Investment Criteria
I use a defined set of parameters to assess a company’s value in the stock market. As an investor, it is important to create your own framework, fully understand it and stick to your approach. It is important to immerse yourself in the process of creating your investment strategy and understanding your reasons for investing in a company’s stock. If you can’t describe your strategy or process to others, you are simply speculating or gambling with your money. And speculating and gambling is not investing. It is also important to constantly revaluate your strategies and workings to keep up to date with evolving market dynamics.
My investment criteria will try to answer the following key questions:
Does the company create value and is it self-funding?
How far from bankruptcy is the company?
How strong are the company’s financials and how have they improved over time?
What factors impact the company’s Return on Equity? What is its biggest drag and what is its biggest benefiter?
What is the intrinsic value of the company determined by using different valuation techniques? And how does the company’s intrinsic value compare to its current stock price?
What is a good price to trade this company in the market? I.e. when to make the investment, when to exit and how long should I hold the investment?
What is my risk appetite? Does the stock meet my risk criteria?
Earnings Power
‘Create Value’ – Company has to be tending towards creating value. This is measured by its Enterprise Income i.e. Operating Margin minus Cost of Capital. If this metric is positive, it means the company is generating more net income from its business operations relative to its overall cost of capital (WACC). Translating Enterprise Income divided by number of outstanding shares gives us a view of ‘Enterprise EPS’
‘Self-Funding’ – Company has to be tending towards being self-funding. This is measured by its reported Free Cash Flow (FCF). The more positive the FCF, the more self-funding the company is. FCF divided number of outstanding shares gives us a view of ‘Defensive EPS’
Earnings per Share (EPS) – Compare the EPS announced by the company against the Enterprise EPS and Defensive EPS. This will tell us whether the company is distributing sufficient amount of its accumulated profits back to the shareholder. In some cases, EPS announced may be far less than Defensive EPS or Enterprise EPS. In these cases, we should check if the company engages in more buy backs than dividends. This can be checked by looking at the company’s number of outstanding shares in the market.
Altman Z Score
This is a measure of how close the company is to bankruptcy. Higher the score, further away from bankruptcy. The score measures the following ratios:
Working Capital / Total Average Assets
Retained Earnings / Total Average Assets
EBIT / Total Average Assets
Net Income / Total Average Assets
Market Cap / Total Liabilities
Score > 3 implies a strong company. Score between 1.8 and 3 implies an OK company. Below 1.8, implies a company in distress
Piotroski F Score
Piotroski F Score measure the following based on a 9 step approach:
Profitability
Leverage, Liquidity and Source of Funds
Operating Efficiency
The 9 step approach is the following: (a score of 1 is given for passing each of the following checks)
Return on Assets in the current year is greater than 0%
Return on Assets has increased year on year
Cash Flow Return on Assets in the current year is greater than 0%
Cash Flow Return on Assets is greater than Return on Assets in the current year
Long Term Debt on Assets has decreased year on year
Current Ratio (i.e. Current Assets / Current Liabilities) has increased year on year
Gross Margin has increased year on year
Number of Outstanding Shares has decreased year on year i.e. company is engaging in more buy backs, resulting in potential increase in share price to benefit investors through capital gains on sale
Asset Turnover Ratio increases year on year
A company that has a Piotroski F Score of greater than 8 is considered to be strong. Alternatively, companies with scores of 0-2 are considered to be financially weak.
Piotroski F Score can be different in different sectors of the economy. Therefore, comparing peers from within the same sector is a useful way to measure relative strength.
Dupont Return on Equity
Return on Equity is Net Income presented as a ratio on Total Shareholders’ Equity. This ratio by itself does not tell much except that being positive is good. Dupont Return on Equity calculated using a 5-step approach is a useful way to breakdown the components of Return on Equity by the following parts so that we can see which component is dragging down the Returns of a company:
The product of Tax Burden * Interest Burden * EBIT Margin gives the Net Profit Margin
The product of Net Profit Margin * Total Asset Turnover gives the Return on Assets
The product of Return on Assets * Financial Leverage gives the Return on Equity
Fully understanding the key drivers of Return on Equity is an important investment criteria. This will help the investor assess the risk and ensure the risk they are taking by investing in the company is well within their risk appetite. As an example, see screenshot below capturing the breakdown of Return of Equity of a sample stock
There is a lot to like about the Benjamin Graham Value as it provides a framework to assess intrinsic value of a company and compare this to the current stock price in the market. It’s a clean way of assessing if a company is overvalued or undervalued in the market.
Benjamin Graham – The Intelligent Investor – is considered the father of value investing. His approach is followed by Warren Buffet’s investment style.
Downside of Graham Value approach is that there are a number of assumptions that an investor has to make which are very subjective in nature. So, tweaking these assumptions and analysing a range of intrinsic values is a good idea.
The Graham formula calculated a company’s intrinsic value using the following formula:
V = Intrinsic Value of the company
EPS = the company’s Trailing Twelve Months (TTM) Earnings per Share
8.5 = P/E ratio for a no-growth company. This is an assumption and worth doing some sensitivity on before making an investment decision
G = reasonable growth rate assumption over the next 7 to 10 year period. Again, this is an assumption and worth doing some sensitivity analysis on before making an investment decision
Avg(YAAA) = Average yield on AAA rated corporate bonds over a 20 year period
YAAA = Current yield on AAA rated corporate bonds
Other Valuation Methods
I use a few other valuation methods to sense check my investment decision. As there are a number of assumptions in these valuation methodologies, specifically around using past performance to predict future value of the company, I use these as a secondary check rather than a primary investment strategy. Also, these valuation methods provide a view of future value i.e. over 3 year to 5 year. It is intended to reassure us (the investor) that when the market tends to be volatile and the stock price fluctuates, we should continue to hold the stock as the company is expected to come out of the volatility in a stronger position based on the valuation model forecasts.
I use the following methods:
Price Multiple Method
Sustainable Growth Method
Discounted Cash Flow and Terminal Value
Price Multiple Method
Taking the current EPS announced by the company and using a reasonable EPS growth assumption (say 5% for a strong company), we first calculate a projected EPS over the next 5 year period.
I then use one of the following three options to calculate a forward P/E ratio:
Linear Fit: This is a linear extrapolation of the past 10 years P/E
Log Fit: This is a log normal extrapolation of the past 10 year P/E. Helps reduce the noise and fluctuations that may exist over a long period.
Morningstar Forecast: The website provides a forecast P/E view for every stock traded on the NYSE and NASDAQ exchanges. This is a useful reference/comparison point.
Apply the Forward P/E using each of the methods above on the projected EPS to calculate a forecast stock price over a 3 year to 5 year period.
Few things to note:
This method ignores a lot of other relevant financials. It only focusses on the EPS and P/E of the company. Therefore, do not use this as a primary measure to invest in stocks.
P/E may not be the most relevant measure to use for all industries. As an example, technology stock prices move in line with expected P/E but capital intensive businesses in sectors like manufacturing or infrastructure do not tend to move in line with projected P/E as they charge significant amounts of depreciation to Earnings, which impacts the EPS projections and therefore a false outcome of a company’s value.
Sustainable Growth Method
This method measures the growth of a company as a product of Retention Rate * Return on Equity
Retention Rate is ratio of earnings that the company has not paid out to its shareholders as dividends i.e. company retains this capital to either redeploy into its business or into further research and development
Return on Equity is Net Income divided by Total Shareholders’ Equity
A very high growth rate implies that a company maybe spending a lot of its earnings on spurring on more and more growth, so may not have sufficient cash left to make any payments on its debt obligations. This can act as a good secondary confirmation of the self-funding check in Earnings Power section
Discounted Cash Flow
I first calculate the total DCF Value as the Terminal Value of the company + Present Value of the company’s FCF
Terminal Value is based on growth rate and a discount rate (WACC) assumption after the company has reached its terminal year. This is a subjective value and the assumptions need to be stressed to analyse a range of options.
Present Value of FCF is a simple calculation using WACC as discount rate
WACC is calculated using Cost of Equity and Cost of Debt. For Equity, I assume dividends paid represent the cost of shareholders’ equity. For companies like Amazon or Electronic Arts that pay Zero dividends, cost of equity is technically 0% but there is nothing like a free lunch, so I floor the cost of equity at a minimum of 10% and cost of debt at a minimum of 8%.
Dividing the DCF by total number of shares provides me with a value per share. This can be compared to the current stock price to evaluate if the company is overvalued or undervalued
Technical Analysis and Deciding Trading Levels
After having done all the financial analysis explained above, we need to figure out when is the right time to make an investment. We don’t want to be making an investment when the stock is on a downward spiral i.e. being oversold or when it is rising too fast in an upward trajectory i.e. being overbought, therefore presenting a risk that the stock price will start to drop in value to stabilize. Therefore, it is important to figure out a pattern during the day to make the investment.
For this, I use the Bollinger Bands approach tweaked slightly for my preference. This approach will indicate when the price is right to buy a stock.
Bollinger Bands present an Upper Bound and a Lower Bound. I use two sets of Bollinger Bands to identify a trading action. It is important to understand the Standard Deviation measure before diving into Bollinger Bands. Standard Deviation provides a measure of volatility, i.e. how far is the current price deviating from the stock’s mean price over a chosen period of time. I generally use 20 day periods to measure standard deviation from a Simple Moving Average (SMA).
First set of Bollinger Bands capture:
Upper Bound (A1) = Current Stock Price + 2 * Standard Deviations
Lower Bound (A2) = Current Stock Price – 2 * Standard Deviations
Second set of Bollinger Bands capture:
Upper Bound (B1) = Current Stock Price + 1 * Standard Deviations
Lower Bound (B2) = Current Stock Price – 1 * Standard Deviations
The first set of Bollinger Bands (A1 and A2) generally captures 95% of the stock’s price movements i.e. stock prices generally fall between A1 and A2. The Bollinger Bands self-adjust, meaning that they widen at various volatile markets and contract when the market is quiet.
Using the bands, I evaluate the following signals:
‘Buy Signal’: When the stock price is between A1 and B1 i.e. Upper Bound of the first set of Bollinger Band and the Upper Bound of the second set of Bollinger Band. This indicates that the stock is being bought by a number of investors, so the price is on an upward trajectory, so a good time to invest.
‘Overbought Signal’: When the stock price breaches A1 i.e. Upper Bound of the first Bollinger Band, it indicates that the stock has been overbought by the market participants, so the price has breached the 2 standard deviation measure. This further indicates that the price is expected to fall before stabilizing between A1 and A2 bands.
‘Watch’ / ‘Do Nothing’: When the stock price is between B1 and B2 i.e. between the second set of Bollinger Bands.
‘Sell Signal’: When the stock price is between B2 and A2 i.e. Lower Bound of the first set of Bollinger Band and the Lower Bound of the second set of Bollinger Band. This signal indicates that the stock is being oversold in the market, so pushing the price in a downward trajectory. Execute on this signal only if you want to stop losses, but do not execute on this signal if you have invested in the company to hold for the long term.
As an example, see below the Bollinger Bands that I have created for Boeing Co, one of the stocks I have been tracking to invest in April 2020 but have not seen the right window to ‘Buy’ the stock yet. You can see how the stock was quite volatile at the start of April (with wide Bollinger Bands), by the end of April the volatility has squeezed and the bands are lot closer to each other, therefore providing less opportunity to trade.
Risk Appetite
Considering the company’s performance relative to market performance is an important step in defining your risk appetite. For example: if a company is generating negative returns while the market is on an upward trajectory, this indicates that the company is oppositely correlated to the market trends. To measure relative performance of the company to the market, I use the Beta (Risk) measure calculated using the following different methods:
Daily Beta: Compares daily company returns relative to the market performance
Monthly Beta: Compares company returns relative to the market performance over a 30 day period
20 Day Moving Average Daily Beta: Average of the daily Beta over 20 day period
20 Day Moving Average Monthly Beta: Average of the monthly beta over 20 day period
Morningstar Beta: Morningstar website publishes a Beta calculated using the past 5 Years of a stock’s performance relative to market. This is a useful measure to compare the Beta values calculated using my preferred approaches.
The average Betas are useful to smoothen out any one off spikes in trading activity and provide a more balanced view of the risk. After I have associated Beta (risk) with every stock, I use the following table to determine my thinking about every stock:
A stock with negative Beta will erode my investment, so I’d rather hold as cash than buy a stock with negative Beta. Stocks with a Beta of 1 perform at exactly the same level as the market. And a stock with a very high Beta, outperforms the market but this may be because of increased volatility or because investors are overbuying the stock. So, very high Beta stocks may not continue having the same trend forever. Therefore, they are considered relatively high risk investments and require further consideration before making an investment decision.
When picking a portfolio of stocks to invest in, having a mix of stocks across the Risk Appetite levels is important. This way the risk can be diversified across your investment portfolio. I try to maintain a balance per the following split (tending towards being more risk seeing per my table above):
50% stocks with Beta >1 but <1.6
30% stocks with Beta >0.7 but <1
10% stocks with Beta >1.6 (but do more intensive research before buying)
10% hold as cash in a savings account or invest in ETFs or corporate bonds or Gold. Use this as a buffer and drip feed into your investment portfolio over time. I specifically like holding Gold. We will discuss the reasons for this in more detail in the commodities section.
Areas of Improvement
I currently do not track other measures such as Corporate Governance, Stress Testing, Ethics and ESG ratings of the companies. I find these measures to be subjective and I will need to evolve my criteria / framework / strategy / thinking to cover these measures over time.
I also want to build a way to track diversification of my overall portfolio. I tend to pick stocks based on financials, return expectations and risk measures/appetite. However, there is more work I can do to diversify my investments across industries.
Final Thoughts
You are investing your money. It is your capital at risk. Therefore, do your research and understand the companies you are investing in. We have different risk appetites and different views of the world. So, avoid blindly trading or speculating or gambling.
In subsequent posts, I will use the frameworks described in this post to analyse stocks and to make investment recommendations.
Happy Investing! Enjoy the process!
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