How To Determine If A Stock Is Worth Investing In
The world of stocks can be quite a mine field.
Every time I have any finance or business TV channels on the go, my fiancé always shoots me the strongest look of confusion and boredom.
And I guess it’s hard to get excited about something you don’t entirely understand.
But what most people don't realize is how simple the market really is, and that deciphering whether or not a stock is undervalued or overpriced is pretty simple if you know how.
Thats why today, I want to give you the formula you can use to figure out if a stock is worth investing in or not.
In fact, what I'm about to show you is probably the most fundamental factor in what moves stock prices in the long run.
Having this kind of knowledge is what'll set you apart from the other investors.
Simply read on to get your hands on my formula…
The Biggest Driver of Long Term Stock Prices
Hundreds of thousands of trades take place on any given day on the stock market.
But for long term investors like us, what determines where a stocks price goes over 1,3,5 or more years?
Remember, that at the core of it all, by owning stocks in a company you are a partial owner of that business.
That means you own any profits distributed by the company (in the form of dividends) and you bank the difference between the buying and selling prices of the stock when you decide to sell.
The price of a stock represents what the market thinks the company is worth.
As the company grows, the stock price will likely follow.
And herein lies the key to understanding stock pricing in the long term…
Therefore, the value of a company should be linked back to its profitability.
The more profits a company makes the more it can invest in itself in order to grow its profits even more in the future, and the more it can pay out in dividends (if that's part of management’s strategy).
So, the crux of a firm’s stock value is inherently linked to the profits it generates.
And therefore, whilst the fuss about the earnings or profitability of a stock is extreme, it’s definitely warranted!
Not All Earnings Are Created Equally
If you watch any of the business or finance channels on TV you'll no doubt come across the word “earnings”.
This is just another word for profits.
In a simplified example, a firm’s profits are made up of the following components, and the formula for calculating earnings is beneath it:
Earnings = Revenue – Cost of Sales – Operating Expenses – Finance Costs – Tax
In order to simplify earnings, and make them comparable, you’d typically look at earnings on a per share basis.
So, if earnings for the year were R1,000 and there were 1,000 shares in issue, the earnings per share (“EPS”) would be R1.
But this is where things can get tricky…
You see, earnings and how earnings are calculated is not necessarily as clear, cut and dry as this.
REVEALED: The Dark Side of Accounting
Now, there are ways and means within accounting practices for earnings to be manipulated to the extent that they don’t reflect the actual performance of the business.
For example, say an insurance business has a bunch of old laptops that’re outdated, and have been replaced by new ones that’ll last for another 5 years.
The firm sells the laptops for an amount of R10,000.
So, now there’s an additional R10,000 of revenue generated in that year, and ultimately this will lead to higher profits.
But selling used laptops is not the core business of this company. So, the additional revenue from this non-core item can skew how we look at the company’s performance. It can look like the company is growing its business when it actually isn’t and they’re just getting rid of old machines.
What’s more is that this revenue item can also be considered as irregular or once off. It’s not likely there’ll be more laptops sold in the following year.
Now imagine when there are bigger machines being sold, and not just laptops?
Again, if we’re purely looking at the profitability, matters like this will skew figures and show us things that aren’t actually there.
So, typical EPS is not a good measure for comparing current performance with past performance, or for comparing one stock to another.
But then how are we better off in our search for the best measure of long term stock returns?
How To Remove The “Noise” In EPS
The example above is just the tip of the iceberg.
There really are a large amount of issues that can skew the true core earnings of a business:
- The sale of a division of a business
- The closing down/discontinuation of a certain business unit
- Writing down the value of certain assets or investments
- Once off items
- Revenue generated from non-core business operations
So, when it comes to looking at a company’s earnings to gauge performance (and ultimately stock performance) what should you do?
Thankfully there’s a measure to fix a lot of the mess that is EPS.
If you’ve read through any announcement of a stock’s performance, you may have come across it already!
Headline Earnings Per Share (“HEPS”) is a figure of earnings that takes into consideration all the extra-ordinary/once-off/irregular occurrences, strips them out and gives you a much cleaner picture of earnings.
It accounts for profit generated through business-as-usual activities.
This helps to obtain a clearer picture of a company’s ability to generate profit from its core business activities rather than from non-recurring events such as cost-cutting, sales of assets or strange and complicated accounting write-downs.
You may also see the term “normalised” used. Normalised earnings seek to adjust for any non-normal occurrences in a period.
For example, if a company has a huge legal battle in a particular year, its legal fees would be abnormally high. To get a clearer idea of the business-as-usual performance, normalised earnings help to paint a clearer picture.
Let’s take a look at a real-life example from an extract of numbers, released a few months back, by a stock in the SMART Investor Core Portfolio, ADvTECH Holdings:
As you can see there’s a large difference from the initial amount of earnings (R372 million) to the final true earnings figure (R350 million). R22 million to be exact.
ADvTECH received various incomes not from core business (providing education), which included the sale of property and equipment, as well as the receipt of money through a legal claim.
They also incurred larger than normal legal fees, and normalised the tax effects all this would have had, had these events not occurred.
In doing all that, the normal EPS of 70 moved to 66.
This is the number you need to consider as part of any analysis of the stock.
The Difference Between Making & Losing Money
So you understand how to find a stock’s true earnings - What now?
How does that help you in your stock analysis?
Well, I’ve already shown you that earnings are the key long-term driver for stock prices.
Now, I want to show you how to use earnings to quickly see if a stock is fairly valued, cheap or expensive.
Because this information can mean the difference between making money in stocks, or losing it.
The Second Side of The Stock Pricing Equation
Another very commonly used term in the stock world is the price-to-earnings or PE ratio.
This is simply the price of a stock divided by its earnings.
On its own it means nothing, but when compared to its historical PE or PE’s of other stocks (for example those in the same sector), we can get some great comparisons of the valuations of different stocks.
I like to use a company’s PE ratio and its earnings to check where its stock price should be:
Intrinsic Stock Value = Earnings x Earnings Multiple
Let’s use ADvTECH again as an example.
Earlier I showed the normalisation of ADvTECH’s earnings. Based on the number of shares it had in issue, its normalised headline earnings per share for the year ended December 2016 came in at 66 cents per share.
Over the last year, ADvTECH has traded on around a 30 times multiple to its normalised headline earnings (If we re-engineer the formula above we can calculate PE by doing the following: PE = Stock Price / Earnings).
So, if we plug this into the equation above we get the following:
Earnings (0.66) x Earnings Multiple (30) = Intrinsic Stock Value (19.98)
Essentially this is telling us that the real intrinsic value of ADvTECH, based on its earnings and multiples, is around R20.
If we look at where ADvTECH was trading on the stock exchange at that point in time, it was around R20.
Therefore, it’s fair to say that at those levels the ADvTECH stock was fairly priced and not trading significantly higher or lower than its intrinsic value.
This example shows just how much a stock’s price performance is linked to earnings.
The more earnings grow, the higher the calculated intrinsic value of a stock will be.
But there is one major flaw in this…
The One Thing You Can’t Afford To Leave Out
The stock market is forward looking, and you need to be as well.
The price of a stock is theoretically a reflection of all future earnings of a company, discounted back to today by an appropriate discount rate.
The key here is the word ‘future’…
The stock market is forward looking, and therefore you should also be aware of what earnings will be in the future.
Again, going back to ADvTECH, say you knew for certain that ADvTECH was going to see a drop in normalised headline earnings to 50 cents a share in the next year.
Going back to our formula and relevant ratios, the price of ADvTECH once the earnings are announced should be:
Expected Earnings In 1 Year (0.50) x Earnings Multiple (30) = Intrinsic Stock Value (R15.00)
So, with the stock trading around R20 at the time - and you know it’s going to go to R15 - would you just hang around and wait for the stock’s price to drop?
Of course not!
You would sell the stock now, in anticipation of the decline in earnings, and so would the market as a whole.
So, the price of the stock can adjust before actual earnings are released based on what the market expects to happen.
Basically, this shows just how the stock market is forward looking and adjusts according to future expectations of earnings, more than just historical performance.
So we can again adjust our formula to incorporate the earnings of the coming year in order to give us another gauge of a stock’s value.
Now, ADvTECH has managed to grow its normalised headline earnings per share by more than 20% over the last two years.
Say we decide that this trend is likely to continue in the coming year.
66 cents per share of normalized headline earnings grown by 20% is 79.92 cents.
Expected Earnings In 1 Year (0.7992) x Earnings Multiple (30) = Intrinsic Stock Value in 1 Year (R23.98)
Therefore, if our forecast of future earnings is correct, we can expect the stock price of ADvTECH to reach R23.98 in the next year.
Now given that the intrinsic value based on historical earnings indicated a fair value of around R20, and forward earnings indicate a value in one year of R23.98, this tells us the stock is not overpriced at current levels and has a lot of growth opportunity going forward.
Provided ADvTECH can continue to boost its earnings, its stock is likely to continue the strong growth path it’s been on.
Using historical and future earnings, as well as relevant multiples, can ensure that you never buy a stock that is overpriced and helps you to gain a better idea of where a stock’s price could be heading next.
How To Pick Stock Market Winners Time And Time Again
Who says the stock market, and picking winners, has to be difficult?
You now know how to find a stock’s true earnings, and that earnings are the key long-term driver for stock prices.
Better yet, you know how to use earnings to quickly see if a stock is fairly valued, cheap or expensive (IE whether or not you should invest in it).
This is how stock market professionals make money in the market over the long-term.
And today, you know how to do exactly that!
So, what are you waiting for, go uncover your next long-term stock market winner.
Until then, here’s to smart investing.
Analyst, The SMART Investor
The Money Lab
PS: Every month in The SMART Investor I show you how to make money from long-term stock picks (this was actually an extract from one of my previous issues).
Not only that, but each and every month I also uncover the best stocks and assets, including buy and sell levels, you need to beat the market.
In fact, If you get your name down today, I'll send you the exact stock picks I'm adding to the SMART Portfolio this month!
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