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**Lesson # 4**

**HOW TO PICK WINNERS, STEP 1**

Topic of the Day

By

**ALI AKBAR REAL Mentors Consultans Intl**

**HOW TO PICK WINNERS, STEP 1**

Valuation: Buy Low, Sell High

In theory, every investor wants to buy low. We all understand bargains, and we all prefer buying products on sale rather than at full price. But buying low and selling high isn’t as easy as it sounds, because buying low often means diving in while everyone else scrambles to get out of the water. After all, they wouldn’t all be leaving unless someone had seen a shark,

would they?

The buy low, sell high strategy works better if you focus not on the market, but on a specific stock. If you can determine on your own whether a stock is cheap, you can muster up the fortitude to buy it regardless of the state of the broader market.

Study after study has shown that stocks with low valuations tend to outperform. With those decades of research in mind, here are some valuation ratios to consider:

Price/earnings ratio.

Price/sales ratio.

Price/book ratio.

Price/operating cash flow ratio.

While investors can calculate dozens of valuation ratios, the four listed above require statistics anyone can gather at no cost, and all four can help you assess a stock’s value. The paragraphs that follow and Table 4.1 illustrate all of these ratios for Pfizer, the pharmaceutical titan. To get started, prepare a spreadsheet or printed page similar to the table to keep all the data in one place.



Price/Earnings Ratio

The price/earnings ratio is the most popular valuation metric, cited often by professionals and amateurs alike. Earnings, or profits, represent what a company has earned after it pays its bills. Valuing a company relative to its profits makes sense. After all, don’t you want to generate the maximum profit for every dollar you invest? When you purchase a share of stock, you acquire a tiny piece of a company’s earnings. And what the market will pay for those earnings tells you a lot about the company.

To calculate the price/earnings (P/E) ratio of a particular stock, you’ll need the stock’s share price and its earnings over the last four quarters— often called 12-month trailing earnings. Companies report earnings four times a year, with most—including Pfizer—breaking the year down into the three-month periods ending March, June, September, and December. (Some companies report in January, April, July, and October, or February, May, August, and November.)

Visit your preferred financial website, type in the ticker symbol for the stock you wish to analyze and seek out historical earnings data on the page containing information on earnings estimates. Most pages with estimates will list earnings for the four most recent quarters. Simply sum the earnings per share for those four quarters, and you have trailing 12-month earnings per share. For example, Pfizer traded at $28.21 per share at the end of August 2013 and earned a total of $2.10 per share in the last four quarters, or the 12 months that ended in June. Divide the share price by per-share profits, and you get a P/E ratio of 13.4.

After you calculate the P/E ratio, do the same for other companies in the same industry. You can’t just pick other companies randomly, because P/E ratios vary from industry to industry. For example, oil refiners have traded at low P/E ratios for decades. Software companies, on the other hand, tend to command higher P/E ratios than the average stock. If you compare a software company to a refiner, the refiner will almost certainly look cheaper —even if that refiner trades at a far higher P/E ratio than its peers. However, that refiner may not actually represent a better value.

Suppose you select a refiner that trades well above the typical valuation for its industry, and you select a software company that’s among the

cheapest in its group. Even with a higher absolute P/E ratio, the software company might represent a superior value. Before you make that determination, perform a peer-group valuation comparison and also review the stocks’ growth, profitability, and other factors.

In Pfizer’s case, comparable stocks include Merck, Eli Lilly, and Bristol-Myers Squibb. Be careful when selecting competitors for comparison. When possible, you want companies that operate in the same markets as your target and which also compete in the same weight class. In other words, if you want to analyze Pfizer relative to other drug companies, select the biggest ones you can find. As the table illustrates, Pfizer trades roughly in line with two of its largest peers—based on P/E—but looks much cheaper than Bristol-Myers Squibb.

While the traditional P/E looks backward, you can also use the ratio to look forward. P/E ratios that use estimates provide another view of the company, one that hints at a story you won’t hear from valuation ratios relying on historical numbers. Instead of dividing the share price by earnings over the last 12 months, use the estimate for profits in the current fiscal year or the next year. You can find these estimates at any of the financial websites mentioned earlier.

For instance, Pfizer is expected to grow per-share profits 5% this year and 4% next year. For the most part, analysts don’t expect much growth from the big drug makers. Not surprisingly, since earnings represent the denominator of the P/E ratio, rising earnings will equate to a lower ratio. As of August 2013, Pfizer traded at 12.8 times the profit estimate for 2013 and 12.2 times the 2014 estimate. Pfizer looks somewhat cheaper relative to its peers based on the P/E ratio using the 2014 estimate than it did using trailing profits.

While the P/E ratio effectively gauges value for most companies, it’s not perfect. When you consider a company’s P/E ratio, keep the following points in mind:

Earnings do represent the bottom line, but companies can manipulate earnings by changing their accounting.

Companies that lose money have negative earnings, and valuation ratios mean nothing if the denominator—in this case earnings—is negative. P/E won’t work as a valuation tool for unprofitable firms.

As a rule, industries or companies with higher expected growth tend to sport higher P/E ratios, as the market will pay extra for higher profits in the future.

When you see a company with an abnormally low P/E, dig a little deeper. The P/E ratio, like all valuation ratios, reflects the company’s perceived risk. Suppose a company faces increased competition or new government regulation that could slow its growth. In cases like these, it might deserve a lower P/E. In other words, while some low P/Es indicate bargains, others have become cheap for good reason.

Price/Sales Ratio

The price/sales (P/S) ratio focuses on the topmost line of the income statement. Sales, also called revenue, reflect the amount of money a company receives before taking expenses into account. As a raw measure of performance, sales won’t tell you as much as profits will. Companies can spend heavily to boost sales, while inefficient operation squeezes little income from that revenue. However, studies show that the P/S ratio is also an effective predictor of future performance. Stocks that are cheap based on P/S ratios tend to outperform more expensive stocks—not unlike the relationship between performance and P/E ratio.

To calculate the P/S ratio, start with the numerator. You can collect sales data on the same website where you grabbed the earnings numbers. Find the link for the income statement and add up the sales for the last four quarters. Multiply the stock’s price by the number of shares outstanding— this will give you the stock-market value, or market capitalization. Divide that number by total sales from the last four quarters to derive the P/S. Like P/E ratios, you can then compare the performance of the company in question with others in the industry. For example, Pfizer traded at 3.7 times sales at the end of August 2013—pricier than Merck and Eli Lilly, but cheaper than Bristol-Myers Squibb.

Here are some other issues to consider while analyzing a company’s P/S ratio:

The ratio works for just about every company. While many firms post negative earnings or cash flows, just about all of them have positive

sales. When no other ratios work, you can often turn to the P/S ratio for help.

While sales vary from quarter to quarter and will certainly rise and fall with economic cycles, they don’t usually fluctuate as much as other statistics. For that reason, the P/S ratio makes sense for stocks in industries sensitive to cycles, such as companies that sell industrial goods, discretionary consumer products, or semiconductors. Companies’ customers buy more during good times and less when their own situations get dicey. Sales will ebb and flow with that demand, but they generally hold up better than earnings or cash flows.

Accounting rules for sales offer less leeway than the rules for calculating earnings. As such, the P/S ratio is less susceptible to manipulation by accounting than is the P/E ratio.

Price/Book Ratio

While both the P/E and P/S ratios compare the stock’s price to statistics from a company’s income statement (also known as the profit and loss statement), the price/book (P/B) ratio draws on the balance sheet. While income and cash-flow statements report quarterly numbers that will combine to reflect annual performance, balance sheets simply take a snapshot of the company at a particular time.

To calculate the P/B ratio, divide the stock’s market capitalization by the book value, or equity. For example, at the end of August 2013, Pfizer traded at 2.6 times book value—the lowest among the four drug stocks in the table. You’ll find the book value on the balance sheet. But instead of summing the equity for the last four quarters, just use the most recent period.

Equity represents assets minus liabilities. In other words, if a company owns $10 billion in assets, and also owes $5 billion, it has $5 billion in equity. Equity—sometimes called shareholders equity or common equity— should reflect the company’s liquidation value in theory. If the company goes bankrupt and sells its assets to pay its creditors, it should be left with assets that equal the equity balance.

Of course, because of accounting rules and other factors, book value only estimates liquidation value, and for most companies the estimate would be very rough. The book value of an asset reflects its original cost and may not

keep pace with changes in the asset value, either because of inflation, depreciation, or a change in the asset’s ability to generate revenue.

That said, the P/B ratio still serves as a useful check of other valuation methods. A stock cheap on P/E and P/S should probably look good based on P/B as well. This won’t always occur, but a discrepancy between multiple valuation ratios should raise a flag. In other words, if the stock sports a low P/E but trades at a premium to its peers on P/S and P/B, you’d be wise to learn the reason why before you buy it.

Consider the following when analyzing P/B ratios:

Only a few companies have negative equity values, which means you can use the ratio with more companies than you can with the P/E ratio.

P/B works best with traditional businesses that own hard assets— things like factories, machinery, and warehouses full of inventory. Accounting rules also tend to keep equity from fully reflecting the value of intangible assets like patents and other intellectual property. For companies with most of their value tied up in brand names and other intangible assets, book value has little in common with the intrinsic value of the company.

For companies with extremely heavy debt loads—or ones that have posted serious enough losses to erode the value of equity—the P/B ratio can appear inordinately high.

Price/Operating Cash Flow Ratio

Many investors view price/operating cash flow (P/OCF) ratio as the best of the four valuation ratios—and they may have a point.

Remember how companies can skew reported earnings using accounting tricks? Cash flow doesn’t leave them many loopholes. To calculate operating cash flow (don’t worry, you can pull the final data from the Internet without calculating it yourself), companies start with earnings and then strip away costs that aren’t paid in cash as well as other noncash adjustments. Operating cash flow—also called cash from operations— reflects the amount of cash a company’s operations generate.

While aggressive accounting methods can skew earnings (and to a lesser extent, sales), and book value becomes less accurate over time, the P/OCF

ratio probably offers the cleanest, most accurate picture of a company’s valuation. When a company grows earnings but doesn’t grow cash flow, investors should become suspicious. If a stock you’re considering looks cheap based on the P/E ratio, but expensive on P/OCF, the company might have resorted to accounting shenanigans to boost earnings and make its growth look stronger.

To calculate the P/OCF ratio, divide stock-market value by the operating cash flow generated over the last four quarters. You’ll find operating cash flow in the statement of cash flows presented online, again summing the last four quarters. For example, at 12.3 times operating cash flow, Pfizer is cheaper than one of its peers and more expensive than two others.

When you use the P/OCF, remember these points:

Plenty of companies generate negative cash flows, rendering the ratio useless.

Many companies don’t report cash-flow data—at least not in a way that is accessible to beginning investors. In particular, banks and utilities tend to skimp on providing that kind of information.

Not all companies calculate cash flow the same way internally. While federal accounting rules provide guidelines, many companies present their own customized numbers in addition to those mandated by the government. When you compare companies using P/OCF, make sure you collect similar numbers for the different companies. Your best option is to pull the data directly from the statement of cash flows—not from the text in a company’s earnings release.

Importance of Valuation

Value remains arguably the most popular approach for analyzing stocks, and research suggests it’s the most important determinant of stock performance. Stocks with low valuation ratios of all types tend to outperform. However, in the investment world, “tend” is a big word, and by no means implies any kind of certainty.

When studies conclude that stocks with low P/Es tend to deliver higher returns than those with high P/Es, they generally combine data from thousands of stocks and holding periods. When you look at a smaller sample

—say, one stock—the trend doesn’t always apply. Some stocks with high valuations will perform quite well, and some stocks with low valuations will underperform the market. This often occurs with stocks that trade at a discount to their peers because of weakness somewhere else.

You can’t own every stock, and you won’t find all the winners. You also can’t avoid all the stinkers. You just need to find enough winners to offset your losers, and you can increase your success rate by looking at other attributes beside



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