Don't be a stockpicking monkey, mistaking skill for luck. Learn DCF and PER 101.

Don't be a stockpicking monkey
Greg Hoffman
March 21, 2011 - 12:06PM

Monkeys are great stockpickers. Had your common-or-garden variety primate randomly selected five stocks in March 2009, chances are it would now be sitting on huge capital gains, contemplating reinvesting them in bananas - by the truckload.

It's easy enough for us to see that our monkey, who now sees himself as a future fund manager, is mistaking skill for luck. What's harder for us to see is how we might be making the same mistake ourselves.

If examining your portfolio's returns over the past few years engenders in you a feeling of self-satisfaction, you're running that risk. With the sharemarket falling recently now is the time to educate yourself. Consider what follows a lesson in fire safety.


Value investing is theoretically simple: buy assets for less than they're worth and sell when they approach or move beyond fair value. So too are valuing assets: discount future cash flows back to today at an appropriate interest rate for the life of the asset. The discounted cash flow (DCF) model is a commonly-used tool, hammered into every finance and business student.

But DCF models quickly deteriorate when they meet a rapidly changing world. The fact that most analysts failed to consider the impact of falling US house prices on their models played a major role in triggering the global financial crisis. Worse still, the misleading precision imbues investors with unwarranted overconfidence. Too often, models are precisely wrong.

Other tools are available to help you avoid this error. The price-to-earnings ratio (PER) is a regularly used proxy for stock valuation but also one of the most overused and abused metrics. To make use of it you need to know when to use it and when not to.

PER 101

The PER compares the current price of a stock with the prior year's (historical) or the current year's (forecast) earnings per share (EPS). Usually the prior year's EPS is used, but be sure to check first.

Last financial year, XYZ Ltd made $8 million in net profit (or earnings). The company has 1 million shares outstanding, so it achieved earnings per share (EPS) of $8.00 ($8 million profit divided by 1 million shares). In the current year, XYZ is expected to earn $10 million; a forecast EPS of $10.00.

At the current share price of $100, the stock is therefore trading on a historic PER of 12.5 ($100/$8). Using the forecast for current year's earnings, the forward or “forecast PER” is 10 ($100/$10).

It's often said that the PER is an estimate of the number of years it'll take investors to recoup their money. Unless all profits are paid out as dividends, something that rarely persists in real life, this is incorrect.

So ignore what you might read in simplistic articles and note this down: a PER is a reflection not of what you earn from a stock, but “what investors as a group are prepared to pay for the earnings of a company”.

All things being equal, the lower the PER, the better. But the list of caveats is long and vital to understand if you're to make full use of this metric.

Quality usually comes with a price to match. It costs more, for example, to buy handcrafted leather goods from France than it does a cheap substitute from China. Stocks are no different: high quality businesses generally, and rightfully, trade on higher PERs than poorer quality businesses.

Value investors love a bargain. Indeed, they're defined by this quality. But whilst a low PER for a quality business can indicate value, it doesn't alone guarantee it. Because PERs are only a shortcut for valuation, further research is mandatory.

Likewise, a high PER doesn't ensure that a stock is expensive. A company with strong future earnings growth may justify a high PER, and may even be a bargain. A stock with temporarily depressed profits, especially if caused by a one-off event, may justifiably trade at a high PER. But for a poor quality business with little prospects for growth, a high PER is likely to be undeserved.

Common trap

There's another trap: PERs are often calculated using reported profit, especially in newspapers or on financial websites. But one-off events often distort headline profit numbers and therefore the PER. Using underlying, or “normalised”, earnings in your PER calculation is likely to give a truer picture of a stock's value.

That begs the question; what is a normal level of earnings? That's the $64 million dollar question. If you don't know how to calculate these figures for the stocks in your portfolio, now is the time to establish whether it's skill or luck that's driving your returns. And if you don't know that, history may well make a monkey of you.



Greg Hoffman is research director of The Intelligent Investor.

http://www.brisbanetimes.com.au/business/dont-be-a-stockpicking-monkey-20110321-1c32p.html

Calculate investor ratios

Investor ratios are used by existing and potential investors of mostly publicly listed companies.  They can be obtained or calculated where necessary from publicly available information.


EARNINGS PER SHARE (EPS)

This is a popular profitability statistic used by financial analysts.  'Earnings available for distribution' is bottom-line net profit attributable to shareholders after all other costs have been deducted.  Many remuneration packages are linked to EPS growth.

EPS = Earnings available for distribution /  Number of shares in issue



PRICE/EARNINGS (P/E) RATIO

The P/E ratio applies to publicly listed companies and is a key measure of value for investors.  A P/E ratio of 10 means that investors are willing to pay 10 times previous year's earnings for each share.  Generally, the higher the P/E ratio, the higher the growth prospects perceived by investors.

P/E ratio =  Share price / EPS



DIVIDEND YIELD

This measures cash paid to shareholders as dividends.  This should be compared to capital growth, to measure the overall return to shareholders.

Dividend yield = Dividend per share / Price per share

Mature businesses tend to have higher dividend yields than young businesses, as the latter reinvest most of their earnings.  Investors looking for high-income investments choose high-dividend yield companies.



DIVIDEND COVER

This follows a similar principle to 'interest cover'.  It measures how many times a business can pay its dividends from its earnings.  It is used as a measure of dividend risk.

Dividend cover = EPS / Dividend per share

It also measure the proportion of profits retained in a business versus paid out as dividends.  For example, a dividend cover 3 times shows that a business has paid one third of its profits to shareholders and retained two-thirds.  Retained earnings are an important source of finance and therefore dividend cover is often high.

Use investor ratios to see if business goals are aligned with investor goals.


Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

Making A Winning Long-Term Stock Pick

Investopedia
Making A Winning Long-Term Stock Pick
Wednesday April 29, 11:33 am ET

Chris Seabury



Many investors are confused when it comes to the stock market; they have trouble figuring out which stocks are good long-term buys and which ones aren't. To invest for the long term, not only do you have to look at certain indicators, but you also have to remain focused on your long-term goals, be disciplined and understand your overall investment objectives. In this article, we tell you how to identify good long-term buys and what's needed to find them.

Focusing on the Fundamentals
There are many fundamental factors that analysts inspect to decide which stocks are good long-term buys and which are not. These factors tell you whether the company is financially healthy and whether the stock has been brought down to levels below its actual value, thus making it a good buy. The following are several strategies that you can use to determine a stock's value.

Consider Dividend Consistency
The consistency of a company's ability to pay and raise its dividend shows that it has predictability in its earnings and that it's financially stable enough to pay that dividend - the dividend comes from current or retained earnings. You'll find many different opinions on how many years you should go back to look for this consistency - some say five years, others say as many as 20 - but anywhere in this range will give you an overall idea of the dividend consistency.

Examine P/E Ratio
The price-earnings ratio (P/E) ratio is used to determine whether a stock is over- or undervalued. It's calculated by dividing the current price of the stock by the company's earnings per share (EPS). The higher the P/E ratio, the more willing some investors are to pay for those earnings. However, a higher P/E ratio is also seen as a sign that the stock is overpriced and could be due for a pullback - at the very least. A lower P/E ratio could indicate that the stock is an attractive value and that the markets have pushed shares below their actual value.

A practical way to determine whether a company is cheap relative to its industry or the markets is to compare its P/E ratio with the overall industry or market. For example, if the company has a P/E ratio of nine while the industry has a P/E ratio of 14, this would indicate that the stock is a great valuation compared with the overall industry.

Watch Fluctuating Earnings
The economy moves in cycles. Sometimes the economy is strong and earnings rise; other times, the economy is slowing and earnings fall. One way to determine whether a stock is a good long-term buy is to evaluate its past earnings and future earnings projections. If the company has a consistent history of rising earnings over a period of many years, it could be a good long-term buy.

Also, look at what the company's earnings projections are going forward. If they're projected to remain strong, this could be a sign that the company may be a good long-term buy. Alternatively, if the company is cutting future earnings guidance, this could be a sign of earnings weakness and you might want to stay away.

Avoid Valuation Traps
How do you know if a stock is a good long-term buy and not a valuation trap (the stock looks cheap but can head a lot lower)? To answer this question, you need to apply some common-sense principles, such as looking at the company's debt ratio and current ratio. Debt can work in two ways:

During times of economic uncertainty or rising interest rates, companies with high levels of debt can experience financial problems.

In good economic times, debt can increase a company's profitability by financing growth at a lower cost.

The debt ratio measures the amount of assets that have been financed with debt. It's calculated by dividing the company's total liabilities by its total assets. Generally,the higher the debt, the greater the possibility that the company could be a valuation trap.

But there is another tool you can use to determine the company's ability to meet these debt obligations: the current ratio. To calculate this number, you divide the company's current assets by its current liabilities. The higher the number, the more liquid is the company. For example, let's say a company has a current ratio of four. This means that the company is liquid enough to pay four times its liabilities.

By using these two ratios - the debt ratio and the current ratio - you can get a good idea as to whether the stock is a good value at its current price.

Economic Indicators
There are two ways that you can use economic indicators to understand what's happening with the markets.

Understanding Economic Conditions
The major stock market averages are considered to be forward-looking economic indicators. For example, consistent weakness in the Dow Jones Industrial Average could signify that the economy has started to top out and that earnings are starting to fall. The same thing applies if the major market averages start to rise consistently but the economic numbers are showing that the economy is still weak. As a general rule, stock prices tend to lead the actual economy in the range of six to 12 months. A good example of this is the U.S. stock market crash in 1929, which eventually led to the Great Depression.

Understand the Economic Big Picture
A good way to gauge how long-term buys relate to the economy is to use the news headlines as an economic indicator. Basically, you're using contrarian indicators from the news media to understand whether the markets are becoming overbought or oversold. A good example of this occurred in 1974, when Newsweek had a bear on the cover showing the pillars of Wall Street being knocked down. Looking back, this was clearly a sign that the markets had bottomed and stocks were relatively cheap.

In contrast, a Time magazine cover from September 27, 1999, included the phrase, "Get rich dot com" - a clear sign of troubles down the road for the markets and dotcom stocks. What this kind of thinking shows is that many people feel secure when they're in the mainstream. They reinforce these beliefs by what they hear and read in the mainstream press. This can be a sign of excessive optimism or pessimism. However, these kinds of indicators can take a year or more to become reality.

Conclusion
Investing for the long term requires patience and discipline. You may spot good long-term investments when the company or the markets haven't been performing so well. By using fundamental tools and economic indicators, you can find those hidden diamonds in the rough and avoid the potential valuation traps.

Establishing a PE Ratio

The PE ratio maybe derived from the

1. constant growth dividend model, or
2. cross-section analysis, or
3. historical analysis.

Constant Growth Dividend Model.

We derive the PE ratio for a constant growth firm from the constant growth dividend discount model.

PE Ratio
= Dividend payout ratio/ (Required return on equity - Expected growth rate in dividends)

Dividend Payout Ratio: Most companies treat their dividend commitment seriously. Consequently, once dividends are set at a certain level, they are not reduced unless there is no alternative. Further, dividends are not increased unless it is clear that a higher level of dividends can be sustained. Thanks to these policies, dividends adjust with a lag to earnings.
If the dividend payout ratio increases the above ratio increases, which has a favourable effect ont he price-earnings multiple. However, an increasein the dividend payout ratio has the effect of lowering the expected growth rate of dividends int he denomination of the above ratio which leads to a decrease in the price-earnings multiple. On the whole, in most cases, these two effects are likely to balance out.

Required Return on Equity: The required return on equity is a function of the risk-free rate of return and a risk premium. According to the capital asset pricing model, a popularly used risk-return model, the rquired return on equity is:
= Risk-free return + (Beta of equity) ( Expected market risk premium)

Expected Growth Rate in Dividends: The third variable influencing the PE ratio is the expected growth rate in dividends. The expected growth rate in dividends is equal to:
= Retention ratio x Return on Equity.

Cross-Section Analysis

You can look at the PE ratios of similar firms in the industry and take a view on what is a reasonable PE ratio for the subject company.

Alternatively, you can conduct cross-section regression analysis wherein the PE ratio is regressed on several fundamental variables. Here is an illustrative specification:

PE ratio
= a1 + a2 Growth rate in earnings + a2 Dividend payout ratio + a3 Variability of earnings + a4 Company size.

Based on the estimated coefficients of such cross-section regression analysis, the PE ratio for the subject firm may be derived.

Historical Analysis.

You can look at the historical PE ratio of the subject company and take a view on what is a reasonable PE ratio, taking into account the changes in the capital market and the evolving competition.

As an illustration, the prospective PE ratio for Horizon Limited for the past three years was

PE Ratio 20x5 9.25, 20x6 6.63, 20x7 6.23
The average PE ratio for Horizon Limited was: (9.25+6.63+6.23)/3 = 7.37
Considering the changing conditions in the capital market and the emerging competition for Horizon Limite you may say that the average PE for the past three years is applicable in the immediate future as well.


The Weighted PE Ratio

We arrived at two PE ratio estimates:
PE ratio based on the constant growth dividend discount model: 6.36
PE ratio based on historical analysis: 7.37
We can combine these two estimates by taking a simple arithmetic average of them - this means that both the estimates are accorded equal weight. Doing so, we get the weighted PE ratio of:
(6.36+7.37)/2 = 6.87