High priorities for institutional investors in selecting stocks for their investment portfolios: Price/earnings ratio, current and projected earnings, and management competence. Least important: Product quality, the state of the US economy, and the industry group. Middle ranking: Balance sheet, price per share, and long-term earnings record.
Please check out this post on: Big Opportunities in Small Companies.
The Cash-Flow System
My basic thesis: The stock market overvalues reported earnings...and discounts cash flow. But earnings are a function of past actions. What the investor should try to ascertain is earnings two years from now. That's usually a function of current expenses. For that reason, I'd rather have cash flow than
earnings. When I buy a stock, I pretend that I'm buying the entire company at that price. And in analyzing cash flow, I focus on earnings, depreciation, and deferred taxes.
I like to buy stocks at less than three times the annual cash flow per share when the depreciation per share is bigger than the earnings per share. What if the company's earnings go to zero? I want to know how much cash the company is generating and whether it can pay its obligations.
To find stocks, I go through Value Line and Standard & Poor's every day. I look at a company's price chart. Is it up or down? Then I look at its depreciation and the number of shares outstanding. If anything comes close to three times depreciation per share, I take a second look at it.
Every six months or so a stock group is really down...that's when investors can get in. Two years ago, the airlines were undervalued. Almost half of that group was selling for at least three times annual depreciation.
In these cases I totally ignore earnings. All sorts of investment analysts are trying to figure out the next quarter's earnings, and I don't want to be following the herd. I plan to hold a stock for at least three years... .and know that. Virtue: It takes away the pressure on my clients of worrying about earnings for the next quarter.
We also wrote: How to Be Your Own Securities Analyst.
Price/Sales Ratios
The standard advice for investors: Buy into companies when they're unpopular and relatively cheap. Problem: How do you really know when that's the case?
As a guideline, investors have traditionally used the price/earnings (P/E) ratio (the market price per share divided by the net income per share). They compare that ratio with the average P/E ratio of the Dow Jones industrial average or another stock index.
Example 1:
A stock looks especially attractive when its P/E ratio is 10 and the P/E ratio of the Dow is 18. Trap: The P/E ratio is dramatically affected by a company's earnings, which are subject to arbitrary and often outmoded accounting methods.
Better guideline: The price/sales (P/S) ratio, which is more stable, more current, and less susceptible to accounting manipulation. To get the P/S ratio, divide a stock's price by its sales per share.
Example 2:
A company with $100 million in annual sales that sells for $15 a share and has 5 million shares outstanding has a price/sales ratio of .75 ($15 divided by $20 sales per share). Comparison: If the same company has earnings of $5 million a year, its price/earnings ratio is 15 ($15 divided by $1 per share earnings).
When dealing with P/S ratios, think of smaller numbers. Very unpopular companies have a P/S below .25. An average company has a P/S of .5, and a very popular company has a P/S ratio of 1 or above.
Guidelines:
To get the highest growth on an intermediate to long-term basis, stick with stocks having P/S ratios of less than .25. Sell the stock if its P/S ratio approaches 1. We've found that low P/S stocks outperform low P/E stocks-and by a wide margin.
Based on random sampling, there's also growing evidence that low P/S stocks outperform the market.
This isn't to say that P/E ratios don't have a place in stock analysis. Buying low P/E stocks is certainly a viable way to get the above-average reward at below-average risk. No matter which ratios you watch, it's also necessary to use fundamental analysis to identify the quality companies among the low P/S or low P/E candidates.
Limits of use:
P/S ratios don't apply to the stocks of companies such as banks, real estate investment trusts, and others in which ongoing sales aren't the driving force. They're often not helpful in analyzing very small (under $5 million in sales), rapidly growing companies. However, they're especially valid for industrial companies, retailers, and insurance companies.
Investopedia did a good job on How to Use Price-To-Sales Ratios to Value Stocks.
Dividend Yield As a Measure
Dividends are an excellent indication of the growth of a business-even more so than earnings. Earnings can be manipulated but dividends can't. They are real money, not figures on a balance sheet. If the dividend is rising year after year, you know that the company is making good progress.
Although I feel strongly that a stockholder is entitled to some share of the profits, we don't select stocks on the basis of dividend income. Instead, we use dividend yield as a technical measure to identify good buying and selling areas. Over a long period of time, stocks generally fluctuate between perimeters of high dividend yield (marking a valley of undervaluing) and plateaus of low dividend yield (marking peaks of overvaluing). These perimeters seem to be rather consistent.
Each stock must be reviewed individually. IBM is undervalued when it is yielding 4% and overvalued at 2%. Other stocks are undervalued when yielding 3% and overvalued at 1%
We follow 350 blue-chip stocks-mostly NYSE-selected according to specific characteristics. Dividend yield measures value in the stock market, but we measure the quality of an issue by six criteria:
1. We want the dividend to have been raised five times in the last 12 years.
2. The stock should carry an S&P quality ranking in the A category.
3. It should also have at least 5 million shares outstanding, to ensure liquidity.
4. At least 80 institutional investors should be holding it.
5. We look for 25 years of uninterrupted dividends.
6. Earnings should have shown improvement in at least seven of the last 12 years.
A computer figures out the various yield levels that in the past have indicated undervalue or overvalue. All the stocks are then grouped into one of four categories: Undervalued, overvalued, rising trend, or declining trend.
A rising-trend classification indicates that although the stock has been undervalued, it has risen at least 10% from this undervalued base. In the declining-trend group, the stock has been overvalued but has declined at least 10% from an overvalued peak.
READ ALSO: Big Opportunities in Small Companies
People who want to buy stocks would be interested in the undervalued or rising-trend categories. People who own stocks would be interested in the other two to map out a selling strategy. Please don't forget that It Really Pays to Ask Questions.
You don't have to do anything exotic or complicated to achieve superior investment results in the stock market. Simple formula: Buy stocks when they're undervalued and sell them when they're overvalued.
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