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This essay describes how to be confident you pick a financially healthy and worthy company when you decide to invest some of your savings in the stock market.
If you are familiar with exchange traded funds (ETFs) you will see that this information also applies to those.
People invest in stocks because long-term the overall stock market grows more than bonds or inflation.
There are many companies that are large and stable, whose growth exceeds the overall stock market. As long-term investors, how do we identify them?
Our first step is to define more carefully what is meant by "the overall stock market". The most useful and widely-accepted definition is the S&P 500 Index.
You can read more at that Wikipedia link, but the summary is that someone picked five hundred giant companies who focus on both growth and value and whose stocks are most often bought and sold. The index goes up and down as the total value of those five hundred companies goes up and down. Since nearly any economic influence (changes in unemployment, changes in laws, changings in consumer spending, etc.) affects those five hundred companies, how the index responds to economic influences is an accurate measure of how the overall stock market is doing.
Here is a chart of the history of the S&P 500 Index, from 1974 to 2013. You can play with interactive charts like this at Google Finance or Yahoo! Finance.
Now we can do some work.
Our goal is find a company that is large enough to be stable, but consistently grows more than the S&P 500 Index. The first step is to search the internet for nominations by economists who spend a lot more time looking at such things than we do. Try searching for the phrase long-term "large cap" stocks -"mutual fund".
For this essay, let us use Blackrock Investments. It is the world's largest investment management firm. It offers other companies investment and risk management services. In other words, it helps schools manage their endowments, companies manage their pensions, etc. Blackrock Investments is a big company (about $54 billion) so it is stable. Because it is so big, one great invention or innovation will not make its investors rich, and one mistake or scandal will not make its investors poor.
The symbol for the company is BLK. Now look at the interactive chart for Blackrock Investments in Google Finance and Yahoo! Finance.
Let's also click to set the time frame to one year. On a Google Finance chart this option is at the top of the chart. On a Yahoo! Finance chart it is at the bottom of the chart.
If you were also doing this when I did (in late December 2013) the charts would look like this.
Both charts have the option for adding the S&P 500 Index line.
On a Google Finance chart this option may be as simple as clicking a box at the top of the chart. If not, start typing S&P 500 in the "compare" box and you will see options appear, including the S&P 500 Index (which Google nicknames .INX).
On a Yahoo! Finance chart click on the word "compare" and then pick the S&P 500 option (which Yahoo! nicknames ^GSPC) from the drop-down menu.
Now our charts look like this.
Those charts show the same information. During the past year, Blackrock Investments did better than the S&P 500 Index. Most importantly, the stock price ended up above the index.
Now change the time frame to five years on both charts.
Again Blackrock Investments finishes above the S&P 500 Index. For this time frame it is a closer race!
The Yahoo! Finance chart has an option for a two-year time frame.
Again Blackrock Investments finishes above the S&P 500 Index.
The Google Finance chart has an option for a ten-year time frame.
Again Blackrock Investments finishes above the S&P 500 Index.
Finally, both charts have an option for a "max" time frame. For this stock the history goes back to late 1999, when the company first started selling its stock to the public..
Again Blackrock Investments finishes above the S&P 500 Index.
This example was an ideal case. For every time frame we could quickly check the stock did better than the overall stock market. Very few companies are so successful. Usually a company is worth investing in if it is big enough to be stable and it usually does better than the overall stock market. One time frame of "failure" is excusable. Two tell us to pick a different stock.
Actually, Blackrock Investments is even more amazing. It pays a nice divdend (at the time I wrote this essay, its dividend rate was 2.13 %). This means every year it pays its investors that much as cash earnings as a "thank you" for investing in their stock.
Many stocks almost grow more than the overall stock market but not quite—but when we include their dividend they do come out ahead. If a company lags 1% behind the S&P 500 Index but pays a 3% dividend, then each year its investors end up 2% ahead.
This is why my family prefers stocks that normally grow more than the overall stock market and pay a dividend. The dividend acts sort of like a limited insurance policy. Even if the company does not do better than the S&P 500 Index this year, the dividend might make up the difference.
It is true that a history of exceptional growth and health does not guarantee a company will have future growth or health. But that history is still the best prediction available.
Economists and short-term investors study "financial indicators" that attempt to measure a company's health and potential. You may have heard about the "price-to-eanings ratio", "earnings per share", "net profit margin", and other financial measurements. Unfortunately, accountants have learned to legally manipulate these numbers. The numbers are pretty much meaningless to long-term investors because a company can use creative bookkeeping to shift earnings or expenses from one quarter of the year to another—and sometimes shift cash or debt across an even longer time frame.
What are ways that accountants can manipulate the common financial indicators? Here are a few tricks that are legal in certain circumstances.
Perhaps a professional investor could research a company thoroughly to see how its cash flow and reserves changed compared to its earnings and expenses, while also monitoring those potentially misreported categories such as "other income" or "non-recurring expenses". However, I do not have enough time or expertise to do this work.
(I am not an accountant, and hope I have summarized this topic accurately. My information was taken from resources such as Investopedia and news articles such as this one.)
Besides the share price, there are three financial indicators I do find helpful.
Although none of them can provide a "green light" that reliably shows a company is a good investment, they can provide "red flags" that a company might not be a wise investment despite its strong historical performance.
Both Google Finance or Yahoo! Finance provide pages of data about companies in a section called "Financials". There are two subsections, called "income statement" and "balance sheet".
On the income statement section, under annual data, I look up the Diluted Normalized Earnings Per Share. This provides a rough idea about earnings without quite as many accounting tricks.
On the balance sheet section, under quarterly data, I look up three items. All of these three are counted in millions.
The first is the Total Debt. How much does the comapny owe?
The second is the Total Equity. Equity is like a company's "war chest". It is an estimate of how much more the company has than what it owes. It is different than cash: if I borrowed $1,000 then I would suddenly have an extra $1,000 of cash as well as an extra $1,000 of debt—but no change in equity. Just like a "war chest", equity can include junky stuff (to acquire a small competitor the company paid much more than the acquisition was worth) or ancient stuff (the company was profitable twenty years ago but has been sitting on those profits ever since instead of using them wisely).
The third item from the balance sheet is the Total Common Shares Outstanding. How many shares of stock are out there for this company?
Then I use those four numbers to do three calculations.
Calculation One: Equity as a Percentage of Market Capitalization
Consider Total Equity ÷ Total Common Shares Outstanding ÷ Share Price.
This tells you what portion of each share of stock is equity.
This number is a red flag if below 10%.
The company might be healthy and well-managed. But it has a small "war chest". It does not have a lot of flexibility to do strategic things if economic conditions change. It does not have a stockpile of resources that give it an advantage compared to a newly established rival.
Calculation Two: Leverage Percentage
Consider Total Debt ÷ Total Equity.
This tells you how easily the company can pay off its debts.
This number is ared flag if above 100%.
Not all debt is bad for a company. For example, borrowing money to build another factory might allow additional earnings far greater than the amount of that loan. Using small debt to pay for bigger growth is called "leverage". A healthy company need not behave as if it is allergic to debt. Leverage is like a crowbar: it can be a heavy thing to carry around needlessly, but sometimes it is the right tool to get a job done.
However, if the company is deeper in debt that the value of its "war chest" then it could have trouble paying off its debt. The company might be healthy and well-managed. Perhaps it is currently so profitable that it is buying new infrastructure with confidence that the new debt is not a risk. But it is has more worry about debt than a less-leveraged company.
Calculation Three: Years to Buy Itself
Consider Share Price ÷ Diluted Normalized Earnings Per Share.
Imagine the company tried to use all of its profits to buy a copy of itself. How many years it would this take?
This number is a red flag if above 25.
This calculation is yet another way to measure whether a company has an advantageous position compared to a newly established rival.
First, a qualification. Remember that I am a lazy, amateur investor. A real economist would know enough to adjust the red flag criteria for different industries. Perhaps real estate companies need more leverage than health care companies? I do not know. I do not care. I just want some quick numbers to slow me down when I might be about to make a bad decision.
So I have two rules.
First, I hesitate to buy stock for any company with any red flags. The historical performance tempts me. But I am wary. This is not a firm rule. But I must really understand why I am making an exception.
As one example, at the time I write this essay the "Years to Buy Itself" for Amazon is an amazingly high 1,410. However, I know that Amazon is busy spending all of its profits to improve its website, offer new services (recently the first free music for Prime members), refine its infrastructure, and release new products (recently the first Kindle phone). The company has minimal earnings because it is solidifying its presence in several portions of the economy. The company's historical performance is strong and it has no other red flags, so I am not worried.
Second, I strongly consider selling investments I own with two red flags. Something has changed for the worse since I bought that stock.
As an example, at the time I write this essay UPS and FedEx are struggling for dominance in their industry. A year ago UPS was doing better with my three financial indicators. Now it has three red flags, while FedEx has none. Time to switch which company I am investing in.
(Tangentially, since I used Blackrock as my example above I should mention that currently it's three numbers are 50% equity as a percentage of market capitalization, 31% leveraged, and 72 years. No red flags!)