Stock evaluation methodsBy Den Somera
Philippine Daily Inquirer
When the market’s main index settled at 6,574.21 last Friday, it was on its third week of rally that has so far resulted in the recovery of 392.04 points or 6.34 percent of lost ground.
This brought the market to its current level, with a year-to-date record of 14.86 percent gain and a year-on-year record of 28.84 percent gain.
Last Friday on Wall Street, the Dow Jones Industrial Average (DJIA) and S&P500 also “surged to record highs for a third week of gains.”
According to the source, S&P500’s close last Friday was “its biggest rally since Jan. 4, (which) helped erase losses since Bernanke first signaled the Fed might trim its $85 billion in monthly purchases later this year.”
DJIA’s performance last Friday yielded a year-to-date gain of 19.59 percent and a one-year gain of 24.29 percent.
S&P500 shared an almost equivalent performance record of 19.17 percent year-to-date gain as well as a one-year gain of 26.76 percent.
At these price levels, stocks were deemed ripe for profit taking. They presented good margins and became the “selling thresholds” of both local and Wall Street investors.
Owing to this nature of the market, the prospects of having winning stock plays— that is, being able to buy low and sell high or buy high and sell higher—had become a difficult proposition, making value investing an ideal strategy.
When we started to discuss value investing last week, we came to distinguish it from growth investing which we found out are mutually exclusive strategies.
The so-called “growth investors use some measure of value to time their purchase.” “Value investors also use some measure of growth potential to evaluate a troubled company’s chances of recovery.
They are actually a continuum rather opposite strategies likened to north and south. As such, one author calls value investing the “value growth” method.
In understanding value, we also came to learn how the market deduce value from corporate earnings, called the price or earnings multiple.
Otherwise known as the P/E ratio, it is the valuation ratio of a stock’s current price in relation to the earnings or net income per share of the company.
For instance, if the net income of a company is P4 per share and its stock is trading at P40 a piece, the company is said to have a P/E ratio of 10 times, or its stock valuation has a price multiple of 10 times earnings.
The earnings figure applied to derive the stock’s P/E is either based on past or future (projected) data. As advised, both figures are to be used. It affords better insight in appreciating a stock’s valuation.
Also, the data used in the analysis can be both the company’s annual or quarterly earnings figures, depending on one’s purpose.
In order to appreciate a stock’s value through the P/E ratio, one is to compare its historical record. Another method is to compare it to the P/E ratio of other stocks in the same industry. This can be extended in relation to the P/E ratio of the market, in general.
At certain circumstances, a low P/E may suggest a stock’s undervaluation. It can also mean otherwise when a stock falls out of favor and is, thus, sold down by the market due to a number of negative factors.
These negative factors could be bad management, loss of market share and fall of gross margins due to competition and/or the introduction of alternative products, the loss of comparative advantage in technology or in human resources, and the like.
As such, this makes a high P/E a general sign of better valuation. It usually suggests, among others, the investors’ high confidence in the future growth and continued profitability of a company. A case in point is Ayala Land Inc. (ALI). Compared to its other peers in the property sector, it has a much higher multiple. Yet, it is a highly sought stock by value investors.
But with things being equal, a comparatively low P/E in the same industry or sector is a sign of a stock’s undervaluation, which is the target of value investors.
It is not recommended to use the P/E ratio as a standard to determine the relative valuation of stocks that do not belong to the same sector. This happens, for instance, when you compare the P/E of a stock that belongs to the industrial sector vis-à-vis stocks from the bank, real estate or utility sectors.
Any sense of valuation is lost as you compare them. As one reference explained it, this was because they “have different (earnings and) growth prospects.”
Lastly, it is advised to avoid the use of the P/E ratio as the lone basis of one’s decision. To quote one source, “the denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying number.”
Bottom line spin
There are two main ways to evaluate a stock. The first way is the use of fundamental analysis. This involves the examination of information that largely deals on the company’s financial resources and potentials to operate successfully. It is through this way that you learn about a company.
The second is the use of technical analysis. This examines the price dynamics of the company’s stock under different market conditions. It is through technical analysis that you will learn about the company’s stock price. The result of which is a prediction of the stock’s future price. The said predictions are influenced by anticipated market conditions and trading volumes.
It is through fundamental analysis that you come across good companies. As explained by one author, this will be the main foundation to successful investing.
Fundamental analysis is “looking at a company’s management, its rate of growth, how much it earns, and how much it pays to keep the lights on and the cash register ringing,” as described by the same author. Through these variables, you will be able to determine what is called the company’s “intrinsic value.”
As explained, intrinsic value is simply “the price at which a stock should sell at under normal market conditions.”
Technical analysis, on the other hand, “uses charts of price history.” It subsists on the idea that “supply and demand drives all stocks prices.” Watch out for the continuation next week.
(The writer is a licensed stockbroker of Eagle Equities Inc. You may reach the Market Rider at email@example.com , firstname.lastname@example.org or at www.kapitaltek.com)