BOSTON — Plenty of beaten-down stocks appear to be attractively priced nowadays relative to their earnings. But in an unusual market like this one, figuring out what stocks are good buys is more complicated than relying on the standard comparison tool, price-to-earnings ratio.
Many market observers are taking a fresh look at alternatives that try to measure a company’s prospects amid shrinking credit availability and a sputtering economy that are eroding revenue, casting doubt on future earnings and even threatening some companies’ survival.
“Price-to-earnings ratios in and of themselves don’t mean an awful lot in markets like these,” said Hersh Cohen, chief investment officer for ClearBridge Advisors, and manager of the Legg Mason Partners Appreciation Fund.
Price-to-earnings ratio is a company’s stock price divided by earnings per share; the lower the P/E ratio, the higher the earnings “yield” of the stock. P/E ratio is still worth throwing into the mix when assessing whether a stock’s price is justified by how much a company is actually earning, said Jim Cataldo, an assistant professor at Suffolk University in Boston who teaches financial statement analysis and accounting.
But these times aren’t normal.
“The best investments will probably be the firms which are least vulnerable to continued problems in the credit markets,” Cataldo said.
He suggests considering the following factors before investing:
Cash flow: Look at the cash flow statement, and trends in cash flow generated from operations. Companies can temporarily bolster cash through additional borrowing or by selling assets. But the only sustainable source of cash long-term is what the company can generate from its business operations.
Interest coverage ratio: One of the best and simplest ways to assess a company’s ability to meet its debt obligations. This ratio divides earnings before interest and taxes for a time period — often a year — by current interest expenses over the same period, or how much a company pays to borrow. Higher is better, particularly when comparing against companies in similar industries.
Customer creditworthiness: Look at trends in allowance for doubtful accounts and days receivable to detect any shifts in the creditworthiness of a company’s customers. Allowances measure the company’s own estimate of its customers’ likelihood of default. Days receivable measures the amount of time it takes customers to actually pay their invoices. Increasing trends in either of these measures can be cause for concern, indicating the company may eventually have to write off bad debts.
Undisciplined growth?: Look at company’s growth history: Has it recently undergone major expansion, and was the expansion funded primarily by debt? This may call for caution. “Sometimes a company expands too quickly, so it can meet shareholders’ expectations,” Cataldo said. “It’s been a growth stock, so management feels it has to maintain that growth to sustain the stock price. But this can cause the firm to overextend itself financially. When a downturn hits, they’re in trouble.”
Taken together, factors like those above can help gauge a company’s ability to manage its finances in a credit market that has recently showed signs of thawing, but is far from returning to normal.
Cataldo also advises looking for companies whose stocks have been hurt by the recent broad sell-off, despite having decent balance sheets and healthy earnings prospects.
“All stocks have been hit, and the good buys out there are the ones that have been painted with the same brush as the rest of the market, but don’t deserve to have been hit so hard,” Cataldo said. “The ones that do survive this market will come out stronger, because the current hard times will have thinned out the competition.”
But Cataldo also cautions that anyone investing in the current market needs to adopt a long-term perspective. “No one can expect to be good enough to time a purchase at the absolute bottom of the market,” he said. “But careful consideration of fundamentals should pay off in the long term.”