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GROWTH PROSPECTS: Further to this investors should invest in those companies that have good growth prospects in relation to their Price Earnings Ratio. One way to do this is to compare
Prospective Price Earnings Ratio of Company (i.e. for current year) against expected annual growth in Earnings per share. If figure is below 0.75 times then a purchase of shares should be considered.
A practical example that illustrates this point in Cyprus in past is shares of Multichoice (a paid for subscription TV Channel). The Prospective P/E Ratio of business is estimated at around 13 times with expected growth of earnings estimated at 20% per year. I believe growth rate is high due to management skills of Group and expansion plan of Group. Since PEG factor is 0.65 times then this is a good candidate for investment. Had investors used PEG factors when index was high then nearly all shares would have registered a sell signal.
PRICE EARNINGS RATIO: Additionally investors should use Price Earnings Ratio to help them decide if shares are cheap or not. I believe that way to do this is to compare similar companies in both domestically and abroad. However investors must be careful in that they should use future earnings not past earnings as a guide to making this calculation. This is because historical earnings do not always provide a good guide of what future performance will be. Another important point that I always highlight in my articles is that P/E Ratio must be based on operating activities. It should eliminate effects of exceptional items (i.e. non recurring events).
An example to illustrate this is as follows. A Company last year made CYP 5.5 million of which CYP 5 million were investment gains. The P/E Ratio should be based on earnings from operating activities (i.e. Maintainable Earnings) and not Earnings including exceptional items. Hence figure to use for calculating P/E Ratio in this example is CYP 0.5 million plus/minus an adjustment for current year’s earnings.
Another point that needs to be considered is if Company is heavily geared or not (i.e. if its Debt is high in relation to its Shareholder Funds). A highly geared company has a high financial risk. Such companies will be badly hit if there is a recession in economy and/or if industry as a whole has been badly hit. This is because if there is a fall in their Operating Profit then they may not be able to cover their interest obligations since latter is fixed cost. In times of recession lowly geared companies will not have same problems since they will have low interest charges. Since there is possibility that Cyprus economy may move into a recession (i.e. due to CSE slump) investors should tread carefully when considering investments in highly geared companies.
NET ASSET VALUE (NAV): Another vital question that must be answered is whether net asset value per share is higher than share price. Another way one can put this is whether Price to Book Value (PBV) is under 1 times. If a Company has a PBV of less than 1 then it means that share price is supported by strong asset backing and it may indicate that downside to share price is restricted. The opposite may be true for companies with high PBV values.
There are a number of old industry stocks (especially in retail sector) where NAV is equal if not greater than share price. That means an investor can buy shares at a price below net asset values of a business. If one carries out research on other stock exchanges this is a phenomenon that occurs in a bear market. In a bull market this is likely to reverse with few shares below their NAV.
An example in London Stock Exchange of a share where exceptional gains were made when a company had a low PBV was Aston Villa (the football club) who had a PBV of around 0.2 times in 2003 and whose share price from middle of 2003 to middle of 2004 has increased by around 200%!
Investors should also pay attention to investment sector where there are companies whose share price is at a 30% discount to their NAV. In bull markets this discount tends to narrow hence providing markets stabilise at these levels such investments could represent good buying opportunities.
Finally, liquidity of company is also important since many profitable businesses have failed due to a lack of cash. There are a number of ways of doing this. One away is by looking at Cash Flow Statement that indicates whether company has increased its cash balance and this analyses its sources and applications of funds. A more easy method is to examine Current Ratio of Company. This is Current Assets divided by Current Liabilities of a company. If figure is above 1.5 times this suggests that short-term liquidity is satisfactory. If figure is under 1 times then this indicates business may have problems. Care needs to be taken in interpreting this figure since new sources of finance (e.g. share issues) or new applications of funds (e.g. purchase of fixed assets) may affect figure since Balance Sheet date.
CONCLUSION: After bad experiences of past it is important that investors do carry out their own research before making investment decisions. I do not believe that investing on basis of “rumours” will work as an investment strategy but do believe that investing on basis of value will pay dividends in long-term.
Andy George is an accountant with years’ experience as a lecturer. Andy was financial correspondent for eight years at the Cyprus Financial Mirror where he wrote articles on business & accounting related issues to a non-technical audience.
He is the author of eBooks: How to write and Publish Your Own With a Shoestring Budget http://www.budgetebook.com New! Easy Way to Make Auto-Pilot Income http://www.budgetebook.com/cbmall
