While there's no single 'right' way to buy ASX shares, buying when a share is trading at a discount to the sum total of its worth based on earnings, dividends, equity and debt – aka intrinsic value – means you are more likely to make money. That's because the price at which you enter a stock has a major bearing on your future returns.
But avoiding paying too much for ASX shares is easier said than done. As an investor, you don't have the resources to analyse companies across key criteria like growth, value, quality and timing. Even the fund managers and brokers invariably get it wrong. That explains why after 10 years, 85% of large cap funds underperformed the S&P 500, and after 15 years, nearly 92% are trailing the index.
The key to maximising future returns is to understand a handful of financial ratios, plus some other key indicators. Do this and you'll significantly improve your ability to buy the right shares at the right price.
First, the key financial ratios
No single piece of data should ever be looked at in isolation. The smarter approach is to draw from a handful of criteria to get a much better snapshot of a share's overall health. Firstly, let's take a look-see at the financials.
- Price-to-earnings growth (PEG) ratio: A combination of the price-to-earnings (PE), divided by the prospective earnings-per-share (EPS) growth rate gives the PEG ratio, which measures the price of earnings growth. Ideally you should be looking for a PEG of less than one. Tip: the lower the PEG ratio, the more a stock may be undervalued relative to its future earnings expectations.
- Price-to-earnings (P/E) ratio: Contrary to the popular belief of many investors, P/E is not a measure of absolute value. As such, it can often raise more questions than it answers. However, a share's P/E – which is its current share price divided by its earnings per share (EPS) – provides a useful starting point for comparing different shares within like or similar sectors. If you're set on using P/E as a measure, you need to understand: A) why it might be low, relative to its peers; and B) the outlook for the next 12 months. If you don't understand these 2 factors, you risk buying value traps, which will drag down your overall portfolio performance.
- Payout ratio: As a percentage of net profit paid out as dividends, the payout ratio is an important proxy into the sustainability of a company's dividend. It also provides strong clues into a company's future growth upside. A payout ratio less than 50% can also signal that the company plans to use surplus cash to grow the business.
- Return on equity (ROE): A key measure of how well management uses its equity, ROE is earnings (revenue minus expenses, taxes and depreciation) divided by equity. As long as debt remains controllable – ideally with a net-debt to equity ratio under 70% – there's no better indicator of business performance than the ROE. Another way to look at ROE is to ask whether or not every $1 used in financial growth is able to convert into $1 of market value.
- Return on investment capital (ROIC): ROIC measures the cash rate of return on the capital that a company has invested. In some cases, it's modified by replacing earnings with earnings plus the interest on long-term debt. In this case, a comparison with return on equity (ROE) determines whether the company benefitted from the extra debt. Assuming the return on equity (ROE) is higher than ROIC, the debt has succeeded in adding value to the business.
- Earnings per share (EPS) growth rate: Within normal markets, share prices typically increase if EPS increases. And the faster a company grows its EPS, the higher those earnings tend to be valued.
Next, the more qualitative measures
It's important to overlay the above key financial ratios with some important measures of growth and value. Digging around in the annual report can provide valuable insights into:
- Management's track record and industry knowledge. One key element to look for within managements' talents is evidence they've carved out a sustainable competitive advantage for the business. Without it, a company can't generate long-term, above-market returns.
- Sales activity: There's no smoke and mirrors here, either a company's revenue has tracked upwards over the long term or it hasn't. If not, why not, and more importantly, when did the rot set in?
- CAPEX, staff numbers and R&D: You want to see sufficient evidence that the company is investing in future growth – this includes its staff. If there is no evidence of sufficient investment, then why not, and equally important – when did the wheels start falling off?
- Structural growth: Unlike cyclical growth, which is vulnerable to the economic cycle, you want to find out how much structural growth is being driven by what's happening inside the business. A shift or change in the basic ways a company functions or operates can signal that it's serious about applying new technology or adopting to regulatory or industry-changing reforms.
A little homework returns in spades
Running a ruler over of any of the stocks you have on your radar – before you buy (or sell) – is tantamount to a health check. The good news is that using the 10 criteria above isn't rocket science; all of the data you're looking for is publicly available.
Instead of buying purely on share price momentum – which isn't investing, it's speculating – this checklist will ensure that at the very least, you're entering stocks with solid balance sheets and sustainable income streams, both of which are needed to support either consistent dividends and/or reinvestment in future growth.
