Investing step by step
But at the end of the day, as a few of you have mentioned, what do I do to make money in the market? Great question. I too am overwhelmed.
How about a step back to basics. Let’s say you hear a good story on Cramer and he gets you all excited about a stock. Should you buy because he is all jazzed about it. NO NO NO and he will even tell you that. What about Baron’s, probably one of the most respected investment publications. When they pimp a stock, should you go out and buy it. NO NO NO and they would tell you so. So when do you buy a stock.
Before you buy a stock you need to do some basic homework and answer a few questions. If you do just react to a sound bite on Cramer or an article in USA Today, you are throwing money away in many cases.
Here is how you do some basic homework. Before buying a stock, know how the company makes money and what factors influence how they make money. You can easily find this by going to Google Finance or Yahoo Finance or Rueter's or Bloomberg and type in the company’s ticker. If you want to play along, I will be using Google Finance and Reuter's. (Footnote since the November 2009 post, I have been using Morningstar and FinViz to evaluate stocks.
So there you are pumping gas on I-15 (for our int’l readers, that is a major highway in the western US) and you look up and see the Chevron logo and think that you are paying more for gas than you did 3 months ago. Then you hear Cramer pontificating about how great Chevron is. Then you read an article in the Wall Street Journal about oil shortages and possible oil price increases. So you know this is sign from above to buy, buy, buy Right? NO NO NO. Let’s do about 10 minutes of homework on the stock first to confirm our feelings.
Go to Google Finance and type in the ticker CVX. Ooo It closed Friday at $78.17 a share. This is not a cheap stock. FIRST Mistake, the price of a stock has nothing to do with the relative value of the stock. The price of a stock is the result of its comparison to its earning per share and the demand for that stock. So let take a quick look at the PE ratio. You calculate this by taking the last reported annual earnings estimates and dividing into the price of the stock. In CVX's case you can see a PE ratio of 12.72 and right below it you see EPS of 6.15. Just do the math. (6.15 X 12.72 = 78.17 or 78.17 / 6.15 = 12.72)
Now go down the screen and see all of CVX’s peers. You got XOM, BP, TOT, COP to name a few. Take a quick second and click on some of them and look at their PE ratios. XOM 17.56, BP 20.21, COP – no profit no PE ratio, TOT 16.77. So out of that list CVX is the cheapest stock regardless of the price. So now you want to BUY BUY BUY. NOT.
We do a little more homework. Like I said know how your company makes money. You think Chevron would be easy, because they sell gas. Scan down the page and you will see the description section. Give it a read and you’ll be impressed with what else your company does. At the end of the description section it says more from Reuter’s. Click on that link.
You will see a complete profile on Chevron. Now you know how your company makes money and you might be able to figure out what other factors influence the value of that stock. Now off to the left hand column, you will see a link called ratios. Don’t let it scare you,just click on it.
Hey look at that Reuter's says their PE ratio is 12.72 just like Google. Math is Math. Look at the column next to the 12.72 the industry average is 19.42 at this very moment it will be different when you look at it. But that means that CVX is selling for a 37% discount off the rest of the oil industry. It’s like a sweater being on sale so now you BUY BUY BUY, NOT. Let's look at few more numbers.
They throw a 3.48% dividend always a good thing. Recently I have been looking for stocks throwing dividend above 4%. Thanks TIM I am a slow learner. Now you can anguish over all those number, but I like to look at just couple that most value investors consider important. Go to Net Margin. Net Profit Margin is 7.53% The industry average is 4.12%. Think about this, you can buy a stock at a 37% discount to the industry whose margin is 82% higher than the rest of the industry. So now we BUY BUY BUY, NOT. A little more homework.
I look at the ROE or return on equity. In a nutshell it is a measurement of how management is utilizing the resources of the company. The higher the number the better. I like an ROE of more than 25. Look at the 5 year average for CVX’s ROE. Currently it is 13.86 but its 5 year average is 25.75. Very nice. No don’t buy it yet.
Up there on the left of the page, you see a link called Financial Statements. Click on it. The first thing you see is an Interim (Quarterly) Income Statement. Here is what I look at and it only takes a couple of minutes. First off top line sales. Stocks rise short term when profits improve, they rise long term when you have both sales and profits headed up. You can see that in September 2008 they had 76 billion in revenues then they dropped to 43 billion by December. Remember oil was selling for 117 a barrel 3rd quarter 2008 and dropped to about 90 by years end before plummeting to 56ish by March 2009. Keep that in mind when you look at the quarterly revenue. Now take a look about halfway down the page to Net Income Before Taxes. AKA Profits. You can see a similar trend from 14 Billion down to 3 and back up to 6 for the last quarter.
Now back at the top where it says income statement click on the button that says “annual”.
Instead of seeing 5 quarters of Income statements you are seeing 5 years. You can see the ups and downs and you can see that they finish 2008 at 268 billion. If you go back to the quarterly numbers and add up the last 3 quarters, you know they will need a 100 billion dollar fourth quarter to hit their 2008 number. Now what is real pretty about their annual number is the growth of the Net Income. Look at that 5 year trend. That gets high points in my book. So we BUY BUY BUY, NOT.
Sales are good profits are good but cash is very important. Let’s take quick look at their annual trend of how they handle their checkbook. Go to the top, leaving the chart on annual, and choose Cash Flow Statement from the drop down menu. What you want to know is, do they make cash from running their company. So go to the line that says Cash From Operating Activities. There too you see a nice trend upward and they have gobs of cash. NO NOT YET BUT CLOSE
You got sales, you got profits you got cash. All set. The US Government has lots of cash and all they sales you could possibly imagine (Taxes). Would you buy stock in the US government? Let’s look at the debt of CVX. Leaving the chart on annual, and going to the top again click on the drop down box and choose Balance Sheet. The accountants out there are getting all excited right about now. About two thirds of the way down you see current liabilities. What you are looking for is Long Term Debt. That would be anything they don’t plan on paying off in less than a year. OMG, they have 5 billion in long term debt. Terrible, well not that bad. Think back to the Income Statement. They made 42 billion in 2008. So in essence they could pay off their long term debt in about a month and half out of most recent earnings. Not to Worry. Great Stock BUY BUY BUY. Yes.
But before you go buying, what is a good price to buy in at? $78.17 was the closing price on Friday. Its high was $78.73 its low was $77.26, but there is a bid price there of 74.44. I would watch the Asian indexes the night before and look at the Dow futures around 5:30 AM. If the market looks like it is going to head down, put in a LIMIT order just below the closing price. Let’s say 78.00.
Your not done yet because all you did was buy a good stock. You need to have an idea of where to get out. What if this whole Dubai thing gets really ugly and for what ever reason everyone feel safe with the US dollar and the dollar gets stronger sending all of the commodity prices in the toilet. Chevron starts heading down to $70, a 10% loss. Be sure to protect yourself the minute you own the stock. My rule is a stop order at 8% below my buy in.
Also determine where you might want to get out or at least take a profit. Where will that stock be in the spring or next year. You can kind of look into the future. Let me tell you how. Go back to the Reuter’s page and at the top left you will find a tab called Estimates. Click on it. There you will see what all the experts (remember I am not an expert. Just a cute, funny, chubby, guy who has no life.), think how CVX will perform over the next 3 6 9 and twelve months. I like to go to the end of the following year as these are the most complete and conservative estimates around. Now you can see there are 20 experts covering CVX. Their consensus for 2010 earnings per share is $7.53 a share. Now think about how we calculate PE Ratios. Earnings time the multiple determines the stock price. So 7.53 times current PE of 12.72 mean that CVX could be worth $95.72 a share in 2010. And if you use the industry standard PE ratio of 20.12 times the analysts estimates, or 7.53 time 20.12, you are looking at 151 a share. Is that possible, sure in May of 2009 this was a 100.00 a share stock.
So I would be looking for 92 around the first quarter of 2010. And 100 by years end. So go ahead and buy at the 78.00 price range, put a stop in at 70.00 and use a limit order to start taking profits next year around the 92.00 range.
Now if you thought this took too long to read and the analysis will take too long to do, (it takes me about 10 minutes to run preliminary scans of a stock before I start getting serious about buying a stock), then you really should not be buying stocks. Buy an ETF or mutual fund where people with no life like me do crunch the numbers. Ok I am going to watch the fourth quarter of the Baltimore Pit game.