Before investing in any company you will want to understand the company’s products and services. One place you can go to learn more about a business is by reading it’s 10-K. Click here if you have not read “How to read a company’s 10-K”
In my research online I’ve gather 5 key indicators you can use to determine if a company is worth investing in.
- Earnings show a smooth upward trend
- Consistent Return on Equity (>20%)
- Consistent Return on total capital (>15%)
- Long term debt less than 4 times earnings
- Pays a dividend and or buys back stock
Earnings show a smooth upward trend
This should almost always be the first thing you look for in a company. They can make money anot? If so, are they able to consistently make money over the years.
The earnings per share should show a smooth upward trend year on year. This is a great indicator that the company has something special or a niche and is able to raise it’s prices without a drop off in customers.
As simple as it sounds, you’ll be surprised how many people skip looking at the earnings of a company and jump straight into really complicated technical analysis.
Consistent Return on Equity (>20%)
Net Earnings ÷ Shareholder Equity = ROE
In essence how much a company is able to make in relation to it’s equity. This is a good indicator of the efficiency of the company’s ability to make money.
Do note that the short comings of using this metrics is that it does not account for companies who take on a lot of debt to make money. To filter out those kinds of company you will need to look at ROTC.
Consistent Return on Total Capital (>15%)
(Net Income + Interest Expense) ÷ (Shareholder Equity + Long Term Debt) = ROTC
This metric gives you an idea of the earnings of a company in relation to the shareholder’s equity while accounting for long term debt (payments due >12 months). This is another good indicator of the company’s efficiency with it’s money.
A little debt is always good to allow company to leverage its ability to make money. But how much is too much? For that we should look at the ratio of long term debt to earnings.
Long Term Debt Less than 4 times Net Income
Long term debt ÷ Net income equals < 4
This is a good guide to show how much “risk” the company is taking when taking on debt. You want them to leverage but not to a point where they expose themselves to too much risk. So as a guide, we would like a company who is able to pay off it’s long term debt within 4 years of net income.
Not that we want them to do that. But we want to know that they have the ability to do so if required.
Pays a dividend or buys back stock
When you buy the stock of a company you are buying the right to earn some of that profit the company is making. The dividend payout gives you a rough idea of the ROI you can expect to receive from investing in this company.
In addition, a company who buys back their own stock effectively reduces the amount of supply in the market. Knowing supply and demand, if the supply reduce the price of the stock goes up.
How much should I pay for the stock of one of these business?
Before you start parting with your hard earned money, you should always ask yourself if there is a better place to put it. For that I always try to compare what is the dividend yield with other instruments.
One of the places I like to compare it against is our gahmen’ts CPF. Remember that your CPF gives you a 3.5% compounded yearly interest risk free. So you are definitely looking for a higher yield for it to be worth it to invest in the stock market.
Click here to see “What ROI do I need for worth it to be worth investing my money in the stock market as compared to my CPF?“
What is the Price to Earning Ratio?
PE = Price (stock price) ÷ Earning
You are looking for a Price to Earning ratio of no more than 20. This number 20 is arbitrary. Essentially the higher the PE the less value you are getting from the stock at that price. Do note that if you are looking at the trailing PE, you might miss out on the intrinsic value of a stock.
For example, say a company has just recently opened a new factory and is poised to make a whole lot of money in the next few years. The trailing PE will not reflect this potential earnings. As such, you might want to look at forward PE when anticipating such situations. You can read this article for examples of forward vs trailing PE.
What is the best time to buy stocks?
“Be fearful when others are greedy and greedy when others are fearful” – Warrent Buffet
If you are looking to invest for the long term technically there is nothing wrong buying into strong companies and holding them for the rest of your life. However being “greedy investors” we always try and time the market to get in when the stock prices are low.
Timing the market is a gamble at best. However there are usually times where the market is obviously in turmoil and opportunities to buy in at a decent price arise. Here are a few suggestions.
- Valuation Method: Wait for trailing PE to get to approximately 15 to buy a blue chip stock (note that during times of crisis smaller companies must not last through the storm)
- Timing Method: Wait for the price to drop about 40-50% before you buy. (Based on previous experience)
Disclaimer: Mr Kua Simi is not an accountant or financial advisor, nor am I holding myself out to be. The information contained on this website is not a substitute for financial advice from a professional. We have done our best to ensure that the information provided are accurate. Nothing on this website should be understood as a recommendation that you should not consult with a financial professional.
Kua Simi Property 
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