Don’t blindly pick a sexy story: This is how to choose a share

As a first-time investor in the stock market, the best starting point is to invest in a unit trust or exchange-traded fund. This allows you to start with a relatively small amount of capital from a little as R200 a month, requires no prior investment knowledge and provides you with a well-diversified portfolio of many underlying companies.

However, if you want to start investing in individual shares you need to be prepared to do your homework, says Craig Pheiffer, chief investment strategist from Absa Stockbrokers & Portfolio Management.

Are the earnings sustainable?

When it comes to buying shares, Pheiffer warns against just blindly buying a share everyone is talking about or one with a “sexy” story.

“You need to delve deeper into the company and look for signs of sustainability and long-term prospects,” says Pheiffer, who explains that this means investing in a company that has been sustainably growing earnings over time.

“While some sectors may be more cyclical in nature, such as mining or commodities where the earnings growth may be linked to larger economic cycles, you can still look at its longer-term trend, taking the cycles into account,” he says.

When it comes to the financial statements, Pheiffer says you do not have to be an accountant or to drill down into the details, but you need to look at some key indicators such as headline earnings, cashflow, income and return on equity (see How to interpret financial results).

Get a piece of the company you want by buying shares

One of the main indicators to help you understand the sustainability of the business is its debt level. “Look at how much debt a company has and whether the cost of servicing the debt will impact on its earnings.”

Sustainable earnings are often linked to a growing dividend payout. Pheiffer says that a growing dividend means that an investor is receiving a regular return on their invested capital instead of waiting for a share price gain.

“While past history is not always a guarantee of future performance, looking at how a company has grown in the past provides a proven track record.”

Pheiffer advises that you read about the company’s outlook which is always contained in the annual report as it provides an idea of how the firm sees its operating environment and its future prospects.

“A company may acknowledge that the current trading environment is challenging, but they may be investing into the business to be ready to expand when the economy improves. They will hope to reap the rewards when there is an uptick,” Pheiffer says. A business that invests in itself is confident about the future.

What business is the company in?

As an investor you need to keep up with news about the company and be aware of management changes, major restructuring or acquisitions the firm may be making. Pheiffer also recommends that you make sure you fully understand the company’s operations. He uses Disney as an example: “People may know Disney from cartoons such as Mickey Mouse or their theme parks, but they have a very extensive business as a multinational mass media and entertainment conglomerate.”

Disney owns ABC News, History Channel, Marvel and Pixar, among others. If you want to invest in a company, go on to its website and understand its full business operations; understand what the company does in its entirety.

When it comes to buying shares, Pheiffer warns against just blindly buying a share everyone is talking about or one with a sexy story.

Given some of the large corporate scandals we have seen, the management of a company is an important factor in the decision to invest. “One would be concerned if a whole new set of executives are brought in with no experience in the company, and the old guard who delivered all the past performance are no longer there, or if there is a frequent change in CEOs” says Pheiffer, who adds that some continuity in the management team is an important indicator of sustainability of growth.

You also need to look at the economic environment – both locally and abroad – as this will impact different types of businesses. For example, strong economic growth in China would be positive for commodities while a strong local economy would be positive for banks and retailers. Then you need to know what positive and negative factors affect a specific type of business.

What is a fair price to pay?

Once you have done your homework and are confident the company has positive prospects with quality earnings, you then decide on a fair price to pay for the share.

You need to look at the company in the context of the share market as well as its peers – you need to compare its earnings and valuations to its competitors’. When looking at a bank, you would want to focus on its credit loss ratios and compare that to other banks. Ideally, you are looking for a good quality company that may be showing value relative to its peers.

The most common metric to use is the price:earnings ratio (p:e). This is the price of the share divided by the earnings per share. For example, if a share is trading at R20 and the headline earnings per share are R2, then the p:e ratio would be 10 times.

This means the share price is 10 times the earnings per share, so it would take ten years of earnings to pay for the share.

The higher the p:e the more expensive the share is – or put another way, the longer it would take for the earnings to pay for the share price. Currently the average p:e ratio for the JSE is 17 times.

Pheiffer also recommends investors use the PEG ratio as part of their valuation. This is the p:e ratio divided by the growth rate of the earnings over a specific period.

The lower the PEG ratio, the cheaper the stock. Ideally a company should not have a PEG ratio of higher than 1 to 1.5 times. Pfeiffer says a company with a PEG ratio of above 2 times would be considered expensive.

One of the main indicators to help you understand the sustainability of the business is its debt level

The PEG ratio is useful as it puts the valuation in the context of the company’s growth prospects. A company with a high p:e ratio may have a low PEG ratio if it is in a high growth period (see 'How to Calculate a PEG ratio', in the block below).

A company’s dividend yield is also be an important metric. A dividend yield is the share price divided by the dividend paid. For example, if the share price is R20 and the company paid out an annual dividend of 40c per share, then the dividend yield would be 2%.

Apart from an indicator of the relative value of a share (a high dividend yield could suggest better value) dividends offer investors a regular income and can form part of a retirement portfolio strategy.

However, Pheiffer warns against just looking at p:e ratios and dividend yields alone. A share price may be cheap for good reason as investors are selling the share due to legitimate concerns. These valuations should only be used as part of a holistic view of a company’s financials and prospects.

How to calculate a PEG ratio
Company A has a share price of R20 and earnings per share of R2 giving it a p:e of 10 times.

Company B has a share price of R30 with earnings of R2 per share which gives it a p:e of 15 times. This makes it more expensive than company A. To calculate the PEG ratio you divide the p:e by the growth in earnings.

Company A’s earnings last year were R1.90 per share, so its earnings grew 5%. It’s PEG ratio is 10/5 = 2.

Company B’s earnings last year was R1.43, so it grew its earnings by 40%. Its PEG ratio is 15/40 = 0.38.

Based on the PEG ratio company B is showing better value. One could also use growth forecasts to calculate a forward PEG ratio.

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