By: Eran Ron
What is the difference between the stock exchange and the casino? In the casino, your chances of winning are random. The profits of the casino are based on the statistically small chance to win. The stock exchange is a market where buyers and sellers exchange shares. The efficient market theory states that investors act rationally, meaning that share prices truly reflect the value of the trading companies.
In reality, the investors' decisions are influenced by different factors, which include political developments and changes in the share rate of other companies (that sometimes have no connection to the company under scrutiny). Sometimes a situation is created in which, for a certain period of time, the rate of certain shares does not reflect the true value of the companies. The outcome is that a person who knows how to evaluate the true value of the companies increases his chances to gain in his investment. When the market value of the company (the value according to its shares' rate) is lower than the evaluation according to an economic model, it is worthwhile to buy the share. Accordingly, in a reverse situation it is worthwhile to sell. When the share's rate reflects a value close to the company's value estimate, the recommendation is to "hold" the share.
There are few economic models to evaluate the companies. The use of an appropriate model will help you reach a numerical value for the companies estimated value. Although I have no intention in this article to teach any model, I would like to offer basic tools, without any need for an education in economics or accounting, which will help you reach decisions in a more professional way.
Short review of economic principles important to the investor:
A value estimate is based upon the principle that any company should be viewed as one who is taking the investor's money in order to create for him future revenue. The higher the expected future revenue, the higher the company's value to the investor (and therefore, to the market). Another important parameter to be taken into account is the degree of risk involved in the company's activities. For example, let us consider two companies, with the same expected future revenue for both. But company A deals in a new field, with a high degree of uncertainty, while company B deals in a more stable field (as food manufacturing), and so company's B value will be higher. It is more attractive as an investment because it enables you to make the same future profit with less risk.
What should be checked and why a low multiplier is rather good:
Important information to appraise the value of a company is found in financial statements published by the companies, in articles on that company, in the exchange rate charts published in newspapers and of course in advanced Internet sites dealing with investments. One such portal is yahoo!. The site provides much information on the companies traded in the New York Stock Exchange and it includes the main financial statements.
It is advisable to check information sources and look for the following details about the companies we are considering to invest in:
| 1. |
The multiplier value (P/E).
The multiplier is calculated by dividing the worth of the company in the market (in the stock exchange) by its yearly net gain. In other words, the multiplier tells us how many years it will take the company's profits to reach its value. The longer it takes the lesser its attractiveness as an investment, and so, the first rule of thumb will be the lower the multiplier, the better. It should be noted that the multiplier is not calculated for companies with losses (there is no significance to a negative multiplier). There are many cases that investors ignore the P/E. Such cases involves companies (like many internet and start up companies) with high potential for profits
in the future
. If investing in those companies, try to get information about the profit
potential
.
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| 2. |
The graph depicting the shares rates over time
(one year to five years). Again, I may surprise some of the readers: I consider a share as having low attractiveness as an investment after it soared up, when the rest of the parameters do not indicate any justification for its continued rise. Remember: we want to buy cheap and sell after the rise, and not the opposite. Of course, it is also true in reverse: the company's shares will be attractive to us if there was a drop in rates that is incompatible with the estimated value of the company. You should as well note companies whose profits rise steadily or that we expect for high profits in the future (especially in start-ups or hi-tech firms), even if the company currently losing money. For those companies it is possible that the share's rate would continue to rise even after a steep climb. For non start ups, we should check and see for "true" profits that follows positive cash flow from operations (will be discussed later on). In the above cases we would say that the recurring rises correspond with the company's value estimate.
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| 3. |
Sales data and net income compared to previous years:
companies showing a steady trend of increasing profits will be more attractive, in most cases, than companies showing similar profits across the years, even when these profits seems high.
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| 4. |
Cash flow data from operating activities compared to previous years:
this important data enlighten us as to the current real status of the company. Cash flow from operating activities shows the money that actually went into the company's till as a result of its business main activity. Perusal of this data may avoid a possible mistake in evaluating companies that recorded paper profit only. For example, when a firm performs a credit sale, the income is instantly registered even though there is no assurance that the client will pay the bill. The cash flow measures the real money going to the firm, and thus we can discover whether there is a failing collection policy and a profit record that will not become real income.
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| 5. |
Management's discussion and analysis:
In this report you will find accounting information, and also information phrased in a clear manner even for lay persons. Sometimes you may learn of opportunities the company has for future profits, and also of threats it will have to deal with (this is a term from the marketing world describing problematic situations, nothing criminal...). Sometimes the statement will include also information on the market in which the company is active, and expected trends. Thus, this report is an important source of information to help you consolidate your opinion about the future prospects of the company's activities.
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| 6. |
Comparative information on the line of business of the firm:
in the site
yahoo!.
you may find such information on different fields of activity. We would expect to see a different average of gain, multiplier and yield on investments in different fields. The comparison between the company's data and other companies will be more relevant when compared in the same sector.
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In conclusion: minimizing the overall risk and a special recommendation to the impatient among you:
There are a number of ways to minimize the overall risk in the investment portfolio. The simplest way is diversification. The more diverse the shares in the portfolio (pertaining to different fields, various target markets for different products, and so on), the smaller the overall risk of the portfolio. You should pay attention to a rule of thumb appropriate to this case and to investments in general: when you minimize the risk, you also reduce the maximum possible return. Risk at the expense of chance and vice versa.
Another point to consider is the commission or brokerage on stock operations and the deposit. Brokerage is calculated as a percent of the share's value, but there is a minimum fee. That is why you should not keep stock in too small an amount.
Despite the tools I offered to reach investment decisions in a more professional manner, you should remember that there are recession periods where the share prices keep going down for quite a long period, even for those companies whose market value is lower than their real value. And so, a piece of advice for the impatient amongst you: do not invest in shares! There are other venues of investment with an assured yield to the investor and without risk. Certainly they will not cause you heartbreak.
Good luck to all investors.
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This condensed article does not substitute professional counseling. Ó 2000 All rights reserved to A.P.P.T. Global Information. The authorization to distribute this article is given providing it is distributed in full, including mention of the author's identification. Web Site: g1948.com |