Saturday, February 2, 2019

Investing using fundamentals - Introduction

It is said that over the short term the stock market is a voting machine and long term it acts as a weighing machine. I think, this is one of the best ways to describe the stock market and thus, I have revived my weighing machine in the form of a simple intrinsic value and earnings forecasting machine.

We invest in shares of a company to own ‘our share’ of the profits. We receive those profits in three ways:
  1.  The company in question makes a profit and reinvests it to maintain or expand its (hopefully) profitable operations. The result is that the share value increases along with its book value and successive earnings. 
  2. Part of the profits maybe paid as dividends and the remainder is kept to maintain the operation and/or expand. Be aware that nearly 50% of stock market profits come from such dividends rather than from appreciation of the share price.
  3. Profits can be used to purchase back company shares and reduce the number of outstanding shares. This divides the profits amongst a smaller number of shares and thus the earnings per share go up (and, typically, so does then the share price).  Of course, it is important that such a buy-back is done at reasonable or, even better, at undervalued prices. This way, the company can reduce the number of outstanding shares with most bang for the profit buck and your earnings per share will increase at the highest possible rate. 
Shareholders pay reduced taxes on dividends from Canadian companies.  A 3% dividend yield on an after-tax basis is often equivalent to an interest rate of 4.5 or 5%. When the share price increases as a result of share-buy-back, then tax rates are not due until you sell, and then only capital gains tax rates apply. So that is the best but… with share-buy-backs you don’t get cash-flow as is the case with dividends unless you sell.

When investing in dividend paying companies, you must always ask yourself, how the dividend is paid. Did the company take out a loan because it didn’t make enough profits to pay for the dividends? That would be a sign of a low-quality dividend and thus potentially a very risky investment.  If a company pays out more dividends than it earns then the pay-out ratio: Dividend/Earnings exceeds 100%. A ‘safe’-dividend requires typically a low pay-out ratio; say 40 to 60% of earnings.

The quality of these profits is another concern: profits exaggerated by high debt are low quality; profits from operations that become obsolete and need to be retooled are also of poor quality. If profits vary dramatically from one year to the next rather than being easy to predict suggests also low-quality profits. Warren Buffet’s competitive ‘moat’ is something that improves profit quality.  Really, it doesn’t take a rocket scientist to figure out what factors may improve and what factors may deteriorate the earnings quality.

Basically, if you know how much profit a company is going to make over several years then you can establish a value you may be willing to pay for that 'income stream'. You can express the profits in terms of time-value of money where you use your desired rate of return on investment as the discount rate.  Say that you want to buy a share of a company and it earns $30 over the next 7 years then what is the net present value of those earnings when you want a compound return of 10%?  Or if you paid $30 per share and received $30 dollars in earnings over the next 7 years then you returned $60 on your original investment, i.e. a double. 

Remember the rule of 72? That means the 7 years it took to double your $30 invested divided by 72 results in a  rate of return of approximately 10%.  The value of your investment may remain $30 but you also received $30 in dividends, i.e. you doubled. 

If instead of you receiving a $30 cash dividend, the company reinvested those earnings, then the shares should have appreciated by $30 and thus be worth $60. If you sell after7 years, then you’d have a capital gain of $30 plus your investment repaid in full. Same rate of return.
Short term share prices, as readers of this blog by now know may fluctuate in value due to the market ‘mood’ or investor psychology – Malkiel referred to this as the ‘random walk down Wall Street’. If, like in our example,  you hold on for 7 years or longer, the share price may average around aforementioned $60. Because of market sentiment, you may even be able to sell your share above $60! On the other hand, when many investors feel like they are in the ‘dog house’ then you may get a lot less than $60. 
To know whether you receive a decent price for your shares considering its earnings, you must know what the  intrinsic value or NPV of your share is at the time of sale using your 10% discount rate (or whatever rate you desire to achieve).

All those calculations and some more can be made in a spreadsheet such as the one I created for this series of postings. For each stock thus analyzed I got the current stock price, dividends and 5 to 6 years of earnings history from the Globe and Mail website. There are other services where you get this kind of data as well, but for me the Globe’s website is most convenient.

Over the next set of blog posts, we will look at this spreadsheet to analyze a number of financial service companies. See how they compare and then make an investment decision.  Brookfield Infrastructure; TD Bank; Bank of Montreal; Royal Bank of Canada; Power Corporation and Manulife.  After the review, ask yourself, with today’s uncertain markets what will you do regarding those companies? You also may realize that not all industries are evaluated based on earnings; oil and gas companies are usually valued based on cash flow or net cash flow.

Please, be advised that I tried my best to get the correct numbers for these companies, but you are responsible for any investment decision that you make on any idea derived from these spreadsheets or this blog.

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