Basic Trading Concepts PDF

The Corporate Finance Institute PART 02 corporatefinanceinstitute.com The Complete Guide to Trading Basic Trading Concepts 44 The Corporate Finance Institute The Complete Guide to Trading Basic Trading Concepts To learn more, please check out our online courses Random Walk Theory Before yo...

The Corporate Finance Institute PART 02 corporatefinanceinstitute.com The Complete Guide to Trading Basic Trading Concepts 44 The Corporate Finance Institute The Complete Guide to Trading Basic Trading Concepts To learn more, please check out our online courses Random Walk Theory Before you decide if you want to be a trader, you have to first decide whether or not it’s even reasonable to believe that trading can be a profitable endeavor. In order to make that call, you have to choose which basic market theory you believe. A “random walk” is a statistical phenomenon where a variable follows no discernible trend and moves seemingly at random. The random walk theory as applied to trading, most clearly laid out by Burton Malkiel, an economics professor at Princeton University, posits that the price of securities moves randomly (hence the name of the theory), and that, therefore, any attempt to predict future price movement, through either fundamental or technical analysis, is futile. The implication for traders is that it is impossible to outperform the overall market average other than by sheer chance. Those who subscribe to the random walk theory recommend using a “buy and hold” strategy, investing in a selection of stocks that represent the overall market – for example, an index mutual fund or ETF. Basic Assumptions of the Random Walk Theory 1. The Random Walk Theory assumes the price of each stock follows a random walk. 2. The Random Walk Theory also assumes that the movement in the price of one security is independent of price movement in another security. One of the main criticisms of the Random Walk Theory is that the stock market consists of a large number of investors and the amount of time each investor spends in the market is different. Thus, it is possible for trends to emerge in the prices of securities in the short run, and a savvy investor can outperform the market by strategically buying stocks when the price is low and selling stocks when the price is high within a short time span. Other critics argue that the entire basis of the Random Walk Theory is flawed and that stocks prices do follow patterns or trends even over the long run. They argue that because the corporatefinanceinstitute.com 45 The Corporate Finance Institute The Complete Guide to Trading price of a security is affected by an extremely large number of factors, it may be impossible to find out the pattern or trend followed by the price of that security, but just because a pattern cannot be found does not mean that a pattern does not exist. A Non-Random Walk In contrast to the random walk theory is the contention of believers in technical analysis, those who think that future price movements can be predicted based on trends, patterns, and historical price action. The implication arising from this point of view is that traders with superior market analysis and trading skills can significantly outperform the overall market average. Both sides can present evidence to support their position, so it’s up to each individual to choose what they believe. However, there is one fact, perhaps a decisive one, which goes against the random walk theory: the fact that there are some individual traders who consistently outperform the market average for long periods of time. According to the random walk theory, a trader should only be able to outperform the overall market by chance, or luck. This would allow for there being some traders who, at any given point in time, would – purely by chance – be outperforming the market average. But what are the odds then that the same traders would be “lucky” year in and year out for decades? Yet there are indeed such traders, people like Paul Tudor Jones, who have managed to generate above average trading returns on a consistent basis over a long span of time. It’s important to note that even the most devout believers in technical analysis – those who think that future price movements in the market can be predicted – don’t believe that there’s any way to infallibly predict future price action. It is more accurate to say that probable future price movement can be predicted by using technical analysis, and that by trading based on such probabilities it is possible to generate higher returns on investment. So, who do you believe? If you believe in the random walk theory, then you should just invest in a good ETF or mutual fund designed to mirror the performance of the S&P 500 Index, and hope for an overall bull market. If, on the other hand, you believe that price movements are not random, then you should be polishing your fundamental or technical analysis skills, confident that doing such work will pay off with superior profits through actively trading the market. corporatefinanceinstitute.com 46 The Corporate Finance Institute The Complete Guide to Trading Since you’re reading a book on trading, we’ll assume that you fall into the latter camp. We wholeheartedly agree with you. So keep reading… corporatefinanceinstitute.com 47 The Corporate Finance Institute The Complete Guide to Trading Fundamental and Technical Analysis I still like the old joke that goes, “How can I end up with a million dollars through trading stocks?” – “Start with two million and trade using technical analysis.” Let me put a disclaimer on that by saying that I am, in fact, primarily a technical trader myself and very much an advocate of technical trading. But it’s still a good joke. Fundamental analysis and technical analysis are the two broad, general approaches to market analysis and trading. Each approach has its advocates and its detractors, and there are hugely successful – and unsuccessful – traders in both camps. The Fundamentals of Fundamental Analysis Fundamental analysis aims at identifying the real, intrinsic value of a security, based on the belief that the genuine value of something is what will ultimately determine its price. Fundamental market analysts attempt to identify a stock or other security’s intrinsic value by looking at factors such as overall economic conditions, industry trends, company management, profit and loss data, and any of a number of financial metrics that are used to determine the financial health and future prospects for a company. Some of the most commonly used financial metrics are the price-to-earnings ratio (P/E), price-to-book ratio (P/B), debt-to-equity ratio(D/E), return on investment (ROI), and return on assets (ROA). Fundamental stock traders rely heavily on data such as a company’s quarterly and annual earnings reports, to see the earnings-per-share which indicates a company’s profitability as divided among the total amount of publicly-traded equity in the company. Additional data for analysis by fundamental traders is gleaned from the published financial statements of publicly traded companies, such as a company’s income statement and balance sheet. The exact nature of fundamental analysis varies according to investments. For example, fundamental traders of the foreign exchange – forex – market eye data such as gross domestic product (GDP), manufacturing, import and export data, and the consumer price index (CPI) in order to assess the overall health of a nation’s economy. Logically, nations with stronger economies will also likely have relatively stronger currencies. Advocates of fundamental analysis point out that it is based on solid financial data, and therefore likely to be reliable. However, a corporatefinanceinstitute.com 48 The Corporate Finance Institute The Complete Guide to Trading drawback of fundamental analysis is that it requires timeconsuming research, and doing things like financial modeling and company valuations is not an endeavor well-suited to many investors. The Fundamentals of Technical Analysis (Get it? – the FUNDAMENTALS of TECHNICAL analysis? See what I did there? ☺ ) Technical analysts ignore all of the factors considered by fundamental analysts, and instead concentrate their evaluation of a security solely on analyzing market price action in order to identify current and likely future price trends. The basic belief of technical traders is that all relevant factors of supply and demand are reflected in the price movement of a security. Technical traders argue, for example, that there’s no need to engage in the practice of fundamental traders attempting to assess whether current economic or marketplace conditions favor increasing demand for a company’s products – Instead, technical traders would say that if the company’s stock price is rising steadily, then that shows that their products are in increasing demand. The basic tool of technical analysts is the price chart. Technical analysts look at all manner of data that can be plotted on a price chart for a security, such as trend lines, trading volume, moving averages, and support and resistance levels. Technical analysts don’t bother attempting to identify intrinsic value of s security, instead using chart analysis to identify price action patterns that indicate probable future price direction and movement. Both the strength and the weakness of technical analysis lie in the fact that there is virtually an endless list of technical indicators to choose from in analyzing a security. That’s strength because you have a wealth of price analysis tools at your disposal to help you determine probable future price movements. It’s a weakness because of the fact that you can get an endless number of conflicting indications and trading signals from different technical indicators. Among the endless choices of indicators to look at – such as moving averages, candlestick patterns, momentum indicators, and pivot points - how do you know what to pay attention to? And the simple answer is: you don’t. Technical traders select the indicators they use based on any number of reasons, and then hope that those indicators are the ones giving the most reliable trading signals. corporatefinanceinstitute.com 49 The Corporate Finance Institute The Complete Guide to Trading So Which One Should You Use – Fundamental or Technical Analysis? Use the analytical approach that you’re most comfortable using, that you have the most confidence in. Okay, you want something more than that? All right, but in the end your chosen method of market analysis really is going to come down to your personal preference and what is best suited to your personal trading style, financial goals, and risk tolerance. The practical fact is that while 50 or 100 years ago fundamental analysis held sway, the arrival of computers has made technical analysis both easier and more widely used. These days, most of the largest market players – such as investment banks – base nearly all of their trading decisions on complex computer algorithms. It’s estimated that as much as 70-80% of all the trading volume on exchanges is generated through technical analysis. That doesn’t mean that fundamental analysis is a useless dinosaur as a trading approach, but it does mean that even fundamental market analysts have to pay attention to technical factors that may be driving market prices. Many traders use some combination of fundamental and technical analysis. For example, a stock trader might select companies to invest in based on fundamental analysis of market sectors and various companies, but select specific price entry and exit points based on technical analysis. corporatefinanceinstitute.com 50 The Corporate Finance Institute The Complete Guide to Trading How to Read Stock Charts If you’re going to actively trade stocks, then you need to know how to read stock charts. Even traders who primarily use fundamental analysis to select stocks still often use technical analysis of stock price movement to determine specific buy, or entry, and sell, or exit, points. Stock charts are freely available on websites such as Google Finance and Yahoo Finance, and stock brokerages always make stock charts available for their clients. In short, you shouldn’t have any trouble finding stock charts to examine. Stock Chart Construction – Lines, Bars, Candlesticks Stock charts can vary in their construction from bar charts to candlestick charts to line charts to point and figure charts. Nearly all stock charts give you the option to switch between the various types of charts, as well as the ability to overlay various technical indicators on a chart. You can also vary the time frame shown by a chart. While daily charts are probably the most commonly used, intraday, weekly, monthly, year-to-date (YTD), 5-year, 10-year, and complete historical lifetime of a stock are also available. There are relative advantages and disadvantages to using different chart construction styles and to using different time frames for analysis. What style and time frame will work best for you as an individual analyst or trader is something that you can only discover through actually doing stock chart analysis. You can glean valuable indications of probable stock price movement from stock chart analysis. You should choose the chart style that makes it easiest for you to read and analyze the chart, and trade profitably. Looking at a Stock Chart Below is a year-to-date daily chart of Apple Inc. (AAPL), courtesy of stockcharts.com. This chart is a candlestick chart, with white candles showing up days for the stock and red candles showing down days. In addition, this chart has several technical indicators added: a 50-period moving average and a 200-period moving average, appearing as blue and red lines on the chart; the relative strength indicator (RSI) which appears in a separate window above the main chart window; the moving average convergence divergence indicator (MACD) which appears in a separate window below the chart. corporatefinanceinstitute.com 51 The Corporate Finance Institute The Complete Guide to Trading Along the bottom of the main chart window, the daily trading volume is shown. Note the large spike in volume that occurred on February 1st, when the stock gapped higher and began a strong uptrend which lasted until early June. Also note the high amount of selling volume (indicated by red volume bars which indicate days with a greater amount of selling volume than buying volume) that occurs when the stock moves sharply downward around June 12th. The Importance of Volume Volume appears on nearly every stock chart that you’ll find. That’s because trading volume is considered a critical technical indicator by nearly every stock trader. On the chart above, in addition to showing the total level of trading volume for each day, days with greater buying volume are indicated with blue bars and days with greater selling volume are indicated with red bars. The reason that volume is considered to be a very important technical indicator is a simple one. The vast majority of stock corporatefinanceinstitute.com 52 The Corporate Finance Institute The Complete Guide to Trading market buying and selling is done by large institutional traders, such as investment banks, and by fund managers, such as mutual fund or exchange-traded fund (ETF) managers. When those investors make major purchases or sales of a stock, it creates high trading volume, and it is that kind of major buying and selling by large investors that typically move a stock higher or lower. Therefore, individual or other institutional traders watch volume figures for indications of major buying or selling activity by large institutions. This information can be used either to forecast a future price trend for the stock or to identify key price support and resistance levels. In fact, many individual traders determine their buying and selling decisions almost solely based on following the identified actions of major institutional traders. They buy stocks when volume and price movement indicate that major institutions are buying, and sell or avoid buying stocks when there are indications of major institutional selling. Such a strategy works best when applied to major stocks that are generally heavily traded. It will likely be less effective when applied to stocks of small companies that are not yet on the radar screens of large institutional investors and that have relatively small trading volumes even on days when the stock is more heavily traded than usual. Basic Volume Patterns There are four basic volume patterns that traders typically watch as indicators. High volume trading on Up Days – This is a bullish indication that a stock’s price will continue to rise Low volume trading on Down Days – This is also a bullish indication since it indicates that on days when the stock’s price falls back a bit not many investors are involved in the trading. Therefore, such down days occurring in an overall bull market are commonly interpreted as temporary retracements or corrections rather than as significant indicators of future price movement. High Volume Trading on Down Days – This is considered a bearish indicator for a stock, as it shows that major institutional traders are aggressively selling the stock. Low Volume Trading on Up Days – This is another bearish indicator, although not as strong as high volume trading on down days. The low volume tends to peg the trading corporatefinanceinstitute.com 53 The Corporate Finance Institute The Complete Guide to Trading action on such days as less significant and usually evidence of just a short-term counter-trend retracement upward in an overall, long-term bearish trend. Using Technical Indicators In analyzing stock charts for stock market investing, traders use a variety of technical indicators to help them more precisely determine probable price movement, identify trends, and anticipate market reversals from bullish trends to bearish trends and vice-versa. One of the most commonly used technical indicators is a moving average. The moving averages that are most frequently applied to daily stock charts are the 20-day, 50-day, and 200-day moving average. Generally speaking, as long as a shorter period moving average is above a longer period moving average, a stock is considered to be in an overall uptrend. Conversely, if shorter term moving averages are below longer term moving averages, then that indicates an overall downtrend. Another commonly used indicator is the trendline. A trendline is drawn on a chart connecting the lowest price points in an uptrend or the highest price points in a downtrend. Price breaking substantially below the trendline in an uptrend indicates a possible market reversal to the downside, while price moving substantially above a downtrend line indicates a possible reversal to the upside. The Importance of the 200-Day Moving Average The 200-day moving average is considered by most analysts as a critical indicator on a stock chart. Traders who are bullish on a stock want to see the stock’s price remain above the 200-day moving average. Bearish traders who are selling short a stock want to see the stock price stay below the 200-day moving average. If a stock’s price crosses from below the 200-day moving average to above it, this is usually interpreted as a bullish market reversal. A downside cross of price from above the 200-day moving average is interpreted as a bearish indication for the stock. The interplay between the 50-day and 200-day moving averages is also considered as a strong indicator for future price movement. When the 50-day moving average crosses from below to above the 200-day moving average this event is referred to by technical analysts as a “golden cross”. A golden cross is basically an indication that the stock is “gold”, set for substantially higher prices. On the flip side, if the 50-day moving average crosses from above to below the 200-day moving average, this is referred to by analysts corporatefinanceinstitute.com 54 The Corporate Finance Institute The Complete Guide to Trading as a “death cross”. You can probably figure out on your own that a “death cross” isn’t considered to bode well for a stock’s future price movement. Trend and Momentum Indicators There is virtually an endless list of technical indicators for traders to choose from in analyzing a chart. Experiment with various indicators to discover the ones that work best for your particular style of trading and as applied to the specific stocks that you trade. You’ll likely find that some indicators work very well for you in forecasting price movement for some stocks but not for others. Technical analysts often use indicators of different types in conjunction with each other. Technical indicators are classified into two basic types: trend indicators such as moving averages, and momentum indicators such as the MACD or the average directional index (ADX). Trend indicators are used to identify the overall direction of a stock’s price, up or down, while momentum indicators gauge the strength of price movement. Analyzing Trends When reviewing a stock chart, in addition to determining the stock’s overall trend, up or down, it’s also helpful to look to identify aspects of a trend such as the following: How long has a trend been in place? Stocks do not stay in uptrends or downtrends indefinitely. Eventually, there are always trend changes. If a trend has continued for a long period of time without any significant corrective retracement moves in the opposite direction, you want to be especially alert for signs of an impending market reversal. How does a stock tend to trade? Some stocks move in relatively slow, well-defined trends. Other stocks tend to experience more volatility on a regular basis, with price making sharp moves up or down even in the midst of a general long-term trend. If you are trading a stock that typically evidences high volatility, then you know not to place too much importance on the trading action of any single day. Are there signs of a possible trend reversal? Careful analysis of stock price movement often reveals signs of potential trend reversals. Momentum indicators often indicate a trend running out of steam before the price of corporatefinanceinstitute.com 55 The Corporate Finance Institute The Complete Guide to Trading a stock actually peaks, giving alert traders the opportunity to get out of a stock at a good price before it reverses to the downside. Various candlestick or other chart patterns are also often used to identify major market reversals. Identifying Support and Resistance Levels Stock charts can be particularly helpful in identifying support and resistance levels for stocks. Support levels are price levels where previously fresh buying has come in to support a stock’s price and turn it back to the upside. Conversely, resistance levels represent prices at which a stock has shown a tendency to fail in attempting to move higher, turning back to the downside. Identifying support and resistance levels can be especially helpful in trading a stock that tends to trade within an established trading range over a long period of time. Some stock traders, having identified such a stock, will look to buy the stock at support levels and sell it at resistance levels over and over again, making more and more money as the stock traverses the same ground multiple times. For stocks that have well-identified support and resistance levels, price breakouts beyond either of those levels can be important indicators of future price movement. For example, if a stock has previously failed to break above $50 a share, but then finally does so, this may be a sign that the stock will move from there to a substantially higher price level. The chart of General Electric (GE) below shows that the stock traded in a tight range between $29 and $30 a share for several months, but once the stock price broke below the $29 support level, it continued to fall substantially lower. corporatefinanceinstitute.com 56 The Corporate Finance Institute The Complete Guide to Trading Conclusion – Using Stock Chart Analysis Stock chart analysis is not infallible, not even in the hands of the most expert technical analyst. If it were, every stock investor would be a multi-millionaire. However, learning to read a stock chart will definitely help turn the odds of being a successful stock market trader in your favor. Stock chart analysis is a skill, and like any other skill, one only becomes an expert at it through practice. The good news is that virtually anyone willing to work diligently at analyzing stock charts can become, if not an outright expert, at least pretty good at it – good enough to improve their overall profitability in stock market trading. Therefore, it’s in your best interest as a trader to begin, or continue, your education in stock chart analysis. corporatefinanceinstitute.com 57 The Corporate Finance Institute The Complete Guide to Trading Stock Investing – Value Investing Since the publication of “The Intelligent Investor” by Benjamin Graham, what is commonly known as “value investing” has become one of the most widely respected and widely followed methods of stock-picking. Famed investor Warren Buffet, while actually employing a mix of growth investing and value investing principles, has publicly credited much of his unparalleled success in the investment world to following Graham’s basic advice in evaluating and selecting stocks for his portfolio. However, as the markets have changed over more than half a century, so too has value investing. Over the years, Graham’s original value investing strategy has been adapted, adjusted, and augmented in a variety of ways by investors and market analysts aiming to improve on how well a value investing approach performs for investors in the 21st century. Even Graham himself devised additional metrics and formulations aimed at more accurately determining the true value of a stock. Keep in mind that whenever you evaluate a company and its stock price, you need to interpret the numbers in light of things such as specific industry and general economic conditions. In addition, good stock analysis requires that you always review past and current financial metrics with an eye to the future, projecting how well you think a company will fare moving forward, given its current finances, assets, liabilities, marketplace position, and plans for expansion. It’s also important to avoid getting lost in a purely numerical analysis to the point where you lose sight of the forest for the trees, so to speak. Non-numerical “value” factors that investors should not overlook include things such as how effectively a company’s management is achieving goals and moving the company forward in a way that is consistent with pursuing its corporate mission statement. A company may be showing impressive profitability for the moment, but in today’s excessively competitive marketplace a company that is not carefully mapping, planning out, reviewing (and when needed, re-routing) its progress will nearly always eventually be eclipsed by a company that is doing those things. Value Investing vs Growth Investing Before we move ahead to review traditional value investing and then look at some of the newer, alternative value investing strategies, it’s important to note that “value investing” and “growth corporatefinanceinstitute.com 58 The Corporate Finance Institute The Complete Guide to Trading investing” are not two contradictory or mutually exclusive approaches to picking stocks. The basic idea of value investing – selecting currently undervalued stocks that you expect to increase in value in the future – obviously involves assessing probable future growth. The differences between value investing and growth investing strategies tend to be more just a matter of emphasizing different financial metrics (and to some extent a difference in risk tolerance, with growth investors typically willing to accept higher levels of risk). Ultimately, value investing, growth investing, or any other basic stock evaluation approach has the same end goal: choosing stocks that will provide an investor with the best possible return on investment. The Basics of Traditional Value Investing In “The Intelligent Investor”, Ben Graham proposed and explained a method for screening stocks that he developed to assist even the most inexperienced investors with their stock portfolio selections. In fact, that’s one of the major appeals of Graham’s value investing approach – the fact that it’s not overly intricate or complicated, and can, therefore, be easily utilized by the average investor. Graham’s value investing strategy involves some basic concepts that underlie or form the foundation or basis for the strategy. For Graham, a key concept was that of intrinsic value – specifically, the intrinsic value of a company or its stock. The essence of value investing is using a stock analysis method to determine the stock’s genuine value, with an eye toward buying stocks whose current share price is below the stock’s genuine value or worth. Value investors are essentially applying the same logic as careful shoppers in looking to identify stocks that are “a good buy,” that are selling for a price lower than the real value they represent. A value investor searches out and snaps up what they determine are undervalued stocks, with the belief that the market will eventually “correct” the share price to a higher level that more accurately represents the stock’s true value. Graham’s Value Investing Approach Graham’s approach to value investing was geared toward developing a simple process for stock screening that the average investor could easily utilize. Overall, he did manage to keep things fairly simple, but on the other hand, classic value investing is a little more involved than just the often-recited refrain of, “Buy stocks with a price-to-book (P/B) ratio of less than 1.0.” corporatefinanceinstitute.com 59 The Corporate Finance Institute The Complete Guide to Trading The P/B ratio guideline for identifying undervalued stocks is, in fact, only one of a number of criteria which Graham used to help him identify undervalued stocks. There’s some argument among value investing aficionados as to whether one is supposed to use a 10point criteria checklist that Graham created, a longer 17-point checklist, a distillation of either of the criteria lists that usually appears in the form of a four- or five-point checklist, or one or the other of a couple of single criterion stock selection methods that Graham also advocated. In an attempt to avoid as much confusion as possible, we’re going to present here the main criteria that Graham himself considered most important in identifying good value stocks, i.e., those with an intrinsic value greater than their current market price. 1. A value stock should have a P/B ratio of 1.0 or lower; the P/B ratio is important because it represents a comparison of the share price to a company’s assets. One major limitation of the P/B ratio is that it functions best when used to assess capitalintensive companies, but is less effective when applied to non-capital-intensive firms. Note: Rather than looking for an absolute P/B ratio lower than 1.0, investors may just look for companies with a P/B ratio that is relatively lower than the average P/B ratio of similar companies in the same industry or market sector. 2. The price-to-earnings (P/E) ratio should be less than 40% of the stock’s highest P/E over the previous five years. 3. Look for a share price that is less than 67% (two-thirds) of the tangible per share book value, AND less than 67% of the company’s net current asset value (NCAV). Note: The share-price-to-NCAV criterion is sometimes used as a standalone tool for identifying undervalued stocks. Graham considered a company’s NCAV to be one of the most accurate representations of a company’s true intrinsic value. 4. A company’s total book value should be greater than its total debt. Note: A related, or perhaps an alternative, financial metric to this is examining the basic debt ratio – the current ratio – which should be greater than 2.0. corporatefinanceinstitute.com 60 The Corporate Finance Institute 5. The Complete Guide to Trading A company’s total debt should not exceed twice the NCAV, and total current liabilities and long-term debt should not be greater than the firm’s total stockholder equity. Investors can experiment with using Graham’s various criteria and determine for themselves which of the valuation metrics or guidelines they consider to be most essential and most reliable as indicators. There are some investors who still use only an examination of a stock’s P/B ratio to determine whether or not a stock is undervalued. Others rely heavily, if not exclusively, on comparing current share price to the company’s NCAV. More cautious, conservative investors may only buy stocks that pass every one of Graham’s suggested screening tests. We think you’ll find that incorporating at least some of Graham’s value investing principles into your portfolio selection process will improve your overall stock trading performance. Alternative Methods of Determining Value Value investors continue to give Graham and his value investing metrics attention. However, the development of new angles from which to calculate and assess value means that alternative methods for identifying underpriced stocks have arisen as well. One increasing popular value metric is the Discounted Cash Flow (DCF) formula. DCF and Reverse DCF Valuation Many accountants and other financial professionals have become ardent fans of DCF analysis. DCF is one of the few financial metrics that take into account the time value of money – the notion that money available now is more valuable than the same amount of money available at some point in the future because whatever money is available now can be invested and thus used to generate more money. DCF analysis uses future free cash flow (FCF) projections and discount rates that are calculated using the Weighted Average Cost of Capital (WACC) to estimate the present value of a company, with the underlying idea being that its intrinsic value is largely dependent on the company’s ability to generate cash flow. The essential calculation of a DCF analysis is as follows: Fair Value = The company’s enterprise value – the company’s debt corporatefinanceinstitute.com 61 The Corporate Finance Institute The Complete Guide to Trading (Enterprise value is an alternative metric to market capitalization. It represents market capitalization + debt + preferred shares – total cash, including cash equivalents). If the DCF analysis of a company renders a per share value higher than the current market share price, then the stock is considered undervalued. DCF analysis is particularly well-suited for evaluating companies that have stable, relatively predictable cash flows since the primary weakness of DCF analysis is that it depends on accurate estimates of future cash flows. Some analysts prefer to use reverse DCF analysis in order to overcome the uncertainty of future cash flow projections. Reverse DCF analysis starts with a known quantity – the current share price – and then calculates the cash flows that would be required to generate that current valuation. Once the required cash flow is determined, then evaluating the company’s stock as undervalued or overvalued is as simple as making a judgment about how reasonable (or unreasonable) it is to expect the company to be able to generate the required amount of cash flows necessary to sustain the current share price. An undervalued stock is identified when an analyst determines that a company can easily generate and sustain more than enough cash flow to justify the current share price. Katsenelson’s Absolute P/E Model Katsenelson’s model, developed by Vitally Katsenelson, is another alternative value investing analysis tool that is considered particularly ideal for evaluating companies that have strong, positive, established earnings scores. The Katsenelson model focuses on providing investors with a more reliable P/E ratio, known as “absolute P/E.” The model adjusts the traditional P/E ratio in accord with several variables, such as earnings growth, dividend yield, and earnings predictability. The formula is as follows: Absolute PE = (Earnings Growth Points + Dividend Points) x [1 + (1 – Business Risk)] x [1 + (1 – Financial Risk)] x [1 + (1 – Earnings Visibility)] Earnings growth points are determined by starting with a nogrowth P/E value of 8, and then adding .65 points for every 100 basis points the projected growth rate increases until you reach corporatefinanceinstitute.com 62 The Corporate Finance Institute The Complete Guide to Trading 16%. Above 16%, .5 points are added for every 100 basis points in projected growth. The absolute P/E number produced is then compared to the traditional P/E number. If the absolute P/E number is higher than the standard P/E ratio, then that indicates the stock is undervalued. Obviously, the larger the discrepancy between the absolute P/E and the standard P/E, the better a bargain the stock is. For example, if a stock’s absolute P/E is 20 while the standard P/E ratio is only 11, then the true intrinsic value of the stock is likely much higher than the current share price, as the absolute P/E number indicates that investors are probably willing to pay a lot more for the company’s current earnings. The Ben Graham Number You don’t necessarily have to look away from Ben Graham to find an alternative value investing metric. Graham himself created an alternate value assessment formula that investors may choose to employ – the Ben Graham Number. The formula for calculating the Ben Graham Number is as follows: Ben Graham Number = the square root of [22.5 x (Earnings per share (EPS)) x (Book value per share)] For example, the Ben Graham Number for a stock with an EPS of $1.50 and a book value of $10 per share calculates out to $18.37. Graham generally felt that a company’s P/E ratio shouldn’t be higher than 15 and that its price-to-book (P/B) ratio shouldn’t exceed 1.5. That’s where the 22.5 in the formula is derived from (15 x 1.5 = 22.5). However, with the valuation levels that are commonplace these days, the maximum allowable P/E might be shifted to around 25 and acceptable P/B ratio to 3.0. Once you’ve calculated a stock’s Ben Graham Number – which is designed to represent the actual per-share intrinsic value of the company – you then compare it to the stock’s current share price. • If the current share price is lower than the Ben Graham Number, this indicates the stock is undervalued and may be considered as a buy. • If the current share price is higher than the Ben Graham Number, then the stock appears overvalued and is not a promising buy candidate. corporatefinanceinstitute.com 63 The Corporate Finance Institute The Complete Guide to Trading The Bottom Line Value investors are always looking to buy undervalued stocks selling at a discount to intrinsic value in order to make sizeable profits with minimal risk. There are a variety of tools and approaches that traders can use to try to determine the true value of a stock and whether or not it’s a good fit for their investment portfolio. The best stock evaluation process is never just a mathematical formula that one plugs numbers into and then in return receives a solid, guaranteed determination of a particular stock as a “good” or “bad” investment. While there are important stock valuation formulas and financial metrics to consider, the process of evaluating a stock is ultimately part art and part science – and partly a skill that can only be mastered with time and practice. corporatefinanceinstitute.com 64 The Corporate Finance Institute The Complete Guide to Trading Stock Investing – Growth Investing Traders can take advantage of growth investing strategies in order to more precisely hone in on stocks or other investments offering above-average profit potential. When it comes to trading stocks, there are always a variety of approaches that can be taken. The goal, however, is generally always the same, regardless of the approach – grow your investments and increase your profits. Growth investors are continually on the hunt for individual stocks or stock-related investments – such as mutual funds or ETFs – that are poised to grow and offer the potential for above average returns on investment. The trades you make should, of course, always fall in line with your short-term and long-term financial goals, risk tolerance, and a number of other factors. Still, there are basic techniques, principles, and strategies that growth investors follow that suit virtually any individual investing plan. In this guide, we want to explain growth investing as a strategy itself, and then break down more specific approaches and strategies that growth investors can employ. The Basics of Growth Investing Growth investing is essentially the process of investing in companies, industries, or sectors that are currently growing and are expected to continue growing rapidly over a substantial period of time. In the investment world, growth investing is typically looked at as more of an offensive rather than a defensive investing strategy. This simply means that growth investing is a more active attempt to generate the highest possible returns on the capital that you invest. Defensive investing, in contrast, tends more toward investments that generate passive income and work to protect the capital you’ve already earned – such as bonds or blue-chip stocks that offer steady dividends. Investing in Hot Sectors One approach growth investors can take is to invest in stocks, mutual funds, or ETFs in specific sectors and industries. The success of businesses in various sectors changes over time. However, it’s fairly easy to identify sectors that are “hot” in the sense of producing above average returns as compared to most publicly traded companies. For example, two sectors that have been particularly hot for a couple of decades or more are healthcare and technology. Companies that deal with technology, technological advances, or corporatefinanceinstitute.com 65 The Corporate Finance Institute The Complete Guide to Trading are constantly putting out new hardware, software, and devices are usually good picks for growth investors. The same is true for companies in the healthcare sector. Think about it logically: Everyone, at some point, needs to care for their health and there are companies that are constantly developing new medications, therapies, treatments, and places to go to access superior health care. The healthcare sector is likely to continue enjoying rapid growth as it serves an aging baby-boomer generation. In fact, these two sectors are related, as many recent technology developments have actually been advances in healthcare technology. Growth investors can simplify sector investing by taking advantage of investment vehicles such as mutual funds and ETFs that contain a basket of stocks linked to specific sectors. As noted previously, ETFs are an increasingly popular investment option due to their superior liquidity and lower trading costs as compared to mutual funds. Understanding Earnings For growth investors in stocks, understanding a company’s net earnings is essential. This doesn’t mean simply knowing their current earnings, but also considering their historical earnings as well, since this enables you to evaluate current earnings relative to a company’s past performance. Also, reviewing a company’s earnings history provides a clearer indication of the probability of the company generating higher future earnings. A high earnings performance in a given quarter or year may represent a one-time anomaly in a company’s performance, a continuing trend, or a certain point in an earnings cycle that the company continues to repeat over time. Even companies with relatively low, or sometimes even negative, earnings may still be a good pick for a growth investor. Remember that earnings are what’s left over after subtracting all production, marketing, operating, labor, and tax costs from a company’s gross revenue. In many instances, smaller companies attempt to make a breakthrough by funneling more capital toward growing their business, which may negatively impact their earnings in the short run, but in the long run generate higher returns and greater profits for investors. In such a situation, smart traders consider other factors, such as the quality of a company’s management, to ascertain clues to a company’s true growth potential. corporatefinanceinstitute.com 66 The Corporate Finance Institute The Complete Guide to Trading Growth Investing through Value Investing Growth investors are effectively value investors sometimes, in that they seek out companies whose stock may be currently undervalued due to reasons that may be as simple as the fact that the company is relatively new and has not yet caught the attention of many investment analysts or fund managers. The goal for such investors is to grab up shares at a low price of a company that is well-positioned to enjoy a sizeable and continued surge in growth. There are a number of possible ways to approach identifying such companies, one of which we’ve already touched on – looking at companies in hot sectors. Investors who can identify a new, well-managed and well-funded company that is part of a hot sector can often reap substantial rewards. Another possible approach is to examine companies that are on the downslope, such as those that have gone through bankruptcy or reorganization, but that are likely to survive and recover. Using the Price-to-Earnings Ratio The price/earnings (P/E) ratio is a financial metric that growth investors often favor to help them in choosing stocks. Generally speaking, a higher P/E ratio indicates that investors are willing to take greater risk on buying a stock because of its projected earnings and growth rate. The P/E ratio is particularly useful for growth investors who are trying to compare companies that operate in the same industry. In established industries and sectors, there tends to be average P/E ratios for that particular industry or sector. Knowing such industry or sector averages makes a company’s P/E ratio a much more useful number than simply looking at it in comparison to the market as a whole. Looking at a company’s P/E ratio remains a useful analytical tool for growth investors, but adding consideration of other fundamental financial metrics can help to fine tune your stock picks. Using the Price-to-Book Ratio The price-to-book ratio – or P/B ratio – is often considered more the basic analytical metric of value investors as opposed to growth investors. However, the fact is that the P/B ratio can also be utilized as an effective tool in identifying stocks with high growth potential. The P/B ratio is calculated by dividing a stock’s per share price by the book value per share. In order to determine the book value of a stock, preferred stock that has been issued must be subtracted corporatefinanceinstitute.com 67 The Corporate Finance Institute The Complete Guide to Trading from the total stockholder equity. The figure calculated from this takeaway must then be divided by all common shares still outstanding. The final number is the company’s book value per share of common stock. It is often helpful for investors, especially growth investors, to compare a company’s book value to its market value. This comparison can provide a good indication of whether a stock is undervalued or overvalued. Companies with high growth potential are frequently undervalued due to heftier debt loads and capital expenditures. High-Risk Growth Investments Growth investing may also extend into investments beyond traditional stock market investing. Investing in high-risk growth investments – also referred to as speculative investments – is an approach that is not suited for individuals with a low threshold for risk. This is a strategy best suited for individuals looking for maximum profits within a relatively short time frame and who have sufficient investment capital to sustain them during periods of losses. High-risk investments include such things as futures, options contracts, foreign currency exchange (forex), penny stocks, and speculative real estate, such as land that hasn’t been developed. These investments involve greater risk in that they offer no guaranteed return and their value tends to change quickly (in other words, they’re subject to greater volatility). However, the draw for many investors is that when such investments do pay off, they often pay off big. If you’re considering any of these investments, remember that research is key to success. More so than the average stock or bond investor, you have to know the market you’re investing in very well. Because success is based largely on speculation, we strongly recommend that only experienced investors roll the dice on investment assets such as these. A Concluding Note The reality is that there is a multitude of ways that growth investors can find investments to complement their existing portfolio. In the end, it is always up to each individual to choose the methods that work best for them personally, but it is also always helpful to be aware of different approaches to identifying investments with the greatest potential for providing future profits. corporatefinanceinstitute.com 68