Financial Planning Lesson 11

So in lesson 10, we were extensive on the stock market terminologies, this week, let’s talk about how to select a company to invest in.

Now a clear caveat, stock trading is risky, and you can lose all your invested capital, past results in the stock market are not an indicator of future returns. That done, I want to show you how you can identify a company to invest their shares, responsibly.

Now the intrinsic value of a share is different from the market price of a share. The intrinsic value of the share is what a share of that company is worth, or the actual value based on variables taken from the company's financial statements and operations. The market price of that share is how much the stock market is asking you to pay for that share of a company.

Look at intrinsic value as the value of a business regardless of the price it is selling for on the market. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value.

If the market price is higher than the intrinsic value of the share, the share is said to be overvalued, if the market price is lower than the intrinsic value of the share then the stock is undervalued and a good buy.

So clearly the way you make money from share trading is to buy a share of a company below the intrinsic value of a company. This is very simply but extremely difficult. How do we determine value? How do we value a mango tree? Do we calculate the revenues from sales of the mangoes? Do we value the tree if we sell the wood for firewood? Do we measure the cost we paid for the tree? All three methods are correct. The difficulty is agreeing a price that corresponds with how much that mango tree will give us in earning over its lifetime.

Thus if we determine a mango tree will sell mangoes over its entire life fir N100, we thus want to buy that mango tree for less than N100. Right? So the key is buying at a price lower than its value.

How do we determine value?

Valuing a company

1. Market share; they company or the brand you are buying should be a leader in their sector or the company should be in the position to bring out a product or service to be a brand or market leader. Market share must also be growing. Reading the chairman's comments in the Annual Account will give you an indication of new plans, competitive environment, threats to the company etc

2. The market position must translate to Sales. So read the annual reports, there is a page that has a five year summary usually at the end, Sales must have been increasing all these years, if not find out why

3. Sales should lead to Operational Profit (gross profit), i.e. the proceeds from Sales should be able to pay for the Operational Expense of the company salaries, commissions etc, you can also get this from the annual report of the company, it make no sense if the company is borrowing money to pay salaries for five years!

4. Operational Profit should lead to Net profit, i.e. the company should also generate enough profits to pay its costs which are not sales related eg government taxes, auditors remuneration, long term investment projects etc. get the 5 year summary, the coy must be profitable long term, unless it’s a new coy in which case you are looking at reduced loss each year

5. This then translates into Cash generated. A company can manipulate earning but can’t manipulate cash earned, you can get the cash earned from the cash flow statement which in my view is the most important measure of financial strength. A company must produce cash to pay salaries, dividends, fuel cars etc. Look for surplus cash generated from operation i.e. total cash flow less operational cash and investing cash flow.

6. Cash generated should then be paid to you as dividends, so you are looking at dividends yields. Again you will see dividend paid every year for 5 years in the annual report. It will not make sense to you as an investor if the coy makes billions and does not pay you good dividends. However some coy may say “we will not pay a dividend but reinvest that money to grow the coy”… nothing wrong with that, but then the share price must rise to compensate you for not getting cash.

if you get a positive in all these, then they coy seems good. If the trend (market share to sales to operational profit to net profit to cash dividends) is broken find out why.  That’s the analysis part. But also look at, Management quality, Return on Assets and Return on Equity which are all in the annual report, again you want positive figures.

If you want to buy any stock, check to see all these are present, i.e. it must have a good share of the market, I must have sales figures going up year on year, it must have a good stable profit margin and Return on Equity, it must have Operational Cash flow, and then it must pay the investors dividends or reinvest that for the good of the company, but it must produce cash.

Ok we stop, here, next week we talk about how to trade in shares…

Jargon of the Week

The Price Earnings Ratio

The P/E ratio divides a stock's share price by its Earning per Share to come up with a value that represents how much investors are willing to shell out for each dollar of a company's earnings.

If the Price of a stock is N50 and the Earning Per Share is 10, then the PE ratio is 5. The PE tell you how long at the current earning it will take you to get a full return on your investment. Hence if you buy that stock at N50, with a PE of 5, at the current earning you will get your money back in 5 years…it should be used as one of a series of indicators.

Question of the Day

If you had N100,000.00 today, would you spend it or invest it?