Akin to alchemists seeking the formula for turning lead into gold in centuries gone past, the mythical formula for riches beyond telling has become the foolproof investment strategy. Despite the immense wealth of individuals such as Warren Buffett and Carl Icahn, there is no incontrovertible way to outperform the market year after year – is there?
While there may not be a specific way to distil immense amounts of market data down into an ultimate strategy, there are certain factors which have been proven to lead to outperformance over the decades gone past.
When building your portfolio and judging stocks, keep the three ratios below in mind:
The Price-Earnings Ratio of a company is a simple valuation tool – how much money do you need to invest to see back a dollar of earnings?
To take a simplistic approach, it would make more sense to buy a company with a comparatively low P/E Ratio compared to its rivals. You needn’t pay in as much money as other stocks to see earnings back.
A low P/E Ratio suggests that the company may be undervalued or currently going unnoticed by investors. It may also be a company in an established sector unlikely to see a lot of growth. Conversely, if a company has a fairly high P/E Ratio then they must be anticipating higher growth in the future.
However, it is important to compare the PE Ratio of a company to other stocks within that same sector, as can be seen by the table below which looks at the top ten U.S. stocks by market cap.
The top ten companies in the U.S. by market cap
The lack of a P/E Ratio for both General Electric and Amazon.com means that theirs was in fact negative for the past twelve months, meaning that they were both losing money.
One only needs to take a look at the technology sector for one with an incredibly high P/E Ratio. Facebook’s P/E Ratio for the past twelve month currently stands at an incredible 89.06. Twitter, meanwhile, has never even made a profit!
It is these sectors, which are relying on future growth to a near-incredible extent, which will be some of the first to suffer during a market sell-off as we can see happening at the time of this article being written.
P/E Ratio is an extremely useful tool in valuing companies and, in general, companies which do have a lower ratio tend to outperform in the long-term.
The second ratio, Asset Turnover, looks at the value of a company’s sales or revenues generated relative to the value of their assets. It’s a simple calculation:
Asset Turnover = Revenue / Total Assets
As a measure of how efficiently a company’s assets generate revenue, typically the higher a company’s Asset Turnover, the better they tend to be performing. A low Asset Turnover can mean problems with inventory management or excess production capacity.
As with many factors for judging stock characteristics, it’s important to compare companies to others within the same sector. Low-margin industries tend to have higher asset turnover ratios than high-margin ones as low-margin sectors need to offset lower per-unit profits with higher unit-sales volume.
Our research has shown that companies with a higher Asset Turnover, and more efficient use of their resources, tend to outperform the market on a consistent basis.
Finally, Earnings Yield is calculated by the earnings per share for the trailing twelve-month period divided by the current market price per share. The inverse of the P/E Ratio, Earnings Yield shows exactly how much of each dollar invested in the stock that was actually earned by the company.
It should be of no surprise to learn that those stocks with a higher Earnings Yield—companies which have generated more of their own wealth—have also been shown to outperform the market as well.
Of course, success following the three aforementioned ratios above is not guaranteed but we would strongly recommend you take each of those factors into account the next time you are selecting a stock for your portfolio.