How to Find a Stock Market Bargain

US stocks climbed overnight. And it didn’t have anything to do with the ‘trade war’ or the Fed!

No, it was good old company earnings that did it.

From the Wall Street Journal:

U.S. stocks climbed Tuesday as investors cheered strong results from banks and health-care companies at the unofficial start of the third-quarter earnings season. 

The outlook for profits had dimmed in recent months, with Wall Street analysts lowering earnings expectations for all 11 sectors of the S&P 500.

But UnitedHealth Group, Johnson & Johnson and JPMorgan Chase — all components of the Dow Jones Industrial Average — kicked off the reporting period with a shot of optimism. Goldman Sachs Group shares also climbed, despite a mixed report. 

Those four stocks contributed nearly 180 points to the blue-chip index, which climbed 290 points, or 1.1%. The S&P 500 rose 1.2%, led by the health-care sector. The Nasdaq Composite added 1.4%.

Ahh…the power of low expectations…

It’s the old Wall Street game folks. Lower earnings guidance first. Then report ‘better than expected’ results.

Going into these quarterly results, the expectation is that earnings will decline 4.7%. It’s not exactly a high hurdle. So any outperformance will lead to a rally.

The issue is, what happens next quarter, and the quarter after that? Following a short term dip this year, analysts expect earnings to rebound sharply. That’s going to be a challenge…

The topic of earnings is a good segue into how companies really grow their share price. Or, more accurately, how they grow their ‘intrinsic value’.

I mentioned I’d have a crack at explaining this yesterday. So here goes…

It’s easy to get stuck in the weeds when talking about this stuff. So, I’ll make it as simple as I can.

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How a company creates shareholder value…

The only way a company can create shareholder value (increase intrinsic value) is to generate a return on their assets (or capital employed) that is higher than their cost of capital.

What does that mean, exactly?

Every company has an asset base from which it derives revenues and earnings. Those assets are usually ‘plant and equipment’. But they can also be ‘brands’, a distribution network, proprietary technology, or human capital.

Companies must fund their assets by either raising capital (equity funding) or borrowing from a bank (debt funding).

A balance sheet is a representation of this. The assets are at the top. Below are the liabilities and the equity to ‘balance’ the books. If a company has debt funding, it sits in the liabilities part of the balance sheet.

Borrowing money and raising equity capital comes at a cost. The cost of debt is easy to work out. It’s the interest rate. But the cost of equity is a tricky one.

Academics have been writing about it for decades. I’m not going to get into it here.

The gist though is that equity is more expensive that debt. That’s because equity holders take more risks. Therefore, they should receive the prospect of greater returns.

With this in mind, let’s say the combined cost of a company’s funding is 10%.

To see if the company is creating any value, we measure this against its return on capital employed. This is similar to return on equity, but adjusts for debt.

Without getting into the nuts and bolts of the calculations, here’s the main point:

A company must generate a higher return on capital employed than it costs to finance that capital.

So if a company’s cost of capital is 10% and it generates a return on capital employed of 20%, it is increasing intrinsic value. Over time, its share price will increase.

But if it’s generating a return of 5%, then it’s in trouble.

A good rule of thumb is to avoid companies with really low returns on equity (ROE). This website is a handy free resource for company financials, including ROE. It includes analyst forecasts for future earnings, so you’re not just getting past data. Just add the ASX code and click on the ‘financials’ tab.

(Return on capital employed is not often available for free. That’s because it’s a more subjective calculation.)

Companies with a low ROE destroy shareholder value. But, if there is a cyclical reason for the low ROE, there could be good value present.

Here’s a tip to see if there is: Compare the balance sheet equity value of these companies with the market capitalisation. Usually, investors mark down the price of a company with a low ROE. Sometime it might trade at just 50% (or less) of its balance sheet equity value.

In that case, the company with a 5% ROE is actually generating a 10% ROE based on the market value. If you think earnings are just cyclically depressed and that profitability will improve in the years ahead, you may have just found a bargain.

Granted, in this market, there aren’t too many of these opportunities. But they are there if you look hard enough.

Regards,

Signature

Greg Canavan,
Editor, The Rum Rebellion

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Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own. Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts. At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates. Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.


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