So far in this series, I have shared the first seven of 10 questions that you should answer before you decide whether or not to buy a share of stock in a particular company. The gist of these 10 questions is to help you understand the company you are investing in and items to pay attention to when sizing up what’s on the horizon, both good and bad. After all, how do you know how to gauge a company’s business and the competitive landscape if you don’t have a firm understanding of what the company does and how it makes money for itself and its shareholders? These are some of the tools I use each time I look at a new opportunity that I may share with subscribers to my Growth & Dividend Report newsletter.
- What does the company do?
- What are its key products or services?
- At what business unit or units does the company make most of its profits?
- Who are the key competitors and how are they impacting the market?
- What is driving growth at the company?
- What is driving the company’s profit picture and, if it’s not improving, why is that?
- What does the company’s balance sheet look like?
If you haven’t reviewed those questions yet, and maybe even if you have, you may want to do so, because the next three questions build on the previous answers. With that said, let’s tackle the next question; it’s one I get all the time when I speak at conferences and other events:
8. What valuation metrics are key?
This is a fantastic question and it moves us from thinking about the business of the company we’re thinking of investing in to the shares. Subscribers to my Growth & Dividend Report invest in companies that are benefitting from PowerTrend tailwinds, and I use that same strategy for the Thematic Growth Portfolio I manage at Fabian Wealth Strategies — but to do so, we must buy their shares at the right time.
If you buy them too late, you may have missed most, if not all, of the upside to be had in the shares. While it’s a bit trite, the old Wall Street adage of “Buy low, sell high” does ring true, but how do you know what is “low?”
All of this speaks to one of the most important toolkits an investor, either individual or professional, has to have. With a variety of valuation tools at your disposal, you can be prepared like Batman confronting one of his various villains: the Dark Knight has to know which tool to grab from his utility belt to thwart whatever mayhem is before him. The same goes for us; granted, we’re not facing off against the Joker, Penguin or Catwoman.
There is no shortage of valuation tools, and odds are you’re rather familiar with some of the more common ones, like the price to earnings (P/E) ratio or dividend yield. What some may not be familiar with are some of the variations. Just as you can exercise with variations of the standard push-up, there is the basic P/E form that we all know, but we can scrutinize these P/Es on a historical basis, compare them to the industry peers that we identified with Question 4 (peer valuation) and even compare them against multiples for the S&P 500 (better known as the relative P/E). The same tweaks hold true for using dividend yields.
Of course, not all companies pay dividends, and there are more than a few that do not generate earnings. In situations like these, we turn to other valuation metrics, such as enterprise value (EV) to revenue or EV to earnings before interest, tax, depreciation and amortization (EBITDA) and price to book value. As with P/E ratios and dividend yields, these metrics can be scrutinized on a historical, peer and relative basis, as well.
While not overly difficult, it can be taxing to pull all of the various pieces of information together, but I find doing so really helps me understand the company and how it stacks up against its competitors. As you start to roll up your sleeves and do your homework on both the company and the stock, my recommendation is to build a valuation framework that include some combination of historical, forward-looking, peer and relative metrics mentioned above.
Personally, I like to go two steps further with this part of my analysis. First, I like to triangulate the upside by using several valuation tools to hone in on a price target. If three metrics zero in on the same price, or thereabouts, I have a lot of confidence in that target. If, however, those tools kick out three different and varying price targets, then I have far less confidence in any one of those figures.
Second, most investors, I have found, focus on the upside, while too few consider the downside, which is how low the shares may go. I look at that to assess what my net upside (upside less the downside) is likely to be. To get interested in a stock, I generally like to see net upside of 20%. That could take the form of up 30% with 10% downside, up 25% with 5% downside or a different permutation.
I realize that is a rather down and dirty view on valuation tools, and whole books have been written on them. I’ll be discussing these further in upcoming issues of PowerTrend Bulletin.
That leaves us with two remaining questions of my 10 Questions You Have to Answer Before You Buy Any Stock. We’ll tackle them in the next week’s edition.
In case you missed it, I encourage you to read my e-letter column from last week, which expanded upon the seventh question on our list of 10 questions to answer before you buy any stock. I also invite you to comment in the space provided below.
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