There are so many investment opportunities available today, how are investors to navigate through the clutter of options and make an objective decision?
Studying things like market trends, liquidity, and the economy and investor sentiment can surely help.
But to make an objective decision whether to buy a wind farm in Brazil, a technology stock in Japan, or simply put your money in treasury bills, investors need tools that will help them evaluate the relative merits of each investment opportunity.
“Regardless of the type of investment you’re mulling, valuation tools will help you make an objective decision, said Jack Ablin, chief financial officer of Harris Private Bank.
“This becomes particularly crucial the more volatile and fast moving markets become, when emotions distort asset prices.”
Making valuations for stocks often are more difficult than for bonds.
Bonds are relatively straight-forward, Ablin said in his book, Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace. What matters to investors is the price they pay for each issue, the issuer’s credit quality and whether the company makes enough money to make its interest and principal payments to investors on time and in full.
Stocks are significantly more complex for a variety of reasons: will the company meet its forecasts, is it a takeover target, what are its competitors doing position in the marketplace and what is happening with its senior management?
These and other considerations affect the company’s stock price and market value.
Perhaps the most widely used valuation methods for stocks are those that link the price of a security, index or other security to an item on a company’s income statement, such as revenue or profit.
The most common of these is price/earnings (P/E) ratio, but others such as price-to-cash flow, book value and sales, dividend yields and debt to equity ratio also are often used.
The P/E ratio divides the price of a stock, index or other security by the expected or actual earnings and arrives at a number that can be compared to the security’s peers, industry or market as a whole.
“The key is that you don’t just look to the headlines,” said Patricia Lovett-Reid, senior vice-president at TD Waterhouse.
“Read the footnotes (to the financial statements) and information on exceptional items. It’s still all about numbers, and the more information you have the better.”
Ablin believes an even better valuation tool is the earnings yield model, also called the Fed model in recognition of its beginning in the period of U.S. Federal Reserve Board Chairman Edward Greenspan.
Basically it is the inverse of the price earnings ratio and can be applied to an individual security or an index.
“If you take that earnings yield and put it on a chart against the current interest rate an investor could capture by investing in a 10-year Treasury bill, you’ll see an easy-to-understand comparison of the relative allure of stocks and bonds,” Ablin said.
The Fed model has its critics, who say it’s good for the short-term but not for the long-term.
“As long as you remember that it works best for the coming 12 to 18 months you can still treat it as a very useful gauge of the relative valuations of the two key assets of stocks and bonds,” Ablin said.
Once you’ve used valuation metrics to decide whether to invest in stocks or bonds and other asset classes, there’s the option on where to invest: in Canada, the U.S., established overseas markets or new emerging ones.
Ablin suggests tracking the relative P/E ratio of one market to another over a period of time.
“If the P/E ratio of market A has tended to trade at a 10 per cent premium to that of market B over the past 20 years, and now it trades at a discount or at only a five per cent premium, that tells me that market A may look relatively attractive on a valuation basis,” he said.
“Your job as an investor is to go beyond looking at the price you must pay for an investment and find a way to establish a value on it, compare that value to the prevailing market price and to the values and prices of other investment options,” Ablin said.
Talbot Boggs is a Toronto-based business communications professional who has worked with national news organizations, magazines and corporations in the finance, retail, manufacturing and other industrial sectors.
He can be reached at email@example.com.