When we’re looking for the best investments to recommend in our newsletters and investment services, including our flagship publication, The Successful Investor, we start by putting all the important information we know about a company into perspective. That new invention may be a marvel, but how does it compare to what the competition is doing? The new project sounds impressive, but how much impact will it really have on the company’s profit? The debt sounds high — will the company be able to keep up its agreed-upon interest and principal repayments? Investors intuitively understand this, but they often find it hard to apply when they are looking for the best investments to add to their portfolios. Financial ratios are one way to spot the best investments, but the answers you get can be ambiguous, if not misleading. For instance, if a company takes on a large debt, you can test how big a burden it will be by calculating its interest coverage. To do that, you divide its yearly profit by its yearly interest costs. The higher the number, the better. If its profit is 10 times bigger than its interest cost, it can suffer a big earnings downturn and still keep up its interest payments. If its profit is 1.0 times its interest cost — equal to its interest costs, in other words — it has no margin of safety. Any earnings downturn will leave it short of cash to cover its interest.
Spotting the best investments: Unusual conditions can skew your view of a company’s prospects
But things are never quite so simple. Your stock pick’s latest earnings may reflect unusually favourable or unfavourable conditions. This can make the company look safer or riskier than it really is. In addition, the company may put the funds it borrowed to immediate profitable use, increasing its earnings and its ability to pay interest. It may plan to sell assets to reduce debt, or cut costs to increase earnings.
[ofie_ad] The debt/equity ratio is another way to assess the company’s financial condition. The conventional idea used to be that a debt/equity ratio should be less than 1.0; this is, debt should be less than equity. But the conventional definition of equity only includes capital invested in a company, plus earnings that were retained in the business rather than paid out. For many companies today, this is not a particularly accurate way to look at things. That’s because the company’s main value is in assets that it built out of a tiny asset base. In cases like this, it may make more sense to compare a company’s debt to its market capitalization or “market cap” — the value of all of its outstanding shares. Market cap tells you what the market thinks a company is worth. When looking for the best investments, market cap often makes a lot more sense than the equity value that appears on the company’s books.
There’s no single indicator of a company’s value
In the end, there are many ways to try to put the facts about a company into perspective. None are perfect, since all involve a mental balancing act between high and low estimates, history and the future, and faith versus skepticism. Our goal, through The Successful Investor and our other newsletters and investment services, is to put the information in a form that lets us weed out the extremes — excessively overvalued stocks, and those that are suspiciously cheap.
In the long run, investors make most of their profits in investments that offer good value and an attractive long-term outlook. You can get our advice on investment issues, plus buy/sell/hold advice on stocks you may be considering buying in our Successful Investor newsletter. Click here to learn how you can get one month free when you subscribe today.
