The secret to choosing good common stocks is that there really is no secret to it. The winning techniques are tried and true, but it’s how you assemble and apply them that makes the difference.
Information is the key. Having the right information about a company and knowing how to interpret it are more important than any of the other factors you might hear credited for the success of the latest market genius. Information is even more important than timing. When you find a company that looks promising, you don’t have to buy the stock today or even this week. Good stocks tend to stay good, so you can take the time to investigate before you invest.
You get the information you need to size up a company’s prospects in many places, and a lot of it is free. The listing on pages 6 and 7 offers a guide to the most readily available sources of the data described below.
Perhaps the smartest way to succeed in the stock market is to invest for both growth and value. That means concentrating the bulk of your portfolio in stocks that pass the tests described on the following pages and holding them for the long term— three, five, even ten years or more. For those in search of income, not growth, it means applying the same tests so that you don’t make any false and risky assumptions about the stocks you buy. This method is not based on buying a stock one day and selling it the next. It does not depend on your ability to predict the direction of the economy or even the direction of the stock market. It does depend on your willingness to apply the following measures before you place your order. If you do that, you’ll find most of your choices falling into the growth, value, income and bluechip categories.
You’ll quickly discover that the number of stocks that meet all these tests at any given time will be low. So what you’re really looking for are stocks that exhibit most of the following signs of value and come close on the others. These should form the core of your portfolio.
VALUE SIGN #1: Look for companies with a pattern of earnings growth and a habit of reinvesting a significant portion of earnings in the growth of the business. Compare earnings per share with the dividend payout. The portion that isn’t paid out to shareholders gets reinvested in the business.
This is the company’s bottom line—the profits earned after taxes and payment of dividends to holders of preferred stock. Earnings are also the company’s chief resource for paying dividends to shareholders and for reinvesting in business growth. Check to be sure that earnings come from routine operations—say, widget sales— and not from one-time occurrences such as the sale of a subsidiary or a big award from a patent-infringement suit. The exhaustive stock listings in Barron’s give the latest quarterly earnings per share for each stock, plus the date when the next earnings will be declared. Historical earnings figures are available in annual reports, Standard & Poor’s (S&P) and Mergent, Inc. publications, and Value Line Investment Survey, plus the databases offered by many Internet services.
VALUE SIGN #2: Look for companies with P/E ratios lower than other companies in the same industry.
Many investment professionals consider the price-earnings ratio (P/E) to be the single most important thing you can know about a stock. It is the price of a share divided by the company’s earnings per share. If a stock sells for $40 a share and the company earned $4 a share in the previous 12 months, the stock has a P/E ratio of 10. Simply put, the P/E ratio, also called multiple, tells you how much money investors are willing to pay for each dollar of a company’s earnings. It is such a significant key to value that it’s listed every day in the newspapers along with the stock’s price.
Any company’s P/E needs to be compared with P/Es of similar companies, and with broader measures as well. Market indexes, such as the Dow Jones industrials and the S&P 500, have P/Es, as do different industry sectors, such as chemicals or autos. Knowing what these are can help you decide on the relative merits of a stock you’re considering.
It’s hard to say what the “right” level is for a company’s P/E ratio, or for the market as a whole. You should expect to pay more to own shares of a company you think will increase profits faster than the average company of its type. But high-P/E stocks carry the risk that if the earnings of a company disappoint investors, its share price could drop quickly. Just one poor quarter—or a rumor of one—can mean a steep loss for a stock with a sky-high P/E. By contrast, investors don’t expect a low-P/E company to grow so rapidly and are less likely to desert the company on mildly unfavorable news. If profits rise faster than expected, investors may bid up that low P/E. The combination of higher earnings and a growing P/E add up to profit for investors.
One way to employ P/E ratios in the search for good stocks is to find companies with low P/Es relative to others in their industry. Assuming prospects are good for the industry as a whole and companies show signs of strength, relative P/Es can be a good clue to their value. For instance, the auto and truck manufacturers industry has traded at an average annual P/E of 10 or so in recent years. By comparison, the telecommunications services industry has experienced an average P/E closer to 17. Thus, when the price of an auto manufacturer’s stock gives the company a P/E of 15, the company is relatively expensive for its industry. But if a telecommunications company’s stock is selling at a P/E of 15, it’s relatively cheap for its industry.
A low P/E is not automatically a sign of a good value. A stock’s price could be low relative to earnings because investors have very good reason to doubt the company’s ability to maintain or increase its earnings. Never pick a stock on the basis of its P/E alone.
You don’t make any money from the stellar performance of a company before you buy its stock. You want it to do well after you buy it. So look not only at the “trailing” P/E, which is based on the previous 12 months’ earnings, but also at P/Es based on analysts’ future-earnings estimates. While not infallible, they are another piece of information on which to base your decision to buy or not to buy. Brokers will happily provide the forecasts of their firms’ analysts, and you can find other forecasts in many of the sources listed on pages 6 and 7.
There are other factors to weigh before deciding which stocks to buy. But P/E ratios are the natural starting point because they provide a quick way to separate stocks that seem overpriced from those that don’t.
VALUE SIGN #3: For long-term investments, look for a dividend to generate income to reinvest in the company. The target: a pattern of rising dividends supported by rising earnings.
Dividend yield is the company’s dividend expressed as a percentage of the share price. If a share of stock is selling for $50 and the company pays $2 a year in dividends, its yield is 4%. In addition to generating income for shareholders, dividends are a good indicator of the strength of a company compared with its competitors. A long history of rising dividends is evidence of a strong company that manages to maintain payouts in good times and bad. Even better is a company with a history of rising dividends and rising earnings per share to match. A stock’s current dividend payout and yield are included in the daily stock listings in the newspaper. For historical information, the S&P Stock Guide and Value Line are excellent sources, as are the stock data bases of the online services .
Sometimes lowering the dividend can boost the price of a stock. It’s important to know why. For example, investors might see a cut in the dividend, coupled with a plan to close down some unprofitable operations and write off debts, as a smart step toward a stronger company in the future. Although dividends occasionally are paid in the form of additional shares of stock, they are usually paid in cash; you get the checks in the mail and spend the money as you please. Many companies encourage you to reinvest your dividends automatically in additional shares of the company’s stock, and have set up programs that make it easy to do so. Such arrangements, called direct investing plans, dividend investment plans, reinvestment plans, or DRIPs.
VALUE SIGN #4: For stocks with good long-term potential, look for book value per share that is not out of line with that for similar companies that are in the same business.
Also called shareholders’ equity, book value is the difference between the company’s assets and its liabilities (which includes the value of any preferred stock that the company has issued). Book value per share is the that number most investors are interested in.
Normally, the price of a company’s stock is higher than its book value, and stocks may be recommended as cheap because they are selling below book value. A company’s stock may be selling below book value because the company shows little promise, and you could wait a long time for your profits to materialize, if they ever do. You need to look for other signs of value to confirm that you’ve found a bargain priced stock.
Still the idea of buying shares in a company for less than what they’re really worth does have a certain appeal. At any given time, there will be stocks selling below book value for one reason or another, and they aren’t all weak companies. Some may be good small companies that have gone unnoticed or good big companies in an unloved industry. How can you tell? If the company has a low P/E ratio, a healthy dividend with plenty of earnings left to reinvest in the business and no heavy debts, it may be a bargain whose down-and-out status is a temporary condition that time and patience will correct.
On the other end of the scale, you want to stay away from companies whose price is too far above book value per share. It’s difficult to say what’s too high because the standards vary so much with the industry. In some industries, such as technology— where the greatest assets reside in the brains of the companies’ employees, not in buildings or machinery—book value per share isn’t considered particularly significant. In start-up companies, book value is utterly meaningless. Not only do they have few or no assets, they may have very high liabilities as a result of borrowing to get started. Still, in general, when the figure is available, you want it to be on the low side.
VALUE SIGN #5: Look for a return on equity that is consistently high, compared with the return for other companies in the same industry, or that shows a strong pattern of growth. A steady return on equity of more than 15% may be a sign of a company that knows how to manage itself well.