Methodology

Stocks

Module 5

What is unsystematic risk?

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Analysing companies

Analysing companies

In last lesson we discussed how investors that took a top-down approach tended to spend more time analysing the economy, rather than on analysing individual stocks.

That is not to say that they do not analyse individuals stocks at all, they just focus on it less. They spend the majority of their time analysing the economy first, before analysing individual stocks.

The opposite of the top-down approach is called the bottom-up approach. The bottom-up approach involves placing more importance on the characteristics of an individual stock, rather than on the economy.

A bottom-up investor believes that a stock can perform well under any economic conditions, as long as they have the right characteristics.

As a consequence, bottom-up investors really get to know the companies that they invest in. Of course, they consider the wider economy as part of their overall analysis too, it is just secondary and not as important.

Whether you are a top-down or bottom-up investor depends upon your own philosophy towards investing.

Earnings-per-share, P/E ratio & P/B ratio

Financial ratios play an important role when it comes to analysing companies. We discussed a few earlier on in this course – they were earnings-per-share, the price-to-earnings ratio and the price-to-book ratio.

Just as a quick reminder, to calculate the earnings per share of a company, you just need to divide the earnings of that company by the number of shares that they have outstanding. 

Whether an EPS figure is attractive or not, depends upon the share price of a company. For instance, an EPS of $1 would be great if the share price was $1, but it would be horrendous if the share price was $1000.

The price-to-earnings ratio is calculated by dividing the market capitalisation of a company by its earnings. 

A P/E ratio of 20 is seen as the standard, with a high P/E ratio suggesting that the company is set for significant growth in the future, while a low P/E ratio suggests that the company is set for low growth.

On the other hand, P/B ratios are calculated in 2 steps. First, you need to subtract the liabilities of the company from the assets. Second, you need to divide the market capitalisation of the company by this number.

A P/B ratio that is under 3 is considered to be good value, with a ratio under 1 considered the stock to be under-valued and a ratio above 3 suggesting that the stock may be over-valued.

In order to more accurately analyse a company, it is important use these ratios to compare stocks against other stocks that operate in the same industry. This way, it gives you an idea of the average for each ratio and can tell you if one stock stands against the others.

The current ratio & debt-equity ratio

Other financial ratios that are important to cover are the current ratio and the debt-to-equity ratio.

The current ratio examines how well a business can cover their liabilities in the short term, using assets and cash. Ensuring that companies can meet their short term liabilities well is important as it can lead to financial difficulties if they can’t.

The current ratio is calculated using the following formula: current assets ÷ current liabilities (For example, $100m ÷ $50m = 2).

A current ratio between 1.5 and 3 is considered to be desirable. Please note that information on current assets and current liabilities is freely available in the annual report of a stock or via Yahoo Finance.

The debt-to-equity ratio examines the extent to which a company is using debt to fund itself, rather than its own finances. It judges how well a company can pay off the debt that it holds using shareholder funds.

If a company relies too much on debt, then it can be a risk to investor as the company would have to spend significant amounts of their profits on interest payments. This means that shareholders may not receive a dividend or that the company may grow at a slower rate.

The debt-to-equity ratio is calculated using the following formula: (long term debt + short term debt) ÷ book value (for example, ($20m + $5m) ÷ $100m = 0.25.

Remember that book value is calculated by subtracting the total assets of the company by the total liabilities.

Although it varies from one industry to another, a debt-to-equity value below 1 is consider safe, while values above 2 are considered risky.

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