Thursday, October 08, 2009

BAGAKOAA Oct 8 2009 How to evaluate a stock


October 8, 2009 late night with Brian

Recently I replied to an answer off line to an individual on

I highly recommend you check out this website.  It is a great place to test your investment prowess and get involved in stock and investment banter.  You may even pick up a great trading or investment idea along the way.

But I digress, the exchange I had asked me how I go about valuing a stock.  Great question.  Here is what I would suggest.  First, get a copy of The Intelligent Investor: A Book of Practical Counsel (Hardcover) by Benjamin Graham.  This is the bible of value investing and was the primer Warren Buffet often touts.  Then get Security Analysis: Sixth Edition, by Benjamin Graham and David Dodd with  Foreword by Warren Buffett (Hardcover).  If The Intelligent Investor by Graham is the bible, Security Analysis is the Rosetta Stone.  The reason why you want these books, (hardbacks not kindle edition as there are many charts and illustrations), is two fold.  It will overwhelm you with all the possible information you need to value a company, but more importantly the actual valuation is much easier than reading all this crap.

I’ll mention more books later, but these are required reading.

OK, you know my rules for investing:

Be sure to have more than adequate health and disability insurance.

Fund your Roth and or 401 K account as much as you possibly can before investing in the market.

Only invest in what you know or understand.

Know when to get in a stock.

Know when to get out of a stock, before you buy it.

My personal guidelines are out at 8% down and don’t look back.

Review and reset at 20% up.  If the stock drops from the reset by 8%, get out and take your 12% gain and run.

Remember to annualize your gains.  In other words if you make 10% in 1 month, that is a 120% annual gain.

Now here is the step by step process I use to value a stock.  I use a homegrown spreadsheet for collecting and analyzing the information, but here it goes.

Decide on a stock.  So we can all play along, lets look at GLW, Corning Glass Works. 

For basic research I use Google Finance.  I like there linkage to Reuters’ and I have always found Reuters’ as very reliable information.  So go to

Type in Corning or the ticker GLW. You get all the cool information you need so just go and buy a bunch of it.  NOT.  Here you see a lot of information.  I call it pulse information including news, interactive chart, PE ratio range figures, market info of the day, related companies (That is how Cramer plays the lightning round.  For his picks, he knows a lot about the related companies as he likes to play best of breed), and a description of the company to name a few items on this page.  Please note the area under more resources.  This is where you will get the guts of the company later when you decide to trade or invest in the company.

See the link “more from Reuters. . . . “ below company description, click on it.  You are now on the Reuters’ Company Profile Page.  This will give you all the details publically available on the equity in question.

On the left of the page you will see a link to Ratios.  Click on it.  Here you will see many, but not all of the fundamental information assisting you in making a trading or buying decision.  Right off the bat you will see a recap of the days pricing and volume and there to the right of that you will see the analysts recommendations, IGNORE it for now.  Analysts only want to be right not wealthy.  It is more important for them to be correct and have no surprises then to value a stock correctly.  In many cases, you will find incredible opportunities valuing a stock before looking at guidance (sell, hold, buy outperform etc,)  Now look at the PE Ratio.  You all know what that means, but just in case .

GLW’s PE ratio is currently 14.71.  Their current price is 15.48.  Quick tell me what their last reported earnings per share figure is?  Quick- That’s rate it is about $1.05 a share.  ($15.48/14.71).  Now compare that to the industry and sector figures.  14.71 seem expensive.  Remember that a lot of companies are not making a profit right now so this is a relative, not an absolute comparison.  Compare it to the overall S & P PE which is 43.64 (wow that seems high, got to check on that later) and GLW seem to be a cheap stock by comparison.  I capture this PE ratio and put it in my spreadsheet just as a point of reference and to do some forward looking calculations later on. 

Now come down a few lines to Price to Book.  Again here is a definition if you need it.

At 1.73 GLW is basically worth, in true net value $8.94 a share if they were to totally liquidate today.  ($15.48/1.73= $8.94)  Again, only a relative comparison.  Almost any popular brand earns a premium value when looking at the P to B ratio.  McDonald’s usually is a multiple of 4-5 P to B and Kellogg’s is 9 or 10.  It is the benefit of good branding.

Now scroll down to net margin.  This one is important as sales are good but profit is great.  At 19.47 this is higher than its 5 year average and the industry average.  My spread sheet allows 2 points for being above the industry average and an additional point for being above the 5 year average. 

Now scroll down and look at the ROE.  This is a very important metric.  It is the basic measure of how effective management is at getting profit for each of our shares we own.  For the formulaic definition of ROE,

in my spread sheet I allow up to 4 points for ROE.  An ROE of 30 or more gets 4 points, 21 to 30 gets 3, 15 to 20 gets 2, 12-15 gets 1 and less than 12, its gonna have to have some really good metrics to get in my portfolio.  At 11.96 GLW is a 0.  It was higher in the year (July) when I did my original analysis.  This is why you have to go back and check on these things from time to time.

Now over there to the left, you see Financial Statements below ratios, click on it.  Oh no more scary numbers.  Here is all you do.  First, I look at annual numbers for my analysis, don’t get me wrong I look at the interim numbers (quarterly), but use annual numbers for the calculations.

So, on that page, which should be the income statement, click the little button next to the box income statement and choose annual.  The Annual income statement of he last 5 year should populate.  Got it.  OK.

First this I look at is 5 year revenue growth.  I have told I adjusted my spreadsheet in July to account for revenue growth.  I give 1 point for every year revenue has increased over the year before.  So looking at GLW, They get a point for 04 to 05, from 05 to 06, from 06 to 07, and 07 to 08.  That right they got 4 points the best you can do in this category. 

Then I go down a few lines to NIBT, Net Income Before Taxes and do the same analysis and valuation.  They get one point for every year improvement over the previous year.  Even if, in GLWs case if they are staring in a negative NIBT, they improved from 04 to 05 so they get a point, 05 to 06 the get a point, 06 to 07 the get a point, and 07 to 08 the get a point.  Again a possible 4 out of 4.  Looking good.

Now go back to the top of the Income Statement and click on the toggle switch next to Income Statement,  You will see Balance Sheet, (we’ll get to that in a second) and Cash Flow Statement.  Click on Cash Flow.  Make sure the statement is annualized.  Now go to the most important line, Cash From Operating Activities and not loans from Uncle Joe or preferred capital from Warren Buffet.  It won’t say that but you get the point.  This is where profits are converted to cash.   Let’s give one point for every year they have a higher cash flow than the year before.  04 to 05 gets a point, 05 to 06 NOT, 06 to 07 gets a point, and 07 to 08 gets a point.  Three out of four.  Not too shabby.

Now we can go to the Balance Sheet.  Click on the toggle for Balance sheet and wait for the page to load.  Make sure it is annualized.   We are looking for a line called Total Long Term Debt.  For a definition

Now take the Total Long Term Debt (TLTD) for 08, and remember it.  Just kidding you can write it down.  You need to do some long division here in a second.  Go back to the income statement and get the last years (08) NIBT.  Now divide the TLTD by the NIBT and what is your answer.  1523/1527=.997.  That means that Corning can pay off all of its Long Term Debt in under a year.  Don’t you wish you could?  I allow 2 points if a company can pay off its TLTD in under 5 years, 1 point if they can pay off their TLTD between 5-15 years and if it takes longer than that, 0 points. 

By now you can see why I built the spreadsheet.  Dropping these value into the spread sheet only takes a few minutes.  If you have been following along, how many points does GLW have. 

0 for ROE

4 for revenue

4 for NIBT growth

4 for cash Flow

3 for profit margin

2 for debt load

That is a grand total of 17 out of 21.  Now I rate my stock like my wines with 21 being a Wine Spectator or Wine Advocate 100.  Not many of those and not many stocks that have met that benchmark.

SQM was the only one I have found in the last 15 months.

I like to collect and drink wines rated 88 and above.  Similarly, I will usually only trade stocks if the are above 85.  (18 out of 21).  If I buy something lower than that it because I have done a lot of research and found some reason.  Or I had too much wine that night a clicked BUY.

So I got my 85 stock and jump in abuy the heck out of it. NOT  Now I read a lot.  Remember that link on Google finance I mentioned called more resources.  That is where you going now.  There you will usually see analysts estimates.  (I usually use the link on Reuters for this but the information is usually close to being the same)  Click on Analysts estimates.  Ok you are on the Market Watch website, (FYI part of the WSJ and Baron’s site.  I highly recommend subscribing to both).  Here you see a bunch of estimates.  Look for next fiscal years estimate.  See it.  The average estimated profit for GLW in 2010 is $1.49 a share.  So what.  Well let take a look at their current PE Ratio.  That would be about two hours ago, but just few paragraphs above for you, see it 14.71.  Now multiply their current ratio by their estimated profit per share and you will get their estimated price per share for 2010.  Get it.  (14.71 X $1.49 = $21.92) That’s right, this 15 dollar stock will sell for 21.92 in 2010.  Ok Borrow all the money you can and buy it all.  NOT.  Let’s keep exploring.  Remember its called homework.

Go back to the Google Finance Page and under more resources click on SEC filings.  This is the public interface for SEC filings called EDGAR.  You should have a big long page of documents that Corning has filed with the SEC.  Every time an office buys or sells a stock is listed here, they’re quarterly and annual reports are filed here, there is lots of valuable information.  When you get the time go and play and figure out what an 8K is or a 4 or a 10Q.  Its fun.  The one I want you to look at is almost to the bottom of the page.  The 10Q form.  Click on it.  It is their Quarterly report submitted to the SEC.  It will have a lot of the data we already saw on Google finance, but now you can see what the executive are saying about the business.  You should be looking at a long list of submittals that make up the 10Q.  Go down about half way to “Management Discussion and Analysis of….” And click on that.

In the following 7 or 8 pages you will see what management is saying about the company.  Read this and make sure you can understand how the company is making money and managing you investment.  If you don’t understand something, make a note of it.  Later if you are ready to pull the trigger, call Investor relations and ask you questions.  You will be blown away as to how helpful some investor relation companies can be helpful.  To digress a minute, I had a problem with a Verizon phone and got little satisfaction at the store or with Tech support.  I called and sent a note to Investor relations as I have been a shareholder on and off form several years.  In the end, I got a free replacement phone and a direct line to a level two tech. 

Anyway talk to these people it is a great learning experience.  And it does not matter how many shares you have.  One or a million.  So read the document and then say OK I am going to by the stock.  Sell everything and buy the Stock NOT.  Go back to the Google Finance page for GLW and again under more resources, click on options.  You will be taken to the option chains for GLW.  An Option Chain is a listing of call and put option to buy or sell the underlying stoc at sometime in the future at some predetermined price.  I will not go into the mechanics of option here, I just want show you how you can use this information to determine the POSSIBLE direction of the stock price.

Don’t bother messing with all the custom display options on the Morningstar site, EXCEPT click on the button that says OPEN POSITIONS.  Towards the bottom of the page you will see a black bar that says expiration date.  On the right of the bar you will a link called “SHOW ALL”.  Click on it.  This will display all of the opting for GLW all the way out to 2011.  for kicks lets look at 2011.  remember the stock is currently selling for 15.48, its at the top of the page if you need it.  Now a call is an opportunity,, not an obligation to buy a stock in the future and a put is an opportunity to sell a borrowed stock in the future.  On this page, you can see from these options (technically called LEAPs as they are out a year or more), you know where the money is betting on future pricing.  The strike price is the price you would buy or sell the stock for in the future.  If you thought the stock was going to be higher in the future you might by a 17.50 cent call to buy.  That would cost you $1.95 which mean you sound not see a profit until the underlying stock GLW hit 17.43 ($15.43+$1.95).  Now you only pay 1.95 for this opportunity so the most you could loose on 1 option (controls 100 shares) would be 195 dollars. 

Anyway, what I’d like you to look at is where the money is flowing.  For the January 2011 chain, it looks as though most of the call money is on the 17.50 to 20.00 range a good sign for long term price movement upward.  Lets back in a few months to first quarter 2010.  The January weight is at abive the 15 price level if you add them up there are about 40,000 contract written above the current price.  There is much lighter pressure on the Put side so the market is indicating a push above 15.  This is a good stock with good fundamental (watch the ROE), with good price pressure upward.  So let’s go and buy some.  Yeah now you actually get to buy some.

Salve Lucrum


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