After studying the basic knowledge of stocks, it's time to participate in capitalism now.
In today's global economy, weeding through vast amounts of information to arrive at an investment conclusion is very difficult. But there are steps you can take to create a screening process to help sift through the large universe of ideas and arrive at a manageable number that merit further investigation. Here, we'll take you through those steps.
Step 1: The Broadest View
Some investors start their search with an industry or theme that has compelling drivers for growth but is currently out of favor. As an example, prospects for growing household formation led some investors to favor building stocks after the real estate crash of the early 1990s. Others look for industries that are strong but still have room to grow based on their positive long-term fundamentals. With the aging baby boomer population, healthcare has been such a theme in the 2000s. Choosing a theme can be a first step toward creating a smaller universe of stocks.
Step 2: Company Statistics
Once a theme is established, whittling down the potential universe of stocks is necessary. Many investors have a particular company size they are comfortable with. Market capitalization of the firm, calculated by multiplying the number of shares outstanding by the current stock price, is a common measure of company size. Generally, firms are categorized as micro-, small-, mid- and large-capitalization, depending on the outstanding value of their stock. Most investors are familiar with the large-cap companies that are household names, such as General Electric (NYSE:GE), Proctor and Gamble (NYSE:PG) and Pfizer (NYSE:PFE). However, some themes focus on more obscure segments of the market where only smaller companies participate, such as ethanol or modular rental companies.
After narrowing the potential list of companies by market capitalization, investors may review company characteristics, including growth prospects. If a company or industry is in the early stages of the business or product life cycle, investors generally expect very high growth in sales, earnings, or other relevant numbers. More mature companies are expected to display slower growth, but at a steadily rising rate. Growth also plays a role in dividend payments. Younger or high-growth companies usually reinvest free cash flows back into the company, while more mature companies may choose to use cash flow to pay above-average dividends.
Other components of a screen focus on a company's financial position through financial ratios, such as liquidity ratios, debt ratios and profitability ratios. Liquidity ratios generally look at a company's cash and short-term asset position relative to its short-term liabilities and its ability to meet its short-term obligations, particularly working capital. Debt ratios generally look at a company's ability to service its debt obligations and the size of a company's debts relative to its equity or assets. Finally, profitability ratios provide information about the return on assets employed, dollars invested, or equity held.
Another screen includes stock valuation parameters that help investors determine whether a stock price is attractive relative to the company's earnings, assets, book value, and other characteristics. Common valuation multiples include price-to-earnings (P/E), price-to-sales (P/S), price-to-book (P/B) and enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA).
Step 3: Constructing the Screen
There are several professional software packages for screening, and some brokerage firms and public websites also offer much of this information. To construct a screen according to the above criteria, investors first need to determine investment goals, particularly time horizon, tax implications and risk tolerance. Once goals are determined, investors can choose the criteria parameters used in the screen.
Example 1
A 22-year-old investor just landed his first job out of college and wants to put some graduation gift money into some stocks. He has a long time horizon, wishes to minimize taxes, and has a high risk tolerance. He feels comfortable with an early-stage company that offers high growth potential over the long term, but also higher risk than a more mature company. His screening criteria focus should be the following:
Early-stage industries
High revenue growth
Smaller market capitalization (less than $1 billion)
Ratios: early stage companies generally have unattractive ratios as they seek capital and spend more than they have to launch the business
Valuation: generally only price-to-sales is a possible measure as earnings are typically negative
Example 2
A recently retired man with no dependents other than a spouse and no long-term debt generally has a lower risk tolerance and needs to ensure his savings will last through the remainder of his life. This investor feels more comfortable with mature companies with lower growth potential. His screening criteria should focus on the following:
Mature industries
Low- or no-growth companies
Larger market capitalization
Ratios: strong liquidity and low debt ratios, high return ratios
Valuation: generally any ratio fits, but using P/E, P/B or EV/EBITDA are common; this investor should seek low multiples and high dividend yields
Step 4: Narrowing the Output
Even after the use of screens, many companies may still fit your criteria. Narrowing the list requires some further scrutiny about the particular companies, such as one's comfort level with the industry, or personal or social concerns. When the field is narrowed sufficiently, it is time to perform deep analysis of the company using all publicly available information, including Securities and Exchange Commission (SEC) filings and company or investor websites.
Conclusion
While an abundance of information and options can make investing overwhelming, understanding your investment goals and constructing a screen based on those goals will help you select stocks that meet your needs. However, it is important to remember that these screening steps, while narrowing down the list of potential investment candidates, are no replacement for in-depth fundamental analysis.
Showing posts with label Price-to-book (P/B). Show all posts
Showing posts with label Price-to-book (P/B). Show all posts
2009-03-14
Understand What kind of stock investors you are?
One of the first things to understand about buying stocks is that what you buy is in some ways a function of who you are. If you're an optimist, growth investing might be for you. Long on patience? Value investing may be the better fit.
Individual investors generally fall into one of three categories: growth investors, value investors or dividend investors.
Growth
A stock's price often reflects how profitable investors think a company will be in the future. So most investors follow a growth strategy, which means that they look for companies with strong prospects for growing their sales and earnings. Definitions vary, but stocks expected to increase their sales (and their net income) from one year to the next by at least 15% generally qualify as growth stocks.
Value
Value investors follow a different path. They believe that the broader stock market always overreacts to news about a company. They seek out formerly hot stocks that have stumbled and whose share prices are at bargain levels.
Being cheap, though, isn't enough by itself. Value investors try to zero in on stocks that were beaten down due to temporary problems that can be fixed.
Dividends
Dividend investors buy stocks that pay a cash dividend based on the number of shares you own, usually on a quarterly basis. Unlike value and growth investors, who only make money when they sell, dividend investors get paid while they hold the stock.
Thus, dividend investors buy stocks as much for the income as they do for capital appreciation (which is what you get when you sell a stock at a higher price than you paid for it). Dividend investors look for financially solid companies with the wherewithal to continue paying their dividends, regardless of what's happening in the economy.
Putting a price on a stock
How do you know whether a stock is a value or priced for growth? Most investors rely on certain ratios that compare a stock's price to the underlying company's results.
The most commonly used valuation ratios are:
Price-to-earnings (P/E): This is a company's stock price divided by how much it earns per share over 12 months (expressed as earnings-per-share, or EPS). Most often, the EPS used is the most recent 12 months' earnings. Another way to calculate P/E is by using the consensus of Wall Street analysts' forecasts for a company's earnings in the current fiscal year. P/E is the most widely used valuation gauge.
Price-to-sales (P/S): A company's stock price divided by the most recent 12 months' sales-per-share. Some investors favor P/S over P/E because sales don’t vary as much as earnings from quarter to quarter. Another advantage is that you can calculate P/S, but not P/E, when a company loses money in a quarterly or annual reporting period.
Price-to-book (P/B): Also called book value, this is a company's assets minus its liabilities. A P/B ratio divides a company's stock price by its book value per share. Value investors tend to favor P/B.
There is no universal agreement on ratio values that define value or growth. Here’s my simplified take.
Defining value and growth
Ratio Value Growth Overpriced Growth
P/E Less than 15 More than 20 More than 50
P/S Less than 2.5 More than 3 More than 10
P/B Less than 3 More than 5 More than 15
Stocks with valuations in the gaps between the value and growth definitions -- say, a P/E of 18 and a P/B of 4 -- could be in either category, depending on the circumstances. Valuations in the Overpriced Growth column define stocks that many investors would consider overpriced.
But remember, your research doesn't end with these ratios. Figuring out whether a stock is worth buying is another task. A stock may be a value in terms of price, but its price may be depressed because something is seriously wrong. These ratios can help you understand whether a company's shares are cheap or expensive. If they are cheap, and you've done your work trying to find out why, then they may be attractive as a buy.
Individual investors generally fall into one of three categories: growth investors, value investors or dividend investors.
Growth
A stock's price often reflects how profitable investors think a company will be in the future. So most investors follow a growth strategy, which means that they look for companies with strong prospects for growing their sales and earnings. Definitions vary, but stocks expected to increase their sales (and their net income) from one year to the next by at least 15% generally qualify as growth stocks.
Value
Value investors follow a different path. They believe that the broader stock market always overreacts to news about a company. They seek out formerly hot stocks that have stumbled and whose share prices are at bargain levels.
Being cheap, though, isn't enough by itself. Value investors try to zero in on stocks that were beaten down due to temporary problems that can be fixed.
Dividends
Dividend investors buy stocks that pay a cash dividend based on the number of shares you own, usually on a quarterly basis. Unlike value and growth investors, who only make money when they sell, dividend investors get paid while they hold the stock.
Thus, dividend investors buy stocks as much for the income as they do for capital appreciation (which is what you get when you sell a stock at a higher price than you paid for it). Dividend investors look for financially solid companies with the wherewithal to continue paying their dividends, regardless of what's happening in the economy.
Putting a price on a stock
How do you know whether a stock is a value or priced for growth? Most investors rely on certain ratios that compare a stock's price to the underlying company's results.
The most commonly used valuation ratios are:
Price-to-earnings (P/E): This is a company's stock price divided by how much it earns per share over 12 months (expressed as earnings-per-share, or EPS). Most often, the EPS used is the most recent 12 months' earnings. Another way to calculate P/E is by using the consensus of Wall Street analysts' forecasts for a company's earnings in the current fiscal year. P/E is the most widely used valuation gauge.
Price-to-sales (P/S): A company's stock price divided by the most recent 12 months' sales-per-share. Some investors favor P/S over P/E because sales don’t vary as much as earnings from quarter to quarter. Another advantage is that you can calculate P/S, but not P/E, when a company loses money in a quarterly or annual reporting period.
Price-to-book (P/B): Also called book value, this is a company's assets minus its liabilities. A P/B ratio divides a company's stock price by its book value per share. Value investors tend to favor P/B.
There is no universal agreement on ratio values that define value or growth. Here’s my simplified take.
Defining value and growth
Ratio Value Growth Overpriced Growth
P/E Less than 15 More than 20 More than 50
P/S Less than 2.5 More than 3 More than 10
P/B Less than 3 More than 5 More than 15
Stocks with valuations in the gaps between the value and growth definitions -- say, a P/E of 18 and a P/B of 4 -- could be in either category, depending on the circumstances. Valuations in the Overpriced Growth column define stocks that many investors would consider overpriced.
But remember, your research doesn't end with these ratios. Figuring out whether a stock is worth buying is another task. A stock may be a value in terms of price, but its price may be depressed because something is seriously wrong. These ratios can help you understand whether a company's shares are cheap or expensive. If they are cheap, and you've done your work trying to find out why, then they may be attractive as a buy.
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