For investors who favour a fundamental approach to investing, there is plenty of help available from software programs that crunch the numbers they need – digesting and comparing companies’ reported sales revenue, cash flow, earnings, dividends, assets and liabilities.
Programs such as Stock Doctor, Conscious Investor, Value Gain, Bourse Data and MetaMarket+ have made it easy for an investor to sift quickly through large numbers of companies to find those that meet their specific investment criteria.
Investors can ‘screen’ the entire market for a list of the best – or worst – stocks on any fundamental number or ratio they choose. But while the good news is that the instant ability to identify, classify and list stocks by any criterion makes the investment task easier, it doesn’t replace it.
“Screens are exactly that, they are not a selection tool themselves,” says Tim Lincoln, managing director of Stock Doctor. “After you’ve screened for particular fundamental data – and got the shortlist – you really need to drill in to each company that comes up as part of that screening process, especially to make sure that they’ve got a level of sustained performance in each of those areas – they’re not just coming up looking good over one year,” says Lincoln.
Andrew Page, senior strategist at Hubb Financial, stgeloper of Value Gain, says most fundamental investors use the price/earnings (P/E) ratio), dividend yield, earnings per share (EPS) growth rate, debt/equity and return on equity. “You can’t go past those – they would be the most popular screens – but the screens that individual investors prefer really depend on whether they are a value investor, a growth investor or an income investor.”
Value investors, he says, focus heavily on the valuation ratios: the P/E, the price-to-net-tangible-assets (NTA) ratio (sometimes called the ‘price-to-book’ ratio) and the price/earnings-to-growth (PEG) ratio, which determines the relative trade-off between the price of a stock, the earnings and the company’s expected growth.
Page says the P/E is the most commonly used metric for whether a stock is cheap or not, but what constitutes an attractive P/E at any time depends on a number of things – the market average, how the industry is going and what the company’s prospects are.
” Generally speaking, the P/E you want to see depends on what state the market is in. It depends on the broader picture. We know that the Australian market’s long-term average P/E, on historical earnings, is about 16 times earnings. Anything below that generally looks OK, but you have to validate that by comparing it to the industry average. You could see something on a P/E of 16 at the moment, and say ‘that’s on par’, but if all of its peers are trading at 12 times earnings, the stock would look relatively expensive.
“With any of the valuation ratios, you want to see it at or below the market average, or even better, at or below the sector average. You can also compare it to the long-term historical average: we like to compare them to industry averages over five years. Then, we like to validate the P/E using the PEG ratio, which divides the P/E by the forecast earnings growth rate, to see whether this P/E is valid given our expectations of future earnings potential.”
The general rule of thumb, he says, is that a PEG of 1 means a stock is fairly valued, a PEG ratio of less than 1 implies an under-valued stock and a PEG ratio of more than 1 implies on over-valued stock.
Page says income-oriented investors screen for dividend yield, and the dividend payout ratio – the proportion of earnings that are returned to shareholders.
“The long-term average dividend yield on the Australian market is 3-4 per cent. That’s fairly attractive, especially if the yield is fully franked. At the moment, there are much higher yields, because share prices have come down. For example, the major banks all have yields of 6 per cent.
“A dividend payout ratio below 90 per cent allows for a bit of flexibility, if earnings drop next year. In this environment, about 80 per cent is ideal.
Growth investors scan for earnings trend, looking firstly for the most impressive earnings growth rate from one year, but also for who has the most steadily improving earnings over time. Growth investors will also use the dividend payout ratio, but differently: growth companies tend to have a low payout ratio, because they are reinvesting most of their earnings in growing the business.
“Growth investors are looking for as high an EPS growth rate as possible, and more importantly, one that looks to be sustainable. They’ll match that with future earnings potential, from forecast EPS growth rates. The software will give you forecasts, as long as there are broker forecasts for that stock, of not only EPS and DPS, but actual buy, sell or hold recommendations.”
All three kinds of investor, says Page, will also look at the return on equity – he would like to see a minimum of 10 per cent – and the company’s gearing, as shown by the debt/equity ratio. “In this environment, where high debt levels are a no-no, you would start to be concerned if the debt/equity ratio is above 80 per cent. If the debt/equity is over 80, a good idea is to validate it by looking at the company’s interest cover (the number of times interest payments are covered by earnings). Interest cover goes hand in hand with debt/equity – I’d look for a minimum of three times, and the higher, the better.”
Lincoln cautions that any metric that is affected by the share price – price/earnings (P/E) ratio, dividend yield, price to net tangible asset (NTA) value – can be a problem. “Anything that’s affected by share price, you have to watch. You can’t just pick out the ten lowest (P/E) ratios or the ten highest dividend yields. The highest dividend yield, or the lowest P/E, might be a result of a sharp fall in the share price.
“Where the ratios are calculated from the balance sheet, the income statement or the cashflow statement, you’re on more solid ground. But really, you’ve got to be looking for a sustained trend. So if you’re screening for ‘best earnings growth’, you should be looking for the most strongly sustained trend in earnings growth over recent years, rather than just this year’ s leader in earnings per share (EPS) growth.”
Lincoln says the main limitation of using screens is that they only tell you at that point in time which stocks fit your limited criteria. “They’re only a short-listing tool: you then need to do in-depth research on those stocks to make informed investment decisions,” he says.
Dr John Price, stgeloper of ConsciousInvestor, says the program scans the market for stocks that meet stringent criteria based on the investment style of Warren Buffett. But he says running scans or screens should best be seen as a time-saver, to identify opportunities. “The second step is to perform more analysis on any of the companies that have been passed through the initial filters. The third step is calculating what price to pay,” says Price.