The Profits from Hidden Value

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Canadian Value Stocks:
How to Spot Undervalued Stocks
PLUS! Our Top 4 Value Stocks

Topic: Value Stocks

Stock analysis websites can be a valuable tool for investors—if you know what to look for

Paying attention to tips and strategies from stock analysis websites—and in particular our web site—can help you make more informed stock buying and selling decisions

Stock analysis websites can provide an array of information to investors. And while we are of course biased, we think is the best one out there. Here’s just one reason:

Experienced investors will often check out a company’s debt-to-equity ratio using stock analysis websites. But we think there’s a better metric to look at. Here it is:

The Profits from Hidden Value

Learn everything you need to know in 7 Pro Secrets to Value Investing for a FREE special report for you.

Canadian Value Stocks:
How to Spot Undervalued Stocks
PLUS! Our Top 4 Value Stocks

Many investors use stock analysis websites to find debt-to-equity ratios. However, that may not be the best way to assess a company’s debt.

This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity. In essence, you assume an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of its capital.

In that case, excess profits accrue to shareholders, and that in turn raises shareholders’ equity on the balance sheet. But leverage works both ways. If the total return falls short of interest payments, the difference comes out of shareholders’ equity.

A high ratio of debt to equity increases the risk that the company won’t survive a business slump.

However, a debt-to-equity ratio can mislead, because it compares a hard number with a soft one.

Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are not as precise. They mostly reflect asset values as they appear on the balance sheet—minus debt, of course.

But a balance sheet’s equity value can be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance-sheet figures by trimming them back or “taking a writedown.”

Or, the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate and other investments.

Instead of debt-to-equity, we prefer to use the ratio between a company’s debt and its market capitalization, or “market cap” (the value of all shares the company has outstanding).

Market cap may differ widely from the net value of a company’s assets, just like the shareholders’ equity figure on the balance sheet. However, a moderate debt-to-market cap ratio will tend to provide a conservative starting point for analyzing a company’s chances of survival.

Bonus tip #1: Use a break-even analysis to determine your potential gains—and losses— on stocks you’re interested in

A break-even analysis is basic arithmetic, but has significant value in analyzing potential gains—and losses—on stocks. For example, if you lose X% in the stock market, you’ll need X% to recover, or break even. An understanding of this relationship can help you stay out of poor-quality stocks where the risk of a big decline is high. For example:

  • If you lose 10%, you need an 11% gain to break even.
  • If you lose 20%, you need to make 25% to break even.
  • If you lose 40%, you need to make 66.6% to take you back to where you started.
  • If you lose 50%, you need a 100% gain to break even.

An 11% gain is relatively common; in fact, the market has gained nearly that much annually, on average, over the past 75 years or so. A 25% gain is a little harder to achieve. You need an above-average year to make that kind of return. Gains of 66.6% to 100% or more can take years. Even if you make enough money to regain your losses, however, that only brings you back to where you started.

Bonus tip #2: Use our three-part Successful Investor approach for better stock selection

  • Invest mainly in well-established, dividend-paying companies, with a history of rising sales if not earnings and dividends.
  • Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities.
  • Downplay or avoid stocks in the broker/media limelight.

What are the biggest problems you have seen with stock analysis websites?

How has a stock analysis website kept you from making a big investing mistake?


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