The below article is a guest post from Jonard delos Santos, blogger of Philippine SMART.
Based on what I read, each investment instrument is competing with each other. Here’s an example. In the current situation,
Treasury bond – 5% annual return
*EDC stocks – 8.07% annual return
If you have money that you want to invest, which of the above will you choose? Obviously, you should pick EDC since it will give you an 8.07% earnings assuming it will earn the same amount every succeeding year.
However, how could you know how much is the value of stocks compared to Treasury bonds? Note that I compared stocks versus Treasury bond since T-bond is a low risk investment. Here is the example to give you an idea,
EDC EPS (current earnings per share) = 0.49
Relative stock value of EDC = 0.49/0.05 = Php 9.8, where 0.05 is the T-bond return per year
To explain this equation further, if you will buy EDC for Php 9.8 per share, it will earn the same amount if you invest in Treasury bond. Therefore, if you will buy EDC, you should buy it at price lower than 9.8 otherwise it is better to invest your money in Treasury bond which is low risk!
But you know that stocks are high risk. So the solution for that is “margin of safety” if you want to still invest in stocks. Meaning, you will buy your prospect stocks with 30-50% discount compared to the Treasury bond.
If you are risk averse, you choose higher discount rate. In my example, if you use margin of safety of 35% then I will buy this stock at Php6.35 per share. However, we need also to answer this question: Will this company increase its income in the future? Because if not, then the earnings will go down and so its stock value.
So how will you know if there’s a potential growth or at least maintain its current income?
1. Check the history. Of course past performance doesn’t guarantee the future but it is a good assessment of the company management’s competency.
2. Upcoming development plans. What are the company’s plans for expansion?
3. Competition. Do they have many competitors? What is the company’s advantage over their rivals?
Earnings per share (EPS) and Treasury bond percentage return can be a good way to estimate the value of a stock. However, there are other factors involved in choosing a profitable stock. Some of the criteria you can use to gauge the profitability of a stock are mentioned above. You may add more criteria depending on your preferences and investment goals.
*Energy Development Corporation