The main keys to investing
What are important keys to investing?
Many people think about investing money in a major global economy like the US. This can be done with the S&P 500 stock index of over 500 first-class US companies. That doesn’t seem like a lot compared to the roughly 5,000 stocks traded on the US market. However, these 500 companies account for around 80% of the total capitalization of the US stock market.
The Standard & Poor’s 500 is the primary US stock indicator. Its performance influences the GDP of exporting countries and wage growth as well as many derivatives. The entire world tracks the index daily.
As for the companies (components of the S&P 500 index), everyone knows and uses the services or products of these companies, among those are Microsoft, Mastercard, Google, McDonald’s, Apple, Delta Airlines, Amazon and others. If you invest in securities of such major US companies, it may be the best investment you can make.
Is it difficult to build a profitable stock portfolio on your own?
Indeed, it will seem something unattainable for a non-professional. Anyone desiring to start investing needs to have extra money, understand and read company reports, regularly make appropriate changes in their portfolio, monitor market share prices, and most importantly, decide which 500 companies to buy at the beginning of their journey as an investor. Yes, there are some issues, but they are all solvable.
Share price
This is the price of a company’s share at a point in time. It can be a minute, an hour, a day, a week, a month, etc. Stocks are quite a dynamic instrument. The market is unstoppable, and price will be higher or lower tomorrow than it is today. But how do you know what price is good enough to buy, whether it is expensive or not or maybe you should come tomorrow? The answer is simple, there are financial models for determining what is called fair value. Each investor, investment company and fund has its own, but at the heart of these complex mathematical calculations is usually a DCF model. There are many articles explaining DCF models and we will not go into the calculations and examples. The main goal is to find a currently undervalued company by determining its fair value, which is later converted to a price per share. We make daily calculations and find out the fair prices of all components of the S&P 500 Index based on annual reports, track changes in the index and update the data.
Investment algorithm
For the forecasting model to work well, we need financial data from companies’ annual reports. We process this data manually, without using robots or automated systems. That way, we dive into the companies’ financials completely, read and discuss the report, then feed that data into our forecasting model, which determines the fair price. It is essential to have at least 5-year data and look closely at the dynamics of revenue, net income, operating and free cash flow. The very decision to possibly invest in a company comes only after determining the company’s current fair value and value per share. We consider companies with a potential of more than 10% of fair value, but first things first.
Beginning
So, the company’s annual report comes out today. The report must be audited and published by the SEC (Securities and Exchange Commission). Based on section 8 of the report, we make calculations in our model, substitute values, calculate multipliers, and finally determine the fair value. By all criteria, the company is undervalued and at the moment the share value is much lower than the calculated values, let’s go deeper into the report.
Revenue
Let’s look at revenue dynamics (it is a significant factor). Revenue has been growing for the last 3-5 years, it would be ideal if it has been increasing year after year for ten years, but the proportion of such companies is negligible. We give priority to revenue in our calculations—no revenue – no need to include the company in our portfolio. We pay attention to possible fluctuations. For example, during the pandemics (COVID-19), many companies from different sectors have suffered financial losses and the revenue decreased. This is an individual approach, depending on the industry. The best option: revenue growth + 5-10% over the last 5 years.
Net Income
We look at the net profit figure, and it is good if it also grows, but in practice the net profit is more volatile. In this case the important factor is that company has profit, rather than a loss, which is 10-15% of revenue. Of course, a strong decline in profit will be a negative factor in the calculations. The best option: a profit of 10-15% of revenue over the last 5 years.
Assets and liabilities
We go to the balance sheet and see that the company’s assets increase year after year, liabilities decrease, and capital increases as well. Cash and cash equivalents are increasing. We pay attention to the company’s overall debt, it should not exceed 45% of assets. On the other hand, for companies from the financial sector, it is not critical, and some feel comfortable with 60-70% debt. It is all about an individual approach. We consider only short-term and long-term liabilities, credits and loans, leasing liabilities. The best option: growth of company assets, total debt < 45% of assets, company capital more than 30%.
Cash flow
We are immediately interested in the operating cash flow (OCF), growing year by year at a rate of 10-15%. We look at capital expenditures (CAPEX), it may slightly increase or remain the same. The primary indicator for us will be free cash flow (FCF) calculated as OCF – CAPEX = FCF. The best option: growth of cash flow from operations, a slight increase in capital expenditures, and most importantly, annual growth of free cash flow + 10-15%, which the company can spend on its further development, or as an example, on repurchasing of its shares.
Dividend
Apart from everything else, we need to pay attention to the dividend policy of the company. After all, we like it when profits are shared, even just a little bit, for our investments in the company. If the dividend grows from year to year, it only pleases the investor. In addition, the overall return on investment in companies with a dividend should increase. Many investors prefer a “dividend portfolio,” investing in 15-20 dividend companies with yields of 4-6%, in addition to the growth in the value of the shares themselves. The best option: annual dividend and dividend yield growth, dividend yield above the average yield of S&P 500 companies.
Multipliers
Moving on to the multiples of the company, they are all calculated using different formulas. When calculating the same multiplier, you can use two or three formulas with a different approach. We tend to lean toward the average. The critical indicators are the 3, 5 and 10-year values. The index for ten years has the lowest influence in the calculations as well as the annual. In today’s economy, we consider 3 and 5-year indicators to be the most important ones.
The number of multiples is enormous and it makes no sense to calculate every single one of them. We should pay attention only to the major ones. Among them are Price/Earnings ratio (P/E), Price/Cash Flow ratio (P/CF), ROA and ROE, Price/Book (P/B), Price/Sales, Enterprise Value/Revenue (EV/R), Tangible Book Value, Return on Invested Capital (ROIC). It is necessary to look at these indicators in dynamics over 5-10 years. The best option: price/profit and cash flow ratios are declining or are at the same level (these ratios should be less than 15), efficiency ratios are increasing year by year and moving towards 30, other ratios are above average in this sector.
Let's summarize
This is a small set for investors. Of course, there are many indicators in a company’s annual report, the important ones include operating profit, depreciation, earnings before taxes, taxes, goodwill and many others. We prepare the key and most important financial indicators, you can save a lot of time and research all companies in the S&P 500 Index.
Now we have a general idea about the financial health of the company. We made some calculations in our financial model, where we determined the percentage of undervaluation at the moment and made a decision whether to buy shares of this company or not. There are no impediments. Allocate 5-8% of your available budget and buy the stock. Remember to diversify your portfolio. Buy undervalued companies, 1-2 in each sector. There are 11 sectors in the S&P 500. Choose only those companies whose business you understand, whose services you use or whose products you buy. Do not rush the calculations in your model, if you are not sure, do not invest in this company.
Surprisingly, an undervalued company may not reach its value for a long time. The dividend paid will improve the situation. Beware of companies with information noise. As a rule, they talk a lot but do not do much.
The S&P 500 index of companies has been yielding an average annual return of 8-10% for many years. Of course, there have been bad years for companies, but they are recovering much faster than their “junior colleagues” in the S&P 400 or 600.