Stocks And Shares – What You Need To Know
MBA, BSc, DipFP
Financial Planner / Managing Partner
Investing In Stocks And Shares – What You Need To Know
With bank interest rates so low, and anticipated to stay that way for some time, many investors are turning to the stock market to make their savings work for them. So, when it comes to stocks and shares, what do you need to know before investing?
Understanding the language can be a great first step. Let’s take a look at some of the terminology, and the different ways you can approach evaluating stocks to choose those which best suit your needs.
Understanding What You Are Looking At
When you first dip your toe into investing in shares it can seem like you need to learn a whole new language. There are a few key phrases that will help you understand how to evaluate the relative value of a company so you can avoid making costly mistakes when investing in shares.
Earnings Per Share (EPS) – this is the company profit divided by outstanding shares of common stock. The higher the EPS, the better value of the stock. One thing to look at is the trend of the EPS. Is it moving upwards or downwards? If a company has a consistent EPS it is easier to make an accurate prediction of future earnings.
Price To Book Ratio (PB) – this is the value of a company if it was to be broken up and sold off today. It incorporates assets like factories, equipment, stock, bonds, and also shares. Even if a company is not in a growth phase, a good price to book ratio can make it a solid investment.
Price To Earnings Ratio (PE) – To work out the PE, you divide the current stock price by the EPS. Without a good PE, the price of a stock will eventually fall. This ratio will help you determine if the stock is over or under valued and can be looked at ether historically (trailing), or projected (forward estimate).
Price To Earnings Growth Ratio (PEG) – The ratio uses the historical growth rate of the company’s earnings by taking the PE and dividing it by the year-on-year growth in earnings to determine how much you are ‘paying’ for growth. This ratio can be used effectively to compare two similar companies. The one with the lower PEG will provide better value if earnings for both continue as they have in the past.
Dividend – This is the amount of money, per share, a company pays to its shareholders from its profits. The amount of the dividend paid can have either a positive or negative effect on the value of the shares. Larger and more established companies usually provide the best dividends because they are not reinvesting as much into the business as start-ups. Stocks paying good dividends are generally considered ‘income’ stocks as opposed to ‘growth’ stocks.
Dividend Yield – is the amount of the dividend divided by the current share price. This amount can sometimes seem high if the price of the stock is declining, so it is important to look at why the DY is high. There is often an inverse correlation between the value of the stock and the DY.
Payout Ratio (PR) – this is the proportion of company earnings paid to shareholders as dividends, which is expressed as a percentage of total company earnings. It is also referred to as Dividend Payout Ratio.
Price To Sales Ratio (PSR) – is estimated by the total market capital (value of total shareholdings) divided by projected revenue. The resultant figure is used to determine whether a company is over or undervalued based on similar companies in the same industry.
Price To Cash Flow (PCF) – this ratio uses the share price divided by the cash flow per share to measure the value of a stock compared to the operating cash flow of the company. Generally, a lower PCF is optimal, however, this needs to be considered comparative to similar companies and the maturity of both the industry sector and the company.
Cash Flow Per Share – is the operating cash flow of the company, divided by the number of outstanding shares.
Now that you know some of the methods used to calculate the value of a stock, you can start to combine them into a ‘model’. Different models are suitable for evaluating different types of companies, so you need to look at the marketplace or industry in which the company is operating, the maturity of the company, and the maturity of the marketplace.
These aspects of an organisation will help you decide whether to opt for an Absolute Valuation Method, or a Relative Valuation Method. Or perhaps you might decide to use both, using the consistency of your results, or lack thereof, to help you make a decision.
Absolute Valuation Methods
Are generally used to evaluate blue chip, mature companies, and use cash flow and dividends to determine the value of a company. These models may include:
Dividend Discount Model – This model relies on the consistency of dividends and a stable EPS, so is generally used for companies in well-developed industry sectors.
Discounted Cash Flow Model – which may be used if there is no dividend payment, or it is inconsistent. This model relies on predictable future cash flow estimations, so is not generally used for new companies or those involved in heavy investment cycles.
Relative Valuation Methods
These methods use the ratios we talked about earlier, including the PE, PEG and PSR to compare company to company or company to benchmark, allowing you to evaluate which company in a particular segment, market or industry might provide the best growth and/or income opportunities.
Many experienced investors will use a range of more than one Valuation Method in order to provide them with a robust evaluation of any given stock available.
The Importance Of Due Diligence
Never take anything at face value. If you are serious about investing, do your due diligence. Figures can be manipulated to look better than they actually are, so make sure you are confident that the figures you are using to evaluate a company are not just smoke and mirrors. To that end, finding an experienced, qualified financial planner can help you ensure you don’t get smoke in your eyes!
One Last Thing…
Now that you have some idea of what you need to know when investing in stocks and shares, and some of the key terminology, you will want to look at what types of stock suit your investment style. Check out our articles on Asset Allocation Strategies, Modern Portfolio Theory and Active vs Passive Investing for some tips to help you get started.
If you would like advice on how to get started on investing in the stock market, Manly Financial Services have the experience, expertise, and knowledge to help you. Give us a call on (02) 9976 3388 or contact us via the below link.Interested in knowing more?