Saturday, October 31, 2009

Why Catholic Investors Should Use Fundamental Analysis - Part II of II

Vegas Vacation

It's Not a Game of Chance!
This is the second half of my intro to Fundamental Analysis. When you buy a stock, you do not need to hope and pray once that buy order has been filled. It is NOT like when you play roulette and the ball has been spun. This is because you know you have bought a stock that will likely go up! I will talk about a few tools that will help you identify whether a company is undervalued or not.

Price-to-Sales Ratio
Ken Fisher pioneered the use of the Price-to-Sales ratio (P/S ratio) in the 1980s. One of the disadvantages about using the P/E (profit-to-earnings) ratio is that it doesn't really work if the company is not making any profit! Sometimes, you may find a company with very good prospects but is not currently making any money. How do you judge if this company is worth buying? The price-to-sales (P/S ratio) can help you.

The concept behind this ratio is simple. A company has a certain amount of sales or revenue and also costs associated with running the company, etc. For a good company, a portion of that sales will become profits. For really good companies, that percentage can be as high as 50% or 60%. What that means is for every dollar that its customers pay, 50% of that money is pure profit.

This helps us very much. Let's say a company has sales of $10 per share. The price of the stock is $15. It's not making any profit currently, but what if it starts cutting costs and starts making money at 50% margin? That means that it has $5 earnings per share ($10 sales × 50%). The P/E ratio becomes 3 ($15 divided by $5). And we know that for a healthy company, a P/E ratio of 3 is a dream come true for us investors! So, we definitely want to by this company!

So, what was the P/S ratio for that company we just talked about? It was $15 / $10, or 1.5. Of course, an operating margin of 50% is not easy to achieve. You will need to do some research on the particular industry you're looking at. If the profit margins for most of the companies in that industry is 20-30%, you may want to use 20% for your analysis.

Some people recommend that a P/S ratio of 1.0.  I would definitely not go blindly and start buying any stocks that have a P/S ratio of less than 1.0.  The company may be in huge debt and could go bankrupt at any moment!  So, please do your homework!

Price-to-Book Ratio
A ratio that has been used for many, many years is the price-to-book ratio. It is a very well known ratio in value investing circles. The theory is very simple as well. A company owns many assets such as buildings, machinery, computers, product, etc. If it were to be liquidated, all of these assets can be sold for a value. This is the "book value". Sometimes, a stock may be traded at value that is lower than the book value. It's almost like someone coming up to you to sell you a $1 bill for $0.50! It's a little irrational, but it does happen!

So, a P/B ratio of less than 1 will start to get us excited. A caveat is that the book value may be inflated. It is a matter of accounting and goes beyond my knowledge. My advice is the same as always: be prudent and dig a little deeper. What seems too good to be true may be just that!

Get Out of Debt!
A company may have great P/E and P/S numbers, but it may also have a huge amount of debt. You have to wary of these companies. As we all know, with debt also comes interests. Debt is not necessarily bad in itself. Most companies borrow money so it is able to expand or to carry inventory, etc. However, if debt is too high, then you may want to avoid buying the stock of that particular company. You want the debt to be small enough that the company can pay back the debt in a few years. Simply compare the amount of debt to the earnings or free cash flow of the company. That will give you an idea of whether a good deal is really that good!

It's All So Complicated
You know what? You are right! Fundamental analysis is not easy and is still very much an art than a science. Most books will tell you exactly what I have told you...a whole bunch of ratios and no real way to evaluate if the business is fundamentally sound. Also, they will not give you a real quantitative way of determining under what price we should buy a company.

There's no need to fret! Take a look at one of my older posts: Rule #1 - The Book That Energized Me. It talks about a book that gives a very, very simple and quantitative way of determining whether a company is undervalued or not. I will likely write another post that is more in depth to discuss the actual calculations that the author, Phil Town, teaches. Stay tuned!