What information should you look for?
Don’t underestimate the importance of identifying companies with strong underlying fundamentals that can weather a few stock market ups and down over a long-term investing timeframe.
There are at least three key considerations:
- Are the company’s earnings growing?
- Is it generating cash flow?
- What is the company’s level of debt?
The price to earnings (P/E) ratio is a good place to start in relation to looking at a company’s earnings. A P/E ratio is basically the amount investors are willing to pay for a share in a company, relative to its earnings. It shows how many years it would take for the company’s earnings to match the current price of its shares. It is worked out by dividing the company’s current share price by its earnings per share.
- Current share price ÷ earnings per share = P/E ratio
Earnings per share (EPS) is the proportion of a company’s profit that can be attributed to each outstanding ordinary share in the company.
EPS is worked out by taking a company’s net profit and dividing it by the number of ordinary shares on issue.
- Net profit after tax ÷ number of shares on issue = EPS
But it's important not to look at these figures in isolation. Compare them with a company’s historical value, as well as to the P/E ratios of other companies in the same industry and the market as a whole.
Earnings per share (EPS) can also be used to quickly see if a company’s earnings are growing from one period to the next.
Where to look: Individual companies’ EPS can be found in annual reports and financial statements. These are easily downloaded from the Australian Securities Exchange (ASX) website or the investor information section on the company’s own website.
How much debt?
The advantage of a strong balance sheet cannot be over-emphasised. It’s not just about how much a company borrows; it’s also about its ability to pay off that debt and its interest.
Ideally, a company’s earnings before interest and tax (EBIT) should be several multiples of the amount it is spending on interest.
In terms of quickly gauging debt levels, ‘debt to equity’ can be a handy metric. Essentially, this compares the amount of debt a company has to its shareholder equity. A ‘high’ debt to equity ratio indicates a company has taken on quite a lot of debt to finance its growth. This can ultimately impact the amount of money a company returns to shareholders (for example, in dividends), as a significant chunk of its earnings may be used to cover its interest payments.
Much like a price to earnings ratio, debt to equity is most useful when compared with other companies in the same industry.
Where to look: While the definitions of metrics themselves can seem quite complex, the figures are usually quite easy to find in a company’s annual report.
If you’re struggling to sift through all the detail, look for the ‘cash flow’ section of the financial statement or search for specific terms within the document, such as EBIT, net interest and debt to equity.
How important is management?
It’s definitely worth getting a feel for management’s track record. Shareholder presentations, also available via the ASX, are usually good sources of information for this sort of detail.
Sometimes you can research other companies where management previously worked. Knowing the history behind people might give you more information for making a decision about buying shares in companies they are involved with.
What else might affect the share price?
A company’s share price can also be an indicator of how underlying fundamentals are performing. The challenge, however, is understanding what’s behind share price movements, particularly if you’re not following the market closely all the time.
For example, newer investors are often confused if a company reports an increase in profit and its share price subsequently drops.
This might happen because the profit did not rise as much as analysts were expecting or because of something negative in the company’s outlook, like a downgrade to the amount it expects to earn in the following year.
Broker research, such as the reports available via CommSec, can give you a good idea of what analysts are focusing on for a particular company and what events might trigger a reaction in the share price.
Of course, share prices can be affected by a number of factors. When making investing decisions, it’s important to remember that any forward-looking statement is just that – a future prediction that may or may not come to pass.
Avoid these common pitfalls
Aside from the basic earnings, cash flow and debt trifecta, investors can also learn from a few common errors:
- Don’t react to a spike in profitability due to a one-off event; you need to look at consistency. Is that event likely to be repeatable?
- Don’t be lured in by an extremely high dividend yield. This often reflects a falling share price, meaning investors are reacting to something negative happening in the company.
- Don’t take earnings growth at face value, particularly if the company has made a number of recent acquisitions. You want to make sure earnings are growing organically, not simply increasing as acquired businesses are added to the balance sheet. Look at the financial statement to get a break down of where revenue is coming from.