Accountancy Resources
Finding the right price to pay for a stock or the best price to sell a stock is the way investors make money in the stock market. Seems obvious, but like many things in life, it is not easy to do.
The first task is to buy at the right price, but what is the right price? Different investors will have different answers, but they would all agree that you should buy below what the future price will be.
Of course, figuring out what price the market will pay for a stock in the future is difficult. There are many ways to come up with a future price, however since we can’t know the future for sure, any future price is the best guess.
You may have a better chance of coming up with a current fair value price, which is not the same as what the market is paying. A fair market value or intrinsic value is an assessment of what the business is worth as a going concern.
It considers the company’s ability to generate free cash (cash remaining after all the bills are paid and current debt obligations satisfied).
This is money the company can use to fund expansion, buy other companies, pay dividends or simply bank for future use.
A strong free cash flow is an important signal that the company has a competitive advantage over competitors. How big of an advantage (or economic moat) the company has plays into deciding how strong the company’s future looks.
Here are some indicators to consider:
Look for companies that post year-to-year growth in earnings (an occasional hiccup during recessions is acceptable). While this is not a perfect metric (remember accounting charges can reduce earnings), it is one you should look at. Make sure the target company is reporting earnings substantially higher than its sector (you can find these numbers in Yahoo! Finance in the stock research section). Also, compare it to major competitors.
Strong companies generate a lot of cash and, particularly, have a large flow of free cash. Free cash is what is left over after the company reinvests in itself to keep the business operating. Another way to think of this is how much cash you could pull out of the business without forcing a change in operations (closing plants, layoffs, and so on).
This measure tells investors the company is using assets wisely and creating value for the owners. How efficient is the company in generating earnings? Strong companies have a superior return on assets to their sector. For example, two companies each have $100 in assets. One company uses those assets to create $5 in earnings, while the other company uses the same amount of assets to create $15 in earnings. Which would you choose to own? Compare companies in the same sector for a valid check.
Another way to look at a company’s profit-generating efficiency figures is how the company uses debt in addition to assets. Since most companies use some debt to run the business, it is important to take it into consideration. Return on equity considers how well the company uses investors’ capital and includes the debt. It is very important to compare companies in the same sector. If a company has an ROE that is much higher than its sector, be careful that something unusual is boosting the number (recent acquisitions, buying back stock, and so on).
A company’s net margin is simply net income divided by sales. What this tells you is how efficient the company is in wringing profits out of sales. Some industries (grocery stores, for example) have low net margins and must drive a lot of revenue to generate profits. Other industrial sectors have higher net margins thanks to the nature of the business (software, for example). Great companies beat sector averages and close competitors.
Finding strong companies with strong futures takes some work, but investors willing to put in the time can be richly rewarded. Remember, strong companies with strong futures can be found in any industrial sector, so don’t confine your search to the currently hot sector.
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