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Valuation ratios tell you something about whether the market is
pricing your candidate as a value, growth, or momentum stock. In this
context, value stocks are out of favor; that is, they are of no interest to
most market participants who prefer growth stocks. Momentum-priced
stocks are not really a separate category; rather they are the most in-favor
subset of the growth category. They have already substantially
moved up in price, outrunning their fundamentals, and hence represent
higher risk than growth-priced stocks.
Multex displays four valuation ratios: price/earnings (P/E),
price/sales (P/S), price/book (P/B) and price/cash flow (P/CF). Each
valuation ratio has its pluses and minuses. Your goal at this point, however,
is simply to determine you candidate’s category. The P/S ratio is,
in my view best suited to the task. Again, there’s no universal standard,
but here are some guidelines for using the P/S ratio:
Use these guidelines to rule out stocks that clearly don’t fit
your investing style, but since they’re arbitrary, don’t take them too literally.
For instance, a value investor shouldn’t reject a stock because
its P/S is 2.6. Nevertheless, it would be unusual to find a worthwhile
value candidate with a P/S ratio of 5, for instance. Conversely, it’s unlikely
that a growth investor would find a stock with a P/S of 0.5 that
had sufficient earnings growth potential to qualify as growth candidate.
Growth investors will find momentum-priced stocks interesting,
but caution is advised. Use these guidelines to avoid obvious misfits,
not as a final arbiter of value.
Trading Volume
Trading volume, also referred to as liquidity, is the number of
shares traded daily, on average. When considering trading volumes,
higher is usually better. Stock message boards on Yahoo and other sites
are filled with postings intended to move a stock price up or down. It’s
not hard, with a well-crafted message, to motivate gullible investors to
buy or sell enough shares to move a stock’s price if only 10,000 shares
trade daily. It’s another story if, say, a million shares trade every day.
There’s another equally important reason to prefer high trading
volume stocks. You want mutual funds and other institutional buyers to
buy stocks that you own, because it’s their buying pressure that usually
moves a stock price up.
Institutions have hundreds of millions, if not billions, of dollars
to invest. They must buy many thousands of shares to take a meaningful
position. These large buyers prefer stocks that trade enough shares daily
to enable the institution to move into or out of positions without disrupting
the market for the stock. Obviously, they can’t do that if only a few
thousand shares trade daily.
As a rule of thumb, avoid stocks with daily trading volumes below
50,000 shares, and higher is better. When I looked, Comverse Technology’s
5 million share trading volume easily qualified.
Float
Stock prices, like the prices of so many things, respond to the
laws of supply and demand. Stock prices move up if buyers want to buy
more shares than sellers want to sell, and vice versa. Ideally, when good
news hits the wires for a stock you own, you’d like to see buying demand
overwhelm the supply. It stands to reason then, in terms of supply,
smaller is better, at least up to a point.
The supply side of the equation starts with the number of shares
outstanding; that is, the number of shares issued by the corporation. But
that’s not the total story. Insiders such as key executives, directors, and
other large shareholders hold some of those shares. Insiders can’t freely
trade their shares. They can only trade at certain times, they must notify
the SEC of their trades, and there are other limitations on their trading.
So shares owned by insiders are not considered available for daily trading.
The number of shares that are available for trading, which is the total
shares outstanding less the insiders’ holdings, is termed the float.
Multex lists the float as well as the total number of shares outstanding
on its Snapshot report. By the way, you can determine the
shares held by insiders by subtracting the float from the number of
shares outstanding.
While in terms of supply and demand, smaller is better, a too
small float would dissuade institutional investors. As a rule of thumb,
below 5 million shares is too small, and a 10 million to 25 million-share
float is ideal. However most stocks won’t fit that criterion. For instance,
Microsoft’s float exceeds 5 billion shares.
Multex listed Comverse Technology’s float as 186 million
shares, about typical for a mid-cap stock.
Cash Flow
Cash flow is the amount of cash moving into, or out of a company’s
bank account generated by its basic business. Very fast-growing
companies often burn cash (negative cash flow) in their early stages.
However companies growing sales 30 percent or less annually should be
generating positive cash flow. Growth investors should require positive
cash flow of candidates in that category and would be well served by
avoiding cash burners entirely.
Value investors need candidates capable of producing large
cash flows, but they may not be doing so now, due to their current
problems. Therefore, value investors should not eliminate cash burners
at this stage.
You can tell if a company is burning cash by looking at its
TTM (trailing twelve months) cash flow per share listed on the Snapshot
report. The TTM cash flow will be negative if the company is a
cash burner. Multex listed Comverse Technology’s cash flow as $0.29
per share, indicating that its trailing 12-months cash flow was positive. |
Disclaimer
