Candlestick Trading Blog

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The idea of building a strong portfolio should be the central focus for any investor looking for successful long term investing results in the stock market. While it is true that a trader can find an occasional gem with stock buying tips or a hunch, the majority of good investments will be the result of doing the “dirty work”. This work will help a successful investor to discover the strengths and weaknesses of a company, as well as helping to understand the business economics and market position of the company. Such research of a company would fall in the category of fundamental analysis and is important to making a good decision on the purchase of a company’s shares and to building the strong portfolio that you need to succeed in the stock market.

How does the company earn cash?
A trader can’t really add a company to a strong portfolio unless he or she knows how the company is generating its cash. This is critical and needs to be specific and void of assumptions. Papa John’s Pizza is a perfect example of such a need for understanding cash flow. Millions of people recognize the brand for Papa John’s; it’s easy to assume that the company makes their money from selling pizzas. While Papa John’s does make pizzas, many of the actual stores are franchises, separately owned and making products according to the ingredients and recipes of the parent company. In other words, Papa John’s creates the pizza and other products that its franchises make. After making this connection, it is easy to see how important the relationship between Papa John’s and its franchises is both to the company’s value in the stock market and to a strong portfolio.

How much cash does the company make and how quickly?
Because of the time value of money, a company that makes a million dollars today is worth more than a company that makes two million over the next twenty years. Making such connections between cash flow and time is critical to implementing successful stock market strategies.

Can the company continue to maintain its cash flows?
At one time the American steel industry was considered a blue chip stock in a strong portfolio and countless analysts advised adding it to a stock portfolio. An extended history of profitability led many investors and analysts to believe that this business would always be a strong investment. The past, however, is of little value in projecting future cash flows. One way to evaluate whether a company can sustain its cash flows is to look at its earnings estimates. A company that is struggling to make its numbers might not prove to be a successful investment and its purchase might not help to make a strong portfolio.

How costly is a business to operate?
For a strong portfolio, it is wise to consider that some companies need a lot of money to make their profits, while others can operate successfully on very little revenue. A utility company needs billions of dollars each time it opens a new power plant, yet an Internet company can operate on a small amount of ad revenue while it develops its product. The less money it takes for a business to survive, the more appealing it will be for someone investing in the stock market and the more desirable it is to give investors the advice to add it to their strong portfolio.

Is the company managed in a shareholder-friendly manner?
The management team and its attitude towards the shareholders are extremely important both in the company’s success and in creating a strong portfolio. A company that looks at its own investment philosophy and investment options, such as repurchasing shares when the stock price has fallen rather than invest in another company is more likely to create wealth than a one only looking to build the company. Reading a company’s actions before you buy can help make a strong portfolio.

Is the price attractive?
Simply put, price is the single most important technical analysis tool. The most common metrics for stock technical analysis are found because of the share price. A $20 per share company that earns $6 per share has a yield of 30%, but a $100 per share stock that returns the same $6 only turned a 6% yield, hardly anything that will excite investors or cause a company to be included in a strong portfolio.

The best investment advice happens to also help to make a strong portfolio; follow the money flow. If a company is successful at making and sharing its money, it will be a company that has strong investment potential.

For those of you who are value stock investing, I am going to put in your hands one of the most important weapons you could have; in reality, this is an excellent tool for anyone who is searching for good investments. Value investing involves looking for stocks that, for whatever reason, the market has undervalued. The price to sales ratio is perfect for this and something that you need to learn today.

The key to price to sales ratio is the concept that it is critical to know if a stock still has room to grow before you invest your money. If the stock is reasonably priced or under-priced and you have confirmed its growth prospects, you have found your next potential purchase. On the other hand, a stock that is over-priced won’t do anything but drop. You may want to purchase this company but only after the stock market has found its true value. Price to sales ratios can help you to make that determination.

The Better Bargain
Here’s the perfect place for a pop quiz? Which is a better purchase…IBM at $94.00 a share or Dell at $44.00? Your gut will tell you that IBM must be a better company because its stock is more expensive. Here’s the paradox; stock prices don’t really tell you much. If you don’t know anything about the two companies, you just cannot make a judgment based on price. This is where price to sales ratio can help you with your investment strategies.

Calculating Price to Sales Ratio
The price to sales ratio creates a metric that allows you to compare companies in the same stock sector. To calculate price to sales ratio you need to divide the market cap of a company by its revenue. Market cap is the number of outstanding shares multiplied by the per share price. If a company has 10 million shares outstanding and the per share price is $100, the market cap of the company is $1 billion.

By dividing this number by the revenue, you get a number that is consistent and can be used to compare different companies. You are looking for the lowest number here. It is also important that you only use the price to sales ratio to compare companies in the same industry since there will be differences among industry groups.

What is the Result?
Let’s go back to our pop quiz. IBM’s price to sales ratio in this example is 1.7 and Dell’s price to sales ratio is 2.2; the ratio for the industry group was 2.8. Both companies were selling under the same stock sector but IBM’s number was better than Dell’s. Looking at their price to earnings ratio, IBM’s P/E was 20 and Dell’s was 34.5, with the industry average at 33. Once again, IBM appears to be the better value. If the numbers here had conflicted, there is a very good possibility that something questionable had happened in one of the company’s books; look for a one-time event that has temporarily skewed the numbers.

Conclusion
There are two parts to successful fundamental and technical analysis: picking the right company and buying at the right price. The price to sales ratio is one tool that will help you determine if “the price is right”.