Some high level considerations I make before buying shares

When deciding which shares to buy, many considerations need to be made in order to help you decide whether you not you think the shares will be profitable. This will normally involve a combination of fundamental analysis, review of annual reports and broker views as well as the views of investment writers (from publishings including The Motley Fool, Investors Chronicle and Shares magazine). Here are some metrics I tend to use to screen a list of shares before shortlisting for more detailed analysis.

  1. Price Earnings ratio

Commonly known as the PE ratio, this metric is calculated by dividing the share price by earnings per share. The earnings per share is the net profits attributable to ordinary shareholders divided by the number of outstanding shares. This is a popular and widely used tool by investors in order to assess whether a company is cheap or dear.

The higher this number indicates the shares are more expensive, as in this case you are having to pay more per unit currency (whether that be pound, dollar, euro or any others) of earnings attributable to ordinary shareholders; and hence the lower this number, the cheaper the shares are in comparison to its peers. It is most useful comparing this rating of a company to its nearest competitors (for instance if you were valuing Shell, you’d ideally want to compare this rating to Exxon Mobil, BP or similar oil companies).

There are 2 types of PE ratings investors use, retrospective and prospective.

Retrospective PE ratings use the most recent full year financial results, and can be found on various websites, such as Bloomberg, Yahoo Finance, Morningstar and many other sources. Personally I examine the average over the past few years, say 3 year, to see how the most recent PE rating compares to previous years; if it is below the 3 year average it would indicate relative cheapness.

Prospective PE ratings involve using broker future forecasts of earnings per share. In one way this is more useful as this is a forward-looking measure, especially since if the forecast PE ratio is lower than its previous values, investors could potentially realise a capital gain should the forecasts materialise. However, forecasts are often proven wrong, as there could be unforeseeable market events impacting results adversely, hence this measure should be taken with a reasonable pinch of salt.

2. Dividend Yield

The dividend yield is a very simple metric. It involves taking the previous full year dividend and dividing it by the share price. I am a very big fan of dividend investing, especially since over the long run, dividend reinvesting generally forms the largest proportion of shareholder returns. There are however a few considerations I make before picking a dividend paying stock.

First off I tend to prefer companies yielding 4% or above, as this will help to ensure that I’m achieving an above-inflation return based on dividend receipts alone. Also, should the company repeat or increase dividends in the next financial year, share price will often follow suit. The reason is simple, companies with higher expected yields will often attract shareholder attention, increasing demand for the stock, hence resulting in a raised share price.

Secondly I also want to check if the dividend is affordable or sustainable. This can be found by looking at the dividend cover, which is simply how many times the dividend is covered by the company’s earnings. A dividend cover close to 1 suggest that the dividend is at risk of being reduced (or even stopped) in years of weaker company performance since it is barely covered by profits. I tend to prefer dividends that are at least covered twice by earnings, as this shows greater sustainability and allows more room for possible increases.

Finally I like to check dividend history of the past few years, including what the average growth rate is. In particular I like companies that have long records of dividend increases spanning 5-10 years or more.  One example of a firm with a long history of dividend increases is Legal & General, having had an almost 10 year consecutive dividend increase, which would have been longer had it not been for the reductions as a result of the Global Financial Crisis of 2008; this company is a favourite of mine which is why I’ve included it in my list of companies for 2018.

If you’d like to read more about dividend investing, I have written a previous blog post last year on this topic, which can be found on this link.

3. The Price to Earnings Growth Ratio

The price to earnings growth (PEG) ratio is an extension to the PE ratio, by dividing it by the earnings per share growth rate. In other words this is the PE rating with consideration to the earnings per share growth over the year. While a PE rating might appear high, it might be justified if it is backed by a high growth rate over the year. An example of calculating this metric is as follows: let’s say a share is priced at a PE rating of 40, and there is 50% growth in earnings per share over the course of the year. The PEG rating is calculated by dividing 40 by 50 to give 0.8.

The example above is a retrospective PEG rating (using the past year’s earnings). I tend to use the prospective earnings per share and growth, as it considers future prospects. A rule of thumb used by investors typically is if the prospective PEG rating is below 1, the stock is undervalued. Also the closer to zero the PEG rating is, the greater upside potential is on the cards, especially since in the long run, share prices are strongly correlated with earnings per share. Therefore should the forecast growth materialise, the share price will often jump at the release of the news. Furthermore sufficiently low PEG ratings allow for a degree of safety, as the shares will still be undervalued in the event that brokers overestimate growth by a certain margin.

Jim Slater, a former investment writer, wrote a book on investing called “The Zulu Principle”. He is a big fan of this metric and explains in further detail why this measure is so powerful. He includes this in his preferred investment strategy which has performed very well over the years, and he explains it very clearly in this novel. It is a very well written and easy-to-read book which I highly recommend.

 

So these are just a few valuations metrics I consider in assessing which shares to buy. However these are preliminary and are by no means a guarantee of profitability. I personally would go into much more in-depth analysis, including examining the annual reports, as well as gauging what other analysts’/writers’ views are. Be sure to conduct your own research in order to help you make a more informed decision before purchasing shares in a given company.

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