Alright, you are ready to put your money to work and invest in shares. The only questions: How do I know which share to invest in? How do I know the difference between a good stock and a bad stock? Are there any indicators that can help me determine what stock to invest in?
Frequently when the conversation turn to finances, saving for a mortgage down payment or retirement, the topic of share investments pops up. Yet, for two reasons most people stay away from investing in one of the most rewarding financial instruments that is available to every single person, no matter how wealthy. The consensus among those refraining from putting money into stocks is that either it is too risky and they know too little about investing in stocks or that in order to become an investor in shares, you need to be very rich.
It is amazing that we are being taught about history, mathematics, and art in school, yet something that affects all of us on a daily basis is neglected. Investing in companies is so much fun and enriches your life not just in a financial sense, but also gives you a different look on entrepreneurship, where to shop, what company is ethical, good management, employee relationships, company strategies, and organizational structures. It even affects the way you look at products and where you shop. Why shop at Company X if you are holding shares in their rival Company Y?
Investing in shares is only enriching and fun, however, if you choose the right company. But how do you choose which company to invest in and which shares to buy? Besides the obvious such as the financials, there are others things that will help you determine whether you should put your hard-earned cash to work and invest in a company's shares. Across Captain Finance, you'll find many articles on deciding upon investing in a particular company, here we want to focus on some financial indicators that are used by professionals in determing the value of a share but are similarly not overly scary for those just starting.
Before we talk about how to choose a good stock
The reason for this post is in fact a conversation I had with a friend the other day. During the conclusion of a cultural event displaying some wonderful Moroccan music our conversation touched on the low interest rates in France, or for that matter, in the Eurozone. How to earn money from your savings, the question popped up. An issue all Europeans have to deal with thanks to the decade-long policies by the European Central Bank.
Property, right? Property tends to be a very good investment and relatively stable over the long-term. At least a lot more than fiat currencies such as the old Mark, Franc, Lira or the Venezuelan Bolívar. All these currencies have seen their ups and downs and suffered from inflation, the aspect by which your dollar becomes worth less over time. Add a monetary reform to the picture, that is, the decision by a government to render the existing currency worthless and replace it by another, as has happened only recently on a small scale with the old five pound notes in the UK, and you'll find that fiat currencies are relatively unstable.
But back to properties as an alternative to low interests on savings. Great, but a property investment simply requires a huge principal and is not feasible with someone who wants to invest, for instance, € 5,000. This brings us full circle to shares and the different aspects in determing whether a company's shares are a good investment.
How do you know if a company's shares are a good investment - The financials
There's a few things you should look at before investing your hard-earned cash in shares of a particular company. Let's start with the most common financial ratios:
Price to Earnings Ratio:
The Price to Earnings Ratio or P/E Ratio as it is frequently abbreviated. On sites such as Bloomberg or Yahoo Finance you will often find a number of different P/E Ratios. The two most commonly found are P/E (TTM) or Trailing P/E and an Estimated P/E ratio, aka, Forward P/E ratio, that is, as the name suggests an estimate of the P/E ratio in the future. A quick side note: the TTM in P/E (TTM) stands for P/E (trailing 12 months, thus the last twelve months).
Both of them are important, as the backward-looking P/E Ratio tells you the story about the company's performance over the last twelve months, whereas the forward-looking P/E Ratio (Est), gives you an indication of the potential pitfalls and opportunities lying ahead. However, I prefer to focus on the former, because no one knows what the future holds, but the past is already written in letters.
The P/E ratio of a share reflects how long, in theory, it would take to earn your invested money back. Assume a company has a P/E ratio of 10. In essence, it would take the company 10 years to earn the value of the share price. Obviously the lower that figure, the better, as the lower the investment principle, the quicker you can earn your money back.
Expressed as a formula, the P/E ratio = Current share price / Earning per share.
Thus, the P/E ratio you see on Bloomberg and similar sites is today's, or even the actual momentary share price as of this minute (depending on how quickly the numbers on the website are updated), divided by the company's earnings per share for the last twelve months.
An example (the numbers are accurate as of 27/03/2019):
Coca Cola trades at $ 46.53 with a P/E ratio of 22.07. It would consequently take 22.07 years before your investment in Coca Cola would have earned $ 46.53.
It's rival Pepsico trades at $ 121.77 and has a P/E ratio of 21.97. It would thus take slightly shorter, given current earnings, for Pepsico to earn back your investment.
GIven the P/E ratios of these two companies, Pepsico is the slightly better investment.
But P/E ratios are obviously no the only aspect that matters when deciding on investing in a company. Other aspects such as dividends, management, projects in the pipeline, and use of earnings play an important role as well in deciding upon a share investment. Take, for instance, a company that prefers to use its earnings for R&D or that puts the money straight back into the business to gain market share or develop new products.
There is another important aspect besides comparing the P/E ratio of one company to its peers and that is: the insight of history. As important as it is to compare against other companies, it is similarly important to compare the evolution of a company's P/E ratio over the years. Returning to our example:
Coca Cola had a P/E ratio of
31.57 in 2018
158.21 in 2017
27.83 in 2016
25.72 in 2015
26.39 in 2014
21.74 in 2013
18.40 in 2012
Comparing the current P/E ratio to Coca Cola's P/E ratio for the last seven years gives you a good idea of whether the investment in the company is costing you more dearly or is cheaper than in the past. Ignoring the outlier in 2017, Coca Cola's shares have neither become cheaper, nor have they become more expensive.
As a general rule of thumb: The lower the P/E ratio, the higher the probability that the company's shares are fairly priced.
As an investor you want to make money with your investment. As an investor in shares there are only two ways of making money: dividends and share price gains.
Taking Coca Cola's share price performance over the last few years, for instance, you'll find that with a number of wonderful companies, it isn't so much about share price gains, but their stability and strong position in a competitive world economy, that is appealing. Yet still, why invest money if you don't see a return? Investing is about being rewarded for taking risks in companies and going the extra mile in terms of researching and understanding finance, management, the economy, and products. Otherwise you could just leave your money sitting in a savings account. It only pays dismal interest, but it does not require you to do any extra work. Just put it in your savings account and receive 0.01 %.
No one wants that, thus, here another indicator to look at before you invest in shares: Check their dividend yield. For instance, here a link to Coca Cola's dividend history dating back to 2011. At first glance, a very high dividend yield might seem an attractive investment, but it depends. Of course, a high dividend is fantastic to build wealth, but if a company increases their dividend out of the blue and without any fundamental reason; namely an uptick in profit, you should be wary. A company that, for instance, pays a 2% dividend for years and suddenly increases its dividend to 7% without better business performance, management may simply be attempting to attract new investors. Higher dividends = greater appeal. Thus be certain that the higher dividend payments are in line with better business performance, higher profits, and solid cashflow.
In fact, the worst scenario is a company that pays high dividends by draining its cash reserves. This will leave less money for future investments, new products, and puts the company on shakier feet if the economy turns south. Worst still, if the company uses debt to pay dividends to its shareholders.
An exception are special dividends. These are dividends that are paid by companies following an extraordinary year or because it sold off some assets such as Intercontinental Hotel Group has done repeatedly over the years. Each time IHG sold one of its hotels, it passed the profits on to its shareholders in the form of a special dividend. I will write another post of how I repeatedly managed to make in excess of 10% in dividend gains alone.
Stable Dividend Payments:
This leads us to a related aspect: the company you are eyeing to invest in should pay dividends not merely sporadically, but consistently. Some companies such as Apple under Steve Jobs refrained from paying dividends as Jobs' policy was to put all profits back into expanding the business and developing new products. But, unless management has a solid and feasible reason not to pay dividends, stable dividend payments are one of the aspects to look at before investing your hard-earned cash in a company's shares.
Importantly, did the company pay dividends for multiple years, ideally 10 years plus, and has kept the dividend steady, or even better, increased it year on year? If yes, that is a good sign for a stable company, able to manage its resources and likely to continue its successful journey.
There are, of course, exceptions to the rule:
1) an event such as the Great Recession a decade ago. In extraordinary circumstances such as the world seemingly coming to and end, one may forgive a company suspending the dividends temporarily in order to keep more cash reserves in the company for more potential hiccups. It is more telling how long it takes a company to resume its dividend payments.
2) A company such as Tesla that may not yet pay dividends, but if it manages to smoothen out the bumps, it potentially could. Importantly, however, if you look at a company that is innovative and only just establishing its legacy, the dividend payment history will probably be rather short. In such a case, you preferably want to consider the years when it has paid its dividend as a measure of its future potential.
In short, dividend history is a good indicator for whether or not to buy shares in a company. Just ensure that dividend payments have been steady, regular, and preferably raised year on year.
The share price in itself is a good indicator of whether or not you want to invest your hard-earned cash. On its own it carries only limited weight in determing whether or not to invest your hard-earned cash, if you want to get a good feel for where a company's share price will go in the future, it is useful to look at its past. Frequently the share price is beaten down by bad news, macro-economic factors, global market conditions, tweets, rumors, management changes - just to name a few.
Looking at the history of a company's share price can give you valuable insight into the psychology of markets. Frequently a particular share price will trigger an aftermath in market participants' reaction. Take for instance a company whose shares trade in a range between 93-99 Euros for a prolonged period. Let that share price jump above 100 Euro for the first time may trigger more people willing to buy the share at a higher price. Assume the share price rises to 108 Euro in the following two weeks, only to retract and fall again to 97 Euro. There are now two possibilities: 1) people start worrying and part with their shares for ever lower prices or 2) market participants are in waiting for the share price to cross above the 100 Euro mark again.
History can tell you when a share price finds its bottom and the likelihood of a further fall or an imminent rise in the share price again.
History gives, things equal as in the company is still intact, products are still sought after, cashflow is equal or higher than during previous periods, a great indicator of the potential of a share and what others are willing to pay for a share in the company.
Undoubtedly, it is only an initial indicator and you should only invest your money after having looked at other factos such as key fundamentals, product pipeline, management and its strategies, and acceptance by customers (the latter is probably the easiest by just observing the world around us).
What would a company be without its people. Before making the call on whether or not to invest in a company I always check their employee figures. You will find the information in the quarterly and annual reports on the Investor Relations section on any listed company's website.
You can also check sites such as statista.com to get a quick overview over the evolution of employees over the last few years. Here an example for Unilever. If you go back a few years, until 2010, you will see the number of employees working for Unilever has decreased by 12,000, from 167,000 to 155,000. However, the figures for 2019 are 161,000 Unilever employees. In order to understand these fluctuations, just quickly dig into Google News or Unilever's annual reports to get a better understanding. Fluctuations can be due to parts of the business being sold or acquired, part of the older workforce leaving and not being replaced – which may sometimes support the company's efficiency (depending on the company), or it may be part to some fundamental problems.
I also check, on their recruitment site, whether they are hiring, whether there is an uptick in recruitment or a downturn and if employee numbers have gone down, the reason behind it. Truth be told, this is obviously much easier when analyzing a smaller company than a multinational, but with multinationals I prefer to focus on jobs that will be relevant in the near future to determine whether HR and company management are in fact realizing their mission statement. For instance, there is little use for a company to talk about blockchain if it does not hire blockchain engineers.
Price to Book Value Ratio:
Another indicator you should look at is the Price to Book ratio, which tells you how expensive a share is in comparison to the book value, or shareholder equity on a balance sheet. When talking about Price, we mean the share price. The Book Value is nothing else but the assets minus the liabilities:
Book Value = Assets - Liabilities
In fact, it is one of my preferred ratios, as it tells you how much money a company is really worth. Or in other words, a company's intrinsic value.
Okay, so what is book value? In fact, you could do this in your own house. Look at all the furniture, electronics, etcetera and add it to the value of your house, then subtract the outstanding mortgage, that will give you your personal book value. This is no different for a company. A company owns machinery, properties, products, patentes, and many other items, these are all assets that the company owns, their assets. Liabilities would be the company's debt, whether in the form of bonds or credit lines from their bank.
Again, if you aren't keen on reading a financial statement, then just go to one of the many easily available websites such as Reuters (the link will take you to an overview of Unilever Plc, the company making products such as Axe, Ben & Jerry's, Dove, Magnum ice cream, and Rexona) and look at their Price to Book Value ratio.
Just as with any other measure, you will need a benchmark. The two benchmarks for all these indicators are the industry and the company's history. Just as the P/E ratio, however, generally the lower the Price to Book Value ratio, the better.
To sum up, these are all some of the indicators that can tell you whether a company is a good investment or not, and whether you should buy shares in that company or not. As with everything in life, it is difficult to predict what the future will bring. Thus, and this really is the most important measure of whether or not you want to invest in a company, trust your guts. I have written a post on Invest in What you Believe In. If you want to read more about how to determine whether a company is a good, non-risky investment, or a bad, risky share to invest in, check out: 10 Things to Consider When Buying Shares, the difference between blue chips, mid-sized, and small-cap companies, and the three part series about getting started buying shares and investing, brokerage fees, and minimum trades.