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When I've chosen shares for the portfolio or for the watchlist, I've often mentioned a share's price-to-earnings ratio. I tend to look at dividends a lot as well, and I keep an eye on debt. But other than that, I don't dig too much into figures -- largely because I think it's likely to be too confusing for beginners.
People will pay more for a share that they think will bring in greater future earnings. So, if a company has been growing its earnings averagely, then a P/E close to the FTSE average of 14 won't be far from a fair long-term valuation (other things being average, too). But if a similar company is growing its earnings faster, then a fair P/E valuation would be higher.
Growth = high P/E
Forecasts suggest a fall in earnings this year of 7% for Tesco (LSE:TSCO), with a rebound next year of 5%. We would, therefore expect Tesco shares to be on a lower-than-average P/E, and that is what we find -- the shares on on a forward P/E (that is, based on forecasts) of 10.5 for this year, falling to 10 next.
Compare with Blinkx (LSE:BLNX), and you'll see a P/E of 30 for the year to March 2013, which is over twice the FTSE average. The reason is that Blinkx is still a small company, just getting its technology accepted -- and if it should become a de facto standard in the world of video advertising, potential future growth could be enormous. In fact, analysts are predicting an 85% growth in earnings for the following year, which would bring the P/E down to around 16.
Dividends = cash
Dividend is important for me, too, because cash is really what we want in the end, and I look for companies paying above their long-term average and toward the top end of their sector. Tesco's dividend yield is likely to be around 4.5%, which I think is very good for such a low-risk business, and that's part of the reason I think Tesco is undervalued.
Vodafone (LSE:VOD) has a modest 4% growth in earnings forecast for this year and next, but there's a dividend yield of nearly 7% forecast. To me that suggests the shares are undervalued, and I expect a price rise. But even if that doesn't happen, I'll be happy to keep taking 7% a year! There's a risk of a dividend being cut if the company can't sufficiently cover it with earnings, but I don't thank that's a big risk with Vodafone, which seems to be committed to raising shareholder value -- it's spending oodles of cash on share buybacks.
Watch that debt
Debt is important as well, and if a lot of cash is going in repayments then the portion left for shareholders is at greater risk. Should business falter, the same repayments still need to be made, leaving proportionally less for things like dividends. We saw a lot of overstretched companies suffer exactly that fate during the recession.
If a company has a sizable amount of debt, I want to see dependable income. United Utilities (LSE:UU), which we have in our watchlist, has an annual turnover of around 1.5 billion pounds, but debts of more than 5 billion pounds! But the utilities companies really do have a captive market with pretty much guaranteed prices -- water and energy are not luxury items that people can do without.
When you're starting out, if you stick to good solid companies that look undervalued on a combination of P/E and dividend and don't have too much debt, the chances are you'll do pretty well. You'll learn more about detailed analysis with experience, but you can't afford to wait -- you don't want to miss those all-important first years of investing.
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Alan Oscroft has no positions in the stocks mentioned above. The Motley Fool owns shares of Tesco. Motley Fool newsletter services have recommended buying shares of Vodafone. The Motley Fool has a disclosure policy.
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