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Long-term Investing: 3 more value signs of stocks (rules of thumb for company valuation)

Updated on January 29, 2012

Long-Term Investing

This article will focus on book value, return on equity, debt-equity ratio.If you are here because you liked my last article on Long-Term Investing, you will remember that I had previously coveredearnings growth, P/E ratio, and dividend growth. When you find a stock that has all 6 of these value signs, you know you have found a winner.

First a little more about value investing... Value investing is basically a way of finding a company that is on sale. The intrinsic value of the stock does not match up to what the investing public is willing to pay for the stock. This price differential is where smart value investors (Ben Graham, David Dodd, Warren Buffett) look to for long term price appreciation. A stock that is undervalued is not always so obvious, but there are value signs, which we will continue below...

Book Value

Value Sign #4: Book Value of a Stock

Book value is the difference between what company owns (its assets), and what the company owns (its liabilities). Most often the price of a company's stock will be higher than it's book value, but there can be exceptions. When a stock is below book value it may be considered cheap but most often it is because it shows little future promise. In "Invest your way to wealth" (Kiplinger), which I mentioned in my last article is the inspiration for this article, it says that you should Look for stocks selling at a price no higher than 1.3 times the book value per share. This is generally a good rule of thumb because it makes sure that the company has some financial assets to back them up in times of trouble, and EVERY company will eventually go through times of trouble. It's important that they have some money in reserves, similar to a household keeping an emergency fund in their budget, for when it is necessary.

Little Books with Big Messages

Return on Equity

Value Sign #5: Return on Equity

          The return on equity is the company’s net profits (after taxes are accounted for) divided by the book value of the company. I apologize for having to break out math, but financial analysis sadly requires it every once in a while (it is the only thing I hate about finance... seriously).  A declining return on equity, coupled with steady profits, would be a good indicator of debt (or possibly trying to keep hidden, hoping investors will focus on the stocks growth, or consistent profits and not noticing, or placing less emphasis, on the company’s accumulation of debt.Basically when the investor notices that ROE is dropping or fluctuating quite a bit, but the company still is showing profits as always, you can be pretty sure that they are borrowing from Peter to pay Paul... or, if you don't follow analogies very well, they are over-financing to keep the impression that their company is doing fine. But, if they can't get out of the rut and start paying back it's debt, the company could be in huge trouble. The rule of thumb for value investors is to look for a consistently high return on equity (compared to competitors/industry). A ROE of 10% or higher is generally a good sign that the company is managing itself pretty well.

Debt-Equity Ratio

Value sign #6: Debt-Equity Ratio

The debt to equity ratio shows the debt (or leverage) of a company compared to the shareholders’ equity. This ratio basically indicates whether or not the company is using all it's assets to the best of it's abilities. A highly leverage company is using more of other peoples money, while a company that reinvests its own money is less risky, but this could also indicate that the company is not being aggressive enough. As with all the above value signs; the debt load of a company needs to be compared to other companies with an industry to get the best idea of whether or not a stock is a bargain. Kiplinger notes the value investor should Stick with companies whose debts amount to no more than 35% of shareholders’ equity.


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      Kevin 5 years ago

      Typo in your summary..."invensting"