Accounting Cash Flows Where Would Investment Dividend Income Go A Primer on Stock Investing (Part 1)

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A Primer on Stock Investing (Part 1)

The purpose of this article is to summarize some of the key metrics and evaluations of stock investing; and help investors make informed decisions using a relatively simple framework.

There is a lot of information about stock investing, investors are regularly bombarded by the financial media. This flood of information is disseminated through multiple media. While some of these industry resources provide valuable information, these reports may not support informed decision making. Studies have shown that the value line, with its highly sophisticated analysis, can hardly compete with the market index. Research shows that beating the market index requires “excellent” analysis and well-timed execution. The term used for this unique skill is alpha; And some examples of alpha seeking gurus are Warren Buffett, George Soros, Peter Lynch and others.

Before getting into the more practical framework of stocks, it is important to define the various categories of stock investments. Stocks are broadly classified as common stock or preferred stock. The main difference between the two is indicated by the following. First, as the name suggests, preferred stock has priority over common stock in case of shareholder claims in case of default by the company. Second, preferred stocks are purchased to earn dividends (income) that are less likely to appreciate; Common shares can be used for both dividends and capital appreciation, with a focus on the latter. Third, preferred stocks behave like bonds in some cases, as interest rates rise as the price of the preferred typically goes down. The difference in interest rates is somewhat related to the stock market as a whole because when interest rates rise, the stock market suffers. For individual common stocks, the effects of interest rate differentials depend on several factors, particularly the capital (or debt) structure of the firm.

Other categories of common stocks include: First blue chip stocks of well-known Dow Jones companies with an established history of dividend payments to investors. Second, value stocks are under-valued gems, likely to grow over the long term. Third, growth stocks, as the name implies, are growth-oriented stocks that are priced higher because of the perception of their appreciation in the future. Fourth, cyclical stocks that are sensitive to changes in the business cycle. And fifth, stocks that stay quiet during market swings like utilities.

The key metrics of stock investing are summarized below:

1-52 Week High-Low: Find the stock price prevailing in the stock market and compare the current price with the previous 52-week high and low prices of the same stock. The idea is simple: stocks with lower price ranges in rising markets have more upside potential than stocks that have already hit 52-week highs.

2-Market Capitalization: This metric shows how big a company is. Market capitalization is obtained by multiplying the number of outstanding shares of the company by the prevailing market price. Generally stocks are classified as large cap, mid-cap and small cap stocks. Large-cap stocks like Exxon generally don’t have much potential for price appreciation compared to some of the gems in the mid-cap and small-cap stocks category. The latter category of mid-cap and small-cap stocks has the highest potential to represent rising star investments, which grow multiples and tens of folds over a period of time.

3-Volume: This metric tells us how many dollars are being traded in a day. Volume is calculated by multiplying the number of stocks traded on a particular day by the average price. Blue chip stocks such as Exxon, Microsoft, and Apple are heavily weighted. In contrast, small and mid-cap stocks tend to have less volume, which creates some liquidity risk.

4-Earnings Growth (Past and Future): This is a key metric that determines the price of a stock. Earnings per share (EPS) is calculated by dividing a company’s earnings by the number of shares outstanding. Earnings growth (year-over-year) is important from two angles: whether earnings have grown over the past five years; And whether the actual earnings have exceeded the estimated earnings for the current year. In particular, the performance of growth companies is evaluated by the relative growth in earnings. Interestingly, issuing more shares reduces earnings per share; or conversion of fixed income securities into common stock. This action will reduce the value of EPS. Conversely, if a company buys back its shares, the earnings per share will increase proportionally. For example, if a company, with plenty of cash reserves, buys back half of its shares, the EPS will arithmetically double, making the stock more attractive to investors. Remember that EPS is strongly correlated with stock price. As a result, buying back stocks and assuming external factors do not change can eventually increase the stock price.

5-Price to Earnings (P/E) Ratio: Despite some caveats to this ratio, P/E is the most popular ratio in the world of stock investing. The P/E ratio is simply the current price of a stock divided by the trailing 12 months of earnings (although analysts sometimes use 12 months of projected earnings as well). Growth investors want growth in earnings regardless of share price direction. Conversely, value investors want to see the P/E ratio fall to find undervalued gems. Value investors typically go after companies whose earnings growth rate exceeds the P/E ratio. Another metric appreciated by value investors is that the current P/E ratio is below the average of the past five years.

6-Price to Sales (P/S): It is a common understanding that sometimes companies change accounting methods to manipulate earnings. Applying such manipulation to sales figures is difficult. This metric highlights how much you are willing to pay for the sales the company generates. For growth companies, this number should remain low. However, growth investors will not care much about this ratio compared to value investors. Value investors would like to see this ratio lower.

7-Price to Book Ratio (P/B): Book value means how much a company would be worth if it were liquidated today. The price to book ratio is a simple comparison of a company’s net asset value to its stock price. The main caveat is that this metric focuses on a company’s tangible assets. Investment research has shown that intangibles also play an important role in creating value for shareholders. For this reason the P/B ratio is not a comprehensive metric.

8-Value Creation and Growth Metrics: Most stock analysts focus on the EPS (earnings per share) metric especially for the last five years. Although earnings and sales are like the lifeblood of a company, making stock investment decisions based on earnings (and sales) standalone can be misleading. More specifically, the analyst should analyze in more detail the following three key areas that ultimately determine the company’s earnings (sales):

a-Quality of revenue earned by the company and transparency of revenue recognition (compliance standards). What are the company’s growth prospects?

b-Net profit margin or earnings quality: What is the company’s strategy to optimize costs and maximize return on investment? Of course, management plays an important role in increasing the size and quality of earnings.

c- What is the cash flow position? It is important to buy stocks of companies with positive cash flow.

9-Dividend Yield: This metric is typically relevant for large blue chip companies, such as the Dow Jones Industrial Average. This is less relevant for small and high growth companies, as these companies rarely declare dividends. Some investors prefer large companies churning out consistent dividends depending on their risk profile and investment objectives.

10-Relative Price Strength: This metric compares the previous year’s price performance of stocks in the same group. A similar comparison between share siblings is made for earnings per share. This type of analysis is usually done by an investor’s business daily.

11-Return on Equity (ROE): This is an important metric, which explains how much money the company is earning as per the shareholders’ equity command. In simple terms, it explains that the company is using the resources at its disposal efficiently and making a profit. This metric is particularly useful for growth investors. Growth companies should track return on equity (ROE) to ensure growth projects are generating positive net present value (NPV). The ROE metric speaks volumes for the depth and competence of management.

12-Insider ownership: It is argued that a large amount of insider ownership is a good indicator of a company’s success. This proposal makes sense because when owners are shareholders, they work hard to make the company successful. However, this metric cannot represent the strength of a standalone company. There may be periods when shareholders will sell stocks to make money from their changing personal and business needs.

13-Prediction of Company Performance: The value of a company is not based on its past performance. This is because past performance is relevant only to the extent that it can help analysts make some predictions about future trends and growth. However, there is no guarantee that the external environment will remain the same and that the company will repeat its past performance. Forecasting (estimation) about future earnings and earnings of the company is equally difficult. Investors should perform their own due diligence to analyze actual earnings and the likelihood of meeting revenue targets.

14-Integrity and depth of management: This is perhaps the most important metric for evaluating the future performance and direction of any company. Performance is a relative term; And may vary depending on the nature of the company. For example, from the perspective of growth companies, performance is defined by year-over-year (YOY) growth while maintaining a positive return on equity (ROE). For technology companies, innovation in the form of new product introductions underpins performance. The caveat is that innovation is difficult to measure because it is wrapped up in both tangible and intangible areas. How can you, for example, measure the success or long-term value of Apple iphones? The ubiquity of disruptive technologies makes this task even more difficult. Overall, the depth, maturity and commitment of management is the most important metric for evaluating a company’s future performance.

15-Stock Volatility: This metric is absolutely crucial to decide about the risk-return profile of an investor. Simply put, volatility is a measure of how much returns deviate from the average value over a given period of time. More volatility indicates more risk. Volatility tends to be high in the short run and moderates somewhat in the long run. Of course, volatility depends on the correlation of share price to market changes (called beta).

In order to draw conclusions, the above framework needs to be analyzed in a holistic manner. Again these metrics, when combined together, will be viewed differently by value and growth investors. A value investor will focus on long-term competitive advantage, brand reputation and relative current valuation of the company. On the other hand, a growth investor will care about the past and future growth patterns without considering the 52-week price volatility and growth potential (revenue generation) of the company.

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