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6 Ways to Value Equity Investments
By Luke Blackburn, InternationalMan.com
In my junior year of college, I had the great fortune of getting a job with a financially independent business owner. He was a lifelong entrepreneur who excelled at turning around failing businesses. In early 2000, he sold all of his day-to-day businesses and, to "keep his mind sharp", started day trading e-mini S&P 500 futures contracts. My job was to help him run the trading platforms on his computer.
The "slow" market days were my favorite, as it gave me an opportunity to pick his brain and learn from his experience.
On one such occasion, we discussed how to recognize value in stocks. He said, "Valuable companies are often ones that go unnoticed because of their consistency. While they are never the trendy pick, I am interested in those companies. Often people pass on them, because they think they are too average and not likely to double or triple overnight."
At the time, that didn't make much sense to me. I couldn't understand how one could make a fortune by investing in "average" businesses. I didn't understand the concept of value investing.
Now I do, and it starts with ...
Learning the Language
There is a lot of information available when studying investment opportunities (international or otherwise). But it all starts with understanding some of the common terms used to judge a good opportunity.
(Admittedly, this will be old hat to some of our readers, but the occasional review of the basics is never a bad idea).
A Few Investment Terms You Should Know:
- Market Capitalization is the amount of shares outstanding multiplied by the nominal share price. For example, the largest company in America is Apple. The reason for this is because it has the largest Market Cap. This piece of data gives the investor a much clearer idea of how large a company is, compared to its competitors.
A representation of this would be Microsoft and IBM. Both are giants of the tech industry. Microsoft has a Market Cap of $251 billion and IBM's is $220 billion. But if you look at share price, Microsoft's price is around $30 per share, while IBM trades closer to $200 per share. Both may be phenomenal companies, but many investors pass on IBM just because of its share price.
Market Cap = # Shares x Share Price
- Earnings Per Share (EPS) is the dollar amount of earnings divided by the number of outstanding shares. EPS is important because it shows investors how much money each individual share represents as a portion of the money earned by the company.
EPS = Earnings / # Shares
- Price to Earnings Ratio is share price divided by Earnings Per Share. When analyzing companies, a higher PE ratio indicates that the market is anticipating higher earnings growth compared to companies with a lower PE ratio. It is important to always compare PE ratios of companies within the same industry. For example, tech stocks usually have a high PE ratio as compared to bank stocks.
Value investors tend to choose stocks with lower PE ratio, because they seek strong, established businesses that consistently generate significant earnings, rather than 'high flyers'. Many of these companies also have stockpiles of cash on their balance sheet. Companies like this do not have wide swings in profitability or growth. On the contrary, they grow consistently year over year.
P/E = Share Price / EPS
- Book Value is calculated by subtracting total liabilities from total assets. It is basic accounting but very important, because it indicates the strength of the company's balance sheet. Book Value compared to a company's market value can be a good indication of whether or not the company is currently overpriced and relatively expensive or underpriced and relatively cheap.
Book Value = Total Assets - Total Liabilities
- Dividends are an often-overlooked benefit of holding certain stocks. Most large, highly profitable businesses issue dividends to shareholders. Sometimes dividends are a modest 2 or 3 percent, which acts as a buffer for inflation. Other companies, particularly Mortgage REITs, often have dividend yields in the 13 to 15 percent range. These companies offer higher dividend yields because of the greater risk involved in owning that company. When researching good buying opportunities, one should not overlook the added value that dividends present.
Dividend Yield = Annual Dividend Per Share / Share Price
- Debt Ratio is the company's total debt divided by total assets, and is one easy way to determine the company's debt risk. A lower ratio indicates low debt levels compared to total assets. As the financial system continues to unwind before our eyes, most IM readers know that a big part of this entire mess has been unsustainable debt levels. Many believe that the current US debt levels will bankrupt the country. Businesses are much more vulnerable to debt than governments, because they cannot print more money.
Debt Ratio = Total Debt / Total Assets
All of this information is already calculated for you and available for free on sites like Yahoo Finance, but it's still good to know how to manually put the figures together as needed.
My old boss used to say, "Wealth is created by recognizing value when others cannot." This is extremely true with investing. If you can learn how to find great businesses and buy them at great prices, you will become a more successful investor.
But first, you need to speak the language.
[Just as understanding the language is important, so too is identifying the right investments on which to apply your analysis skills. Take a test drive of World Money Analyst and have a selection of the best undervalued (easily-traded) opportunities from around the world served up to you on a silver platter each and every month.]
About the Author: Luke Blackburn is a rookie entrepreneur, avid tech enthusiast, and contrarian investor. He is a student of Austrian Economics and free market philosophy. He seeks truth, and desperately searches for the marrow of life.