Studying a Stock
Studying a Stock
To start studying a stock, we suggest that you concentrate on the major features found on every company page of Ratings & Reports. These are:
- The Value Line Ranks: Timeliness, Safety, Technical
- The Analyst's Commentary
- Financial Estimates
- Historical Financial Data
- Annual Rates (of Change)
- Target Price Range
- Projections (of 3- to 5-year stock prices)
- Price/Earnings Ratios
One way Value Line ranks stocks is by their expected price performance relative to all other of the approximately 1,700 stocks Value Line follows, over the coming six to 12 months. The Timeliness rank identifies those stocks followed in The Value Line Investment Survey which are likely to have the best relative performance.
All of the approximately 1,700 stocks Value Line tracks in The Value Line Investment Survey are ranked in relationship to each other, from 1 (the highest rank) to 5 (the lowest rank). Stocks ranked 1 and 2 are expected to show stronger price performance than the remaining stocks, while those ranked 4 and 5 are likely to underperform or have weaker price performance.
At any given time
100 stocks are ranked 1
300 stocks are ranked 2
900 (approximately) stocks are ranked 3
300 stocks are ranked 4
100 stocks are ranked 5
Relative earnings and price growth over the past 10 years is the major factor in determining Timeliness. Companies whose earnings growth over the past 10 years has been greater than the increase in their stocks' prices tend to be ranked 1 or 2. Other factors that influence the Timeliness rankings are stock price momentum, quarterly earnings performance, and earnings surprises.
Stocks ranked 1 and 2 for Timeliness can be more volatile than the market in general, and frequently are stocks of smaller companies.
There are several circumstances that may cause a stock's Timeliness rank to change. This includes:
- The release of a company's earnings report. A company that reports earnings which are good relative to those of other companies may have its stock moved up in rank, while a company reporting poor earnings could see its stock's rank drop.
- A change in the price of a stock can also cause a stock's rank to change. A change in price carries less weight than a change in earnings, but it is still an important determinant. Generally speaking, strong relative price performance is a plus, while negative relative price performance is a minus (relative to all other approximately 1,700 stocks).
- The "Dynamism of the Ranking System." This phrase means that a stock's rank can change even if a company's earnings and stock price remain the same. That's because a fixed number of stocks are always ranked 1, 2, etc. Every time one stock's Timeliness rank moves up or down, another's must also change. As an example, let's suppose one company reports unusually good earnings, causing its stock's Timeliness rank to rise from 2 to 1. Since there can be only 100 stocks ranked 1, some other stock must fall to a rank of 2, even though there has been no change in its earnings or price.
Value Line also ranks stocks for Safety by analyzing the total risk of a stock compared to the approximately 1,700 stocks in the Value Line universe. Each of the stocks tracked in The Value Line Investment Survey is ranked in relationship to each other, from 1 (the highest rank) to 5 (the lowest rank).
Safety is a quality rank, not a performance rank, and stocks ranked 1 and 2 are most suitable for conservative investors; those ranked 4 and 5 will be more volatile. Volatility means prices can move dramatically and often unpredictably, either down or up.
The major influences on a stock's Safety rank are the company's financial strength, as measured by balance sheet and financial ratios, and the stability of its price over the past five years.
Value Line provides a Technical rank for each stock as a predictor of short term (three to six months) price changes. Like the other Value Line ranks, this one is relative, assigning scores to each stock tracked in The Value Line Investment Survey in relation to the others, from 1 (the highest rank) to 5 (the lowest rank).
The rank itself is based on a proprietary model which evaluates 10 price trends over the past year.
Every Value Line page contains a written commentary, describing the analyst's assessment of how the stock will perform in the future. The text section provides an opportunity for the analyst to:
- Evaluate and interpret the data that's available
- Explain the factors that he or she thinks are important to the forecast
- Provide relevant additional information
The analyst's commentary is especially useful when the sales or earnings numbers don't tell the full story about a stock's performance, or when a new trend is emerging. For example, a stock might have a low Timeliness rank, but the analyst may have reason to believe that earnings will turn around in the near future.
The reverse could be true as well. The analyst might caution investors about earnings surprises, expected management changes or other factors that might make a stock less desirable than its recent history might indicate.
The commentary is the forum for explaining why conditions are likely to change, and giving the reader insight into why these changes will happen.
A wide range of financial data is presented in the statistical section in the center of each Value Line page. The numbers to the right in bold typeface are estimates made by Value Line's security analysts. These estimates cover a wide variety of items, some of which are:
- Sales, Earnings, and Dividends Per Share
- Annual Price/Earnings Ratios and Dividend Yields
- Total Sales, Net Profit Margins, Long-term Debt and Shareholders' Equity
In most cases, estimates are made for the current year, the next year, and the period out 3 to 5 years.
The center section of every Value Line page, known as the statistical array, contains a wide range of historical performance information for a company and its stock.
- Some of the historical information is reported for as much as 17 years into the past, some for 12 years, and the balance for 10 years, provided in each case that the company has been in operation that long.
- The data include ratios such as the operating margin, net profit margin, and return on shareholders' equity.
This information helps identify trends in the company's performance. The trends are important because they show whether there has been a consistent pattern across a number of different areas, including sales, earnings, operating and profit margins, and return on equity.
You can use this data to do your own analysis of a stock's potential and to help determine whether or not you want to add it to your portfolio.
Value Line provides historical data and projects future performance for five key measures of a company's current financial health and estimated growth potential.
This capsule summary of important indicators gives you, at a glance, an overview of how a company has been doing and how it is likely to perform in the future.
This data, which is usually positive but can also be negative, is expressed as an annual compound rate of change over the past 10 years and the past five years as well as projected rates three to five years into the future.
The measures are:
- Sales - Gross volume less returns, discounts, and allowances; net sales.
- Cash flow - The total of net income plus non-cash charges (depreciation, amortization, and depletion) minus preferred dividends (if any).
- Earnings - A company's total profit before non-recurring gains or losses, but after all other expenses.
- Dividends - A payout to shareholders determined by the Board of Directors.
- Book value - Net worth (including intangible assets), less preferred stock at liquidating or redemption value, divided by common shares outstanding.
- Annual Rates -Compounded annual rates of change of per-share sales, cash flow, earnings, dividends, and book value (or other industry-specific per-share figures) over the past ten years and five years and estimated over the coming three to five years. All forecasted rates of change are computed from the average figure for the past three-year period to an average for a future three-year period. If data for a three-year base period are not available, a two- or one-year base may be used.
A Target Price Range appears in the upper right portion of each Value Line report, in the same section as the stock price graph. It shows the range in which Value Line's analyst thinks a stock's price is most likely to trade in the three- to five-year period indicated just above.
- The Top Horizontal Line indicates the highest level at which the stock is likely to trade in the three-year period.
- The Bottom Horizontal Line indicates the lowest level at which the stock is likely to trade in the three-year period.
The Target Price Range is based on information available to an analyst at the time a new report is written, but could obviously change in the future. The data is the same as that appearing in the PROJECTIONS box to the left of the graph. (see the next section, Projections)
The stock price PROJECTIONS box appears in the upper left of every Value Line report, just below the stock ranks. This shows:
- The most likely high and low price of a stock in the time period specified.
- The percentage gain (or loss) if the high or low prices are reached.
- The total compound annual rates of return to shareholders (including dividends) if the forecast prices are attained.
The price projections are derived from the forecasts of earnings per share and price/earnings ratios shown in the far right column of the large statistical section. They are based on the best information available at the time a report is written and, obviously, may change in the future.
Earnings per share is the amount of a company's profit or net income after taxes attributable to each of its common shares outstanding. The price of each share is its value based on the last public sale of a share. The ratio between them, or the price divided by the earnings, is the stock's P/E.
For example, if ABC Corp's share price was $22.50 and its earnings per share $1.25, the P/E ratio would be 18. If its earnings were $1.50 and its price $22.50, then its P/E would be 15. And if its earnings were $1 and the price $22.50, its P/E would be 22.5.
There is no "right" or "wrong" P/E, but there is a current median P/E, or midpoint of the ratios of all the stocks Value Line tracks for The Value Line Investment Survey. The median is shown each week on the front cover of the Summary & Index section. On March 8, 2013, for example, that median was 16.1. That means that roughly half of all stocks in The Value Line Investment Survey had a higher P/E and half had a lower P/E as of that particular date by that median.
In general, buyers will pay higher prices and accept a higher P/E to own the stock of a company whose earnings they believe will grow at a faster rate than those of the average company. In fact, one of the fascinating things about investors is that they are often willing to pay high prices for certain "hot" stocks that have low, or even no, earnings on the anticipation that they will be money makers in the future. The reverse is also true.
Value Line computes the P/E ratio that appears at the top of the Value Line page (highlighted) using the current price and an earnings figure that typically includes six months of past performance and six months of anticipated earnings based on the analyst's assessment of current data. In contrast, a trailing P/E is a ratio of the current price to the past year's worth of reported data.
A trailing P/E, which is the number usually reported in the financial press, can sometimes be misleading if you're considering buying a stock, because it does not give you information about future expectations. A company whose earnings are about to fall might appear to be selling at a modest P/E based on reported data. But if, in fact, the company reports a big drop in earnings in the near future, the price may also drop and any advantage offered by the modest P/E will disappear. That is the type of information a Value Line analyst is alert to, and the information can influence a P/E that includes six months of projections.
Value Line also provides the 10-year median P/E that puts the recent P/E in historical perspective. This information shows what investors have been willing to pay for a stock in the past. If the current P/E is higher than that median, it suggests that investors are optimistic that the company's earnings will grow.
Remember, though, that general economic conditions and the momentum of the stock market itself also exert a major impact on stock prices and therefore on P/E ratios. If valuations in general are high, a company's current stock price may be higher than it might be in more "normal" times.
You can use the P/E as a factor to help evaluate whether or not to buy a particular stock at a particular time.
- If you believe that earnings are going up and that the current price/earnings ratio will be maintained, you might want to buy now, because you may benefit from a future earnings increase.
- If the earnings estimate is for continued growth but the P/E is already high, you may want to wait for a dip in prices in the market as a whole for an opportunity to buy without paying more than you want to for the stock based on the total return you anticipate.
Stocks of companies whose earnings grow quickly tend to have higher P/E ratios than stocks of companies whose earnings grow more slowly.
Suppose ABC's earnings had been growing at an annual rate of 13% over the past five years, it was selling at a price of $22.50 a share and had a P/E ratio of 18. If the company's earnings are expected to jump from $1.25 this year to $1.50 next year, that would be a 20% growth rate [$0.25 ÷ $1.25 = 20%]. Suppose also that ABC has developed a hot new product and it appears that the new, stronger rate of earnings will persist for several years?
In that case, investors will probably be willing to pay more for the stock and be willing to accept a higher P/E ratio than that of the general market. For example, if the price went up to $30 a share based on earnings of $1.50 a share, the P/E would be 20 [$30 ÷ $1.50 = 20].
Price/earnings ratios and stock prices can also go down. If earnings are expected to fall, e.g., to $0.96 a share, investors looking at the reasons for the weakness may conclude that the company's business prospects have dimmed. If that happens, the price may slide, perhaps to $11.50, which produces a P/E of 12 [$11.50 ÷ $0.96 = 12].
First, read Value Line's current summary and opinion of the economy, the stock market, and advisable investment strategy entitled "The Value Line Equity View" in Selection & Opinion.
Remember that it is not necessary for the ordinary investor, who usually has other business interests, to read everything that is published. The service is so organized that it can also be used as a reference. You can look in the Summary & Index every week to find updated references about stocks that you own or in which you may be interested. The stock ranks also provide you with buy and sell recommendations, which you may act upon.
We must caution that a prudent investor ought to think of stocks as components of a portfolio, rather than as single entities. Diversification reduces the overall risk of stocks within a portfolio to below that involved in holding one single stock. Diversification is an important advantage, long recognized by sophisticated investors, yet often ignored by many who think in terms of single stocks without reference to the portfolio as a whole.
Second, look at industries ranked in order of Timeliness in the screen on page 24 of the weekly Summary & Index. To be sure that your portfolio is diversified, pick from the that list at least six industries shown to be most timely -- i.e., those industries ranked one through six.
Third, look to the 100 stocks ranked 1 (Highest) and the 300 ranked 2 (Above Average) for Timeliness. These ranks for relative performance for the next six to 12 months appear in both Ratings & Reports and in the weekly Summary & Index. (Once a stock ranked 1 or 2 for Timeliness has been bought, it may be held until its rank drops to a 3, 4, or 5.)
Timely Stocks Within Timely Industries
Fourth, pick at least six stocks that are in the top-ranked industries. Then, if possible, pick at least four or more stocks -- either those that also have Safety ranks of 1 or 2 and are within the top 12 industries or those that ranked 1 or 2 for Timeliness or safety, even though the industry isn't top ranked. To narrow the list, follow steps five through seven. Remember that the suggested diversification is ten or more stocks.
The Big Picture
Fifth, read the industry comments that precede the stock report to see the big picture of the long-term growth patterns of earnings and values for stocks in the industries you are interested in.
Sixth, from the stocks selected so far, choose those that also conform to your safety requirements.
If you are a conservative investor, or if you think the market is headed lower, give preference to stocks ranked 1 or 2 for Safety.
If you are bullish on the market and are willing to buy more volatile, or riskier, stocks, accept those with lower Safety rankings from 3 down to 5.
A low safety rank may be acceptable when the market is undervalued. At such a time, riskier stocks are usually depressed. Since they are apt to be more volatile, they are capable of rising faster when confidence in the market is restored.
Seventh, select from the remaining choices stocks that meet your current dividend requirements. Dividends for the coming year are shown in the Summary & Index and on Ratings & Reports pages, as well as many screens and articles that appear in Selection & Opinion. Bear in mind that it may be difficult to find a stock that is ideal on all counts. It may be necessary to trade off, accepting a lower dividend yield, depending upon the relative importance of your various goals. For example, conservative investors may at times have to select stocks ranked 3 for either Safety or Timeliness.
Value Line University has provided a basic tutorial for those getting started with the important job of building their own investment portfolios. We have introduced you to the tools you need to analyze the fundamentals underlying the Value Line approach to building a portfolio. For more knowledgeable investors, the links to various pages of The Value Line Investment Survey provide more complex and detailed information.
All investors, of course, must always bear in mind that the market constantly changes, that with change come surprises, and that there is always risk. Fortunes have been made and lost in the stock market, but over the long term, the stock market has outperformed all other investment options. Nevertheless, risk is always there.
And that is why every investor, or potential investor, must carefully determine his or her risk tolerance and set clear investment goals that reflect that tolerance. We hope we have shown you how to do just that at Value Line University.