Concentrate On Value Part III - Debt/Equity Ratio

As I wrote in my previous two Post, Ignore the headlines and stick with the facts at hand, not the B.S. that is hyped in the media or the tips you hear at a party. Investing, although not so simple can be enjoyable and profitable if you approach it in the right manor. As mentioned in my previous two posts book value, free cash flow and return on equity are just some of the tools used to finding the right business to invest in. Another tool to help guide you is the debt/equity ratio which is simply liabilities divided by the stock holders equity. A simple example of this would be: Take your homes current market value, say it is $200,000 dollars and lets say you owe the bank $100,000 dollars, your debt-to equity ratio is 1.0 or 100 percent. Lets also take your neighbors home current value of $200,000 dollars and suppose he/she owes $150,000 dollars. The debt/equity ratio is $150,000/$200,000 3.0 or 300 percent. In this formula we are looking for low debt/equity ratio's. The lower the better. However keep in mind that some industry's will have higher figures than others. Also take note that this is how many company's finance their growth,however if the debt/equity ratio gets to be to high this could be a warning sign to get out or stay away altogether. Also let me reemphasize that you should never take just one of these methods all on its own. Choosing a stock using a combination of these methods can yield some profits for the patient investor with an eye for value.

Ignore The Headlines And Concentrate On Value Part II

As I said in my previous post concentrate on the fundamentals. We as investors are constantly bombarded with news via 24 hour news channels, the news paper and now that Ultra 24 hour news channel The Internet. Hey information is great and now we can receive more of it and at a faster speed than ever. As an astute investor one needs to turn off the hype and noise and concentrate on those fundamentals. I mentioned earlier terms such as book value and free cash flow, well their are other important things to look at when buying into a business. For example One of the most important profitability metrics is return on equity [or ROE for short]. Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own”. Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.

A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth [shareholder’s equity] of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity [$5 / $100 = .05, or 5%]. The higher you can get the “return” on your equity, in this case 5%, the better.

Some businesses that cosistantly have high returns on equity are Philip Morris International $PM w/59% ROE, Johnson & Johnson $JNJ w/30% ROE, and Coca Cola $KO w/28% ROE.

Return On Equity is another investment metric used by many famed Value Investors such as Warren Buffett, Bruce Berkowitz, Mohnish Pabrai and many other notabe investors.

Ignore The Headlines And Concentrate On Value

Ignore the headlines and concentrate on the fundamentals. The market has had a nice run the last two weeks bouncing up over 20%. Hey this is great but don't get caught in the hype. Sure you want the market to go up just like most everyone else, however to many people get caught up in the NOW, that is, what the Stock Market is doing today, this week or next month. Forget that crap and concentrate on investing in businesses. As an Independent Investor one needs to focus on the true worth or the actual value of the business. Its the same thing as if you were to buy a pizza parlor. How much does the business make? How long will it take to get my money out of it? How much debt do they have? Is this business located in the right place? Is this a dying business or a growing one? These are some of the things you would ask if you were buying an existing establishment. Well the same rules apply to the stock market, except most individuals and institutions do not adhere to these principals. Of course their is no sure fire way but if you focus on a few basic fundamentals such as book value or free cash flow this will help in whittling down some prospective investments. For those that might be new, book value is defined as the total value of the company's assets that shareholders would theoretically receive if a company were liquidated. Warren Buffett uses the book value as a measuring stick, often looking at the growth in book value. Free Cash Flow represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Currently Wellpoint $WLP is a good example of a business with excellent free cash flow.