Smart Investor: Getting Started, July 2012

Smart Investor – Getting Started, July 2012

How do you pick what stocks to buy? A familiar name? A recommendation from a friend? A hunch? The most successful investors combine knowledge of the company and the market with some valuation metrics. They can sound daunting, but really they’re not that complicated, and they can help you make a decision on when to buy and sell.

The king of all share valuation tools is the price to earnings ratio, or the PE. There are investors who never use any other metric but this in their shareholding decisions, and many of them do perfectly well out of that arrangement.

If you want to calculate a PE, you divide the share price by the company’s earnings per share. Better still, just look it up: publications such as the Australian Financial Review publish PEs in their share data tables, and its likely that your online broker will be able to provide it too (along with some of the other metrics we discuss in this column). There are two types of PEs you might see: a trailing PE, which is based on the most recent published earnings, and a forward PE, which is harder to locate and is based on analysts’ views on what earnings are going to be in the future.

So what does this magic number tell you? Basically, it’s about value. A company with a low PE costs less, per share, than one with a high PE, for the same amount of financial performance. So, provided the stocks are comparable, it’s a useful way of seeing which one costs more, and which one looks like good value.

Two caveats, though. One is that PEs are only really useful for comparing peers in the same sector; they don’t tend to work when comparing different sectors. For example, tech stocks have always traded on high PEs, utilities on much lower ones. The other is that just because something is trading at a relatively inexpensive value doesn’t automatically mean it’s a bargain; your next step should be to work out why it is cheap, and if you think there’s a good reason for it to go up.

[Subhead] Price to book and debt-equity

Another much-beloved piece of data for value investors is the price to book ratio. Once again, it’s a measurement of value, but this time you divide the share price not by earnings per share but by net assets. So if a PE tells you how much you’ll be paying for a company’s earnings, price to book tells you how much you’ll be paying for its assets.

This is, once again, a good way of comparing stocks in the same sector. A rule of thumb is that a price to book ratio of 1.5 times or less could be good value; this is something that companies look at closely when deciding what price they should pay in taking over another company. Again, there is a limitation when it comes to comparing different industries; service companies won’t have a lot of physical assets so will have a high ratio compared to one that requires a lot of property or machinery.

Since the global financial crisis, one ratio has become much more important than it used to be (or, at least, it’s getting noticed a lot more than it used to): the debt to equity ratio. Basically this gives you a sense of how much of a company’s money it has borrowed, which will have to be either repaid or refinanced. Debt is bonds and loans; equity is shares.

A company can be growing fast, but how did it finance that growth? If the debt-equity ratio is high, then perhaps it has borrowed too much to expand and will be vulnerable to a slowdown. Plenty of businesses hit the wall during the GFC because of this. Still, what does ‘high’ mean? This, too, can vary from sector to sector, so the most important thing is to see if one company has a ratio much higher than others in its industry. This ratio also has to be combined with a bit of common sense knowledge about the industry it’s in. If, for example, a luxury car manufacturer had a very high debt equity ratio at a time when economists were predicting an economic slowdown and belt-tightening among the population, that would be a warning sign.

[Subhead] Chasing dividends

Most Australian investors take a close look at dividends before deciding whether to buy a stock. Among developed world markets, Australia is one of the highest yielding in the world, so it’s a big part of a stock buying decision – far more than is the case in, say, the USA or Hong Kong.

The dividend yield is the percentage of a company’s share price value it returns in dividends in a given year. So if a company has a share price of $25 and pays out $1.50 in a year, then the dividend yield is 1.5/25, or 6%. In Australia, the tax system complicates thing further, so there are two dividend numbers you might see: the usual yield number, and a grossed-up dividend, which takes into account franking credits (that is, where the company has already paid tax on the dividend it’s paying out so you don’t have to pay it again). Generally, since corporate tax is 30%, the grossed up yield is the regular yield, times 100, divided by 70, to reflect the 30% tax that has already been paid.

Is a high dividend yield automatically a reason to buy a stock? No. Remember that, if a share price falls, then the dividend yield will go up assuming the dividend stays the same – so before you go running after a 9% yield you might want to ask why the stock fell so far, and if it’s going to be able to sustain dividend payments at previous levels. However, there are numerous tried and tested dividend payers like Telstra and the banks who quite justifiably attract investors because of the dividend. Smart investors think about capital return as combining the likely dividend with capital growth.