How did legendary investor
Warren Buffett make his money? Charles Munger, vice chairman of
Buffett's company Berkshire Hathaway and a four-decade confidant, offers the following
clue: "The way to win is to work, work, work, work and hope to have a few insights. How
many insights do you need? Well, I’d argue that you don’t need many in a lifetime. If you
look at Berkshire Hathaway and all of its accumulated billions, the top ten insights
account for most of it."
This course can't offer Buffett-style
insights, naturally; those you need to come up with
on your own. But we can describe some of the basic ways that investors analyze stocks to
determine whether or not they are good buys. What follows is an overview of some of the
most common methods; we'll have more to say about several of these in future Money 101
Broadly speaking, there are
two ways to approach stock analysis: you can either look at
the technical indicators for a company, or at its fundamentals. We can't cover technical
analysis in detail here -- it deserves a lesson unto itself -- but in essence, it's a
highly mathematical way of evaluating investments. A technical investor might compare the
performance of a number of stocks over the past year or so, for example, in order to find
ones that appeared to be breaking out of their recent trading ranges, and then buy those
issues in what amounts to a momentum play (see "Different strokes"). Or she might
construct a computer model of the overall market and its relation to other economic
factors, such as industrial capacity utilization, currency values or interest rates. The
model would be set up to yield "buy" or "sell" signals for the market as a whole or for
individual groups of stocks.
Properly used, technical
analysis can be a very powerful tool -- especially so for
determining when to buy or sell. The alternative approach, fundamental analysis, is pretty
good for helping determine what to buy or sell. Here, the aim is to look at the
fundamentals of a company and its business outlook in an effort to identify those stocks
to which Mr. Market has assigned an unreasonably low value. Here are some of
the factors that investors may examine:
* Price/earnings ratio.
A stock’s price divided by its earnings per
share. The higher the P/E ratio, the higher the expectation that earnings will continue
to grow at a rapid pace. Traditionally, investors have looked at P/Es based on the
previous 12 months’ profits, known as trailing earnings. Today, though, investors commonly cite
P/Es based on the consensus analysts' forecast of the next 12 months’ profits, or
forward earnings. The rationale for this change is that forward P/E is a better
reflection of a stock's future value -- and that, after all, is what you're buying
when you invest in stocks. But take care: all projections involve guesswork and
analysts frequently err on the high side when making such forecasts.
* Profit margins.
Income divided by revenues. Good margins for a software company might
be 25 percent, while 2 percent is considered fabulous for a grocery chain. So when
gauging a company’s profit margin, be sure to compare it with that of other companies
in the same industry.
* Debt-to-equity ratio.
A company's debt divided by shareholder's equity (or the value
of its assets after all liabilities have been subtracted out). This ratio is often used as
a measure of a company’s health: the higher it is, the more vulnerable a
company’s earnings may be to industry changes and swings in the economy.
* Return on equity.
Net income divided by shareholder’s equity, or,literally, how much
a company is earning on its money. This ratio can be used to show how a company’s
earnings measure up against those of the competition, as well as how they compare
with past performance. A rising return on equity (ROE) is a good sign in that case,
and a falling ROE is often a warning.
* Price-to-book value
ratio. A stock's price divided by its so-called book value,
expressed on a per-share basis. The book value is calculated by adding up the worth
of everything the company owns and then subtracting its debt and other liabilities.
The price-to-book ratio compares the price that investors are willing to pay for the
company to the value they would receive -- at least in theory -- if the company were
totally liquidated. A service business that has few hard assets is likely to sport a
high price-to-book ratio, while an auto maker, which probably owns a huge amount of
expensive plants and equipment, is likely to have a low one. As with all ratios, this
one is most useful when looked at in the context of a particular industry and a
company’s own history.
* PEG and PEGY ratio.
The PEG, or price/earnings/growth, ratio is calculated by taking
the P/E ratio based on forward earnings and dividing by the projected growth rate.
Stocks with a PEG ratio of less than one (meaning that they are trading at less than
their projected growth rate) are generally said to be cheap, while a PEG ratio of 1.5
or higher indicates a stock that may be overpriced. For stocks that pay a substantial
dividend, the PEGY ratio -- which is the P/E divided by the projected growth rate
*and* the dividend yield -- may be an even better measure than PEG alone. Keep in
mind, though, that both PEG and PEGY are highly speculative measures, as they are
based on projections and no one can really foretell the future.
You can find measures like
these at virtually any online investing site. In fact, thanks
to a proliferation of financial data on the Internet, the average person today can tap
into information that would have been available only to investment professionals 10 years
ago -- and much of it is free. Popular sources include the Personal Finance section of
America Online, Yahoo! Finance, Quicken.com, Investor.com, Money.com, Fortune Investor and
many brokerage and mutual fund sites.
You might use these measures
as a gauge to check on a company that you hear described as a
good investment. You can also use them to search for stocks directly, using a screening
tool like those offered at many sites (Fortune Investor and Microsoft Investor among
them). Either way, taken together with the latest news on a company (as opposed to rumors
flying around Internet message boards), measures like these can give a rough idea of
whether a stock is cheap, fairly priced or overpriced compared to others in its class.