Fundamental factors in stock selection

It was pleasing to see young people at the 7th Money Summit and Wealth Expo at the SMX Convention Center last weekend to learn from seasoned resource persons on the private accumulation—and management—of wealth through savings, stock investing, foreign exchange trading and real estate.

Among the various presentations on the subject of stock investing, my topic (if you likened it to methods in gathering information and evidence to solve a crime) was the use of what can be referred to as plain lengthy police-work-process of investigation as compared to the rather fancy approach of intelligence-gathering by secret agents like the rocket sciences employed on stock selection.  My topic was the “bottom-up method” of investing.

I made a short article on bottom-up investing before but it dealt mostly on explaining the theoretical basis of the method.  I outlined my presentation concentrating just on that, thinking it was enough considering the retail type of event the expo was.

Nonetheless, I incorporated a checklist of preferred financial ratios in bottom-up investing that makes it an effective method for stock selection, but did not prepare the complete visuals.

To my surprise, far from how casual and carefree looking as they appeared, these young audience who attended the seminar were far from typical retail investors who rely on just market tips either from stockbrokers, friends, neighbors, relatives, or relatives, neighbors and friends of relatives, neighbors and friends and so on to an unending line of incomplete sources of market information.

Key values to know

There are several key fundamental values important in bottom-up investing, namely: earnings, profit margin (PM), return on equity (ROE) return on invested capital (ROIC), price-to-earnings ratio (PER), projected earnings growth ratio (PEG), price-to-sales (P/S), book value (BV) and price-to-book (P/V), dividend payout ratio (DPR) and dividend yield (DY), market capitalization (MC) and enterprise value (EV), and free cash flow (FCF), liquidity and solvency ratios.

Before investing in a company it is important to know first how much the company is making in profits, both at present and in the future.  This can be easily captured through earnings per share (EPS), which is basically derived as the amount of earnings for each share with the following formula: Net income divided by average outstanding number of shares.

Knowing a company’s profit margin is second. The amount of earnings does not tell the full story about a company.  The company’s profit margin reflects how much a company keeps in earnings from its revenue. The formula is net income (NI) divided by revenue (expressed in net amount).

Increasing earnings are good but if cost increases more than revenues, the profit margin of a company may be affected. A higher profit margin is indicative of a company’s control over its cost.

As per the formula, profit margins are displayed in percentages.  For example, a 10 percent profit margin denotes that the company has a net income of maybe P0.10 for every P1 of revenue.

The resultant ratio from a company’s profit margin becomes more significant when used to analyze an alternative company of similar business competing as an investment selection.

Third, is return on equity (ROE) and on invested capital (ROIC).  Return on invested capital is a financial ratio that does not account for the stock price. Since, it ignores the price entirely, it is thought by many financial theorists as the most important financial measure. It is basically considered the mother of all profitability ratios.

This ratio is a measure of how efficient a company is doing in generating profits.  It is a ratio of revenue and profits to owner’s equity (shareholders are the owners).  The formula is net income divided by stockholder’s equity.

Its significance is shown by the example that if two companies both generate net profits of P1 million but the first company has equity of P10 and the second company has equity of P100 million, there ROE will be 10 percent and 1 percent, respectively.

Immediately, you will see the first company is more efficient as it is able to produce the same amount of earnings with 10 times less equity.

The reason why this measure is so important is because it contains information touching on several factors to be concerned about, such as: Leverage (the debt of company, which gives rise to the expression that “a company with significantly more debt is highly leveraged”), revenue, profits and margins, and returning values to shareholders.

Return on invested capital or ROIC is also known as “return on capital.” It is a variant of ROE that also show the efficiency of a company from allocating capital to profitable investments as it gives further sense on how well a company is using its money to generate returns.

Comparing a company’s ROIC with its cost of capital or weighted average cost of capital (WACC) would reveal whether invested capital is used efficiently.

To calculate ROIC, the following equation is used: net income minus dividends divided by total capital.

Take note that total capital includes long-term debt, and common and preferred shares.  And because some companies receive income from other sources or have other “conflicting items in their net income,” net operating profit after tax (Nopat) is used instead.

The fourth, is the very popular price-to-earnings ratio or PER.  It represents the number times the market is valuing the earnings of the company.

The formula is stock price divided by the earnings per share.  As it is, it is an easy way to get a quick look of a company’s stock value. A high PER indicates that the stock is priced relatively high to its earnings and, thus, normally considered expensive.  Again, its significance is better appreciated when compared to the PER of a similar company.

Bottom line spin

We will continue with the rest of the review of the key ratios next time.  In the meantime, the market last week ended within a striking distance to the exciting psychological level of the benchmark index of 7,000.

At last Friday’s closing index of 6,962.28, the market was only 37.72 points or 0.54 percent away. This development even makes it now more important to be aware about the fundamentals of companies in play in the market. Plain market tips or impressions could lead to costly wrong stock investments.

(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)