I’m not saying this is how you should value a stock but am simply sharing how I value the stocks in my portfolio. In fact, this could be a very bad way to value stocks as I’m only interested in broad brushstrokes, trending numbers and I’m always making exceptions, but it works for me. I have also been asked about this stock or that stock, so I figured I would share what I do as I don’t intend to give out buy or sell recommendations for individual companies.
Which Industry to Buy Stocks
To narrow my selection I avoid certain industries all together. So I don’t even bother looking at airlines, auto makers, fund managers, and most banks. I generally avoid highly cyclical companies, mining companies, media companies, and anything in a long term decline. Stocks that don’t pay a dividend are off the table too as the goal of my portfolio is to pay me an income. Of course you could buy growth stocks that don’t pay a dividend and simply sell a few shares when you need cash but that’s not something that interests me at all. I want more stocks every year, not less.
Newly listed companies and those who are yet to make a profit are also mostly ignored. The only exceptions might be established companies with a long record who decide to list on the stock exchange or listed companies who decide to spin off a business to be listed separately. I would rather wait around and see how the company performs for at least a few years after becoming profitable, otherwise it’s a guessing game.
First Step: PE Ratio
I first check the PE ratio and compare it to other companies in the same industry. So banks and retailers will generally have lower PEs compared to software or big tech companies. I’m not necessarily looking for the companies with the lowest PE in an industry but am just making sure that it’s not ridiculously high in comparison to similar businesses. Great businesses will command a higher PE naturally and they’re the ones I want to own.
So if I’m looking at a bank and it has a PE ratio of 30 while the other listed banks have an average PE of 10 then it better have a very good reason for it. It’s either extremely overvalued or it’s an absolute freak of nature among banks and is growing very quickly. Maybe it’s the latter and I’ll consider buying it but more than likely it’s just too expensive.
I also check what the PE ratio of the company has been historically. Is it trading much higher or lower than normal and why?
Next Box to Tick: Dividends
If the company doesn’t pay a dividend then I’m not interested in it. There’s a lot of really good companies out there that I don’t even bother looking at because they don’t pay a dividend. Warren Buffett and Charlie Munger might be great investors but I wouldn’t touch their Berkshire Hathaway company because it doesn’t pay a dividend.
It doesn’t have to be a large dividend either. I like Apple and Microsoft even though they pay a dividend of less than 1%.
What is important is the company’s track record of paying dividends and the growth rate of those dividends. Ideally I would like to see 10 years of increasing dividends. I also want a growth rate of at least 4% because I want my income to be increasing more than inflation, otherwise you’re becoming poorer over time rather than richer.
So a 10% dividend might sound great at first but when you look closer there might be good reasons for it. Firstly it might just be that the stock price has gone down dramatically over the past 12 months and the dividend could be next to go down. The company could have just had a freakish year and the dividend is about to revert to the norm. Or there may be little to no growth in the company which means the dividend is also going nowhere fast.
Checking the dividend payout ratio can be an indicator of how secure the dividend is. If a company is paying out 100% in dividends then it’s probably neglecting to reinvest in the company or buying back shares to improve the financial metrics. Just looking at Microsoft’s payout ratio now in 2023 it is sitting at 26.36% so they have plenty of cash to reinvest back into the company or buy back shares. If there’s a hiccup in cashflow then they can readjust that 26% payout ratio to keep investors happy. Investors like myself don’t like to see dividend cuts and companies will only cut dividends if they’re really in trouble.
Franking is important to me when I’m looking at dividend paying Australian companies too. As an Australian resident you will receive a tax credit of 30% if the shares are fully franked or have 100% franking credits. So when I receive a $100 fully franked dividend it has already paid 30% taxes. If you’re in retirement and pay zero taxes then you would receive a $30 refund from the government.
Return on Capital Employed (ROCE)
I’m looking for long term wealth compounders where my money is put to work and increases year after year. Otherwise why bother? We’re here to grow our wealth, not to let it sit dormant and lose value with inflation powering onwards and upwards forever.
So if a company isn’t growing faster than the cost of capital then it is destroying value over time. For example, if your business borrows one million dollars with an interest rate of ten percent but it’s only getting a return of five percent then you’re destroying value. You’re going backwards by five percent each year. This sounds very simplistic and you would think that no highly paid executive would ever do such a thing but it’s a surprisingly common practice.
I don’t have a concrete number that I stick to but I do like to see it consistently high over a long period of time. To see an example of a great company who compounds wealth over time see Microsoft and compare it with almost any airline company who destroys value over a period of 10 or 20 years.
They say past performance is no indication of future performance but it’s a pretty good predictor of what to expect. I’m not looking for turn around miracles or putting my faith in a fancy new CEO, I want a track record of black and white numbers telling me the company is creating value year after year after year.
Earnings Growth
If revenue and earnings are decreasing year after year then no other metrics matter as you’re in trouble. The share price and dividends will eventually catch up to them.
Sometimes revenue will continually increase while earnings or cash flow will continually decrease. I’ll tolerate this if the company is reinvesting and creating value over time, but if it’s a long term trend then I’ll avoid the company like the plague.
Again, see Microsoft over a period of 10 or 15 years as an example of what I’m looking for. Their numbers are like music to my ears.
Shares Outstanding
Shares outstanding will affect how much of the company you own. If there are 10,000 shares outstanding and you own 1,000 then your percentage of the pie is 10 percent. If the company then issues 10,000 new shares because it had to pay a new hotshot CEO and a bunch of programming wizards then your percentage of the company has decreased by half. You still have your same 1,000 shares but there are now 20,000 shares outstanding and you own just 5 percent of the company. You’ve been diluted.
I’m looking for companies that at least keep their shares outstanding steady. But ideally I’m looking for companies like Microsoft who have a long term track record of buying back shares. I want to own more of the pie every year, not less.
Using the same diluting example above, let’s imagine that the company buys back 5,000 shares and burns them. Your 1,000 shares which was previously 10 percent of the company is now 20 percent of the company.
Other Things to Look for when Valuing a Company
By now I’ve probably already made up my mind but I will look at things like the 50 or 100 moving day average, 52 week high/low, debt compared to cash, and anything that isn’t improving over time.
If all lights are green and I’m serious about investing in the company then I’ll start reading as much as I can about it. I’ll do a search online and look for news articles, changes in the industry, company reports, CEO interviews, and anything I can find that can inform or influence my decision.
I think about it like I’m spending a billion dollars to purchase the company rather than the $1,000 that I’m probably spending on it. My plan is always to add to the position forever. Of course things may change in the future and I may sell the business but my mindset when I’m buying is to hold for 100 years.
I’ll also do a search on Youtube to see what other people are saying about the company. If it’s a large American company then there’ll be a whole bunch of financial pundits and ‘finfluencers’ giving their two cents on the company. There’s very few that I would actually listen to though as they’re seriously all over the place. I’ll generally avoid what big banks and major investment houses have to say as their interests are not the same as ours. I would trust a little Youtuber with 5,000 subscribers more than I would trust a global investment bank.
Valuing Stocks Conclusion
Basically, I want things to improve over time and I’m not interested in hoping and praying for things to improve someday. I want the numbers to tell me that I’m investing in a compounding machine and if that trend changes then I’ll review my decision.
When I buy a company my hope is that I’ll hold it forever and continue to add to my investment but if a good company becomes a bad company then I’ll sell. I have no emotional connection to any company as they don’t care if I own them or not. Microsoft has never told me how much it loves me and I would sell the stock in a minute if I thought the company was moving in a direction that I didn’t like.
Value creation is the game. Increasing cashflow and dividends, decreasing debt and shares outstanding. Simple, really, kind of…
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