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ProThinker helps you to make data-driven stock decisions.
Instant analysis of all aspects of a stock including visual representation of what a stock is worth and why. Covers the following areas:
When calculating the fair valuation of a stock, ProThinker relies on five indicators, which together take into account all the main aspects of the company. These five indicators are Price to Earnings, Price to Sales, Price to Cash Flow, Price to Book and Dividend Yield. There are countless valuation indicators out there but they are all variations of these five indicators.
Investors know that they need to use multiple valuation indicators to value a stock but when they do so, they face certain dilemmas. Different valuation methods arrive at widely different valuation for the stock. Which one to pick? For example, below is the valuation of Apple’s stock using different methods.
When Apple was trading at around $155, was the stock undervalued or overvalued? If you rely in DCF, it is undervalued and if you rely on Graham Number, it is overvalued. The dilemma in choosing the indicator to rely on is difficult because often you don’t have a visual representation of how well the stock price has correlated with that indicator in the past.
ProThinker’s method of valuing stocks is vastly different. Rather than using various indicators separately, which give you different signals about the company, we examine all possible combinations of the five indicators above to come up with the best combination that mathematically best explains the stock price. We then show you visually how this Composite Valuation Indicator moves with the stock price so as to give you confidence to act on the data.
Knowing whether a stock is currently undervalued or overvalued is only part of the process in looking for a good stock. An undervalued stock may remain undervalued if its fundamentals are poor while an overvalued stock may grow into its valuation as fundamentals continue to improve. Therefore, knowing where the fundamentals of a stock – its sales, earnings, cash flow, book value and dividends – are heading is key to determining its future share price direction. We provide a visual representation of where the fundamentals are heading in our graphs (see above).
We also analyze the historical and future growth prospects of the company. Growth companies like Facebook will experience slowdown in growth as the company gets bigger (see below). When this happens, the high valuations that the stock is trading at will come down. We adjust our valuation expectations in line with this growth slowdown to give investors a realistic target price.
While profits are important, cash is the lifeline of a business as expenses have to be paid in cash and not profits. An analysis of the cash situation of a company reveals a lot about its financial health. General Electric is an example of a stock that languished because of cash flow problems. A cash flow analysis of the company would have revealed problems as early as 2015 (see our cash flow analysis below).
While the giant conglomerate generated a cash from its operations (the purple boxes), negative cash flow from financing activities (the green boxes representing debt servicing and dividend payment) resulted in an overall cash flow deficit. In order to plug this gap, the company had to raise cash from investing activities (the red boxes represent money raised by selling away businesses), which will have an impact on future profitability and cash flow.
Dividends are an important component of our total return on a stock and many investors rely on dividends as part of their income. While it is tempting to just go for stocks that have high dividend yield, our analysis goes deeper to determine whether the current dividends are sustainable given the company’s situation.
In the case of General Electric, while the company generated positive cash from operations, a lot of that is spent on capital expenditure which means that the remaining free cash flow is declining. As dividends have to be paid from cash, this may impact future dividend payments.
Indeed, analysts are already expecting that dividends are going to be cut at the company.
A drop in dividends is detrimental to an income investor as not only will he receive less regular payouts, the stock price of a company typically falls when dividend cuts are announced.
In addition to raising cash by selling businesses, General Electric also resorted to raising cash by issuing new debt. As a result, the financial condition of the company is rather weak and near the distressed zone.
Quality of Earnings
Companies are becoming increasingly creative in their earnings calculation and this could sometimes fool even the most sophisticated investors. A recent example is Valeant Pharmaceutical, which later admitted that earnings recognition had been overly aggressive and are restating past earnings. This caused the stock to nosedive.
Source: Yahoo Finance
The good news is that there are tools that can access the likelihood that a company is manipulating earnings. However, since no single tool can spot all instances of earnings manipulation or overstatement, ProThinker relies on multiple methods to access the quality of a company’s earnings and the likelihood that this earnings have been manipulated.
Before the bomb dropped in 2016, Valeant already had multiple years whereby earnings quality had been poor. Therefore, one way to avoid such earnings disappointment would be to avoid companies that show symptoms of poor earnings quality until you see consistent improvement in the quality of its earnings.
Return on Equity
Return on Equity (ROE) is a favorite metric used by some experienced investors. Warren Buffett, for example, likes to invest in companies that plough back earnings and are able to reinvest them at high ROE. Joe Greenblatt encourages people to invest in stocks that are both low in PE and high in ROE. When we examine a company’s ROE, not only is the absolute level important, we must also examine the trend of the ROE and what caused it to go up and down. In other words, just because a company’s ROE is high does that mean it is a good thing or it is sustainable.
There are several ways that ROE can be increased. Ideally, ROE should go up with Asset Turnover goes up (i.e. company can generate more revenue from its assets) or when Net Profit Margin goes up or both. However, at times, the company takes on more debt in order to boost its ROE (i.e. grow the business with borrowings while keeping share capital constant). This is what happens in the case of Apple. While ROE has remained high in the last few years…
…Asset Turnover actually declined through the years (i.e. Apple is generating less revenue from each dollar of asset)…
…while Net Profit Margin stays rather constant.
How then is Apple able to keep its ROE high with declining Asset Turnover? The next chart shows that ROE is boosted via additional borrowings. Fortunately, the financial condition of the company is still strong even with the increased debt.
Contrast this to Facebook’s Return on Equity. Although its ROE is not as high as Apple’s, it has grown over the last few years.
And the cause of the ROE’s increase is an improvement in Asset Turnover…
…and an improvement in Net Profit Margin…
…while the level of borrowings in relation to equity remained the same.
The Piotroski Score is an overall measure of a company’s operational efficiency. It measures multiple aspects of the company’s business such as profitability, leverage, liquidity, etc. Studies have shown that companies with high Piotroski scores performed well in terms of share prices. The Piotroski Score ranges from 0 to 9 with 9 being the best.
Applied Materials is an example of a company that currently has a perfect Piotroski Score.
And the stock has also done well and its PE has expanded in recent years.
The following technical indicators are available for each stock.
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