The key to making good stock-picking decisions is cold, hard research. When you make individual stocks part of your portfolio, you’re taking on a big task. You’ve essentially become your very own portfolio manager. As such, you have a huge responsibility to actively manage your investments, taking into account your ultimate financial goals, your retirement time horizon, and your tolerance for risk.
Every financial professional has his or her favorite metric–that single make-or-break measurement that tips the scales in favor of an impending stock investment. Black Enterprise tracked down a select group of financial experts to get some pointers on how they gauge a good stock.
Price-to-Earnings Ratio
It’s all about values. “The key thing you’re looking for is to see if the stock is over- or undervalued. The valuation metric that people use in the sector I cover is price-to-earnings ratio–simply looking at the stock price divided by the earnings per share in the current year and the following year. So, that’s current price earnings [P/E] and forward price earnings. You look at that P/E and you compare it to the sector average P/E. If the stock is trading above the sector average, it’s overvalued. If it’s trading below, it’s undervalued. Now, that’s a very general explanation. Within that statement I would say some companies are positioned better than others and thus should trade at a premium to the group. When I say the group, I am referring to the aggregated average price-to-earnings ratio for all the stocks in the industry the company operates in. Some companies are positioned worse than others and thus they should trade at a discount to the group.â€
–Gordon Johnson, Senior Analyst, Hapoalim Securities
Price-to-earnings ratio (or P/E ratio): The most common measure of how expensive a stock is.
To calculate: Divide market price per share by earnings per share.
Forward-Looking Statements
Forget the rearview mirror. Look at the road ahead. “A lot of investors can go down the wrong road if they’re looking at numbers and don’t put them in the right context. You can put too much emphasis on year-over-year growth comparisons. If I’m invested in a company, and they just announced today that earnings were down by 10% year over year, that in itself doesn’t sound overly bullish. It might give pause for many. The key is you have to give context to those numbers. For one, what was the expectation? Maybe the expectation was for earnings to be down 20% and they were only down by 10%. So in that light it would be positive. Most important, any sort of guidance or forward-looking statements that management might disclose are really key in terms of how viable your investment is in the company. Focus on what’s happening next instead of what just happened.â€
–Imari Love, Analyst, Morningstar
Forward-looking statements: A financial statement from a company that predicts, projects, or speculates about future business prospects.
Free Cash Flow
Cash flow is king. “We like companies that can generate free cash flow. If you divide the free cash flow by the number of shares outstanding, you get free cash flow per share. That gives you something you can compare to see whether it’s higher or lower than it used to be. You can also compare it to other companies, especially those in the same industry. If you then take free cash flow per share and divide it by the company’s current share price, you get free cash flow yield, or another way to measure earnings. I would say a double-digit free cash flow yield would generally be considered attractive. In general, the lower the ratio, the less attractive the investment.â€
–Eric T. McKissack, CEO, Channing Capital Management
Free cash flow: The cash that a company is able to generate after laying out the money required to maintain or expand its assets.
To calculate: Subtract capital expenditures from operating cash flow.
Competitive Advantage
Look for change you can believe in. “I like companies that are undergoing some type of sustainable positive change that will result in expanding profit margins. Examples of sustainable positive change might include an improving competitive position such as holding or obtaining a patent, which would afford the company a technological advantage versus its peer group. Another competitive advantage we look at is a strong brand franchise where a company’s products or services provide an obvious value-added proposition to its customers. These are some of the characteristics that help to identify successful companies that have the potential to perform above the Wall Street consensus [estimates of future earnings].â€
–Dawn Alston Paige, Executive Vice President, Piedmont Investment Advisors L.L.C.
Competitive advantage: A unique and sustainable characteristic–product, strategy, or operating procedure–that allows a company to retain more customers and achieve higher profits than rivals in its industry.
Debt-to-Equity Ratio
Do a debt check. “The debt-to-equity ratio is extremely important because these numbers don’t lie. Look at whether the company borrowed too much money. Figure out who really owns this company–the lenders or the shareholders. Companies that take on a lot of debt find it difficult to survive during turbulent times. I like to find companies that don’t go and borrow a ton of money without having substantial revenues and net earnings. I wouldn’t be intimidated by doing the research because everything you need to know you already ask yourself on a daily basis. These are the same fundamentals that you look at when you balance your budget at the end of the month. Look at the company–is their debt-to-equity ratio high, low, or about average compared to its competitors?â€
Debt-to-equity ratio: A measure of the proportion of debt that is used to finance a company’s activities.
To calculate: Divide total debt by shareholder equity.
Debt-to-equity ratio: A measure of the proportion of debt that is used to finance a company’s activities.
To calculate: Divide total debt by shareholder equity.
–Douglas Coe, Chief Investment Strategist, Moody Reid Financial Advisors
Interviews by Renita Burns, a writer and content producer for BlackEnterprise.com.