Principal indices in stock analysis for long-term investment

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April 10, 2018

Article available in English | 日本語

Most investors who have just begun their investing career tend to prioritize stock price information and the market chart. While these pieces of information might be relevant in the short term, trying to guess the market or time the best moment for purchasing is futile. Base the future stock price on the stock market history is like a gamble, and the odds of timing correctly is like the odds of hitting the jackpot. The stock market fluctuates every day, and the current trading shares only occupy about 5% of the total share outstanding, therefore thinking of 5% shares deciding the value of a whole business is just hilarious. In fact, long-term investors often see the stock price as the last factor that should be taken into consideration when purchasing a stock. From what I’ve read and my hands-on experience, I humbly note some of the indices that should be analyzed first when planning on investing in a stock. Hopefully, it may come handy for future investing newcomers. Constructive criticism is always welcomed.

1. Earning per share (EPS)

EPS = Net income / Share outstanding This means the amount of profit one share made at the time it was analyzed. It is calculated by dividing the net income (income after deducting taxes and other costs) to the share outstanding (total shares currently traded on the market). Consistently increasing EPS throughout years is usually a good sign of a company’s growth.

2. Price/Earning (PE)

PE = Stock price / EPS This index is the most prioritized to be looked at when analyzing a company’s performance according to a large number of investors. It is equal to the price of a single stock divided by EPS. Literally, it means ‘If a PE of a stock is equal to X, then for every X dollar spent on buying the stock, it is expected to make 1$ profit every year’. Famous investors often prefer stocks that have PE below 15. If you see a stock that has a PE of hundreds (like Amazon), then it is grossly overpriced and will not make much profit for you even in long-term.

3. Dividend yield

Dividend yield = Dividend rate / Stock price * 100% This is simply the percentage between dividend you will receive per share and price per share. For example, if your stock is priced at 100$ per share and has a dividend yield of 5%, that means one share will return you 5$ a year. Note that if a company does not pay its shareholders dividend, then there will be no dividend yield either. As a rule of thumb, stocks that pay dividends should be favored over stocks that don’t pay dividends, unless the stocks that pay no dividend have a solid value that increases every year.

4. Debt/Equity

DE = Total liabilities / total net value This index is calculated by dividing its total liabilities to its total net value. The value of liabilities and net value can be found at balance sheet (note that total liabilities + total net value = total assets). Debt/Equity reflects part of the company’s current financial situation. If this index is less than 1, then the company’s financial state is quite reassuring. If it is more than 2, double check other performance indices before deciding to own the stock. One related index is debt/asset, which is the percentage of debt to the total assets. A number above 70% means necessary caution when proceeding to invest in the stock.

5. Book value per share

Book value = Total net value / Share outstanding This value is calculated by dividing the total net value to the share outstanding. If a company goes bankrupt, has to liquidate all of its assets to cash, pay all its debts and divide its leftover to all the available shares, then this value represents how much a share will receive. This value plays the role of a safety ruler: comparing the stock price to its book value to see how much it is overpriced, or underpriced. When people purchase a stock that has the premium price compared to its book value, they are expecting that the stock will make more money in the future to compensate for the overpaid amount. Don’t buy into this value excessively though, based on the accounting method it will vary from high to low.

6. Return on equity (ROE)

ROE = Net income / Total net value * 100% The net income can be found in income statement and the net value can be found in balance sheet. A consistently growing ROE in every year is equal to the huge potential of a company’s advancement, and the rise in its market price. It is said that an ideal ROE number is often 10% or higher.

Actually, you don’t have to manually find the necessary elements in the balance sheet and calculate these indices yourself. With the aid of a computer, getting these numbers is a breeze. Just type your stock name + stock” in Google search and the rich context result will be returned with all of our concerned values.

For example, I typed “jfe stock” into the Google search bar. The search engine returned the current market price, and the most two concerned indices: P/E and dividend yield. The Google Finance text below the image offers a link to more information about the stock.

Let’s also try tackling a basic financial report analysis manually. Here is the latest financial report of JFE Holdings that I searched earlier. This report includes an income statement and a balance sheet. We need to calculate the six principal indices to get a summary of how this company performed throughout a year.

  • On page 1 the EPS was calculated for us (Net income per share). If you want to try calculating it yourself, find the Number of outstanding shares (common stock) in page 2 and divide it to the Profit attributable to owners of parent (it means net income, just different wording).
  • The PE is calculated by using the stock price we searched earlier (2201¥ - Report don’t track stock price) and divide the value by the EPS (240.42¥). We get 2201 / 240.42 = 9.15, which is a reasonable ratio.
  • In 2017, each share is expected to yield a dividend of 80¥. Given the stock price at 2201¥ per share, the dividend yield is equal to 80 / 2201 * 100% = 3.63%. Above 2.5% is a premium rate!
  • To calculate DE, let’s take a look at the balance sheet on page 5. In 2017 the total liabilities were at 2,428,240m¥. The total net assets were at 2,012,607m¥. Thus the DE was 2,428,240 / 2,012,607 = 1.2. As long as the company is still able to make a steady income, 1.2 is not a worrisome ratio.
  • We just had the net assets value of 2,012,607m¥, let’s divide it to the share outstanding to get the book value per share. The share outstanding number is 614,438,399, therefore book value per share is 2,012,607m¥ / 614,438,399 = 3275¥. Currently the stock is selling for 2201¥ per share, so obviously it is being undervalued (?! as above said it is just a mean of measure don’t buy into it too much).
  • Finally, get the percentage between net income (Profit attributable to owners of parent on page 1 - 138,620m¥) and net assets (2,012,607m¥) and we acquire a ROE of about 7%. Not a big number though…

After a little attempt on deciphering the financial report, we now have a simple overview of this stock. This stock is currently undervalued, good dividend yield and a not bad PE ratio. Every index compared to its previous year’s counterpart shows sign of improvement. It deserves further researches.

Above are the most significant indices that appear in every stock evaluations. Although to be able to decide whether a stock is worth purchasing we have to consider many other aspects, these primary indices can get you a picture of a company’s current financial condition, its market state, and its future potential. They provide the standard for you to assess a stock value easier, and a good basis to evaluate the stock further. If you have your favorite brands, and intend to own some of their shares, these indices will surely assist you on your way to the very first investment step.

This article is a brief memo of Warren Buffett’s 3 Favorite Books Although the author is not that well-known, he was able to nicely summarize the gists presented in the three must-read investment books and his way of writing and collecting ideas let even the dumbest person be able to digest all the foundations in the mentioned books. If you are new to investing, before reading the notorious One up on Wall Street, Security Analysis, A random walk down Wall Street, this book is a solid recommendation for you to have a grasp of all the basics and continue enjoying the best-sellers later.

P/S: If you find investing in individual stocks too daunting and lots of hassle, ignore them and buy index fund / ETF / mutual fund instead. Generally, these options outperform many other portfolios, and will save you time, money and headaches (pun intended).

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