6 Indicators To Value Stocks

I hope everyone had a wonderful holiday. I hope everyone on Wall Street got a nice sized lump of coal in their stockings this year, however, something tells me they probably got much cooler stuff than us folks. For the wing nuts at AIG who paid bonuses with bail out money, coal simply won’t do. Too bad I do not believe in damnation, because I could take comfort that the AIG executives would be getting the express elevator straight to the seventh ring of hell when they each kick the bucket.

Anyway, the past is the past. As promised from my last post; we’ll discuss how to pick solid stocks. If you looking for ways to time the market and jump in and out like a day trader, then read no further. Day trading is like gambling; eventually, you’ll lose. The odds are stacked against you. Sure, you can day trade in the short term successfully, but only a handful of people on the planet can do it. Day trading too long (or at all) will sooner or later land you in a big long line at soup kitchen. To sum up how I feel about day trading, I’ll borrow a line I heard from Buffalo Sabres play-by-play announcer Rick Jeanneret. Given the choice between the two, “I’d rather sandpaper the butt of a bobcat in a phone booth.”

Now that the wannabe day traders have fled this forum, I’ll discuss some of the indicators that can tell you if a stock looks good or looks bad. I know I said last time I would discuss specific stocks I own and other companies that look good, but are not. I decided to leave that for my first post of 2009.

Back to business. Now just to be clear, this is not an exact science. These indicators can tell you if a stock has a good chance of going up or a good chance of going down. Just remember these indicators are only part of the story. Further investigation is required to see if the underlying fundamentals support the direction of where the indicators are saying the stock is going.

The first indicator I look at is “Free Cash Flow”. This is the amount of money that is left over after paying all the company expenses. What this shows us is that if they company has a large amount of free cash flow, then it has the ability to expand it operations and buy other companies; essentially it shows it has the ability to grow. If a company has a low or negative free cash flow, then it is an indicator that it will not grow and is most likely leveraged to the hilt and not solvent. Determining how much free cash flow is a lot depends largely on the size of the company.

The second indicator is the Debt/Equity ratio. The lower the ratio generally means the company is managing their money well and should have money to invest in other ventures and/or pay out healthy dividends to shareholders. Remember that a low ratio does not necessarily mean the company is performing well and a high ratio does not necessarily mean it is doing poorly. Investigate why the ratio is low or high. A high ratio may indicate the company is financing expansion and a low ratio could mean the company is hoarding cash, which is good for stability, but idle money does not facilitate growth.

The third indicator is Enterprise Value. This is the estimated cost that it would take to buy a company completely and pay off any outstanding debts (at market value), minus the company’s cash holdings. In other words, it is the Net Present Value (NPV) of the company. This can help you gauge if the company’s stock is priced correctly. If the enterprise value is more than the market cap, then that is generally an indicator the stock price is cheap. Many people think a low P/E ratio is an indicator that a stock price is cheap. You must compare the P/E ratio of a company with that of its competitors and the company’s P/E ratio history. High growth sectors tend to have higher P/E ratios relative to low growth sectors, so you must take into account those factors when determining if the P/E is low or high.

The fourth indicator is current debt compared with current assets. This can be found on the company’s balance sheet. The current debt is debt that is due within the next 12 months. The current assets are assets that can be converted into cash within 12 months. Current assets are typically made up of cash, cash equivalents and accounts receivable. If a company has a significantly higher amount of current assets than current debt, that generally indicates they have a solid balance sheet and are generating enough revenue to pay their short term liabilities. If the opposite occurs, then the company can be in serious (or Sirius) trouble. This means the company will have to attempt to refinance their current debt to prevent defaulting, sell off some of their assets, raise additional money through a sale of treasury stock to the secondary market or attempt to merge with another company. If none of these can be accomplished, there are three alternatives: ask Buffett to purchase preferred stock or convertible bonds at ridiculous interest rates, file for bankruptcy or the trendy choice of requesting a government bailout. As we have seen, with the economy receding and the credit market tight as a drum, the only realistic options are bankruptcy or a government bailout. If you are a goliath of a company, then bankruptcy is basically the only option.

The fifth indicator is the percentage of shares being shorted. What this indicates is that if the percentage is high (10% or more), that means the people shorting the stock (hedge funds, investment houses, private equity firms, etc.) feel the stock is heading down in price. The way money is made off of shorting is that the stock is borrowed from an investor (generally an institution) and sold into the open market. If the short works, the stock price will fall and the entity shorting the stock will buy back the same number of shares they originally borrowed at the lower price and return the shares back to the owner. The entity shorting the stock keeps the difference. If the amount of shares being shorted is high, then that means that there are a lot of shares being sold into the open market, which increases the supply and drives the price down. Theoretically, large institutions could crush a stock price, if they all decided to short the same stock and were able to borrow enough shares to flood the open market. If a hedge fund has a huge stake in one company and other hedge funds were aware of it, they could combine their efforts and short the stock and put huge downward pressure. It would not matter if the company is in good or bad condition; simply that the increase in available shares on the open market would drive down the price. If the hedge fund did not realize why the price is nose diving, their whole position could run right to zero and possibly force the fund to close up shop. You want the short percentage to be as close to zero as possible.

The final indicator I look at is the sector itself. Some sectors flourish in bull markets and others flourish in bear markets. Some are linked to the business cycle and others are independent of it. Remember that a sector is not the same as an industry. Industries are basically sub-sectors. Energy is a sector and oil is an industry. Agriculture is a sector and farming equipment is an industry. Take a look at how the sector is growing overall and then try to investigate why it is growing, the catalysts that can grow the sector and also the ones that can destroy it. Once you have found a sector to invest in, take a look at the different industries in the sector and perform the same investigation into each industry to see which industry is performing the best. Once you establish that, then take a look at the companies competing in that industry and try to decide which company best fits your investment strategy.

Overall, this is a daunting process, but the more you do it, the faster and more efficient you will become at it. Using these indicators can give show you if a company deserves more investigation or if it should be ignored.

Be on the lookout for my New Year’s post. I’ll be listing my 10 predictions for 2009 and discuss 10 possible resolutions you can adopt to improve your financial health. Until next time, peace and I’m out!