Investing in stocks can be a perilous exercise as recent stock market events have shown. A successful investor will choose each company that he takes a position in with great care. As a minimum he should make an effort to receive and understand the financial statements of the enterprise, the nature of the business that he is investing in, and the relative valuation of the company on the stock market. For instance, as recent history has shown, even the shares of well run companies in growing industries can fall precipitously if valuations get too far out of line. In addition, even shares of companies with prospects of solid growth can fall off a cliff if the company is inadequately financed or stretches its financial resources too far. The reason for this is that markets are fickle, and projecting the future is at best an educated guess. Companies that are inadequately financed may not be around at the end of a downturn, and downturns always come.

So how do you protect yourself with markets so volatile? The answer is buying cheap stocks. Stocks that trade at reasonable multiples, that are of financially solid companies with a history of success, in industries where there is reasonable comfort that even after a downturn there will be a return to normalcy. It is impossible to protect against any loss, but by adhering to the above rules, it is certainly possible to mitigate any losses that might occur.

Below is a cursory overview of the issues to be considered when contemplating an investment. The first rule of investing is to know what you are investing in. No investment instrument is just a piece of paper, it is a unit of ownership in an institution. You must know how that unit of ownership is valued and how viable the institution it represents is. The following points will give you an idea of what to look for in an investment opportunity.

What is a Share?

A share is a unit of ownership of a company. If a company issues 100 shares then each share has a claim on 1/100th of the net assets of the business. Net assets are the total assets of the business (what it owns) minus the total liabilities of the business (what it owes). Shareholders have a claim on the company’s assets after all other creditors have been paid. They are the owners of the business and therefore bare the risks of ownership. They have what is called a residual interest in the business. That is why in the case of bankruptcy shareholders generally get nothing, since nothing is left after all other creditors have been paid.

Shares are often described as issued or outstanding. Shares that are issued or outstanding are in the hands of shareholders. Companies are often authorized to issue millions of shares in excess of what are currently issued. If companies want to raise extra capital down the road they may issue additional shares. Shares that aren’t issued do not exist for all intents and purposes and are not used in any of the calculations discussed below.

Let’s take the example of Joe’s garage.

Joe’s garage has $200 in assets and $100 in debts. It has 100 shares outstanding.

The per-share value of Joe’s garage is therefore $1 ((200-100)/100). That means, in theory at least, that each share has a market value of one dollar.

Market Capitalization

When you hear announces or analysts talking about the total market capitalization of a company, they are talking about the total value of all shares outstanding. If a company has 1,000,000 shares outstanding at a market value of $50 per share, then the market capitalization is 50,000,000.

You also here about small cap versus large cap stocks. This has to do with a series of benchmarks that determine what category a particular stock fits in. For instance, a small cap company might have up to $100,000,000 of market value and a large cap over a billion. Effectively the market capitalization is the market’s appraisal of the value of the total net assets of the company.

How Shares are Valued - What is Price Earnings Ratio?

The most common technique for valuing shares is using the price earnings ratio. Price earnings ratio is the relationship of the price that a share is trading at, to the per share earnings of the company. Per share earnings are merely the earnings of the company divided by the number of shares outstanding. Let’s have an example:

Let’s say that Joe’s garage earned $500 for the year. Let’s further assume that he has one hundred shares outstanding and that his shares are trading at $100 a piece. His price earnings ration would be 20 or $100/$5 (Market value per share divided by earnings per share). We could also say that the stock trades at a multiple 20, that is, investors are willing to pay 20 times earnings to acquire a share of Joe’s stock.

The rate of return on Joe’s stock would be 5% or 5/100 (Earnings per share divided by market value per share). This assumes that the earnings of the company will eventually be converted to cash and distributed to the shareholders much in the same way bond interest is paid to bondholders. Another way of determining the multiple is 1/rate of return. In Joe’s case 1 divided by 5% or twenty.

In setting a desired rate of return for a company several issues have to be addressed,

Let’s take a look at the market valuation of Moe’s Pharmaceutical’s

First, we’ll assume that the rate of return on risk free investments is 4%. Risk free investments would include government bonds with ten to thirty year maturaties.

Moe’s Pharmaceutical is a rapidly growing company with year over year earnings growth of 20%. The company earned $2 per share in the prior year and currently trades at a multiple of 20 or $40 (multiple x earnings per share). To earn a guaranteed $2 with no risk would require an investment of $50 (Desired return / risk free interest rate or 2/4%).

Bonds and money market investments, despite their guaranteed returns, generally provide little if any growth. After twenty years of getting 4% on your money you still have the same $50 in principal (assuming that interest rates stayed the same). You were guaranteed your 4% return per year but got no appreciation in your capital.

To compare, let’s assume that Moe’s growth rate continues on at 20%. Let’s also assume that the return on risk free investments stays constant at 4%, and that Moe’s shares continue to trade at a price earnings multiple of 20.

EPS (earnings per share) for the following five years are as follows;

2000 $2.40
2001 $2.88
2002 $3.46
2003 $4.15
2004 $4.98

At the end of the fourth year the value of the stock is $4.98 x 20 or $99.6. We have heard a lot about how shares of stock have historically had far greater rates of return than bonds or bank interest. The above is a graphic example of why. The monetary gain of buying shares of Moe’s pharmaceuticals amounts to $59.6 ($99.6 - 50).

There are two points to keep in mind regarding the above.

1) The risk free return must stay low in order to maximize the valuation on the shares. If for example, interest rates crept up to 10% from the four percent that they were at when the shares were purchased, the ensuing multiple would greatly decline. In other words, if you can get 10% without any risk, you would expect an even higher return if there were risk. In our example the multiple might decline to 6.7 or 15% effective return for an investment at the risk level of Moe’s. The valuation in year four would therefore be $33.2 ($33.2 x 15% = 4.98/share).

2) Growth rates must be constant. Shares are valued based on the expectation of future growth. If for whatever reason growth rates slow down, the share valuations could decline dramatically. That is because, in the absence of growth, the market would require a much greater current return on investment. In the case of Moe’s, if the market feared that the growth rate might slow down, it might adjust the required return to 6% from the current 5%. That would adjust the multiple to 16.67 (1/6%) and the current valuation to $33.33 or $2 x 16.67.

One can see from the above that even slight differences in the underlying assumptions regarding a stock’s valuation can have profound affects on its trading price. The greater the price earnings ratio of a stock, the greater its reaction to changes in either earnings expectations, or interest rate variations.

What are Investment Fundamentals?

Fundamentals refer to the underlying factors governing a stock price. Such things as rate and consistency of growth, strength of the company’s balance sheet, level of profitability, and price earnings ratio all contribute to determining the strengths of an investments fundamentals.

Consistency of Growth

As we mentioned previously, company’s that have consistent growth patterns tend be valued at higher multiples than those that don’t. Remember that stocks are valued based on their projected stream of future earnings. Even though a company may have very rosy earnings today, it may trade at a very low multiple since its earnings are not expected to grow going forward.

On the other hand, some companies that show insignificant earnings currently are valued at astronomical multiples since investors feel that earnings will mushroom in the future. If one anticipates compound growth rates of 50% as with some internet stocks, the current earnings appear to bare little relationship to the market price of a share.

Strength of Balance Sheet

This is a key factor in assessing the risk of an investment and therefore its price earnings multiple. If a company has a very solid balance sheet, that is its assets are far greater than its liabilities, then it is considered more able to weather economic downturns or take advantages of opportunities that come up in the market place.

The debt to equity ratio provides information on the relationship between the amount of company’s financing that is generated from debt versus internal sources. Internal sources include income retained in the business and not distributed to shareholders, and funds contributed by company owners, normally through the issuance of capital stock. These are referred to as the equity or the owners’ interest in the company. The greater the ratio of equity financing a company has, the more stable and financially sound it is considered. A company with a debt to equity ratio of one to one or better, is generally considered very solid. This means that for every dollar a company has borrowed, another dollar was provided by either the sale of shares or retention of corporate earnings.

The current ratio is another measure that is considered. It measures the relationship between debts due within one year and assets that will be converted to cash within one year. It is a short-term measure of liquidity, which measures the ability of the company to pay its creditors in the short term.

Level of Profitability

The level of a company’s profitability is the amount of money a company makes from selling its product or providing its service. It is closely related to return on investment which is the amount of income a company generates from each dollar of invested capital. If a company competes in a growing market, has a recognizable brand name that guarantees it consistent market share, and has its costs well under control, it becomes an attractive investment.

Companies that have an established franchise, such as Intel, where consumers are willing to pay a premium to acquire their product are in a very enviable position. They have latitude in passing price increases on to customers thereby protecting their margins, and their financial strength can assure that they have considerable clout with suppliers. Such factors make a company a significant long-term player, and contribute to its ability to grow its earnings.

Discount or Premium to Book

When balance sheets are prepared they are prepared on a historical cost basis. What this means is that the assets are valued at their initial purchase price unless there is evidence of a permanent decline in which case they are written down to current market value. Financial statements are prepared very conservatively, often reflecting values for assets acquired years past. In addition, balance sheets rarely reflect the goodwill of a company. Unless goodwill is actually acquired when an affiliate or subsidiary is purchased it is not reflected on the balance sheet. Goodwill is the value of the company’s name, its franchise, or its ability to earn income. Most companies are worth more than the sum of their parts particularly if they are highly profitable. Goodwill is the difference between the sum of the parts and the going concern value of the company.

If a company sells at a discount to book, we mean that the book value, as disclosed on the company’s balance sheet, divided by the number of shares outstanding, is greater than the market value of the individual shares. This implies negative goodwill, or the fact that the company is worth less as a going concern - unusual in all but the most extreme circumstances. Clearly any company that trades at a discount to book would be considered less risky. At a minimum it could be a takeover target for other more profitable companies in the same industry.

On the other hand, the forces that would push a company to trade at a discount to book may also prohibit it from generating any compelling returns in the near term. This type of situation normally requires a long- term horizon.

Price Earnings Ratio

The price earnings ratio is really a composite of the above points. It is determined by the financial strength of a company, how consistently it has grown it’s earnings, the strength of its balance sheet and its level of profitability.

But price earnings ratio is more than the sum of these four. Very often even the best companies can trade at ratios that are astronomical. A company can have wonderful fundamentals but the market price of the stock is so high, that every favorable variable combined cannot support it. Some internet stocks, despite having otherwise sound fundamentals, trade at price earnings multiples that anticipate future results that are virtually unattainable. The stock no longer represents value but becomes more of a work of art, reflecting a desire for ownership rather than any consideration of what the company might be worth. These are situations to avoid. If simple rule of thumb valuation techniques are used, most investors can steer themselves clear of them.

If the risk free return is around five percent, then a multiple of greater than 80 is clearly dangerous. Let’s look at an example. Let’s say a company earned one dollar per share and traded at a multiple of 80. Let’s further assume that earnings are expected to grow 33% per year indefinitely (a tall order for any company)

Assuming five years of growth at 33%

2000 1.33
2001 1.77
2002 2.35
2003 3.12
2004 4.14

It would take five years to get back to the level of earnings that you could get on a risk free investment presently. Of course this assumes that the company grows at 33% per year which is not easy for any company. What happens if the economy has a downturn and earnings fail to measure up? What happens if interest rates creep up and the multiple declines? Eighty is a very high multiple to sustain and assumes a very low level of inflation, steady astronomical growth in earnings, and a market that is expanding without inflationary pressure. One can can see how any one of a number of factors can derail an investment.

Conclusion

The above is a very cursory view of some of the issues involved in evaluating investments. I hope it has been helpful.