Streetwise for Friday, May 4, 2018
Investing should not be about turning you into a candidate for Prozac. When the market hiccups simply take it in stride. Certainly, the moves can at times be gut wrenching. So, relax, wait for the dust to settle and then decide what you want to do. Never let yourself be placed in circumstances where your decisions are being made under stress or in a panic. Yes, I realize this will probably never be easy.
Remember what I have said so many times in the past. Attempting to guess the direction and depth of daily market moves is a lesson in futility. Stock prices are the result of subjective evaluations by individuals. That makes them dependent on individual whims and subject to change without notice and for no apparent reason.
When a stock trade occurs, it is because both parties disagree as to the utility of the shares being traded. For a trade to come to culmination, it must be viewed subjectively as being advantageous for both. The notion of current market prices is fictional. Prices are neither current, nor of the market. Trades are historical facts and occur only between individuals.
Think of investing as an athletic competition. To be successful, you must have absolute confidence in your own abilities. Consider the plight of the late great tennis professional Vitas Gerulatis. Jimmy Connors had beaten Gerulatis sixteen matches in a row. Did Gerulatis give up? He did not. On the seventeenth try Gerulatis was victorious over Connors. Gerulatis’ comment after the match…”Nobody beats me seventeen straight.”
While it is unlikely you will need seventeen tries to invest successfully, the match will be a long one. To win you must be comfortable with a two to three-year investment horizon at a minimum. Furthermore, no athlete, no matter how skillful, wins every time.
To select investments that are immune from short-term market fluctuations is an impossible task. The trick is to never become discouraged. If the corporate fundamentals of your investments are solid, then stay the course and you will be victorious.
Regular readers of this column know that I continually espouse dividends as a key factor to consider when evaluating a potential equity investment. A key reason is that companies that consistently raise dividends have the financial fundamentals in place to outperform the market.
However, dividends should not be used alone. You need to utilize one or more of the financial ratios that incorporate earnings and/or earnings growth. Those two factors are the hallmark of any successful corporation. As important as dividends are, they are not possible without earnings and earnings growth.
One example is the enterprise multiple. It measures a company’s valuation based on the ratio of its enterprise value (EV) to earnings before interest, taxes, depreciation and amortization or EBITDA. EV includes not only the value of equity but also debt less cash. It can be thought of as the cost to acquire a company.
In other words, EV/EBITDA answers the question, “What is the value of a company per each dollar of EBITDA?” A high (low) EV/EBITDA means the company is potentially overvalued (undervalued).
Using EBITDA measures of the true cash operating profit of a company since depreciation and amortization are non-cash items and taxes and interest are not considered part of the operations of the company even though these two items impact earnings.
The usual shortcut to calculate EBITDA is to start with operating profit, and then add back depreciation and amortization. EBITDA can be used to analyze profitability without the effects of financing and accounting decisions.
Enterprise ratios are used to quickly ascertain and compare potential corporate valuations. All things being equal, the lower a ratio such as EV/EBITDA is, the better.
Screening dividend paying companies via methods such as ratios simply separates the wheat from the chaff. Your final selection process needs to utilize subjective factors such as management strength, franchise in the marketplace, potential earnings and dividend growth.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.