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Evaluating Stocks

Although my “Value Rules” are inclusive, thorough & comprehensive – my peers frequently ask how I attempt to incorporate a target price or assign an approximate value to a stock when I analyze a company. From experience, I’ve found that although some professionals evaluate all stocks technically on the same criteria – my own approach is to treat specific stocks by how they’re grouped among my portfolios.

What I mean when I say that is: I don’t evaluate a stock on the same technical basis all the time. A stock that fits the criteria of my Value Portfolio is never assessed in the same way as my Healthcare or Dividend Growth Portfolios. My reasoning on this is that the objectives of each portfolio require me to select specific securities from the markets for inclusion that fit those criteria.

I’ve shared some of my rules from the Value Port over time, but never the complete list – partly because it’s my baby & also because I continue to add lessons as I learn them. Most of them are based solely on common sense, but each are concepts that for the most part go underappreciated by professionals that have the potential to influence the success of a company on a fundamental basis. I thought I would go through a brief summary of my regular approach to analyzing a stock. At times certain parts will require more focus & research, but as a starting point for a novice investor I think it covers my approach fairly well.

The Books:
One of the first things I always look over when I analyze a company is the balance sheet, income & cash flow statements from the past two years. I do this for a few reasons
Hidden Jewels: I want to look over the balance sheet for anything out of the ordinary (either good or bad) to get an idea of the general health of the business in terms of assets & liabilities. I’m also looking for undervalued assets that I feel aren’t represented at market value due to a variety of reasons.
Cash low is king – this allows you to run your business more efficiently whenever you’re able to control the cash operations of the business. That includes short-term financing, paying down debt, purchasing supplies at a discount to debt or gaining flexibility in operating your business. Generally I want to see stable or increasing cash flows OR how the company managed their cash flows prior to any troubled economic environments they now face.

I should point out that reading through financial statements is never my idea of a “good time”. After looking through the financial guts of a company for a few hours (annual & quarterly reports) my next task is to go through a set of standard ratios to gain insight into the health of the business from an operations standpoint.
Debt/Equity: You have to put into context the amount of debt that a company is responsible for vs. the equity the company holds & generates. Some companies in certain industries/sectors can sustain a high level of debt, while others cannot. I’m looking here to see what balance the company achieves in response to growing a business through debt financing and their ability to pay that off over a targeted time period. A good starting point is to check both the debt quality (how the debt is financed) & also compare the D/E ratio of the analyzed company vs. industry peers.
Current & Quick: These two ratios are the simplest to calculate and can give the most crucial short-term information. The current ratio simply takes the total assets & divides the total liabilities to generate a percentage. This will give you a ratio to compare the D/E against to see how weighted the company is towards its obligations of operating. The quick ratio is often over looked – but can be indirectly compared to cash flows. The quick ratio takes only the liquid assets of a company (cash they can get quick) and divides it by the total liabilities. The importance here is that if the company gets into a troubled spot (a debt-call, accident, unexpected development, etc) they have some way of continuing operations without substantial disruptions to their debt obligations.
Turnover: Here I look at how quickly inventories, liabilities, receivables & other categories are turned over in relation to corporate peers. If a company has a receivables turnover ratio double that of all their competition – that may give me a signal to anticipate them having issues securing cash flow for future operations. I also want to ensure that the company’s idle capacity is utilized efficiently and not simply stock piling product that could otherwise be generating cash flow for the company once sold.
P/E: Everyone knows this ratio – price of the stock divided by the EPS. What I tend to do with this ratio is compare the current P/E of the company against both its historic P/E and against any P/E’s from similar environments as the company’s current position. An example would be my personal preference to buy CDN Banks when their P/E is 60-70% that of the TSX Comp’s P/E
P/CF: This is a simple ratio that takes the current price of a company share and divides it by the cash flow per share. I generally compare this ratio against the P/E and P/S to give me some idea of balance
P/S: A ratio that determines the price to sales of a company. Sales = revenues and if you analyse a company that has increased expenses due to short-term environmental factor, then a depressed P/S has the potential to show value. In reference to my Health Port, a P/S tends to indicate to me what premium the market in general is willing to pay for a stock in reference to its product line or R&D competencies.

Whenever I’ve completed the first two steps and feel that I want to proceed with more analysis – I look to generate either a target price for the stock or an underlying NAV (Net Asset Value through a variety of methods.
Book Value/Share: This can be one of the simplest ratios to calculate or find on a company – but tends to vary depending on the source. Basically this ratio will give you an idea of whether the company is trading at intrinsic value, at a discount to its intrinsic value or at a premium. The importance here is to judge the quality of the assets (their true price)
NAV: The Net Asset Value can be a trickier beast to calculate and generally is something you need to do on your own (time consuming). What you want to accomplish here is to get a specific value per share of what the current assets are worth at market value. This doesn’t necessarily include only material assets, but also the replacement value of current assets, land, machinery or the company’s ability to scale operations (production potential).
DCF: This is what most investors use to generate a value per share of a company that incorporates a margin of safety (MoS). I personally use a dividend discount cash flow model to help me generate a fair value for my DivG Port, but other investors have complex spreadsheets that will generate cash flow assumptions and other criteria much more advanced then mine. A good rule of thumb is to use a simple DCF model from a website in order to provide you with some risk vs. reward balance to what the asset is worth on an earnings basis.
Adjusted Asset Value: This calculation is what I use for my Health Port and is not something easily generated. What I try to do here is assign a value for all current & future earnings generated by the company’s current portfolio of products within the time period that their patent protects them. I then use the time remaining on those patents as a ratio against the AAV to help me develop a target price that offers some discount to the company’s true value.

Optional Analysis:
There are also countless other pieces of information you can use to give you a generalized idea of where you might find value in a specific company you’re analyzing
Charts: Some charts will indicate seasonality in a stock which is exposed to certain cyclical sectors or times of the year when consumers purchase more product/service from a company (hence higher earnings). This is not my forte, but I generally look to long-term trends to help show the relationship and balance between the current price of the company & past fundamentals.
Dividend Yield: Here you can compare a company against its historical high, average & low yields in order to calculate some proportion of value.
Payout Ratio: By comparing the payout ratio of some stocks vs. their peers, you may be able to judge the company’s ability to grow a dividend or the sustainable nature of that dividend to be paid out in future quarters.

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