Filed in Business by on May 9, 2010

Why you need to know the true value of your stocks
By LAYI ADELOYE, Published: Sunday, 9 May 2010

Smarting from the great slip of the last two years at the stock market, few (if any) investors need

be told that there is a need for vigilance. The focus this time should go beyond what is accruable from investments alone. The new orientation, being canvassed by investment experts, is the need for a broadening of knowledge among investors.

Prior to the market decline, the majority of the investing folks at the stock market had mainly one thing at the back of their mind: ‘What do I make from the current and future gains that the company I am buying into will make.‘ Therefore, beyond giving out money to some agents or brokers to buy stocks, many investors hardly care much about monitoring or determining the values or directions of the stocks, except expecting dividends and bonus declarations at the end of the year.

In view of the role played by lack of investor-knowledge in the market fall, the new thinking among experts is that investors need to know beyond the up-and-down movements of stocks. To do this, they say some intrinsic indicators, which do govern or determine the direction (or values) of the stocks, must be learnt and imbibed. According to the experts, some of the indicators, including the book value of stocks, return on equity and total return, among others are key pointers that can help an investor to zero in on quality stocks as well as determine the health of stocks invested in.

Today, it is obvious that names of companies or past pedigrees are no longer enough guarantees of stocks‘ performance or success at the market. The fact that many of the blue chip companies in Nigeria and in other countries have been indicted on impropriety or found lately to have gone bankrupt has further heightened the need for every investor to determine and follow up on the true value of the stocks they buy.

Simply put, a company‘s book value is the difference between its assets and liabilities- what it owns and what is owed to it, minus what it owes to others. This is sometimes referred to as shareholder‘s equity. How does the price of your stock relate to its book value? Jide Atewolara, a stock analyst, says this is done by dividing the book value by the number of outstanding shares. Theoretically, he says book value represents the amount stockholders would receive for each share they own if the company were to shut down, sell all its assets, pay all its debts and go out of business. Stocks may be recommended as cheap because they are selling below book value or very little above it. Kiplinger‘s Personal Finance magazine, an online investment magazine, notes that such stocks sometimes become takeover candidates, attracting the attention of other companies that see a chance to buy them up cheaply. It adds that the process can drive up the price of the shares and thereby reward investors who spotted the bargain sooner.

However, it is possible that a company‘s stock may be selling below the book value not because it is an undiscovered bargain but because that company or its industry has fallen on hard times. ”Therefore, there is the need for ‘rich information‘ before an investor starts buying stocks, and not just be stockbroker-dependent. You may also need to review your holdings in some companies now,” Atewolara cautions.

Return on equity is another index to consider and monitor as you try to identify the actual value of your stocks. This refers to a company‘s total annual net (after-tax) income, expressed as a percentage of the total book value that measures how much the company earns on the stockholders‘ stake (in the enterprise). Return on book value (also called return on equity) varies from company to company and from industry to industry, and it fluctuates with economic conditions. Experts say that the health or performance of this should be a signal on the prospect of your investment.

Etse Chamberlain, a respected authority in this area, writes in an online bulletin, ‘Investment Know-how‘: ”One year‘s return on equity means little, but by comparing several years‘ results for the company and its industry, you can spot trends and get an idea of how well the company manages its assets.”

Total return, a cumulative end result of both the price change and what an investor gets at the end of an investment era, is another pointer to the stock‘s value. Investors tend to think of their gains and losses in terms of price changes, and forget about dividends. But experts argue that both price changes and current income should be taken into account in order to evaluate a stock‘s performance.

Maxwell Edim, another stocks analyst with Kiplinger‘s Personal Finance magazine, notes, ”Together, they show your total return, which is the only fair way to compare stocks that pay dividends with stocks that don‘t; and to compare results from stocks with results from bonds, treasury bills and other alternatives.”

The debt profile of the company is another indicator of the true value and health of your stock. How much debt does the company carry? A company‘s debt-equity ratio, which is its book value divided by its debts, is a good measure of its fiscal health. This is based on the reasoning that the more it pays out on debt service, either as interest on bonds, for instance, or on other lines of credit with banks, the less it has available to pay dividends, invest in the future or set aside as a cushion for business downturns.

Most companies do carry some debt. What is acceptable in one industry may not be acceptable in another. Experts‘ advice is that an investor should always be sure ”to compare debt-equity ratios of similar companies. Other things being equal, the lower the debt the better.”

Volatility is another measuring yardstick used to measure the health and the intrinsic value of a stock. How volatile is your stock? Edim says a stock‘s past volatility, which can be measured with some precision, is as good a gauge of its future risk as you are going to get. At the least, knowing a stock‘s volatility gives you some idea of the kind of behaviour you can expect from it in relation to the market, especially in a transparent market.

Some stocks‘ prices move slowly and within a relatively narrow range, while others bounce up and down a lot. Analysts have developed several measures of price volatility. Perhaps, the most easily understood is the beta, which tells you how much a stock characteristically moves in relation to a change in a stock market index, usually the Standard & Poor‘s 500.

”A stock with a beta of 1.0 moves in step with the index. A stock with a beta of 1.1 historically rises or falls 10 per cent more than the index. A stock with a beta of 0.9 is less volatile than the index; it would be expected to go up nine per cent, if the market rose 10 per cent; or down by nine per cent, if the index fell 10 per cent.”

These are essential indices that an investor should try and get a good grasp of in order to be in charge in his investment forays,” Chamberlain says.


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