Hypothetical situation: A brand new iPad is listed on eBay starting at $100. Assume there’s nothing wrong with it and it’s brand new in the box. How much would you be willing to bid? If it goes to $200, do you keep bidding? What about $300 or $400? Now what if the bidding was for a 6″ Amazon Kindle with wifi only? Would you keep bidding if the Kindle was at $300? Why not? What if you could sell that Kindle for $300, would you? Why?
Buying and selling stock is essentially the same as the above examples. You either bid on a certain price for a certain stock (attempt to buy) or ask a certain price for a certain stock (attempt to sell). What people are willing to bid is dependent on value. In the above example, the iPad would likely be bid up to a higher price than the Kindle because the iPad is more valuable to more people. That is intuitive to most people. The difficulty in applying that example to the purchase of stocks is that the value of stock is not so intuitive. In this post I will attempt help you value stocks.
There are literally dozens of methods in valuing companies that are far more advanced than the scope of this blog. Several methods are great, some are good, some are awful, but the truth is for the average investor those methods really don’t add enough information to make it worth their time. The most basic thing you need to know is what people are willing to “spend” for a certain stock. Most times you can use the price to earning multiple (stock price divided by a company’s full year earnings). Since all companies have a different amount of stock available on the open market, the dollar amount for a stock is meaningless in and of itself. The PE lets you compare stocks to each other while ignoring the dollar amount.
How PE applies to value is that the multiple goes up as company’s stock is more sought after…demand. Where stock is concerned growth is usually valued more than anything else, therefore high growth companies get a higher PE multiple than do slow growth companies. This doesn’t mean that high growth companies are “better” than low growth companies, it simply means more people are willing to pay up for the growth. In bull market cases, many people will pay a PE multiple of twice the growth rate of those high growth companies. So if a company’s growth rate is 25% (which IS high growth), a PE multiple of 50 is not out of the realm of possibilities. You then multiply the PE times the full year earnings (usually the next year) to arrive at an upper price limit for a stock.
The trick to using the PE multiple is to find what people are willing to pay for a certain type of company during the current type of stock market. You can look at historical PE multiples for comparison, compare multiples to competitors, or compare the PE of the individual company to that of the industry or even the S&P 500 as a whole. If the company is outperforming its industry or the S&P 500, it generally deserves a higher multiple. If you believe the multiple should be greater than is currently applied to the stock, you are saying it is undervalued by the market. If you think the multiple is too high, it is synonymous to saying it is overvalued. That may be extremely simplistic, but it’s a place for most people to start…and far easier than trying to figure out all the dynamics that come into play when estimating a companies future earnings power.
It’s absolutely embarrassing watching most of the so called experts that are rolled out in front of the cameras hour after hour, even in the financial media. All of them with their superficial and often generic analysis of the economy consistently show their lack of rigor. For example, this continual belief that consumer sentiment can be relied upon and quoted as an indicator of future economic activity and stock market performance. If you actually run an analysis (as I did this last week) you’ll find there is NO correlation whatsoever between monthly consumer sentiment and future S&P 500 performance (1 month, 3 month, 6 month, 1 year, or 1.5 year levels). What you will find, again through actual statistical analysis, is that consumer sentiment is tied much more closely to prior month S&P performance. Additionally, the relationship between prior month S&P 500 performance and consumer sentiment has been getting stronger for the last 10 years. This relationship could be headline related or could indicate more people having a stake in the stock market. Either way, current use of consumer sentiment as a forward indicator is either ignorant or lazy.
A second indication of the headline writers’ lack of analysis is this constant question of unemployment and why it is persisting. My response is simple: listen to what companies themselves are saying! Talk to actual business owners, listen to company conference calls, and simply open your ears. The experts are so tied in to making their “data” fit their political views that they refuse to take the time to listen. If they would listen they would see the problem is the government. If you take the time (and it DOES take a lot of time) to go through the calls and talk to people the theme is clear: companies are squeezing as much production as they can out of resources they have. There is an indication that many want to hire, but simply can’t take the chance when they know the government is going to squeeze them and the consumer more (health care, fin reg, cap and trade, tax hikes). I am the first to admit that I AM biased (again, who else will admit that publicly), but this is what is being said, regardless of personal bias.
The bottom line here is not an opinion, but the lack of rigor by others in formulating their opinions. Read or listen to calls and talk to real people. It’s the ONLY way you can arrive at a truly informed opinion on the economy OR individual stocks.
Sorry it’s been awhile, my summer pro hockey camp has been much more work than I anticipated. That said, I think it’s finally stabilized enough for me to get back to writing on a more regular basis. At the very least, I’ll be updating on Twitter more often (follow me @InskoInvesting).
Beyond all the written information, the 10-Ks, 10-Qs, and the financial statements, lies a source of information that simply should not be ignored. The quarterly company conference call is often the best source qualitative information you can find on a company, yet most retail investors ignore this source entirely. I contend that if you can’t or won’t listen to (or read) the conference calls of the companies you invest in, you SHOULD NOT be in charge of your own investments. You simply will not have enough information to make informed decisions.
Typically the quarterly conference call will be an hour in length broken up into two main sections. The first part of the call usually consists of prepared statements focused on on current company performance, current issues, and future outlook. The second part of the call is the questions and answers section. This is when analysts can press the company executives for more information or clarifications on previous information.
As mentioned before, the conference calls for most companies can be listened to or read. You can listen live by calling in or listening to the webcast. Information is generally on the company’s investor relations web page. If you can’t listen live you can usually get a recording of the call on the web page or you can read a transcript of the call (most can be found at seekingalpha.com). There are advantages and disadvantages to either listening or reading. For me, reading the transcript is much faster and it allows you to highlight items you want to investigate further. However, listening allows me to catch many of the subtleties that don’t come across in the written form. For example, when listening I often notice tone of voice changes when certain questions are asked. Is the executive getting defensive when he/she shouldn’t be, are they confident, are they hiding something…voice modulation and how they say things provide a lot of information that I find extremely valuable. That’s why I typically prefer to listen, regardless of the extra time.
So what should you be trying to find out during a conference call? Simply stated…everything you can! What impacted the company’s current quarter? What will effect the company going forward? What is management doing to improve results?
Usually, the executives want to present themselves and their company in the best light so, yes, it is somewhat subjective. How can this be overcome. First, publicly traded companies are obligated by law to present truthful information to the best of their ability. Even if there is bias involved, it gives you an indication on the state of the company and the sector. Beyond this, the most important thing to do with conference calls is to question everything. Look at them with a skeptical, even cynical eye and compare what they say to other information you have or can find (here are some questions to get you started). Critical thinking is your friend.
For example, if an individual company in a sector says the consumer has stopped spending while every other company in that sector says consumer demand is good it may indicate that it’s an individual company problem that’s effecting results.
If nothing else, listening to conference calls every quarter allows you to get to know your company. As a shareholder or potential shareholder, you ARE part owner of that company (however minute that piece may be). Take ownership, be engaged, and get comfortable with what your company is doing. There are plenty of stocks in the world. If, after reviewing the conference calls, you aren’t comfortable with taking ownership, DON’T take ownership.
I could take pages and days to talk about interpretation of financial statements, but there are dozens of books that would do the subject far more justice than I could. For the individual investor who has limited time to study stocks, there are far easier ways of judging the financial stability of a company…call it the quick and dirty method.
First, I believe you should actually look at the company’s balance sheet. It’s one of the most straightforward financial documents you can look at and they’re pretty much uniform across publicly traded companies. You can find the balance sheet on most stock sites including Google Finance or Yahoo Finance. On the balance sheet, I immediately compare assets to liabilities. If a company has more liabilities/obligations than it has assets, you can pretty much stop your stock analysis right then and there and move one. There are enough stocks to choose from that you don’t have to gamble on a company in such a precarious financial situation. Even if you want to call it a speculation, a company that has more bills and debt than it has the ability to pay for is just not worth the risk. The next place I look on the balance sheet is the long term debt. Can they pay it? I like companies who’s current assets (assets that can be most readily converted to cash) value is higher than their long term debt. Again, if the debt is higher than the total assets, you’re not looking at an investment, but straight gambling…you’re better off putting your money on red and letting the roulette wheel do the work.
Another helpful source for judging a company’s financial stability is how the ratings agencies rate the companies debt. Both Standard and Poor’s and Moody’s let you look at how they rate a company’s debt. And there are a number of resources to interpret what the ratings mean. Anything lower than a “speculative” rating is generally something to stay away from. As a side note, the ratings agencies have been under fire over the last couple of years for giving high ratings to companies that didn’t deserve them so I believe the result will be more reliable ratings (if only to save their own credibility).
Again, those are quick and dirty ways to judge financial stability, but it’s a good start. If you want to dig down further, I suggest going to the full financial statements in the 10-K. This will be far more detailed than you’ll find on the financial statements. You’ll find in depth descriptions of where money is coming from and where money is going. Both are useful in extrapolating what certain scenarios will do to a companies earnings.
Like I said, there are a number of resources to dig further and there are just as many experts who claim certain ratios are important, but don’t lose site of what is important: can the company sustain business and will they be profitable. In reality, that’s all that matters.