Philip Fisher once said “the stock market is filled with individuals who know the price of everything, but the value of nothing”.
With the lacklustre performance in the Singapore market, followed by volatility around the world, the way to make money, is chasing alpha correctly, and yes, try to minimise your losses.
Internally, we do have a system that we put the stocks through before doing deeper drilldown, but I shall spare you the copious amount of dirty mining and let you in on some key ratios you can put your interested stocks through to give you a preliminary health check prior to deeper digging.
Without further ado, let’s bring you through these five stock ratios that we like to use as a preliminary check.
Price Earnings Ratio
Of course, how can we not stop in our tracks if we see a stock with a ridiculously low Price Earnings ratio (PE) right?
Formula: Price / Full Year Earnings Per Share
Seriously high PE ratios for stocks would already throw us off the fence sometimes as that’s generally how much growth the market expects from the stock. That said, we note that you should do some homework on this and deck the PE against an industry PE or the stock’s PE range over the past 5 years at least to determine the median PE, mean PE, and of course the range of its highest and lowest PE.
It is noteworthy to mention that tech companies traditionally have very high PE multiples due to a small base in its earnings per share and rocketing share price as a result of growth expectations from the market especially in the initial growth stage.
A general yardstick for us on our first filter round is that stocks hitting PE ratios of 20 times and above are considered “high” in our appetite range, while stocks with PE ratios of 40 times and above to be excessively high and expensive.
Comparable analysis of the PE multiple with the stock’s closest peers will need to also be done in your deeper analysis for a better understanding of whether it is normal for the genre of stocks you are looking at to be trading within such PE bracket.
Price To Earnings Growth Ratio
The Price To Earnings Growth ratio (PEG) follows up directly after the check on the PE is done. In simplicity, it is for us to ascertain on a brief note if there is still a good enough margin of safety left if we factor in a simple growth rate.
Formula: PE Ratio/Growth Rate
How does that work? For instance, you calculated the PE of the stock to be 10 times, and you think that perhaps assigning a five percent growth rate is pretty much fitting for this company based on the general industry growth you’ve seen, so we’d use that as a growth rate.
Now, it is important to note that the formula will need to be taken “as is” for the growth rate. The PE number of 10 will need to be divided by the number 5 (growth rate of five percent).
Therefore, the PEG derived will be two. Technically, for PEG ratios more than one, I’d be wary, as I’d essentially have no more margin of safety left. However, it is helpful to know the general PEG of the industry which your stock is in for comparison before blindly following a set range. In this case, the PEG ratio of two times just means the stock is too expensive.
If you find it difficult to establish a growth rate, try looking through analyst reports related to the stock and get a general feel of the growth rate.
We prefer to look at stocks with a PEG ratio of less than 1. As a general rule of thumb, for stocks with PEG ratio of 0.5, you’d essentially get a margin of safety of 50 percent.
Price To Book Ratio
This is a valuation approach specifically aimed at giving you an idea of the value of certain asset-based companies such as property companies and financial institutions. Note that not all businesses should be valued by this ratio.
Formula of Price To Book Ratio (P/B) : Price/Net Asset Value Per Share
Akin to that of the P/E, it is best used on a comparable basis with relevant peers, and its specific band of P/B over a five year period.
Generally, if a stock that’s heavy in assets are trading below the P/B of 1, they are deemed to be trading at a discount to their P/B book value, if the P/B is more than 1, it will be deemed to be trading above their book value.
From previous articles written recently, especially that of property companies or real estate industrial trusts, you would’ve noticed that we specifically pointed out the discount to P/B ratios among the property stocks are close to crisis level lows seen in 2008 and 2009.
That should warrant you to dig more on the company if it clears this filter of yours.
Basically this is the inverse of the PE ratio. We use this to quickly establish a general comparison between other asset classes bonds or interest rates.
Formula of Earnings Yield: Full Year Earnings Per Share/ Price
Note that the Earnings Yield is displayed as a percentage, for an apple to apple comparison that is more relevant.
A localised example for you to consider is to run the earnings yield benchmark against the interest rate that your CPF special account is paying you to put money in there; four percent.
If the earnings yield of your stock is not higher than that of a risk free investment in your CPF, you might be overpaying and cutting yourself short on buying into something that doesn’t justify the risk that you are taking on.
Price To Cash Flow Ratio
If you have seen our recent write ups on the stocks we’ve been selecting, you’d have realised that we are critical on the cash position of the company.
Price To Cash Flow Ratio (P/CF) is used in a similar way to that of the PE ratio. Albeit the fundamental approach is far from similar. P/E ratio uses the net income as a base while P/CF uses the operating cash flow, which is harder to manipulate compared to the net income.
Formula of P/CF : Earnings Per Share/ Operating Cash Flow Per Share
In a nutshell, the higher this measure is, the more expensive the company is considered, which is similar to that of the P/E ratio.
It is important to also note the industry (tech sectors command a higher number as more growth is factored in it) the stock is in, its past levels of P/CF, and conduct comparable analysis with the industry’s P/CF and that of its peers.
For the P/CF, a general range of less than 15 to 20 is considered good. Back-testings for P/CF range have shown P/CF between 0 – 10 revealed stocks that performed relatively well over the last 10 years, while anything above 30-40 reveals stocks that generally underperform the S&P 500 in the past 10 years.
By and large, these five ratios serve as a reasonable first layer filter for you before digging deeper into your stock research.
You should also observe the consistency of the stocks’ earnings, net income margins, sales and income growth, gross margins, borrowings, strength of operational cash flow, over the past three years.
Investing the right way takes discipline, and to prevent losing money, you’d have to show commitment ensuring your picks meet a certain standard. We hope this set of filter serve as a good first round of filtration for you when thrown with stock ideas you are unsure of by your friends or brokers.