1. Net Income and Margins
Of course, the bottom line, the profits. With every AFS released, our main concern is whether the company made money, and if it was better than the last statement. We hear it all the time, profit estimates and targets from companies and outsider investors alike. Lynch pointed out that it will be pointless to compare net income across industries, but it will worth doing within the same industry, compare the competing companies. We should not just take the net income figure on a nominal value. Instead, we should look at profit margin, or net income divided by total revenues (or sales). This figure will show you the most efficient company, the company who spends the least to get the greatest revenue. The higher the profit margin, the better.
2. Cash Position
More famously called the P/E ratio. This is computed as the stock price divided by earnings per share. In turn, earnings per share is computed as net income divided by total outstanding shares. In principle, PE ratio is the ratio of how much the stock is valued in the market vis-à-vis how much that stock earns. For Peter Lynch, the PE ratio should be equal to the earnings growth rate of the company. If more, then the stock may be overvalued, if less then you are getting the stock as a discount. In simpler terms again, the ratio is the number of years it will take for you to recover your investment, assuming earnings growth rate is constant (caution this a big assumption). For example, if a stock is priced at P10, and earnings per share for a year is P2, then PE ratio is 5. If the company gets earnings per share of P2 a year, then it will take 5 years for you to recover your investment of P10. Note the assumption that earnings per share remain constant. Upside on earnings growth, big recoveries, or lower income for the year are some things you need to consider together with PE ratio. Likewise, some analysts also compare PE ratios of the whole market, and the close competitors, to see if a certain PE ratio is within reasonable levels.
4. Debt-to-Equity Ratio
This is simply the sum of short- and long-term debt divided by total shareholders’ equity. This shows you how much the company owes vis-à-vis how much it owns. Very low ratio is perfect while very high ratio is troublesome. Remember that as a shareholder, you will be the last ones to be paid by the company, and that debtors have a higher priority. As such, if a company is buried in deep debt, then I suggest you be careful and see if the company has rosy chances to pay these off. If very little debt, plus lots of cash (see #1), then you hit a jackpot! How to find a healthy DE ratio? Peter Lynch quotes 25% but it won’t hurt to compare once again with competitors (e.g. DGTL vs GLO vs Smart portion of TEL).
5. Percent of Sales
Or we can also adjust this to percent of subsidiary market cap or income for holding companies. Back to sales. Say you noticed a star product selling like hotcakes, and you wanted to invest in the shares of that company. Then I suggest you look at percent of sales provided by the star product that intrigued you to the whole revenue of the company. To localize an example, let us assume that you noticed that cheeseburgers and Smart Bro and Sun Unlimited Call and Text have become a hit lately. Then the next thing to check is whether cheeseburgers are driving AGI’s sales, or whether Smart Bro is a big chunk of TEL’s business, or how much of DGTL income is from Sun Unli Calls and Texts. Other examples will be how Gold figures in the sales of mining companies such as PX, LC and AT. I’m sure you’ll find varying numbers. This ensures that the star product you have seen, is not just a drop in the bucket in the sales of a company.
Dividends are steady income streams that you can get from the companies, assuming of course that they pay this out, through the good times and the bad. For me, dividends is how company shares its income with its shareholders and investors, without sacrificing the liquidity needs of the company. Though one can argue that the company is better off using the money for dividends into more productive use such as expansion. Lynch tells us that if the stock is a slow grower, a company that is already too big, and not much room to expand, then dividends is really a plus. But for a young stalwart company with so much promise and rosy prospects, then a dividend is not really necessary (use it for further expansion) but a welcome add-on nonetheless. One should check though whether the company has always paid-out dividends, whether it pays out increasing, consistent or decreasing dividends. Also, dividends is not just about cash dividends, but also stock dividends, stocks splits etc. The dates on dividends also come into play with the short term pricing of the stock. See my related post on dividend basics here.
7. Growth Rate
Very critically tied to #1 and #3 above, growth rate of earnings (net income) shows that the company and its value is growing. And if the company value is growing, that means the stock prices ought to grow too. Increased sales does not always lead to increased growth rates. Company expansion does not always mean growth in income as well. Here is where the profit margins come into play. If a company gets more sales or expands to new markets, then it has to have a very good profit margin to support growth in income. Note that every move of the company entails costs, so the better they get to manage the profit margin, the better the income growth rate will be. Lastly, it will also be good to compare growth rates of competing companies within the same industry, to see not just who’s growing obese, but who’s growing healthily.
8. Cash Flows
By cash flows, we mean positive cash in-flow. This time, this is very much tied to #2 which is the cash position. Of course, what is good is there is more cash that is coming in compared to the cash that is coming out. Capital intensive companies (e.g. mining, infrastructure, real estate development) and those that invest a lot at this time will surely have challenged cash flows. But lucky you if you encounter companies with very rich cash in-flows. Lynch also computes a price to cash flow ratio wherein the stock price is divided by the annual cash in-flow of the company per share. This should mean that with the stock price you are paying, this is the amount of cash that comes in.
For Lynch, if an inventory builds up, especially for retailers and manufacturers, he considers it as a warning sign. And if inventory build up is faster than sales growth (especially if there is no anticipated future sales growth like seasonal or new big customer), then that is a red flag. Just be cautious though with how an inventory impacts the company. Inventory for a retailer / manufacturing company is definitely more important, compared to say a bank or a hotel. Also, one needs to check whether the inventory is perishable, has a high salvage value, or is practically worthless if taken outside the context of the company. For example, aluminium sheets and precious metals definitely has value even if stocked up for a while, compared to finished jeans and Christmas cards and canned tuna.
10. Asset Play
Another tricky number to look at will be the company assets and whether they have significant disposable value. Lynch says real estate, oil, precious metals will be lodged in the AFS according to their book values, and that could have been decades ago and all might have already appreciated. Not sure if this is the case here in the Philippines but it sounds like a good accounting practice to me. Further, if a company has lots of networks, coverage, and effective wide reach (cable TV, electric grids and water utilities), and are still fully functional, then that must be something that has been fully depreciated already in the company books but are still worth a great deal. Patents and copyrights, exclusive rights are also valuable assets that are not reflected accurately in the AFS.
So there’s the Top10 +1 list from Lynch, with my own two cents. One does not need to use all these, whatever works for you will be great.
My Rating: ★ ★ ★ ★ ★ ★ ★ ★ ★ ☆
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