Whenever someone thinks of finance, their first reaction is to ask for stock tips. Although finance extends much further than just the stock market, it is perhaps one of the more confusing concepts in this field.
The stock market is a vast arena, so much so that research analysts (stock market experts) tend to specialize in a vertical—energy, pharmaceuticals, technology etc. They become experts in their vertical for their firms. Now, the casual investor will never attain such expertise, but there are a few indicators that are at the core of good, fundamental investment strategy—these indicators focus on different aspects of a business and, together, can provide an accurate picture as to the health of the company.
The Price-to-Earnings Ratio
Perhaps the most commonly known financial indicator is the Price-to-Earnings or P/E Ratio. It is calculated by dividing the price per share by the earnings per share (EPS) of a stock.
If the price of one share of Company X is $20 and it earns $5 per share, its P/E ratio would be 4. The strength of the P/E ratio also happens to be a weakness. An investor can use the P/E ratio to determine the relative value of the stock in relation to its competitors.
Let’s assume company A, B and C are all in the same industry with earnings of $5, $6 and $7. Let’s also say that Companies A and B have prices of $20 and $26 (P/E ratios of 4 and 4.33 respectively) while Company C is being traded at $56/share. An expert would take a look at company C’s price-earnings ratio of 8 and investigate why it’s priced at twice what it should be. If it’s unwarranted- it would be classified as overpriced.
Traditionally, the P/E ratio is more sensitive to the price aspect of stocks as investors sometimes get excited over exciting new companies, like Twitter, leading to a highly variable P/E. More traditional/older companies like Pfizer have been around a while leading to more stable prices and in turn more stable P/E ratios. This dichotomy between established firms and new ones exposes the weakness of the ratio, one cannot compare P/E ratios across different industries or lifecycles—large pharmaceutical and technology firms will have lower P/E ratios than software start-ups.
Case in point: when Google first went IPO, it had an exorbitant P/E ratio. As it has matured, the P/E has dropped to a more reasonable 30 as a function of high earnings growth and stable price appreciation.
The high P/E category has become populated by newer firms like LinkedIn with an astonishing 758 due to high investor demand and proportionally small earnings. As the excitement dies down for LinkedIn and earnings continues to grow—the P/E ratio will drop to the software technology industry average of around 25-30.
Another indicator that is commonly used in stock analysis is the earnings growth percentage. The strength of this indicator in comparison to other growth indicators is its inability to be manipulated.
There have been times when companies have manipulated their revenue, whether it was recognizing revenue early, or through some other method. In contrast, earnings are much harder to fake. Another reason to use earnings is that it provides a more accurate picture of the financial health of the company.
Revenue growth numbers don’t reflect the cost structure of a firm, while the gross profit growth only accounts for cost of goods sold (COGS). Earnings growth accounts for COGS, interest, taxes, depreciation and amortizations costs—a much more accurate indicator for future success or failure.
Many companies have been brought down by an inflated cost structure hidden in the revenue growth numbers. Walmart, for example, has a current revenue growth number of 1.5%—not a huge red flag for a company that size. The red flag for Walmart is its increased cost structure and competition for profit margin brought on by more nimble competitors, reflected in its debilitating -21% earnings growth. It is not to say that Walmart is on its death throes—far from it, but saying that it is extremely healthy and faces no issues would also be a mistake, something an investor would have missed if he didn’t know where to look.
Playing the Numbers Game
Putting all these indicators together, let’s explore the financial situation of McDonalds and compare it to a proxy for the fast food industry—Burger King, YUM Brands and Panera Bread, to determine whether it’s a buy or sell.
McDonalds has a P/E ratio of 18 and earnings growth of 0.1% as compared to the industry average of 32 and 22% respectively. With these two factors combined we might have an explanation for why the P/E ratio for McDonalds is so far behind the industry —lower growth prospects are making McDonalds stock unattractive creating downward pressure on the stock price. Although research analysts conduct significantly more detailed analysis before arriving at their conclusions, based on our limited analysis we can conclude that McDonalds is a sell.
Stock analysis is a tricky venture. By definition, for an investor to succeed it must be at the expense of another—it is a zero sum game. Even John Paulson, one of the smartest investors lost $1B in 2013 because of a wrong opinion. The best research analysts are those who perform a detailed analysis that can predict stock movements for the right reasons. Research analysts produce buy, sell or hold ratings and have price targets associated with those ratings—a quantitative measure of how good an analyst is. Casual investors should approach the stock investment process in the same way to instill discipline in the process.
Good investors can predict if a stock will go up or down, but great investors can predict how much. Being able to predict a stock increasing to a certain price based on factual information and then having the discipline to sell it when it does is what separates investing from gambling.
This article is the opinion of the author and is not shared by India Currents or any of its staff. All investors should conduct their independent analysis before taking any actions and should not make any decisions on the information provided in this article alone.
Rahul Varshneya graduated from the Leavey School of Business at Santa Clara University with a degree in finance and is working in the technology industry as a financial analyst.