More on evaluation methods

While “gut feel” has some use in decision making, the methods prescribed to evaluate stocks are primarily divided into two. These are fundamental analysis and technical analysis.

Simply defined, fundamental analysis is about the examination of the company’s health and potential to succeed while technical analysis is more about the study of the price movement of a company’s stock in relation to its price history, pattern and trends as affected by crowd psychology.

Similar to evaluating how you earn, save and spend your earnings to understand the quality of your life, fundamental analysis also involves assessing how a company is running its business to determine its “intrinsic value.”

Intrinsic value is the price at which a stock should sell in the market on normal conditions. In short, it’s about the “right price” of a stock.

Opposite to the above mentioned philosophy, technical analysis asserts that the “value” of a stock is entirely determined by supply and demand.   It has “very little relationship to any intrinsic value.”

Technical analysis provides that “prices reflect everything known about the market, including all fundamental factors.”

It asserts that “each price represents the consensus of value of all market participants.”  These include that of big managed funds, speculators, fundamental investors, technicians and gamblers or gut-feel traders.

Contrary to the impressions given by purists on the said methods, they actually complement each other in helping determine the price of a stock.

As claimed, “technical analysis can give direction and timing” of stock prices.  Fundamental analysis “can give indication of the magnitude of anticipated price movements.”

Thus, like in combining value and growth investing principles, the said methods can help you win your game in the market.

Measurement tools

First in fundamental analysis is cash flow.  It’s a very important indicator to a company’s health.  A large stream is a good sign that there is enough money to “keep the lights on and the water running,” as one author puts it.  This cannot be over emphasized by the recent selloff that happened on San Miguel Corp. (SMC) shares last week.

Due to SMC’s low current ratio—particularly its interest coverage ratio—compared to other conglomerates like Ayala Corp. (AC) and Metro Pacific Investments Corp. (MPI), SMC was sold down by the market, fanned by an article that drew conclusions from an IMF report on the possible devastating effect of a conglomerate’s fall.

The speculation drove down the share price of SMC by almost 7 percent that further dipped by another 7 percent early the following morning before regaining ground before the end of trading when debunked by the SMC management in the afternoon.

From the foregoing, there are three measuring tools mentioned.  All are involved in a company’s state of liquidity or ability to meet (pay) financial obligations.

The first is cash flow per share.  The formula for cash flow per share is total company cash flow divided by the number of shares outstanding.  As such, it also lets you to see what price you are paying for a share of the company’s cash flow.

The second is current ratio, the most popular gauge to a company’s ability to pay its short-term debt bills.  It is derived by dividing current assets by current liabilities.   As a rule, a higher ratio is indicative of a company’s better ability to “deal with unexpected expenses or opportunities.”  Considered a good current ratio is the coverage of “three-to-one” (current assets are three times current liabilities).

Similar to the current ratio but better in providing a more accurate look at a company’s ability to meet short-term needs is the quick ratio. It is measured by dividing only the company’s cash and equivalents by its current liabilities.  A quick ratio of at least 0.5 is considered good.  This means the company has cash worth half of its current liabilities readily available.

The third is interest coverage ratio.  This is calculated by dividing earnings before interest and taxes to annual interest expense.  The same principles apply.  A higher ratio will be indicative of a company’s ability to easily meet its financial obligation.  A lower ratio would speak otherwise.

Another measuring tool is dividend yield.  This is measured by dividing the company’s cash dividend with its current price.  Dividend yields could be pretty boring.  Most of your favorite stock picks are not be paying dividends.  But if you want steady payouts, dividend yield counts.

Next is profit margin.  Like in the aforementioned ratios, a higher profit margin is better.  This is because a company with higher profit margin means it has more money left for stockholders than with a company with smaller profit margin after paying all expenses.

Important as well is the price to book ratio or price/book ratio.  It “compares a stock’s price to how much the stock is worth right now if somebody liquidated the company.”  To get the price/book ratio, divide the stock’s price by the company’s book value per share.  Again, it’s considered good if the ratio is less than one.  That means you are paying less for the stock than its liquidation value.

Price/sales ratio or PSR is another important measuring tool.  To get PSR, simply divide price per share by sales per share.  It may not look that exciting as the price/earnings multiple (this was discussed at length previously), as earnings seems to be the ultimate determinant to a stock’s attractiveness.  However, earnings can sometimes be manipulated by the use of accounting rules.  “But with sales revenue,” according to one author, “there’s not a lot to adjust.  It’s just what you sold—end of the story.”

We’ll go through the measuring tools of technical analysis next time.

Bottom line spin

The market’s high value turnover of P26.57 billion last Friday failed to lift the market.  Trading ended for the day with a loss of 27.33 points or 0.41 percent.  Also, even if foreign buying hit P12.53 billion while foreign selling was P5.45 billion last Friday, the market ended lower.

Everyone blamed the sale of SMC’s shareholdings in Manila Electric Co. (MER) for the market decline last Friday.  Its MER shareholdings of about 63.3 million were priced and sold at P270 a piece.  It was able to raise some P17.37 billion from the transaction but it drove down the market in the process.  The share price of MER dropped by 8.2 percent to P277.60 from P302.40 previously.

Like the price of MER, though, the market is expected to climb back soon.

(The writer is a licensed stockbroker of Eagle Equities Inc.  You may reach the Market Rider at [email protected] , [email protected] or at www.kapitaltek.com)