On stage with Claer Barrett at the FT weekend festival last year, we asked our audience if they had invested directly in the stock. To my surprise, two-thirds of the room raised their hands. First of all, who knew there were hands in the room?
And the response flew in the face of an efficient market. Stock picking is not possible. If 85% of US equity funds have been missing indexes over the past decade, what opportunities does Penelope at Tunbridge Wells have?
I have recently written that there is something deep in the human mind that probably believes in active management. What’s more, you don’t have to beat the index. Make enough money and who cares?
Plus, trading stocks are fun. Learn about businesses, make bets, and watch prices go up and down. It appears that everyone has an opinion on the future of Amazon, British Airways, or Tiktok.
People can even buy stocks with a hunch. But no matter how financially challenged you are, I recommend doing some basic assessment work to make sure you’re not Patsy.
Professional investors want to keep their methods a secret. And most of the time they appreciate the goodness. On the other hand, the simplest approach to assessing a company can quickly become confusing. Anyway, who has time?
Luckily, time isn’t very helpful. When I was a young analyst, my Qantas model became 150 independent Excel tabs. We have predicted all seats, food trays, flight attendants and landing slots over the next 20 years. To discover that only fuel prices and US dollars are important.
Plus, almost everything I’ve been taught has actually not worked out in recent years if you want to earn money seriously. Like most brokers, I calculated Tesla to be worth zero. And I would have been selling other spectacular things before 6 o’clock.
However, many evaluation rules still apply. I have always paid 15 times the profit per share of top banks. JPMorgan’s share price is $281, which is equivalent to 14, dividing it by $20 earnings per share over the past year. He did the same thing with Natwest, finishing in 9th place.
Certainly there are a wealth of issues with price/return rates. So the frequency with which vaguely wise numbers are generated is surprising. We do not use PE ratios to compare stocks between sectors or regions. But rather than checking a single stock price, that’s fine.
That being said, some fine tunings can significantly improve the predictive power of the PE ratio. One of their many mistakes is that revenue volatility is tricking them. Another big name is that they don’t know how much debt the company has.
The first is partially resolved by stripping away so-called extraordinary items from the denominator’s earnings per share. This helps to keep one-off waste, such as disposal, legal settlements, and writing acquisition, to keep the assessment from being softened or dampened.
Or perhaps the underlying business is just as lumpy as the makers of giant machines. Here you can pay to average over several years to smooth out EPS fluctuations.
For leverage issues, PE ratio numerators can be replaced with enterprise value, including corporate liabilities. Meanwhile, just like repayment of this obligation (amortization), profits and repayments are added to revenue.
Using enterprise value on profits prior to interest, taxes and amortization (EV/EBITA) can help resolve fluctuations in capital structure. This is common across industries (such as supermarkets that spit cash on delivery can take on more debt than project-based ones), but it also occurs within the sector.
Taking British energy company Shell and BP, it was featured in the news this week, denialing the former seeing the latter. When using this year’s consensus revenue, both have exactly the same PE ratio of 10 times. However, BP has more than twice the debt compared to stocks, as it has doubled the Shell and its EV/EBITA. In other words, it’s not as cheap as it looks.
Finally, it is recommended that readers store a very basic discounted cash flow model on their computers. Not only are they different attempts and tested methods, but they are also tested methods to help you choose stocks, but they can also use them to cherish almost everything in your income stream, for example, in a rental property.
You have to talk to our legal department. This will probably add a small print of 100 pages, but if you would like to send us a very basic Excel model that requires only a few inputs to create a company rating, please email us at the address below.
The idea behind most discounted cash flow methodologies is to start with from sales and profits to free cash flow. The latter is the purest form of cash produced by the company, taking into account capital expenditures and taxes. Estimate this as much as possible. It’s fine for 5-10 years.
Only two more inputs are required. Since time extends infinitely beyond the model, a “terminal growth rate” is required to derive “terminal values.” It is basically a huge value of future value.
Unless there is a good reason for bloody, I always use nominal GDP as a proxy for terminal rates. This is called 2.5%. Finally, these future cash flows need to be converted into today’s money – what is called “present value.” This requires a discount rate.
Consider the interest you have to pay for the fact that most of the company’s cash flow doesn’t come straight away. So it makes sense that business is higher than risky. Of course, this is oversimplified. Find out the average of sectors and use it.
PES, modified PE, and basic discount cash flow models. Most retail investors need almost all of them. Happy stock picking!
The author is a former portfolio manager. Email: stuart.kirk@ft.com; X: @StuartKirk__
