“You’ve got to know when to hold ‘em
Know when to fold ‘em
Know when to walk away
And know when to run”
– The Gambler by Kenny Rogers
By Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
When it comes to your life savings, can you really afford to gamble? Well, buying a small number of stocks is gambling. In this article we’ll learn how to put the odds back in your favour.
From gambling to investing
Like the gambler that has many games to choose from, there are many investment strategies (which have their own schedules of probability of winning) that we can choose. I prefer a strategy with a high probability of winning so that when we play enough hands, our wins should resemble the probabilistic result and end up coming out ahead.
Searching for profitable businesses
We can find cheap businesses by looking for a low Price to Earnings Ratio = market price per share / after-tax earnings per share). Unfortunately, the P/E Ratio doesn’t tell us anything about the stability of earnings or whether those earnings are growing. It also doesn’t tell us about the quality of the business or the financing risks.
Sustainable Profits Through Time
The financial statements of a business give us a snapshot of where the business was at a moment in time. By going back over the last few years of statements we can get an idea of whether revenues and earnings are stable and growing. To look forward, we examine the PEG Ratio which takes Price to Earnings and divides by the projected earnings growth rate (like over the next 2 to 5 years).
Quality of the business
It’s not just about buying earnings cheaply. We want a quality cash generating machine that delivers earnings well into the future. Here we might want to know if the business creates the best products, does so at the lowest cost, and whether it is the product innovator. We might also want to know about barriers to entry and whether the products are needed in good times and bad.
Financing of the business
Where a substantial amount of debt is used, this can choke the financial health of a business. Should a business downturn occur, the business might be unable to make loan payments and be forced into bankruptcy.
The Debt to Equity Ratio = Total Liabilities / Total Shareholder Equity tells us its relative debt load. As the debt-to-equity ratio increases, the less room that’s available for borrowing.
We also want to learn about the ability to make payments:
- The Interest Coverage Ratio = earnings before taxes / interest expense tells us how well a company can meet its interest payment obligations,
- The Quick Ratio = (current assets – inventories) / current liabilities measures how well a business can meet its short-term financial liabilities. Inventory is excluded as it could take several weeks to months to sell inventory.
The Inventory Turnover Ratio = Costs of Goods Sold / Average Inventory tells us how fast the business is able to sell inventory. We should look at this ratio compared to competitors as well as look at its ratio through time to make sure the ratio isn’t deteriorating.
Management of the business
We want to make sure management is making good decisions. From the outside not many decisions are made are known to us, but we can look at what’s happening with after-tax earnings:
- Are they being paying out as dividends?
- From what’s retained, is debt getting paid down?
- Is it using the cash to increase production, develop new products, buy competitors, or buy suppliers?
- Or is management using earnings like an ATM machine rewarding itself with higher salaries, stock options and stock incentives?
Don’t Put All Profits on the End – Get Paid Through Time!
For me, I like getting cash in my pocket and being paid well through time. Here I look at the dividend yield = annual dividend per share / market price per share. I also look at the dividend payout ratio = annual dividend per share / after-tax earnings per share to make sure that there’s more than ample earnings so that the business can afford to pay in good times and bad.
We’ve identified above the characteristics of low risk quality businesses on sale. Through time, buying a group of such businesses should experience higher returns than the market. We need to buy at least 20 so that we’re likely to come out ahead.