A fundamental approach to investment #2

In the first article, we discussed some of the principal issues to consider when valuing companies based on fundamental analysis. They were: (i) sustainable competitive advantage, (ii) industry structure (iii) potential market size & (iv) size & track record (which itself is a function of management). These then represent the "story" or why you might choose to invest in a particular stock. But equally important, at least to the professional investor, are the numbers, or valuation. There are many stocks where a great story is already reflected in the current price. And sometimes stocks (& sectors) trade at big multiples without even a great story - then it is only a matter of time before their share prices come crashing down (remember 2000's tech wreck).

So how do the professionals evaluate the numbers ? Do they simply look at PEs, margins & yields ? There are four ratios particularly helpful in identifying & selecting stocks for investment.

(i) EPS Growth Rate

As a general rule, share prices increase if earnings per share (eps) increase. I say earnings per share rather than net profit because profit can be acquired & can dilute eps but earnings (after tax, abnormals & minorities) on a per share basis reflect the real underlying growth rate of a company's profits - a subtle but important difference. And the faster a company grows its eps, the higher those earnings will be valued, especially if that earnings growth is consistent.

(ii) Relative PEs

Whilst PEs (the current share price divided by eps) are often too simplistic for many situations, they do at least provide a common basis for comparing different stocks - preferably within the same (or similar) sectors ie. banks, retailers, manufacturers etc.

So when comparing which company is better value, we might look at their prospective PEs compared with the average for the sector (or the average for large industrial companies). Why use the prospective PE (based on next year's forecast earnings) ? Because the actual (or historic) numbers are already out of date by the time they are released. This is why it is not uncommon to see a company's share price fall after a good result or announcement - it was already factored in. Remember that the market is valuing companies based on what they are forecast to achieve over the next 12 to18 months, not what they have just done.

(iii) Price to Earnings Growth Ratio (PEG)

A combination of the PE divided by the prospective eps growth rate gives the PEG Ratio which measures the price of earnings growth - a useful short term valuation tool.

(iv) Return on Invested Capital (ROIC)

The final ratio is a comparison of the Return on Invested Capital (both equity & debt) with the weighted average cost of that capital (WACC). Empirical evidence shows that there is a strong correlation between returns in excess of WACC & share price performance.

What does this mean in English ? If Company A returns 15% on its capital base & its WACC is 10%, then it is making a real return of 5% on every dollar of invested capital - its share price should perform well. If it can increase its ROIC from 15% to 20% then it is making twice the return as previously. However, if Company B returns only 5% on its invested capital compared with a similar WACC of 10%, it is destroying shareholder value & its share price will go backwards.

It is alarming the number of major companies which do NOT even meet this basic threshold. They are burning shareholders dollars & their share prices are generally depressing. My advice is simple - SELL, unless management is taking decisive action to improve returns.

So there we have it. By all means looks at PEs, margins & dividend yields but understand that on their own they will reveal little. Instead focus your attention on the numbers that count - EPS growth rates, relative PEs, price to earnings growth & returns on invested capital (vs WACC). Therein lie the keys to identifying stocks, not just with good stories, but which still have plenty of share price growth ahead. And remember that with stocks, as with so many things in life, you get what you pay for.