- How to pick fundamentally strong stocks
Understanding the basics of investment in the capital market is key and considered the first step to achieving investment goals. Moving away from the basics, irrespective of ones level of experience and knowledge of the market, one cannot at any point trade successfully without any form of analysis.
On the floor of the Nigerian Exchange, there are 156 listed equities and the honest fact is that no investor, either institutional or retail investor could be said to have invested in all these equities.
Investors all over the world only take their time to find out which of these equities is bound to yield good returns. This is where any form of Analysis comes to play. Technical Analysis is a good approach to find the entry and exit time for intraday trading or short term. You can make good profits using different technical indicators efficiently. However, if you want to find a multi-bagger stock to invest, which can give you good returns year after year, then the fundamental analysis is the actual tool that you have to utilize.
While the technical indicators will show you exit signs in the short term whenever there’s a downtrend or small setbacks, however, you have to remain invested in that stock if the company is fundamentally strong. In such cases, you have to be confident that the stock will grow and give good returns in the future and avoid short-term under-performance. Short-term market fluctuations, unavoidable factors, or mishappenings won’t affect the fundamentals of the strong company in the long term.
We have often been advised to take position in fundamentally sound stocks but the big task I guess is how to identify these fundamentally sound stocks among numerous stocks listed on the floor of the Nigerian Exchange, and that is why we deem it fit to delve into this subject.
Fundamental analysis is used to measure the intrinsic value of an equity by examining related economic and financial factors including the balance sheet, strategic initiatives, micro economic indicators, and consumer behavior associated with that firm.
Fundamental analysts study anything that can affect the stocks’ value, from macroeconomic factors such as the state of the economy and industry conditions to micro economic factors like the effectiveness of the company’s management.
So, how does one identify fundamentally sound stocks?
These are few things one must have in mind when you think of stock Fundamentals:
- Quality of the management
When evaluating an equity investment, understanding the quality and skill of a company’s management is key to estimating future success and profitability.
The management of a publicly traded company is in charge of creating value for shareholders and it is normal for management to possess that supreme qualities to run the company in the interest of the owners. Of course, it is unrealistic to believe that management only thinks about the shareholders. Managers are human too and are like anybody else, looking for personal gain. Problems arise when the interests of the managers conflicts sharply from the interests of the shareholders.
Looking at the stock price alone, can give false signals. In fact, several great companies all over the world have soaring stock prices despite corrupt and inept management operating behind the scenes. There is no magic formula for evaluating management, but there are factors to which one should pay attention.
While it’s hard for retail investors to meet and truly evaluate managers, you can look at the company’s website and check the resumes of the top guys and the board members.
Insider buying and Stock Buybacks is also a good factor to consider. If insiders are buying shares in their own companies, it’s usually because they know something that normal investors do not. Insiders buying stock regularly show investors that managers are willing to put their money where their mouths are. The key here is to pay attention to how long the management holds shares. Flipping shares to make a quick buck is one thing; investing for the long term is another.
Checking the track record of the top management, especially the CEO is very vital too. There are businesses one can enter into just knowing who is behind such business through his or her track records.
- Corporate Governance
Corporate governance describes the policies in place within an organization denoting the relationships and responsibilities between management, directors and stakeholders.
It is the system of rules, practices and processes by which a company is directed and controlled. Corporate Governance refers to the way in which companies are governed and to what purpose. It identifies who has power and accountability, and who makes decisions.
Good corporate governance ensures that the company has the proper rules, policies and practices to create long-term value for shareholders.
- Quality of earnings
Another thing to look at is the company’s earnings. Is the company’s earnings growing or stagnated over a long time and without anything. What is the quality of earnings they are bringing?
Current or recent earnings is the fixation of many investors. These are nothing more than snapshots of where a company is, or was, at a given point in time. To see where companies are likely headed, look for earnings momentum; that is, the slowing or acceleration of earnings growth from one period to the next.
It is said that when a small boy fail an examination, he will come home and say he has lost his report card. But he if came first, before he gets home, he would have already announced that this is my report card. It also depends on how early these companies release their result.
- Price movement
Check the behaviour pattern of the prices of companies you intend to invest in. When the market is bad, all stocks will be affected, but the moment the market becomes good, some stocks are leaders that will herald the rally in the market.
You need to pay attention to the products of the firm you intend to invest in. For instance in the cement industry, the company with the largest market share is Dangote Cement, and it will continue to sell as long as there is infrastructural development in Nigeria. Another example is the Oil Palm business. There is no substitute for palm oil; Okomu and Presco will continue to enjoy that.
Fundamentals change. It doesn’t mean that when you are fundamentally strong today, you are going to be fundamentally strong forever. There is no bad stocks forever and there is no good stocks forever.
When we say fundamentally sound stocks, it does not mean that the one you are taking position in, you are expecting for it to be fundamentally sound forever. You keep reviewing fundamentals from period to period, say 3 months, 6 months, 9 months, 1 year and still know that they are fundamentally strong.
Key metrics for sound investment decision
To make sound investment decisions, the following metrics can be calculated out of the figures released by these companies.
These metrics include: turnover growth, profit after tax growth, earnings per share, profit margin, P/E ratio, earnings yield, dividend yield, book value, Free Cash Flow, Return on Assets and Return on Equity.
Turnover is the money generated from normal business operations. It is the top line figure from which costs are subtracted to determine net income. It is also called Revenue, Gross Earnings or Gross Income.
Turnover growth illustrates sales increases/decreases over time. It is used to measure how fast a business is expanding. Revenue growth helps investors identify trends in order to gauge revenue growth over time.
To calculate turnover growth as a percentage, you subtract the previous period’s revenue from the current period’s revenue, and then divide that number by the previous period’s revenue. So, if you earned N1 million in revenue last year and N2 million this year, then your growth is 100 percent.
(Current Period Revenue – Prior Period revenue) / Prior period revenue. It is expressed in percentage.
Profit after Tax Growth
Profit after tax (PAT) can be termed as the net profit available for the shareholders after paying all the expenses and taxes by the business unit.
Tax is an integral part of an ongoing business. After paying all the operating expenses, non-operating expenses, interest on a loan, etc., the business is left out with several profits, which is known as profit before tax or PBT. After that, the tax is calculated on the available profit. After deducting the taxation amount, the business derives its net profit or profit after tax (PAT).
To calculate growth in profit after tax, same formula applies as that for turnover growth.
Earnings per Share
Earnings per share (EPS) is calculated as a company’s profit after tax divided by the outstanding number of shares. The resulting number serves as an indicator of a company’s profitability.
The higher a company’s EPS, the more profitable it is considered to be.
EPS indicates how much money a company makes for each share of its stock and is a widely used metric for estimating corporate value.
A higher EPS indicates greater value because investors will pay more for a company’s shares if they think the company has higher profits relative to its share price.
Profit margin is used to gauge the degree to which a company or a business activity makes money. It represents what percentage of sales has turned into profits. Simply put, the percentage figure indicates how much of profit the business has generated for each Naira of sale.
It is calculated as Profit after tax divided by Turnover, multiplied by 100.
The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company. It measures its current share price relative to its earnings per share (EPS).
It is simply current share price divided by earnings per share.
P/E ratios are used by investors and analysts to determine the relative value of a company’s shares. It can be used to compare a company against its own historical record.
A high P/E ratio could mean that a company’s stock is overvalued, or else that investors are expecting high growth rates in the future.
The earnings yield refers to the earnings per share divided by the current market price, multiplied by 100. The earnings yield is the inverse of the P/E ratio. It shows the percentage of a company’s earnings per share.
The dividend yield is a financial ratio that shows how much a company pays out in dividends relative to its stock price. It is calculated as dividend/price, multiplied by 100.
The Book Value of a company is the net difference between that company’s total assets and total liabilities, where book value reflects the total value of a company’s assets that shareholders of that company would receive if the company were to be liquidated.
Book value per share (BVPS) is a method to calculate the per-share book value of a company based on common shareholders’ equity in the company. Should the company dissolve, the book value per common share indicates the Naira value remaining for ordinary shareholders after all assets are liquidated and all debtors are paid.
If a company’s BVPS is higher than its market value per share, then its stock may be considered to be undervalued.
Book value per share (BVPS) is calculated by dividing shareholders’ equity by outstanding number of shares.
Free Cash Flow (FCF)
Free cash flow (FCF) represents the cash available for the company to repay creditors or pay dividends and interest to investors.
FCF reconciles net income by adjusting for non-cash expenses, changes in working capital, and capital expenditures (CAPEX).
FCF can reveal problems in the fundamentals before they arise on the income statement.
There are three approaches that can be used in calculating Free Cash Flow (FCF). This include:
- Net Income approach
- EBIT (Earnings Before Interest and Taxes) approach
- CFO (Cash Flow from Operations) approach
Net Income Approach
FCF = Profit after tax + Depreciation/Amortisation + Interest expense (net of tax) +/- working capital changes – Capital expenditure
FCF= EBIT – Taxation + Depreciation/Amortisation +/- working capital changes – Capital expenditure
FCF = Cash flow from Operating activities + Interest expense (net of tax) – capital expenditure
While FCF is a useful tool, it is not subject to the same financial disclosure requirements as other line items in the financial statements. FCF is a good double-check on a company’s reported profitability. Although the effort is worth it, not all investors have the background knowledge or are willing to dedicate the time to calculate the number manually.
Using the trend of FCF can help you simplify your analysis.
If stock prices are a function of the underlying fundamentals, then a positive FCF trend should be correlated with positive stock price trends on average.
A common approach is to use the stability of FCF trends as a measure of risk. If the trend of FCF is stable over the last four to five years, then bullish trends in the stock are less likely to be disrupted in the future. However, falling FCF trends, especially FCF trends that are very different compared to earnings and sales trends, indicate a higher likelihood of negative price performance in the future.
Return on Assets
Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company’s management is at using its assets to generate earnings.
ROA is profit after tax divided by total assets, multiplied by 100. The higher the ROA is, the better.
Return on Equity
Return on equity (ROE) is a measure of financial performance calculated by dividing profit after tax by shareholders’ equity. ROE is considered a gauge of a corporation’s profitability and how efficient it is in generating profits.