Stock Forex

One of my longtime favorite ways to make money on options is to buy when the stock takes a serious dip. Check the company’s story though, to avoid further downturns. Look at the following charts:

Motorola (MOT): The stock was $70 to $80 a share. It’s a great company. Earnings were up but not what analysts expected (the whole high-tech arena was

down) and the stock plunged to the low $50 range. I pur­chased the $55 calls and some $60 calls. When the stock rose, I sold the calls at a nice profit. I’m always doing this play with a dozen or so companies.

I like Orga-nogenesis (ORG). When it dipped down to $19, I jumped back in. I’m do­ing both a pure option play and a covered call play. There are so many companies which fall into this category.

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There are five major areas to look at in determining the value of the stock. There are several minor aspects and variations which can also be examined. No one of these should stand alone. You will get a “blind men and the elephant” view if you do so. Also, there is no set “weighting” exercise which I’ve found. In the end it comes down to your feelings and the risk you’re willing to take; the direction you want to go.

Fundamental analysis is different than technical analysis. Technical analysis uses charts to identify significant market trends or specific stock turns. The use of technical analysis, like fundamental analysis, is to help reduce risk.

Technical analysis’ most useful function is to help confirm a movement that seems unrealistic, too hopeful, or even unpopular. Charts tell us things like a doctor does—what is the past history, the diagnosis, the chances, the effect of certain factors like diet or exercise.

This section is about fundamental analysis. I read the technical books, and study their methods, and I use what I understand, but pure numbers have never had that much appeal to me. I like the challenge of figuring out movements, values—entrance and exit points. While I love technical information, I also love the basics, the fundamentals. I use both, but ultimately base my decisions on my own “gut feeling” after looking at all the data I can collect.

The main reason I favor the fundamental approach is that all movements have their genesis in one or more of the fundamental aspects of the stock. Fundamental approaches take a “separate” or a dispassionate look at the stock (or the market). Technical aspects of movements are not apart from, but integral to the stock or the market movements. Funda­mentals give people opinions, while technicals try to confirm those opinions.

Whichever method you favor, trying to predict the future movement is the goal, and trying to reduce risk along the way in order to forecast these movements is what separates winners from losers. Yes, there is risk, but you know you can’t get something for nothing. Risk is the price you pay for the rewards.

The following fundamentals are the five main methods or tools to help you make good decisions, to hit a lot of singles and a few homers, all the while trying to avoid too many strike outs.

 

1) Earnings

We will first discuss earnings and earnings per share, or P/E. The earnings of a company are its bottom line—they are the profits (after taking out dividends to shareholders of any preferred stock and after taxes).

To figure the earnings per share, we take the number of shares outstanding and divide it into earnings—hence we get earnings per share. Earnings are very important and are that which the company uses for dividend payouts, for invest­ment in growth, for excess debt reduction. This figure is most often used by lending institutions for calculation of new debt paybacks.

Earnings should be from sales, and not from one time phenomenons like the sale of a division, or a bad investment charge off. Many sources list earnings per share: Barron’s, Investor’s Business Daily, most local newspapers with finan­cial information, and most computer on-line services.

In determining your stock purchases, you’ll not only want current figures but you’ll want to know where the company has been. Does it have a history of increasing earnings? Did they increase, then slow down? You need to understand why the earnings per share are what they are.

The P/E is a very important number. I teach this from coast to coast. “When in doubt,” I say, “follow earnings.” Yes, the other measuring sticks are useful but not as important as earnings. Think of it. Some companies just don’t need a lot of assets to produce income. Some need a lot of assets and other forms of overhead.

The P/E is stated in terms that let us figure how much each dollar of stock is making. If the company’s stock is trading at $80 and it earns $8 per share, it has a multiple of 10. If it’s making $4 per share, it has a multiple, or P/E of 20; 20 times $4 equals $80. Another way would be to divide the $4 into $80 and get 20, or P/E 20. In this case, what we’re saying as investors is that we are willing to accept a 5% cash flow return (even though we may not actually receive the $4 or the $8); 5% of $80 is $4.

As I’ve said, P/E’s are very, very important. We need to understand how to use them—and how to keep them in perspective.

To decide if a P/E for a particular company is good, we need to: 1) Pick a number we’re happy with—say, “I’ll buy any company with a P/E under 14,” or 2) compare it to the market as a whole, or 3) compare it to stocks in the same sector, say high-tech or pharmaceuticals.

Let’s look at #2, as #1 is self-explanatory. Standard and Poors has a stock index of 500 stocks. It’s called the S&P 500. The combined P/E for these companies is in the mid-teens. Lately, it’s moved to the mid- or upper-teens. You compare your company to this number and get a feel for how well it’s doing.

You could also look at a smaller picture and compare your stock to other companies in the same business. There are so many variables in trying to get a handle on this information. One problem is that different reporting services use different time periods. For example, one newspaper may use “trailing 12 months” numbers to figure a company’s P/E. It could be accurate to the last decimal, but is it appropriate to make a judgment solely based on where a company has been? Are we not buying the future—what a company will earn? Some figures are on projected earnings. Well, if we only used this number, would that be complete—as if anybody knows what a company will actually earn? Yes, analysts (for the company or independent) can make their best guess, but they often fall short or overstate earnings.

Probably the best gauge would be to take a blend of the “trailing” and the “projected earnings.” Many papers report it in some combination: say, trailing 12 and future 12 months. Many use six months back and six months future.

A couple of thoughts:

1. I have been such an adamant proponent of caution in buying stocks. So many investors get caught up in the hype of it all. Yes, I agree we all have to recognize the sensational and buy into it a little— but very little. “Follow earnings, follow earnings,” I shout. People who have attended my seminars and even some of my employees have drowned me out. Let me give an example by way of a story.

Iomega (IOM) is a high tech, software company. The stock got to new highs and kept going up. They announced a stock split (I really like stock splits) and the stock soared. I got in at $14 and $16 and sold out at $30—a really nice profit. The stock went to $50. The hype was still in the air. I bought some $40 options, even though I knew the stock was way overpriced. I got out in days with a double on some and triple on others. The stock went over $60 and headed for $80.

Everyone was getting in—in both stock and options. I stopped. These numbers put the P/E over 100. I think it hit 120 times earnings at one time.

At my seminars, in my office, and on WIN (our internet subscription service) I shouted: “lam not playing,” “the bubble has got to burst,” and “it’s way too high.” Yes, I might miss out, but this high price can’t be sustained. Also, I had been following Iomega for some time as a nice, little, volatile, covered call play, and this time around I wasn’t going for it. This all happened between the spring of 1996 and the fall of the same year.

It’s hard to buy a stock at $50 when you were buying it for $14 just months before. Yes, it’s earnings were up a little, but not that much. The price was not justified.

It did another split. It was a 2:1. The stock split down to the $30 range and went back up to $40. This is when it was at 120 times earnings.

I held no positions, but everyone around me did no matter how hard I tried to stop them. I calculated the stocks (based on earnings and a little hype thrown in) ought to be around $23 per share. I was throwing in about $10 per share for the “internet hype” value. It was really a $12 to $15 stock.

This next part will seem like a joke but it’s true. When the stock was way up there, analysts for the company were trying to justify the high price. They actually made comments like: “The price isn’t so high based on projected earnings three years from now.” That’s right. Three years. Talk about hype. But tens of thousands of people bought into it.

Guess what? It fell to $30, then to $24—almost overnight it was at $16. Then it trickled on down to $13. It rebounded to 1372 to 1472 and I started jumping back in. I bought stock, options, and sold puts. I loaded up. I sold out within weeks, before and when it hit $27.

I’ll play it a lot, but not when the price is too high. One of the questions you must ask is this: What must the company do to sustain this price? The hype-sters that run up a stock are gone; and it could take years to recover from buying too high. Be careful! Follow earnings!

2. The market is crazy, and if not totally wacky, at least hard to understand. This example has played out recently in scenario after scenario. Here’s a typical example: a stock is at $60. An analyst (someone with: what kind of education? What kind of real-world experience in running companies? What kind of motivation?) projects that in the next year the company will earn $3 per share. He/she calculated this by taking numbers supplied by the company, et cetera, et cetera and putting the num­bers through some kind of filter—possibly what other companies in the same field are saying or are doing, and comes up with the $3. This is aP/E of 20 and not bad for this sector. (See P/E for NYSE and NASDAQ). He/she recommends the stock as a buy. Not a strong buy, just a buy, and thousands of investors and funds start to buy. The stock goes up to $62 on this recommendation but within weeks it’s back down to $60.

Let’s thicken the plot a little. More information. Last year the company earnings were $2.90 per share. For this type of business this is a nice profit. The year before it was at $2.40 per share and the year before that it was $1.50 per share. It’s had a nice increase.

Time passes and the actual earnings are $2.97 per share. The analyst was off 3tf and the stock falls to $52, dropping $8 off its value. You think I’m joking, but I can show you a long list of this same story played out repeatedly.

The company is profitable, it’s growing, it’s earning mil­lions—more than the previous year—but alas, the stock gets killed. Note: this author looks for these opportunities. See other sections for taking advantage of these serious dips.

More thoughts on P/E:

• To make sure you’re not overpaying for a stock, watch the P/E in changing markets. In a Bull market the P/E can be higher. In a Bear market you would expect a lower P/E.

•     Certain industries have different P/E’s. Banks have low P/E’s—say, in the 5 to 12 range. High tech companies have higher P/E’s—say, around 15 to 30. Check the sector to see what you’re paying.

•     If your bankP/E is at 9 and the average is 8, you are paying a premium for the stock. It’s okay if you expect higher earnings. If your food sector P/E is 16 and the company you’re considering has a P/E of 12, then you’re getting it at a discount.

•     A low P/E is not a pure indication of value. You need to consider its price volatility (See “Beta”), its range, its direction, and any news you think worthy.

•     You may want to check the historical level (P/E) of the stock. If the current P/E is above the 5 or 15 year historical P/E, the movement of the stock may be about to drop back into line.

IMPORTANT: The activities or news of a company—that which has driven theP/E to its current level—does you no good prior to your stock purchase. This is why you also need to look at, consider, and take into account the future earnings esti­mates. Yes, be careful, but remember, you make your money after you buy the stock so it is the future that will pay you—in dividends and in growth.

 

2) Yields

A company may take some of the cash it has available and pay it out to the shareholders of record. This is called a dividend. It is done on a per share basis. By dividing the amount by the price of each share, you would find the yield or rate of return.

Example: a stock is at $30 and $2 (annual equivalent) is to be paid—that would be a 6.66% return.

Using the dividend yield to determine whether to buy a stock or not is informative, but by no means complete. In the opening sentence I mentioned cash available. I did not say profits or earnings. The dividend could be paid out of debt.

Imagine this: a company has paid dividends every quarter for 13 years, and every payout is slightly larger than the previous quarter. You think all is well. But lately market share of the company’s products are slipping. The directors meet. They’ve seen their stock value continually rise. They feel the shareholders need to see the dividend and see it in an ever increasing amount. But their cash flow has dried up. They borrow money for operations and to pay the dividends. They also feel, at first, that they can turn things around.

The dividend is paid like this for five quarters as the company slips toward complete insolvency and possible bank­ruptcy. Eventually the dividend stops and the stock plum­mets.

Point: dividend yield is important but you need to:

1.    Keep it in perspective

2.    Seek other information

•   read the company’s balance sheets

•   get reports from information sources

3.    Do not rely solely on yields for justification for buying or selling a stock.

 

Good Earnings—Low Yield

Let’s go to the other extreme. A company is doing well. Debt is decreasing, earnings are up and increasing, but the dividend payout is rather small, say 2.1%. What gives? Yes, they can pay out more, but the choice is made not to. Corporate directors, in the past 20 years—in our new infor­mation society—have had to become experts in many fields. One is taxation.

In the current tax code, dividends are not deductible. The company has to pay taxes on all dividends. The corporation may be in the 15, 25, 31, or 35% tax bracket. When you, the shareholder, receive the dividend, you also have to claim and pay taxes on it—and do so in whatever bracket you are in. This seriously reduces your rate of return. This is double taxation. It’s sad that we have politicians who treat us so callously.

Think of this. The company has a $10,000,000 profit. They pay $3,500,000 in taxes. For the sake of this argument, let’s say it was all to be paid out in dividends. Your check is $2,000, and you are in the 31% tax bracket. That’s an additional $620 to go to the IRS. Yes, the IRS gets 66% in this example. It’s a staggering amount. I’d like to comment on the ghastly things they do with this huge amount of money, but I’ll restrain myself.

Now imagine a meeting of the directors. If they pay out the money (hopefully from true earnings) to you, they know you will be taxed. The corporation will get taxed no matter what, but they can stop the second level of taxation by simply not paying it. Also, if they could take this money and expand the business, pay down debt—in other words, increase the value of the company—would you not be better off?

Remember our earnings multipliers. Let’s say the company has a P/E of 15 but it takes this money, using it wisely, and generates 30% more profits. The earnings go way up. Will not the stock value increase? And think, until we sell the stock and have capital gains taxes to pay, the growth is tax free. We could own stock for years with no tax consequences.

Simply put. We want the directors to do the best job they can. If we are investing solely for income (and will take the growth as a bonus) then we may want to find stocks with nice dividend payouts. But most of us should look for companies with great earnings, and hope this money is used effectively to build more value into the stocks we own.

 

3) Book Value

When purchasing stock, one has to ask the question: what is it really worth? In the real estate arena the cliche answer is: whatever someone is willing to pay for it.

It is not quite that simple in picking stocks. One measure­ment of equity is called the book value. It is the dollar amount you get when you subtract all the liabilities (including pre­ferred stock) from the assets. This figure then could be di­vided by the number of shares outstanding and get the value per share. With this number in hand, we can see: 1) how much of each share is real value—possibly expressed as breakup value; 2) we can see how the book value of the company compares with other companies; and subsequently; 3) this value can be used to figure other percentages—as in sales to book: an assessment to determine the percentage of sales to the book value of the company.

Again, the main reason we study this is to make sure we are not overpaying for the stock. I am willing to buy into the excitement of a stock but when the price gets outrageous, even above that which is justified by earnings and way over book value, then it becomes a little scary.

In theory, you would want what the stock is trading at to be the same as the book value. The book value is $30 per share and the stock is $30 per share. But in reality, all stocks trade at a premium (the share price is above the book value/per share amount) or at a discount (the share price is below the book value per share amount).

Most stocks trade at a premium. I’m constantly on the lookout for companies trading below book value. All else being equal, you’re getting the stock wholesale. I really frown on stocks at over three times book value. If the earnings justify the higher price, I might go for it. But I like stock trading at one and a half to two times the book value. If you are after stocks which trade even, you’ll have to look a long time and possibly end up buying nothing.

Don’t despair when you see a great company at two and a half to three and a half times book value. Consider the following: a company has purchased real estate—buildings and factories. They also own.a lot of equipment. These are all depreciable items for tax purposes.

According to GAAP (Generally Accepted Accounting Prin­ciples) it must carry on its books the value of these assets atcost or market, whichever is LESS. This adds an unrealistic dimen­sion to the calculation of book value.

An example is in order. XYZ Company purchases a $10,000,000 factory. It depreciates it over the years to $6,000,000, but in fact the building is actually worth $14,000,000. The amount on the company books (as an asset) is $6,000,000. The same with trucks, computers, and other equipment. And these depreciate faster. You see by this how difficult it is to get a proper “fix” on what a company is really worth.

To protect yourself:

1.    Go out and “kick the tires”—really check the company out. Do your homework.

2.    Learn how to get “behind the scenes” financial information.

3.    Use book value in conjunction with other mea­suring devices.

Not all low book value companies are bad deals. Usually a low book value means there is not a large belief that a stock price will increase. Maybe it’s in an unfavorable industry. There are many good companies with low book values. Also, there are companies ready to explode which have a current high book value ratio.

One possible play is to look for companies with low book value because they are often the target of a takeover. Other companies want to get at their assets and can buy at bargain rates if the stock is trading at or below book value, or if the book value figure does not properly represent true book value.

Book value is extremely important. Look for companies with a low book value percentage, but keep everything in perspective. Book value is also referred to as “Shareholder Equity.” What kind of income and growth do you want your equity to produce?

 

4)  Equity Returns

I hinted at this in the last section on Book Value. We want our equity to be producing for us. In real estate, it’s how much income it can produce. Department stores measure part of their success by “sales per square foot.” What are our assets making?

Return on stock equity is the company’s after tax profits divided by the book value. The important thing here is to see if this return is increasing from year to year. These numbers are usually found in the company’s annual report.

 

5)  Debt Ratio

I’ve saved the best ’till last. Actually, this is not the most important measurement of stock value—that realm is re­served for earnings, but this runs a close second place.

This ratio shows the percentage of debt a company has in relationship to shareholder equity. You want this to be low. The actual figure varies from company to company. Just remember debt is a killer of businesses. Yes, the company may have a well marketed product; yes, cash flow is up, but it may not be enough to cover the debt load.

Let’s say a company has shareholder equity of $100,000,000. Debt is $30,000,000. This is a ratio of 30%. Some companies have debt as high as 70 to 90%. That is way too high, because the earnings are decreased so much to service the debt.

This author (again, many other variables enter the picture) wants the debt to be under 30%. I usually shy away from 50% or higher debt ratios.

There are several other smaller measurement techniques, and all are helpful to a certain extent. The “Big 5″ just mentioned should be in your toolbox to help you make intelligent and timely decisions.

No one measurement alone is foolproof, and even when all five point to a recommended buy, the whole market may turn down.

Remember, these tools are to help you take the best calculated risk possible. When in doubt, remember my stron­gest advice from my seminars: “Follow earnings.”

Choosing Stock Wisely

If there is a way to make the selection of a stock and building a portfolio of solid stocks a fun process, we’ll make every attempt to find it. A few assumptions: 1) we want to find stocks at bargain prices, and 2) we surely do not want to overpay for our stocks.

Isn’t that the essence of it all—to find great stocks at bargain prices? Also, we want to buy stock with the highest likelihood of increases in value and the lowest likelihood of losing value. If the stock produces a dividend (income) that would be nice too.

 

Real Estate: A Foundational Example

Determining value is very perplexing and very diffi­cult. Over the years many ways of determining value have been proposed. Whether we’re buying or selling, we want the best price. The three most common ways to determine real estate value are listed here. After this short exploration we’ll use what’s applicable from this to aid us in choosing stocks.

 

1)  Cost or Replacement Value

Buildings and land have value based on how it is being used. We’ll explore more of this in the income section, but we’ll cover it briefly here. A building used as a factory will be worth so much: use it for residences and it may go up in value. Turn it into a shopping center and it goes up again. You can’t do this with stock, but what the company does with its assets can change what it’s worth.

With real estate we just figure what it costs to replace the building—including the land—and that’s the replacement cost. Is it this simple? Well—not quite.

 

2)   Income

The gross and net income and the use of income multipli­ers are the most commonly used basis for the determination of value. You see, the cost of replacing a structure is not adequate to determine the full or accurate value.

What income does a building make? And even if you know that to the penny, other factors enter in:

A.   How long has it been since a rent increase?

B.   How expensive is the debt? And can it be refi­nanced or paid off?

C.   Can other expenses be lowered?

And none of this has to do with the tax deductions. How does it affect our tax bracket? All sorts of other variations occur. If we raise the rents, will the income remain stable? If we “net” more, the value will increase—could it be refi­nanced at a higher price and the new-found money used to buy more properties?

 

3)  “Comps”

One common way to value real estate is to find properties in the area which have sold recently and determine the value of your property based on an average of several properties— taking into account the differences. This is one of the func­tions of appraisers. Banks use this method extensively so they are not giving mortgages above “what the neighborhood will bear.” Extensive appraisals can be done using all three of these methods. It is wise to use all three with a more nebulous “growth potential” factor thrown in. The potential for growth or increase in value is a reason why many real estate investors invest in the first place, but so many things change, and there are so many chances to be wrong, that hardly anyone uses it as a main factor in determining current value.

I could go on, but since this is a chapter about stocks, let’s just take from real estate the thought behind the process. The example of real estate cannot solve all the problems, or answer all the questions, but it is worthwhile. It’s good to have another point of reference. I’m good at many of my stock decisions because I integrate knowledge I gained in real estate.

The point is not that many companies own real estate, but that the price of the stock, the income, and tax consequences have many similar characteristics.