The secret to choosing good common stocks is that there is no secret to it. The winning techniques are tried and true; it's how you assemble and apply them that makes the difference. The techniques don't work all the time, but they work often enough so that the methods employed by successful stock investors tend to be more alike than different.
Information is the key. Having the right information about a company and knowing how to interpret it are more important than any of the other factors you might hear credited for the success of the latest market genius. Information is even more important than timing. When you find a company that looks promising, you don't have to buy the stock today or this week or even this month. Good stocks tend to stay good, so you can take the time to investigate before you invest.
You'll have no trouble finding candidates for your investment dollars. Brokers are full of suggestions, of course, and you may come across intriguing products or companies while walking through a store or leafing through a newspaper. Or your eye may be caught by one of the gorgeous "corporate image" ads that run in upscale magazines.
You'll quickly discover that the number of stocks that meet all the tests described below at any given time will be low. So what you're really looking for are stocks that exhibit most of the following signs of value and come close on the others.
Earnings. This is the company's bottom line -- the profits earned after taxes and payment of dividends to holders of preferred stock.
Dividing earnings by the average number of common stock shares outstanding during the period being measured gives you earnings per share, a key number for evaluating any company. Earnings are also the company's chief resource for paying dividends to shareholders and for reinvesting in business growth. In the annual report, check to be sure that earnings come from routine operations -- say, widget sales -- and not from one-time occurrences -- say, the sale of a subsidiary or a big award from a patent-infringement suit.
The exhaustive stock listings in Barron's give the latest quarterly earnings per share for each stock, plus the date when the next earnings will be declared. Historical earnings figures are available in annual reports, S&P and Moody's publications and Value Line Investment Survey.
Value Sign #1: Look for companies with a pattern of earnings growth over at least five years and a habit of reinvesting at least 35% of earnings in the expansion of the business. The reinvestment rate can be determined by comparing earnings per share with the dividend payout. The portion that isn't paid out to shareholders gets reinvested in the business.
Price-earnings ratio. The price-earnings ratio is probably the single most important thing you can know about a stock. It is the price of a share divided by the company's earnings per share. If a stock sells for $40 a share and the company earned $4 a share in the previous 12 months, the stock has a P/E ratio of 10. Simply put, the P/E ratio tells you how much money investors are willing to pay for each dollar of a company's earnings. It is such a significant key to value that it's listed every day in the papers along with every stock's price.
Any company's P/E needs to be compared with those of similar companies and with broader measures as well. Market indexes such as the Dow Jones industrials and the S&P 500 have P/E's, as do different industry sectors, such as chemicals or autos. Knowing what these are can help you decide on the relative merits of a stock you're considering. Standard & Poor's 500-stock index tends to have a P/E in the low teens -- that's the combined price of its 500 component companies divided by their combined earnings. Analysts would say that a stock with a P/E, or "multiple," of 10 trades at a discount to the market, because its P/E ratio is lower than that of the market as a whole. By the same token, a stock with a P/E of 20 is said to be trading at a premium, which means that its P/E is higher than the market's.
In addition to allowing you to judge a stock's comparative worth, knowing the P/E of the S&P 500 or the Dow Jones industrials can give you a clue to the bigger picture. A typical range for the P/E of the S&P 500 is 13 to 15 during a rising, or bull, market and 8 to 10 in a declining, or bear, market. When the S&P sports a P/E of 22 or thereabouts, as it did shortly before the stock market crash of October 1987, it's wise to cut back on new stock purchases or even lighten up on your holdings in expectation of a fall to a more sustainable level.
As you might expect, investors are willing to pay more to own shares of companies they think will increase their profits faster than the average company. But high-P/E stocks carry the risk that if the company's earnings disappoint investors, its share price may plunge quickly. Just one poor quarter -- or a rumor of one -- can mean a vicious pounding for a stock with a premium multiple.
By contrast, investors don't expect a low-P/E company to grow as rapidly and are less likely to desert the company on mildly unfavorable news. If profits rise faster than expected, investors may bid up that low P/E. The combination of higher earnings and a growing P/E can push a stock's price up fast.
P/E's serve yet another useful function: Other things being equal, analysts often recommend the stock with the lowest P/E in its industry if they like the business and if several companies look good. For example, the auto and truck industry normally trades at a P/E of around 5 or 6, while the food-processing industry usually has a multiple of about 15. Therefore, if General Motors has a P/E of 4, it is actually selling at a slight discount to its industry and is thus relatively cheap. If General Mills has a P/E of 15, it is right in line with its industry, neither expensive nor especially cheap at that time. (Caution: A low P/E is not by itself a sign of value. A stock's price may be low relative to its earnings because investors have little faith in the reliability of those earnings, and investors could be right. A good example of this was the low premium investors were willing to put on shares of banks just before their earnings evaporated in 1990.)
You don't make any money from the stellar performance of a company before you buy its stock. You want it to do well after you buy it.
So look not only at the "trailing" P/E, which is based on the previous 12 months' earnings, but also at P/Es based on analysts' future earnings estimates. Those could be wrong, of course, but they are another piece of information on which to base your decision to buy or not to buy. Brokers will happily provide the forecasts of their firms' analysts.
There are other factors to weigh before deciding which stocks to buy. But P/E ratios are the natural starting point because they= provide a quick way to separate stocks that seem overpriced from those that don't.
Value Sign #2: Look for companies with P/E ratios ranging from less than 10 to no more than about 12 or 13.
Dividend yield. This is the company's dividend expressed as a percentage of the share price. If a share of stock is selling for $30 and the company pays $2 a year in dividends, its yield is 7%. In addition to generating income for shareholders, dividends are a good indicator of the strength of a company compared with its competitors.
A long history of rising dividends is evidence of a strong company that manages to maintain payouts in good times and bad. Even better is a company with a history of rising dividends and rising earnings per share to match. A stock's current dividend payout and yield are included in the daily stock listings in the newspaper. For historical information, the S&P Stock Guide and Value Line are excellent sources.
Analysts' dividend forecasts play an important role in creating expectations for a stock's future performance. If analysts expected the $30 stock mentioned above to raise its quarterly dividend to 55 cents, its price might creep upward in anticipation of the increase. Then, if the company's profits rose only enough to permit it to pay 52 cents per share, disappointed investors might sell, thus causing the stock's price to fall even though profits and dividends rose!
Sometimes the opposite can happen. Shortly after the death of its nonagenarian founder, Armand Hammer, Occidental Petroleum announced a dividend cut and its price quickly rose. Analysts deemed the move (which was part of a larger plan to close down some unprofitable operations and write off debts) a smart step toward a stronger company in the future. Thus, a dividend cut isn't always a sign of weakness in a company. It's important to know what's behind it.
Although occasionally dividends are paid in the form of additional shares of stock, they are usually paid in cash; you get the checks in the mail and spend the money as you please. Many companies encourage you to reinvest your dividends automatically in additional shares of the company's stock and have set up programs that make it easy to do. Such arrangements are called dividend reinvestment plans, or DRIPs.
Value Sign #3: Look for a pattern of rising dividends supported by rising earnings, and look for a dividend yield of at least 3% or 4% to generate income to reinvest in the company.
Book value. Also called shareholders' equity, book value is nothing more than the difference between the company's assets and its liabilities (which includes the value of any preferred stock the company has issued). Book value per share is the company's book value divided by the number of shares of common stock outstanding.
Normally, the price of a company's stock is higher than its book value, and stocks may be recommended as cheap because they are selling below book value. Such stocks have often attracted takeover bids from big investors and corporate raiders, which in turn attracted other investors who bid up the price of the shares. But the hope of a profitable takeover is not a good enough reason to buy such shares. A company's stock may be selling below book value because the company shows little promise, and you could wait a long time for your profits to materialize.
Still, the idea of buying shares in a company for less than they are really worth does have a certain appeal. At any given time, dozens of stocks will be selling below book value for one reason or another, and they aren't all dogs. Some may be good small companies that have gone unnoticed or good big companies in an unloved industry. How can you tell? If the company has a low P/E ratio (under 10), a 3% or 4% dividend with plenty of earnings left over to reinvest in the business and no heavy debts, then it may be a bargain whose down-and-out status is a temporary condition that time and patience will correct.
On the other end of the scale, you want to stay away from companies whose price is too far above book value per share. It's difficult to say what's too high because the standards vary so much depending on the industry, and in some industries -- insurance and finance, for instance -- book value per share isn't considered particularly significant. In general, when the figure is available, you want it to be on the low side.
Value Sign #4: Look for stocks selling at a price no higher than 1.3 times book value per share.
Return on equity. This number is the company's net profits after taxes divided by its book value, and it can usually be found in the annual report. It shows how much the company is earning on the stockholders' stake in the enterprise. If return on equity is growing year after year, the stock's price will tend to show long-term strength. If the number is erratic or declining even though profits are steady, you may have uncovered problems with debt or profit margins and you should stay away from the stock.
Value Sign #5: Look for a return on equity that is consistently high compared with other companies in the same industry or that shows a strong pattern of growth. A steady return on equity of more than 15% is a sign of a company that knows how to manage itself well.
Debt-equity ratio. The debt-equity ratio shows how much leverage, or debt, a company is carrying compared with shareholders' equity. For instance, if a company has a billion dollars in shareholders' equity and $100 million in debt, its debt-equity ratio is .10, or 10%, which is quite low. In general, the lower this figure the better, although the definition of an acceptable debt load varies from industry to industry. You'll find data on debt in annual reports, Value Line, Moody's and S&P publications.
Value Sign #6: Stick with companies whose debts amount to no more than 35% of shareholders' equity. Price volatility. Probably the most widely used measure of price volatility is called the beta. It is calculated from past price patterns and tells you how much a stock can be expected to move in relation to a change in the S&P 500-stock index, which is assigned a beta of 1.00. A stock with a beta of 1.50 historically rises or falls half again as much as the index. A stock with a beta of .50 is half as volatile as the index; it would be expected to go up only 5% if the market rose 10% or down 5% if the index fell 10%. A few stocks have negative betas, meaning they tend to move in the opposite direction from the market.
Betas are published by several stock-tracking services and are usually available from a broker. The key thing to remember about betas is that the higher the beta the bigger the risk.
Value Sign #7: For the most part, stick with stocks with betas of around 1.0. Whenever you assume the risk that goes with an oversized beta, it should be in the expectation of an oversized reward. There you have the numbers-crunching, balance-sheet approach to finding value in the stock market. Those numbers are extremely important, but they aren't the only facts you need. If the stock meets the above tests, look for these additional signs of value.
The company's industry is on the rise. Even though you can make lots of money in a declining industry, you're more likely to succeed in big and growing markets than in small or shrinking ones. Exciting new industries may still offer exciting profit potential, but the staying power of any particular company is hard to predict. The best long-term prospects lie with established companies in large industries that meet the tests in the previous section.
The company is a leader in its industry. Being number one or two in its primary industry gives a company several advantages. As an industry leader it can influence pricing, rather than merely react to what others do. It has a bigger presence in the market: When the company introduces new products, those products stand a better chance of being accepted. Also, it can afford the research necessary to create those new products.
The company invests in research and development. Any company worthy of your investment dollar should be concerned about product development and future competitiveness. Compare the company's spending on research and development -- both in actual dollars and as a percentage of earnings and sales -- with that of other firms in its industry. If expenditures seem quite low, think twice about buying the stock.
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