So in lesson 10, we were extensive on the stock market terminologies, this week, let’s talk about how to select a company to invest in.
Now a clear caveat, stock trading is risky, and you can lose all your invested capital, past results in the stock market are not an indicator of future returns. That done, I want to show you how you can identify a company to invest their shares, responsibly.
Now the intrinsic value of a share is different from the market price of a share. The intrinsic value of the share is what a share of that company is worth, or the actual value based on variables taken from the company’s financial statements and operations. The market price of that share is how much the stock market is asking you to pay for that share of a company.
Look at intrinsic value as the value of a business regardless of the price it is selling for on the market. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value.
If the market price is higher than the intrinsic value of the share, the share is said to be overvalued, if the market price is lower than the intrinsic value of the share then the stock is undervalued and a good buy.
So clearly the way you make money from share trading is to buy a share of a company below the intrinsic value of a company. This is very simply but extremely difficult. How do we determine value? How do we value a mango tree? Do we calculate the revenues from sales of the mangoes? Do we value the tree if we sell the wood for firewood? Do we measure the cost we paid for the tree? All three methods are correct. The difficulty is agreeing a price that corresponds with how much that mango tree will give us in earning over its lifetime.
Thus if we determine a mango tree will sell mangoes over its entire life fir N100, we thus want to buy that mango tree for less than N100. Right? So the key is buying at a price lower than its value.
How do we determine value?
Valuing a company
So how do we value a company, I have a quick checklist
- Market Share; what market is the company in? is that market growing? what share of that market does the companies brand or company have? Are the brands market leaders? reading the Chairman’s and Management comments in the published Annual Accounts will give you an indication of new plans, competitive environment, threats to the company etc, these are subjective, they give you a direction, which must trend towards growth.
- The market share must translate to Sales. Read the Annual Reports, there is a page near the end that has a five-year summary of accounts, Sales should be increasing in percentage terms all these years, if not find out why.
- Sales should lead to Operational Profit (gross profit), i.e. the proceeds from sales should be able to pay for the operational expense of the company eg rent, PHCN, Commissions etc, you can also get this from the annual report of the company. If the company is borrowing to pay salaries that’s a red flag. So the company should make a profit from sales.
- Ultimately Operational Profit should lead to Net profit. The company should also generate enough profits to pay all costs which are not sales related eg government taxes, auditors remuneration, long term investment projects etc. Also, important to look at the 5-year summary. The company should be profitable, unless it’s a new company with high initial costs, in which case you are look see if loss were reduced each year.
- This then translates into cash generated. a company can manipulate profits but can’t manipulate cash earned. You can get the cash earned from the cash flow statement which in my view is the most important measure of financial strength. A good company must produce cash to pay salaries, dividends, fuel cars etc. When you look at the Cashflow statement, you want to view surplus cash generated from Operation i.e. total cash flow less Operational cash and Investing cash flow.
- Cash generated should then be paid as a Dividends, so you are looking at Dividends yields which is the divided paid divided by the price of the stock. However, some companies may not pay a dividend but reinvest that cash earned to grow the company, nothing wrong with that, but then the share price must rise to compensate you for not getting cash.
If you get a positive in all these, then they company seems good. if the trend of market share to sales to operational profit to net profit-cash to dividends is broken, find out why, that’s the analysis part. but also look at, Return on Assets and Return on Equity which are all in the annual report.
Remember a Low Price Earnings ratio is good, an High Earnings per share is also good, and all these are available in the annual report.
- Jargon of the Week
The Price Earnings Ratio
The P/E ratio divides a stock’s share price by its Earning per Share to come up with a value that represents how much investors are willing to shell out for each dollar of a company’s earnings.
If the Price of a stock is N50 and the Earning Per Share is 10, then the PE ratio is 5. The PE tell you how long at the current earning it will take you to get a full return on your investment. Hence if you buy that stock at N50, with a PE of 5, at the current earning you will get your money back in 5 years…it should be used as one of a series of indicators.
Question of the Day
If you had N100,000.00 today, would you spend it or invest it?
