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Some Famous Numbers
When Peter Lynch's investing classic One Up on Wall Street was first published, it was almost immediately adopted as a bible of sorts by retail investors. Lynch's Magellan Fund had been on an absolute tear, returning some 29% a year over 13 years, so the book had a wide audience.
Among some of the best observations made in the book are that there are specific ways to measure whether to buy or sell a stock. Lynch breaks these rules down into what he calls "some famous numbers." Let's take a quick look at what each of these measures is and why one of the all-time investing greats thinks you can invest successfully by using them.
Percent of Sales
Although Lynch suggests that the numbers are presented in no particular order of importance, the "percentage of sales" concept has likely gotten more would-be investors off track than almost any other. In the 21st century, we have an absolute deluge of information, with data points resembling grains of sand on a vast beach. Making sense of the data and ignoring as much of the background noise as possible is what this metric is all about.
If there's some news about a company's development. Ask yourself how important the news is to the company's overall big picture. If a small company has to pay a $10 million fine, they might go out of business, but when Amazon tries a new phone out and loses several hundred million dollars, it's important to keep in mind that hundreds of millions of dollars is hardly a tiny blip on Amazon's P&L.
With any news story about a company, start by asking yourself whether the story is even material to the company. If it's a large-cap, the chances are good that you can safely ignore this piece of news and move on to the next.
Price-to-Earnings Ratio and Growth
The P/E ratio is an absolute must-have in order to understand whether a company is fairly valued, a screaming bargain, or criminally overpriced. While P/E can tell you about accounting profit and loss, most value investors also consider the cash flow situation, since P/E can tell a misleading picture in isolation. Nevertheless, you can often get a quick idea of how two or more businesses in the same industry are priced relative to one another simply by glancing at this single ratio.
Beyond this classic and well-known measure, Lynch has a fantastic observation of his own to contribute here. You can compare whether the P/E of a company roughly equals the growth rate of its earnings. If a company has a P/E of 10 and has been growing its earnings at more than 10% per year, it very well may be a buy, according to Lynch.
If a boring company like Phillip Morris can raise its prices, it can make up for declining or flat sales and can still increase earnings. By considering earnings growth and not just revenue growth, you find some companies you might not typically think of as underpriced.
Cash Position and Debt
This is among the most intuitive observations, something you probably grew up understanding—if a company has more cash than debt, it's going to be really, really tough to go bankrupt. In fact, cash can often be a hidden asset that's underestimated by Wall Street, particularly if the cash amount is material to the price per share.
You might be able to find a stock selling for $10 a share with $5 in cash, so you're really buying the company for $5 a share. This might be the margin of safety you're looking for.
Similarly, debt-to-equity is an excellent measure that can help you get an ultra-quick appraisal of the financial health of the business. Lynch's example says a normal business has 75% equity and 10% debt, although it's prudent to understand that there can be wide differences in what is considered an acceptable level of debt in a particular industry.
Debt is particularly important if you're considering a turnaround play by buying a business that appears to be near its last legs but is showing signs of recovering. It's also prudent to consider the type of debt and when it will come due.
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Who doesn't want to get paid just for owning a stock? The question of how much always boils down to the dividend payout ratio, and if a company has already intelligently put its cash to use, whatever is left over may be paid out in just such a manner.
It might even be appealing to own a dividend stock that's going down in price since you can set up a DRIP (Dividend ReInvestment Plan) and simply buy more when the price is down while still getting paid. Always consider total return when considering stock performance, so be sure to include dividends when thinking about what a stock is worth. Dividends often put a floor under the price of a blue-chip company, so it might not drop nearly as much as the rest of the market if there's a crash or correction.
It's important to be sure the company will continue to pay dividends in the future, so Lynch suggests buying companies with a long history of paying dividends (preferably increasing over 20 or 25 years) and little debt.
Book Value and Hidden Assets
You have to be careful not to put too much weight into book value, since the number on paper might not reflect what you can actually get for the assets of the company. The closer you get to a finished product, the less a product is generally worth, meaning a large amount of inventory on a company's books might actually be worth a great deal less if it has to be sold quickly, or if it goes unsold for a long time.
Be careful when considering what's on the balance sheet, and remember that the debt is a very real number, while the value of the assets should be thought of as more of a guess (or sometimes even an accounting technicality). Later in the chapter, Lynch goes on to mention that a pension plan can be an especially problematic hidden liability since pensions have to be paid under all circumstances before anyone else is paid.
Inverting this disappointing prospect, there can often be hidden assets on the balance sheet that cause the company's value to go up considerably. Lynch uses the examples of a company with precious metal assets that report a price from when they first had them appraised, and the vast amount of land that railroad companies own appraised decades ago, now worth many times the recorded value.
There are often company-owned subsidiaries, too. Sometimes, the subsidiary may actually be responsible a large portion of the company's share price, and this can give you a free bonus as a shareholder in the larger company. Finally, there may be future tax breaks that can materially affect a company's earnings, giving an enormous boost to share prices in the near term. Consider whether these hidden asset numbers should be updated when contemplating balance sheets.
Here's where the rubber hits the road for DCF analysis. While looking at earnings is important, the amount of cash a business has may be a much better indicator of its health. Understanding how much money is flowing in and out—and at what pace—is crucial to valuing a company.
Consider whether the business will have to add more cash constantly, or if they have a license to print money. Make sure you're looking at free cash flow, though, as opposed to operating cash flow. If a company has more cash coming in than it's going to need to spend, it's very likely that the owners of the company will be rewarded with the extra cash, either via dividends or share buybacks.
During the "Hidden Assets" and "Book Value" sections, Lynch touches on the idea that inventory sitting around for a long time may lose value, and he expands on this concept here. Understanding LIFO (last in, first out) vs FIFO (first in, first out) measures for inventory are important for us to have in our toolbox.
If inventories are up 30% and sales are worth 10%, this might not be the best business to invest in since goods may continue to pile up with nowhere to sell them, and the value of the goods not yet sold might go down over time. On the flip side, consider that there might be some hidden assets among inventories.
The Bottom Line
Profit after taxes is among the most important ways to measure how a business is doing. Keep in mind that it's not useful to compare profit margins across industries. Within an industry, however, taking a look at whether company A or company B has a better profit margin is a really simple comparative pulse check.
Profitability can matter even more if there are hard times for the company, with a more profitable company still making money even as revenues drop. On the other hand, a company with a relatively low profit margin would be better during a turnaround for the opposite reason. Lynch finishes One Up on Wall Street with this metric, underscoring how important he believes it to be.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.