constantly while EPS stays the same for the period. As such, a trailing P/E might not be an accurate valuation measure when a company’s stock moves drastically up or down.

Using a forward P/E ratio has its own set of pros and cons. It may be more forward-looking as it is based on forecasts but there is room for overestimation or underestimation of future performance. When using forward P/E, bear in mind that you should do due diligence and research companies extensively. Moreover, forward P/E will change each time a company updates its guidance.

Price-to-book ratio

The Price-to-Book (P/B) ratio is a commonly used valuation ratio. It measures the market value of a company relative to its book value, which is the total value of assets on a company’s balance sheet.

It is expressed as:

Five factors in evaluating stocks

The book value is essentially the net asset value of the company.

Again, the P/B ratio investors should pay is relative. It is relative to the industry and comparable companies.

Theoretically, if a stock has a P/B ratio of 1.0, it is “fairly valued”. In other words, when all assets in a company are liquidated and debts are paid, the price of the stock will be same as its book value.

The P/B ratio is handy when used for companies with high tangible assets (physical assets) but is not as reliable in evaluating companies with more intangible assets like technology firms.

When both P/E ratios and P/B ratios are far lower than their historical averages, you should go back and look at the business model and the balance sheet.

After viewing a company’s P/E and P/B ratios, some questions you can ask yourself are:

  1. Are valuations low because of cyclical factors?
  2. Are they low for structural reasons?

Cyclical reasons will likely pass. However, structural problems in the company – such as an out-dated product/service or bad management – could result in long-term poor performance of the share price or even corporate failure.

Five factors in evaluating stocks

5. What are the stock’s earnings growth prospects?

Even if a stock appears expensive on its current P/E ratio, a high and sustainable earnings growth rate can make the stock look cheap in a few years.

That is why often when investors look at the PE ratio, they also look at the earnings growth rate.

Price-to-earnings-to-growth ratio

As such, analysts and investors alike turn to using the Price-to-earnings-to-growth (PEG) ratio. In many ways, it is considered an improvement over the commonly used PE ratio as it measures the relationship between the PE ration and growth estimates of a company.

Here is how the PEG ratio is calculated:

Five factors in evaluating stocks

An advantage of the PEG ratio is its use of a trailing PE ratio while considering the future growth of a company. This way, a more reliable estimate of a company’s performance can be made. When using the PEG ratio, a value of 1 suggests that a company is fairly valued. PEG ratios of less than 1 are regarded as attractive as they could be undervalued. On the other hand, if the PEG ration is more than 1, the company is said to be overvalued.

Five factors in evaluating stocks

How do retail investors get information to evaluate stocks?

DBS Bank, for example, offers access to research through various platforms such as DBS Vickers Online and our Research website.

Through DBS Vickers Online you can obtain company specific information such as the stock’s PE ratio, its EPS, 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 on 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 PB and PE; 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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Disclaimers and Important Notice
This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.

All investments come with risks and you can lose money on your investment. Invest only if you understand and can monitor your investment. Diversify your investments and avoid investing a large portion of your money in a single product issuer.

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