I know, I know. I posted up an article a few months ago entitled “The 10 Laws of Value Investing,” which were my selection of ideas that I used as a guide for approaching investing. However, I found this document through Market Folly (one of my favorite blogs) and figured it was relevant enough, so I posted it here too. See the embedded version below. Email and RSS readers may need to come to the site to view it. If you can’t see the below doc, the original page is here.
A quick note: on suggestion from one of our readers, I’ve decided to change these types of posts from the original “Metric of the Week” to a more broad “Investor’s Toolkit”. The reason for this is twofold. First, due to my full time job as well as other time constraints, I have had less time than I would like to devote to this blog. I would rather spend time writing higher quality, lengthy posts than a few short weekly ones. If I stayed committed to a weekly metric post, then what would eventually happen is that these would dominate the blog for those periods when I can’t get at least one other post out that same week. I don’t want this blog to sacrifice quality for regular but abbreviated content. I hope that makes sense.
The second, and more important reason, is simply that we’ll eventually run out of metrics to cover. Because of that, I want to broaden the scope of these types of posts to include things other than metrics, e.g. investing tools, worksheets that I might make, and brokerage platforms.
We (my friend John, who has written most of them so far, and I) will continue to cover the basic metrics, but be on the lookout for different metrics and resources covered in upcoming “Investor’s Toolkits”!
This week we’re looking at beta. In short, beta is essentially the correlation with the market that a particular stock holds, based on past performance. For instance, suppose Intel (INTC) has a beta of 1.1. This is common for established, blue-chip companies. If the market as a whole (S&P 500 or the Russell 3000) moves up 1% on a given day, then we should expect INTC to move up 1.1% that day (on average). Similarly, if the market moved down 1.5% one day, INTC should drop 1.65%. A beta of 1 means that a stock on average is perfectly correlated to the overall market. A beta of -1 means that a stock is perfectly negatively correlated to the market.
In turn, investors would expect to be rewarded (more than the stock market average) by buying stocks with betas that are greater than 1. Why? Because they are taking on more risk. At a beta of 1.5, stock moves are presumably amplified 150%. Vice versa with losses. On the other hand, buying a stock with a beta of less than 1 should not reward investors, because the stock price fluctuations will not be as extreme. The downside risk is lessened as is the upside.
Conversely, if stocks have a negative beta, it would imply that their movements tend to be negatively correlated with the market. However, in practice this doesn’t happen very often because most stocks are subject to market risk, which often means that factors outside the company’s control can affect the share price. I actually did a quick Yahoo Finance screen to see if I could find any company with a negative beta and didn’t find anything. The only stock with a beta of 0 is Central Gold-Trust (GTU). According to Google Finance, it has a beta of 0.04. That is pretty close, and implies that GTU does not have really any correlation to market performance. Again, I didn’t see any that were negatively correlated with the market.
Uses and shortcomings of Beta
Beta is one of those tools that I typically glance at when looking at a stock, but don’t really factor into any decisions. Because beta is a backwards-looking metric, it is only marginally useful to predict the price of a stock going forward, much like the trailing price-to-earnings ratio. Beta can and will fluctuate each day based on the market’s performance on the prior day. Beta won’t force a stock to behave a certain way, but since other investors look at it, it might be partly a self-fulfilling prophecy.
For the mathematically inclined, beta is also used in a number of financial formulas, such as the capital asset pricing model (CAPM). CAPM basically tells you what the “required rate of return” is on a stock given the risk free rate, market risk premium, and the stock’s beta.
Beta is also applicable to other asset classes as well. As with stocks, we use it to gauge the general correlation between that asset’s returns and the stock market. Take, for example, timber: timber is an asset usually uncorrelated with the stock market return. Therefore, it might have an beta equal to or close to zero.
Seth Klarman, a hedge fund manager I follow who is in charge of the Baupost Group, has said the following about beta. It is in his seminal work, The Margin of Safety, which has been out of print for a while now and sells for $1000+ on eBay and Amazon:
“I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments… Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment’s volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.”
That being said, it still helps to understand what beta measures. As I said before, oftentimes in the market, investors seek any metric they can use to justify why they should buy a stock, and this sometimes leads to self-fulfilling prophecies.
So, we took a week off but we’re back with another metric this week. Another basic for you: volume. In this post, my friend John breaks it down and shows us why it is important, and how to generally use it.
Volume, put simply, is the amount of shares that was traded during a single trading day (9:30am-4pm). Average volume is used to analyze the amount of shares traded on average over a certain period of time, as certain days will obviously vary in trading activity. The volume metric can be found on any stock information page, and is also usually included along the bottom of a stock price chart. Here’s an example:
Volume is important to the investor because it can be used to gauge market sentiment on a stock during a certain day or period. A higher than average volume likely means that there was some news, usually an earnings announcement, which caused investors to heavily trade the stock (other instances include merger announcements, new product launches, or changes in corporate leadership). The volume metric can also be used in comparative analysis. For example, if Visa has a much higher-than-average volume day than Discover or Mastercard, this usually indicates that there is some news that solely affects Visa, and not the industry. However, if the news affects an entire industry, the volume for the company you’re watching and its peers will most likely rise in lockstep.
How should the educated investor use the volume number? Once again, volume is just one part of an investor’s toolbox. If you see that the volume of trades is way higher for a stock that you are investigating or holding, do some investigation into whether there is any news to back it up. Oftentimes, there are plenty of other investors following the market full-time, so as a part time investor, it really doesn’t make sense to trade singly if you see higher volume. Others have probably beat you to it by that point. Apart from major news, volume can be used as a timing indicator, but the reasons for that are beyond the scope of this site, as they fall mostly into technical analysis. We, however, have a slight bent towards value investing, and believe that the most important facts about a stock are its fundamentals and whether it is undervalued or overvalued. Just a thought.
One of the problem a lot of new investors have is simply coming up with money to start investing. As with most pursuits in life, whether it’s an athletic goal, wanting to start your own business, or doing literally any challenging activity, the key is just getting started. Seriously, starting small TODAY is the best step you can take if you aren’t sure what to do right now. Having no money to invest is an okay excuse for about five minutes. I’m sorry if that sounds harsh, but it’s true.
I could write another essay about the virtues of saving money and why it is important that we do it, and even convince you (not that it’d be hard), but what would you gain from that? There are already thousands of articles out there which talk about that. We know that it is important to be investing or to be saving, but we don’t do anything about it. With so much information out there, it’s incredibly understandable that we get sidetracked. Psychology research has shown that more choice leads to less action. My favorite paragraph from that article is this:
Understanding how we choose could guide employers and policy makers in helping us make better decisions. For example, most of us know that it’s a wise decision to save in a 401(k). But studies have shown that if more fund options are offered, fewer people participate. And the highest participation rates are among those employees who are automatically enrolled in their company’s 401(k)’s unless they actively choose not to.
Setting up an automated savings plan is easy. I use ING Direct as my savings account, as it is free to use and doesn’t carry any minimum balance requirements or anything. I paused in the middle of writing this to test how easy it was to set up and it took me literally 2 minutes 43 seconds to set up a recurring savings plan. This includes me moving slowly and checking my checking account balance to see what would be possible, so it can be done even more quickly if you focus. But it’s ridiculous how easy they make it for you to do.
Seriously, if you already have an account with ING it will take you less than 5 minutes to do even if you check email once or twice while doing it. The steps are as follows: 1) log in to your account through ING Direct; 2) click on “Automatic Savings Plan”; 3) set up the dollar amount and frequency. That’s it. I set up a weekly transfer from my checking account (which is through Schwab) into my savings account of $25. Not enough to break the bank, but it still amounts to $100 each month that you can then transfer to your brokerage account to invest a little bit. Every little bit helps. It is much easier to stomach transferring $25 or $50 each week out of your account instead of $1000 all at once. Having too many decisions or choices cripples our thought process, so we take the path of least resistance which is always to do nothing.
If you liked this post, check out:
- Ready to Invest? Some thoughts to keep in mind.
If you have worked any length of time in a salaried position, you are probably familiar with 401(k) plans or IRAs (individual retirement accounts). When you set up your contributions, you have to pick where you want to invest your money. Most people will randomly pick a few different mutual funds to invest in to “diversify” their portfolio, without any real knowledge of what they’re picking. If I had to guess, I’d say this is likely the only experience a lot of people have with mutual funds. It’s important to understand first what mutual funds are, and second, how they are different from a similar investment class, the ETF.
Let’s look at what mutual funds are first.
Apart from using them to fill your company 401(k), mutual funds are one of the easiest and most common ways that investors can “play the market.” In essence, a mutual fund is only an investment strategy that you can invest in. Vanguard, which I use, is one of the largest mutual fund companies in the world, and offers more than 100 different funds. The funds might be based either on a specific asset class (such as treasury bonds or precious metals), a retirement date (target retirement 2050), or an investing strategy (emerging markets fund). There is literally a fund for any specific investment type you can think of. If one company doesn’t have it, then another company will. Mutual funds are typically bought through the company that issues them. In the case of Vanguard, they don’t charge any commissions on any of their funds (with a tiny number of exceptions), so you can save more money by buying them directly instead of over an exchange.
An ETF, or exchange-traded fund, is different in that you can buy and sell it on an exchange, just like you would any other stock. If you want to buy an ETF that tracks the S&P 500 Index, the most popular ETF has the ticker SPY. You can buy and sell this as many times a day as you want, but like a stock, you pay your brokerage a commission each time it is traded. Like mutual funds, you can find an ETF for just about any investing strategy that you are interested in: VWO for Emerging Markets, GLD for Gold, etc.
To make things more confusing, you can buy both an emerging markets mutual fundAND an emerging markets ETF from the SAME company (Vanguard). The two funds will have virtually the same strategy and invest in the same companies!
So what then is the difference between ETFs and mutual funds?
The difference between these two types of investments fall in a couple areas, some of which are worth noting: The main three I want to focus on are:
- Tax implications
- Trading costs and expense ratio
First, taxes. These are important to understand as an investor, because your returns are affected by them in a big way. The main distinction is between short term capital gains and long term capital gains. Short term refers to anything held less than a year, and long term is anything over a year. Currently, long term capital gains taxes are around 15%, while short term gains taxes are treated as ordinary income, i.e. 35% at the highest. This can make a huge difference to your annual return if you sell a stock that has been doing well before you hit the one year mark. Either way, you take a risk so it’s always important to not be emotional with investing (see rule #1).
The IRS treats an ETF the same way it treats a stock: you incur short term capital gains taxes if you sell it before the one year mark, and long term gains taxes otherwise. With mutual funds, this isn’t the case. Because of the structure of the funds themselves, each time you or any other investor sells a position, the fund manager needs to rebalance the portfolio by selling off increments of all the stocks represented by whatever strategy you’re tracking. The fund then incurs taxes on the parts of the portfolio it sold, depending on how long each security was held.
All that means is that you might still see short term capital gains taxes on your IRS forms at year end, even if you didn’t touch your portfolio. This can be frustrating for the long term investor, because it diminishes the use of making long term investments, as your effective tax rate will thus increase.
Trading Costs and Expense Ratios
Mutual funds are popular primarily because they tout low or no commissions and low expense ratios (ie the cost of ownership, such as 0.5% a year). If you buy an ETF, on the other hand, you pay a commission to your brokerage just as if you buy a stock. On top of that, you still might have to pay an expense ratio, but this often just comes in the form of a slightly lower return over the course of the year. [Expense ratios go to cover the salary of the fund manager, cost of issuing prospectuses, and other housekeeping costs]. Given this information, it might seem clear that mutual funds offer the better deal, especially if a company like Vanguard offers identical mutual funds and ETFs with the same strategy. However, let’s look at the final difference.
This is the final big area where mutual funds and ETFs differ. Liquidity is just a fancy name for how easily and fairly you can transact a particular security. A popular stock like Citigroup (C) has trading volume of about half a billion shares a day on average, so if you want to buy or sell shares, you will have no difficulty in getting a good price. Something more obscure like a credit default swap on Ford might be a little less liquid and therefore harder to come by.
Mutual funds are not very liquid, because that is built into their structure by law. When you log on to Vanguard.com at 10am on a Monday, you can choose to sell part of your holdings in your IRA account. You would think that your account would be credited with the value of the fund at the time that you sold, but this is not the case. In fact, you only get the value of the fund at the end of the trading day. This means that the fund manager has the entire day to sell the incremental portions of the stock fund, but only has to give you the price at the end of the day, regardless if it’s higher or lower than when you clicked “sell.” Likewise, when you buy, forget about getting the value of the fund then and there; you get the end of day price as well.
ETFs, quite simply, are as liquid as stocks, and when you buy or sell them at market, you pay or receive the value they are trading at right now.
So then, knowing all this, which makes more sense to own: an ETF, or a mutual fund? It’s hard to say. Conventional wisdom says to invest in mutual funds and leave your money there until you retire, but as I mentioned with the tax issue, you might end up paying a higher effective tax rate over the life of your portfolio than just long term capital gains rates, regardless if you don’t sell for 10 years. On the other hand, you incur trading costs with ETFs each time you buy, so that is an important consideration as well. In the end, you need to take time to do your own homework and figure out if a few $10 commissions is worth it when you could be saving 5% on your entire portfolio in the form of lower taxes your whole life.
As with all the other information on this site, I’m not a financial adviser so none of this construes financial advice. If you are unsure about an important financial decision, speak with a registered financial adviser.
Hope this was helpful! If it was, let me know in the comments below!
Over the next few weeks, this set of posts on basic investing metrics will eventually move into more challenging topics. This week we’ll give a taste of what’s to come. My friend John, a law student, is back to talk about the PEG ratio, which is a pretty useful one to know.
Building on what we’ve discussed the previous two weeks, the PEG ratio takes the P/E ratio and combines it with earnings per share growth rate. The equation for the PEG ratio of a company (from Investopedia) is:
Some investors believe that the PEG ratio is a better indicator than the P/E ratio because it takes into account a company’s estimated future growth. It is traditionally held that, like the P/E, a lower PEG means that a company is a better value compared to its peers. The closer the PEG ratio is to 1, the more fairly valued the company. If the PEG ratio is less than 1, investors think that the stock is undervalued and thus is a good investment. If the PEG ratio is higher than 1, investors believe that the stock is overvalued.
Like all metrics, the PEG ratio can be insufficient and should not be taken as the sole support of an investment decision. There are several ways that the PEG ratio can be misleading. First, it is not often known what annual growth rate the source of information is using when calculating the PEG ratio. Therefore, an investor does not know whether the estimated growth is for one year or up to five years. Second, and most importantly, the PEG ratio relies on estimates of future growth by analysts, who have a reputation for not being very accurate. In the next five years, many things can happen to a company’s earnings growth and financial health. Average investors also do not know what assumptions an analyst is using in his or her calculation. Third, the PEG ratio is best suited for “growth” companies and may give a misleading result when used to compare mature or “value” companies. Dividend income is not included in the PEG ratio, so a mature company that pays a high dividend will not look as attractive as a company that has a higher growth expectations.
In the end, the PEG ratio is just another tool in the toolbox of a savvy investor. It should be used in conjunction with other metrics, and never as a standalone reason to buy a company.
In the Metric of the Week posts, we’ll cover different metrics that you’ll hear about when investing. We’re starting off with the basics. Previously, my friend John covered the price-to-earnings ratio and earnings per share. This week, I’ll talk about another important basic: market capitalization.
The concept of market cap is really quite simple. It is the market value of the publicly traded securities of that company. However, investors more accurately look at it as the total value of the company itself. The formula is simple:
Number of Shares Outstanding times Price per share = Market Cap
The number of shares outstanding is pretty easy to find for any publicly traded stock. Go to Google Finance, enter the ticker symbol, and you’ll see it right up top:
The next component is the price per share. In the example above, that is $612.00 per share. Multiply these two figures and you arrive at the Market Cap. For Google (GOOG) right now, that is $195.70 billion. Easy enough, right? That’s really all there is to it.
What is market cap useful for?
Market cap is one way to classify companies by size. There are typically three separate categories:
- Large Cap: A company with a market cap greater than $5-20 billion
- Mid Cap: market cap between $1 and $5 billion
- Small Cap: below $1 billion
There are sometimes further designations, such as Micro Cap, but these three are suitable for our purposes. Knowing the difference is helpful when analyzing mutual funds you want to invest in. Why? Because the risk and return profile for each of these categories can be very different. Depending on the year, small cap companies generally outperform mid and large cap stocks, but they come with a higher degree of risk. This is because they are often younger companies with less established profitability. Large cap stocks, on the other hand, generally include the companies everyone knows about: Pfizer, GE, Exxon, etc. These companies have usually been around for a lot longer, and generally have consistent profits. As a result, investors don’t expect to be compensated as highly for the risk they take.
In essence, the main takeaway is that market cap is a quick way to determine how big or small a company is and what kind of risk/return profile it will have.
Have any questions? Leave them below in the comments section! (Email readers need to come to the site)
Time for the second installment of our metric of the week. This week, my friend John will talk about earnings per share. This is one of the core metrics that every investor should know. Last week we looked at the P/E Ratio, which is arguably the most fundamental. John is a law student who loves following and learning about the markets, so I’m glad to have his help here.
Metric of the Week: Earnings Per Share
Earnings per share (EPS). Seems pretty self explanatory right? It’s the earnings of a company divided by the number of shares outstanding. So, if Company A has an EPS of $6.00 and Company B has an EPS of $8.00, Company B is the better performing company right? Not so fast. Earnings per share can be one of the more misleading metrics because you always have to take into account how many shares a company has outstanding and the method that is used in calculating the EPS.
First we’ll figure out how to calculate EPS. Here’s the formula that is given on Investopedia for the calculation of EPS:
Net Income – Dividends on Preferred Stock
Weighted Average Number of Shares Outstanding
Some sources will subtract the dividends of preferred stock, while others will include it in the numerator. The reason for this is that these earnings are not available to common shareholders. As an aside, when most people talk about net income or earnings per share or similar metrics, they are referring to ones available only to common shareholders. In this specific example, preferred shareholders will receive their dividends in full before any dividends could be paid to common shareholders. Usually, however, the preferred shareholder base is quite small.
With respect to net income, most finance sites like Yahoo! Finance will use the trailing twelve months (TTM) net income for their calculations. Curious to see how this works? Here’s a sample calculation for Visa (V) from Yahoo! Finance data:
2.97B (Net Income available to common shareholders)
716,620,000 (number of shares outstanding)
EPS = 4.14
We arrive at an EPS of 4.14. This is really close to the 4.15 that Yahoo has in its data for Visa. This tiny difference is most likely due to a change in the number of shares outstanding at the time of their calculation or a different net income calculation or it could be a simple rounding error. In general, if you don’t trust the numbers on Yahoo! or Aol, then you could easily calculate EPS yourself, but the number they give you are usually pretty close to what you will calculate yourself.
Now, for the important stuff. How do you use EPS? As I mentioned before, EPS is not a good metric to compare different companies. This is because companies all have different share prices. Take for example, Goldman Sachs (GS) and JPMorgan (JPM). Both are quite profitable. JPM has an EPS of 3.97, while GS has an astronomical EPS of 13.17 (both according to Google Finance on 1.26.11). However, despite this disparity, you can’t really compare them apples-to-apples. GS has a share price hovering around 161, while JPM is sitting at about 45. Thus, it’s not quite as useful in relative valuation as is the P/E Ratio.
EPS, however, is a good metric to measure a company’s current performance to its past performance, as long as you make sure that the number of shares outstanding has not changed. If there has been a stock split, an issuance of new stock, or a share buyback, the number of shares outstanding will change, thus altering the company’s EPS. When the number of shares outstanding stays constant, EPS is a great way of monitoring a company’s performance through time. Read any company earnings report, and you will see how often company managers and investment analysts refer to EPS as an indicator of company performance through time.
The bottom line is EPS is just one part of an investment research strategy. Like P/E, EPS can be an indicator that something is wrong with the company, and should alert you that more research is needed. If EPS seems relatively consistent with expectations, then you can use it as an argument in support of an investment decision. As we always emphasize at Investing Part Time, detailed research should be undertaken before making any investment decision.
From now, the plan is to build from the most common metrics you’ll come across progressing to some of the more advanced, obscure metrics that are more industry specific. If you’ve heard about something and want it to be explained in the Metrics of the Week, just leave a note in the comments and I’ll be happy to include it in a later post.
Disclosure: At the time of publishing, I hold a position in GS, but no other companies mentioned above. Positions may change at any time.
In the series I penned about the basics of investing, I talked about finding investments, buying them at reasonable prices, and knowing when to finally sell the stock you’ve been holding. But what if you are concerned that you will miss the right opportunity to sell the stock? What if you have a day job that doesn’t allow you to log on to your brokerage account to place any trades?
Stop Loss Orders
I want to talk about stop loss orders. Despite the confusing name, they can be really quite simple. This IS Investing Part Time, right? In effect, stop loss orders allow you to set predetermined entry or exit points (i.e. buy or sell prices) for a specific stock. For example, if you own a company that is currently trading at $25.00 per share and you are worried that it might drop rapidly, then you could set a stop loss order at $20.00. If at any point over the next few months you forget to check on this stock each day and it somehow drops to below $20, your brokerage company will automatically close your position and credit your account with the cash sale price of $20 per share.
Stop orders work in the other direction as well. Using the same example, if you think that the company is worth no more than $35 per share based on its current earnings, then you could set a stop order at $35.00. If the share price touches that intraday at any point during the next few months (until you cancel the order), then the position will be closed out too.
A variation of the stop loss order is the trailing stop. This is a bit more advanced of a trade. You can set it up as you would a regular stop loss order, except instead of setting a fixed price, you pick a percentage (say X). The trailing stop will literally trail the upward movement of the stock, and then be limited on the downside. Your brokerage will keep a running number that follows the stock as it advances, but stays put if it is declining. If the stock falls from its peak to an amount X percent lower, your stop order will be executed.
Note: I’m not sure all brokerages support trailing stop orders. If they do, they tend to be a little more expensive, because it is more active than a simple buy or sell order. I use thinkorswim, and here is what an order would look like on their system:
Here’s what it would look like graphically (for AAPL):
How to Manage Risk
As mentioned above, stop loss orders are great for those of us who can’t sit at a computer or keep an eye on the markets all day. We can manage risk by limiting our downside, and lock in profits for a trade that has already been going our direction. I try to have stop loss orders on all my trades, because I never know if I might not have a chance to close out a position and lose an extra 5-10% beyond what was necessary.
How do you figure out what price you should set as your stop loss? It all comes down to the concept of target price (see here for the post I wrote related to that). On the other hand, if you are choosing to place a trailing stop order, the percentage is more subjective. It depends more on your tolerance for risk. If you want to make sure you keep the most profit on a stock that then falls a great deal, a smaller percentage (5-10%) might be suitable. However, in setting a small trailing stop %, you run the risk of the price being hit solely due to day-to-day fluctuations of the stock. The last thing you want is for a stock to fall 5%, trigger your stop loss, and then proceed to rise 40% the next two months. Either way, you take a chance.
This is the final post of the “Getting Started with Investing” series. So far, it covered why investing now is incredibly important, some investing basics to know, how to choose a brokerage, finding investing ideas, and learning the fundamentals of valuation (Part 1 and Part 2). Now, we are going to finish up with knowing when to sell your beloved stocks when the time comes, regardless of whether they have gone up or down.
Investing is tough. You can spend hours researching specific companies, reading their annual reports, reading all the news and blogs that you can on them, and be totally convinced that they are a great company. The company could then even double in value in a year’s time (or more than triple, in the case of MCP!), and make you incredibly happy. This positive upward movement could last for several years, consistently (see AAPL). But perhaps the biggest challenge facing investors is the question of when it is appropriate to sell.
Enter the Value Investing Approach.
I subscribe heavily to the value investing school of thought. According to it, you buy a company that you find is undervalued and sell short a company that is overvalued. In order to protect your downside, you ensure that there is a sufficient margin of safety. You revisit the investment periodically to gauge if anything fundamental has changed with the company. If so, you revise your analysis and sell if necessary.
This brings us to the important concept of a target price. If you ever read news on CNBC or any of the major financial networks, you will hear this term thrown around quite a bit. The context is usually when an analyst at a big institution (e.g. Raymond James or Credit Suisse) upgrades or downgrades a stock. When they upgrade a stock, for instance, from neutral to overweight, they will sometimes set a target price. Despite there usually being inherent conflicts of interest, these analyst recommendations have a disproportionate effect of the movement of the stock.
Let’s look at an example: Oppenheimer (NYSE: OPY) Analysts Raise Price Target on Dominion Resources, Inc. (NYSE: D) Shares to $46.00. This was just written on January 15th, 2011 (same day as this writing). Even by just reading the title, we can see that Oppenheimer, a big institutional bank and broker, raised its target price on Dominion, a big energy producer, to $46.00.
Now, as I mentioned, this is a very commonplace practice. Big banks love to boost up their target prices for companies for a number of reasons. In the end, it really comes down to helping them make more money. I won’t get deep into the mechanics of why Wall Street is fraught with conflicts of interest, as there are many other good books that do justice to this (off the top of my head, Seth Klarman’s Margin of Safety is a great read on the subject, except for the fact that it is out of print and incredibly expensive). A short list of reasons is as follows: banks encourage trading in the stocks that they promote, thus earning their trading divisions commissions, regardless of whether the stock goes up or down; if banks have a relationship with the company such as underwriting its debt or stock offerings, than this helps the company raise more money, of which the bank can take a cut; finally, banks might have positions in the company they promote, which will increase in value if the stock increases.
Now, despite these three conflicts of interest that I mentioned off the top of my head, investors still use these price targets as part of their “homework” when they buy a stock, regardless of how arbitrary the price is. In the article I linked above, the price target is notably unambitious. Dominion (D) closed the day before this was written at $42.98. A price target of $44.00 represents a massive 2.4% increase on the stock, and the revised price target of $46.00 is a whopping 7% increase. Who wouldn’t want to buy this big winner? In fact, the 52 week range of the stock was from around $36 to $45.12. Therefore, the analyst at Oppenheimer really has no risk of being wrong, as the stock will likely touch its target price because of natural fluctuations in the market.
This is where we come in. Despite how bad I’ve made target prices sound, there is actually a lot of value in them for investors like you and me who use them appropriately. In the previous two posts, I covered how to walk through a basic discounted cash flow analysis. The goal of the DCF is to end up with a target price (or range of prices) at which you’d be willing to buy this company. As I mentioned before, we want to have a margin of safety for the company, so even if our estimates are way off in the DCF model, we will still stand a good chance of making a profit.
Since a DCF model (i.e. absolute valuation) is still quite complex to walk through completely, I’ll show you how to figure out a target price using relative valuation. With relative valuation, we attempt to figure out if a company is undervalued or overvalued relative to its competitors. However, we can get specific if we use certain metrics. One I’ve talked about in the past is the price-to-earnings ratio. This is the ratio of the current stock price divided by the earnings per share of the company. If we know the price-to-earnings for a company as well as its competitors, we could compare them.
Let’s use Goldman Sachs (GS) as an example:
It has a price-to-earnings of just under 10. Its competitors have P/E ratios in a similar range, but on average, they are slightly higher. If we take an average P/E for the group, then we can multiply this by GS’s EPS to arrive at an implied price. I put together this spreadsheet quickly to show what I mean:
All else equal, using the implied P/E of its competitors, GS could roughly trade for a price of $333.50 and not be expensive relative to its peers. This represents a premium of more than 90% on the closing price of $175.00 at the time of writing. But something I noticed in the list of competitors was that Nomura, a Japanese financial institution, had a P/E of 61.55. This seems a bit anomalous, so even if we remove that data point from the average, GS still has an implied price of $240.23 (a premium of 37%). Both of those numbers seem attractive to me.
The method I just outlined is probably the easiest way to figure out a target price for your stock. What happens if or when the company hits your target price? Usually at that point, you should either sell or revisit your investment thesis. If you are still comfortable owning it, it makes sense to recompute your target price using the same formula as before (Company EPS times competitors’ average P/E ratio). If your company still seems relatively undervalued, then you will probably want to continue holding onto it!
As I mentioned, this post concludes the Getting Started with Investing series. Now that this is complete, we can move on to more varied topics. Among some of the ideas I have lined up are explanations of common metrics (to be called ‘Metric of the Week’), reviews of brokerages, more book reviews, and helpful things related to 20 and 30 year old personal finance and investing. If you would like to see a topic covered, please leave a note in the comments! As always, I appreciate any feedback that you might have.
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