Part One – Looking For Value
This will be the first of a two part series on Identifying Stocks with the Best Potential for outperformance. Typically, when sophisticated investors are looking for opportunities in the stock market to acquire stocks that will have a better opportunity to outperform, they tend to look for stocks that are trading cheaply, or stocks that show the best opportunity for growth. Cheapness and growth are two process for differentiating stocks, and many money managers build their careers based on either structuring their funds based on value (cheapness) or on growth.
What is value? This is a good question, as most often value is in the eye of the beholder. What can be value to one may not be much value to another. We all know of examples where an individual who knows and cares about something, like say an antique automobile. A 1967 Corvette Stingray Convertible (Chevrolet, General Motors) may seem like great value at a price of $20,000 to a collector, but someone who’s looking for a dependable automobile to get them to work and back every day may consider this price too high.
With investments in stocks, there are certain measures that money managers look at to determine whether a stock is expensive or cheap. Like shrewd shoppers who only buy things that are on sale at a department store, shrewd money managers try to acquire the stocks they are most interested in holding without paying too high a price for.
But when is a stock price too high or too low? We noticed that when Facebook launched their shares for the first time on the stock exchange a few weeks ago, the price of the shares was launched at $38.00 on May 18th. In the early morning frenzy as many who couldn’t participate in the IPO but wanted to buy the shares once they were freely trading on the stock exchange, the price briefly ran up to $45.00. But then, throughout the day the stock price dropped, and continued to drop for two weeks, settling at a low of $25.60 on June 6th. During each transaction, there were sellers and there were buyers. Buyers believed that they were acquiring Facebook shares at good value, while sellers believed the stock was expensive and they were selling.
In the end, an investor needs to be able to determine whether a stock is cheap or expensive. There are several standard measures used by knowledgeable investors that help them spot a stock that is trading cheap. For the most part, these measure compare the price per share of the stock (stock price) with a variety of other measures, on a per share basis.
Price to Earnings ratio (or P/E)
One of the most widely used is the Price to Earnings ratio (or P/E). This ratio measures the price per share with the earnings of the company, on a per share basis. As an example, if a stock is priced at $10.00 in the market, and the company has last twelve months earnings per share of $2.00, then the P/E ratio is 5.00. Typically, the average P/E ratio for stocks in historically has been about 15.00x, or a stock price that is 15 higher than the last 12 months earnings per share. Anytime an investor can pick up a stock that trades for less than 10.00x on a P/E basis, it is deemed to be a cheap, or value stock.
Price to Book Value Ratio (P/B)
Price to Book Value Ratio (P/B) is another standard ratio that money managers look at in determining a stock that is relatively inexpensive. Book value is the net worth of the company – all the assets on the balance sheet minus all the liabilities. Any time an investor can pick up a stock that is trading close to its book value, then it is considered cheap. Stocks trading 3 or 4 times more than its book value could be considered expensive.
Dividend Yield
Dividend Yield is another measure that money managers look at when determining whether a stock is considered a value stock. The dividend yield indicates how much the company pays out in income to its shareholders, relative to the price of a stock. So, for instance, a stock whose price is $10.00 per share in the market, and pays out an annual dividend of $0.50 per share (usually dividends are paid out quarterly, so each payment would be $0.125 per share per quarter), would have a 5.00% dividend yield. Dividend yields are often compared to the yield on ten year government bonds, or on the yield of the same company’s long term corporate bond. Stocks are more risky than bonds, and so dividend yields should be higher than yields on bonds, otherwise value investor would hold bonds rather than stocks. Typically the average dividend yield of stocks trading on the Toronto Stock Exchange (TSX) would be 2.88%. Stocks trading with a higher yield than this would be considered value stocks.
However, investors should be careful with stocks which are trading a exceptionally high dividend yields, such as those that trade at a yield that is 4 or 5 times higher than the average – this could be an indication that a stock is a value trap – one where the high dividend yield indicates that the company is under stress, and could cut their dividend soon because cash flows are deteriorating.
There are many other indicators of value that professional money managers and sophisticated investors look at when determining whether a stock can be picked up cheaply. We feel that we’ve covered three of the most often used by investors. On June 28th at 6:30pm we will be holding a seminar on how to identify stocks that have the highest potential for outperforming the market, and we will cover these value indicators, as well as others that are helpful in building a stock portfolio. We invite you participate, and you can call Anna Procio at 416-763-5575 x200 to reserve your spot.
Michael Zienchuk
Manager, Wealth Strategies Group
Ukrainian Credit Union
416-763-5575 x204
No comments:
Post a Comment