7 Points of Due Diligence to Improve Risk and Reward Ratio

Fair to great value stocks are harder to find when the general market is overvalued and easy to find during crashes. It requires patience to not jump into overvalued situations and the nerve to jump into undervalued situations. This is harder than it sounds because you are going against popular opinion. It is going against the popular decision that improves your chances to buy low and sell high.

Often when stock prices are falling, people do not want to buy them. There is the phrase you do not want to "catch a falling knife." This is the big difference with value investors versus price speculators. Instead of reacting to the stock price changes we are buying based on the value and fundamentals of the company. Value investing does not worry about the emotions of the market, and in fact will buy more when market prices drop. The goal is to take advantage of pricing that is undervalued.

In the article on Market Risk, I focused on portfolio allocations based on where market was valued as a whole. Allocations along with picking good companies at good prices I believe improves the risk/reward ratio. In this article I will cover research required in stock picking to reduce risk in the equities we do pick.

Picking good individual stocks is an exercise in due diligence. My goal is to minimize risk by buying the net assets, earnings and cash flows at a discount to their intrinsic value. I will cover seven areas of analysis I do to improve my risk/reward ratio.

To have confidence going against the grain, homework and due diligence must be done to find strong quality undervalued businesses by checking seven aspects of the business, I will use Apple (disclosure: I am long AAPL) as an example with data from GuruFocus on Feb. 19.

The seven points of analysis are:

1. Financial health of the business balance sheet.
2. Earnings ability of the assets.
3. Value ratios.
4. Determining a stock fair price and a price with a margin of safety.
5. Dividend evaluation if there is a dividend. If not, looking at their ability to pay one in the future.
6. Quantitative evaluation.
7. Technical analysis.

All businesses go through tough times such as recessions and market downturns as seen in the market risk chart. I feel picking stocks with healthy balance sheets at a good value to their earnings helps prevent against business failure during these tough times.

Evaluation involves checking seven aspects of the business:

1. The balance sheet: Here I check for the business levels for equity to assets or how much of their assets are owned outright and how much are owned through debt. Peter Lynch, one of the top performing mutual fund managers during his career, once said that a business without debt cannot go out of business. It is the health of the balance sheet that helps a business survive tough times such as when a commodity like oil price drops, and some of the energy stocks may go out of business if they cannot pay or restructure their debt causing bankruptcy.

Generally a simple balance sheet is comprised of the following:

• Current assets like cash and short term accounts receivable.
• Long term assets like buildings and equipment.
• Current liability such as short term invoices that are payable within a year.
• Long term liabilities like a mortgage on the building or a long term business loan.

When I take all the tangible assets and subtract all the liabilities, I get how much of the business is equity or tangible book value.

A healthy business will have at least half of the business or more owned in equity. I also like to see that if there is debt, there is also plenty of cash to service the debt. A business with more cash than it has debt can ride out tougher times than one that has to sell equipment or other fixed assets to pay its debt in tough economic times.

In the case of Apple, here are a few ratios from their balance sheet: (click on image to enlarge).

Here are ratios on Apple's balance sheet.

One can see here that Apple's cash to debt and equity to asset are not as strong as you might expect. This is where item 6, qualitative analysis, can be a big help.

If you search on Apple's cash, you will find that there is something like $22 billion on the balance sheet and $50 billion in debt. The balance sheet does not account for the offshore money that is held there for tax purposes (it is cheaper to borrow money at these interest rates than be taxed bringing the money in. In fact, Apple has over $200 billion in cash that even after taxes would be about three times their debt. This give them a strong balance sheet.

Chuck Jones of Forbes does a good job of covering Apple's cash position.

2. Earning from the assets:Â If I have determined the financial health of the company is strong and they have significant equity, cash and assets to cover their debt, next I need to figure out the earnings ability of the assets.

There a a few thing to look at:

• Operating margins, which is the percentage of the revenues are after operating expenses.
• Return on equity, Return on assets and return on invested capital, which show what type of returns the business gets on their investment into the assets of the business.
• Revenue growth. This is how much the total revenue is growing. This is important as revenue can only grow if you raise prices or sell more units or service. This is the sign of a strong business and it cannot hide in accounting as much as earnings can.
• Income growth after expenses.

Using the personal finance example, if you own a rental property the earning strength of it is how much the rent pays you as a percentage of your equity. If you made enough on the rent to buy another rental property, then your revenue will grow or if in a non regulated world if you can command higher rent due to the location or desirability of the home then you have strong earnings power.

Where the health of the business keeps it from going broke, the earnings power is what will move the stock price of a business and provide growth to the company.

Here are the ratios for profitablity and growth for Apple from GuruFocus (click on the image to enlarge).

Apple has stellar numbers as often larger companies cannot grow at these rates. To get some perspective, Apple earns about twice as much as the second highest net income Microsoft (MSFT, Financial), so to be growing at any double digit level when you are already generating so much cash is incredible. GuruFocus currently rates the earning predictability a high 4.5 stars.

3. Value ratios such as price comparisons to earnings, sales, growth and tangible book value. These ratios are guides but full analysis of all the areas in this article is required for me to make a buy decision. The most common value ratios I use to look at the quick value of the stock price to the business are:

PE ratio - Here I am looking at the stock price per share to the amount of earnings attributed to that share (total annual earnings divided by the amount of shares offered by the company). So if a stock has a price of $10 and the earnings per share is $1, then the PE ratio is 10/1 = 10.

Another way to look at it is as a business owner. If you invest $10, it will take 10 years to get your investment returned if the business remains the same. If your earnings are growing, then of course you will get your money back sooner. As a result often fast growing businesses stock price does increase, which makes them have a higher PE ratio. Because of this, the PE/growth ratio has been developed to help include growth into the valuation.

Benjamin Graham suggested a PE of 15 to be fair value for a moderately growing company. I would agree with this. Lower values tend to be slower growing although at the time of this writing, Apple is still growing over 20 and only has a PE of about just over 10. Along with a strong balance sheet, this makes Apple an attractive buy to me.

PE to growth ratio (PEG ratio) takes the PE ratio and divides it by the earnings growth. There are two ways of measuring growth, past growth or analysts estimates. I prefer past growth and trends.

By applying growth you get a better idea of the value. For instance the example above was a PE ratio of 10. If this company has earnings growth of 5%, then the PEG ratio is 10 divided by 5 for a PEG of 2. Peter Lynch says a PEG of 1 is fair value, below 1 is good value and above 1 is over valued.

So the PE 10 company seems attractive with PE alone, but in this case when you apply the slow growth for the PEG, it appears overvalued.

Below are ratios for Apple.

Apple's ratios indicate it is selling at a discount on its earnings with a PE of about 10 and PEG of 0.31. It is here where I still buy in even though the stock has dropped 25% in the past year. It is still a deal in my estimation.

PB ratio is the price to book ratio. The book value goes back to our evaluation of the balance sheet. A lower book value is better, but if it is higher, then more emphasis is on the earnings ability of the assets.

Revenues:Â The PS ratio is one that many use, but I focus more on the growth of sales. To me the ability to grow gross revenues is one of the strongest indicators of a healthy business. The only ways a company can grow revenues is by raising prices, increasing sales and market share. To me all of these traits are those of a strong long term dominant business. Such companies can support and grow their dividends with additional money coming in each year.

I do look at earnings and revenue, but revenues are harder to misrepresent compared to earnings. Expenses can be managed to make the earnings figure higher or lower. With revenues different ways for accounting for them can alter them, but still I believe they are more reliable in determining the success of the business products and services. Good management can make good earnings through cost control if they have good revenue.

4. Setting a price with a margin of safety using the discount cashflow calculator. I believe the best way to value a stock is take the tangible book value and add the earnings over a period of years factoring in growth. This is the essence of what a stock is worth:

• The value of its tangible assets less any liabilities (debt) plus the money the assets will earn over time.
• For the time period, I pick seven years although the GuruFocus Discounted Cash Flow calculator website defaults to 10 years.
• I pick seven years because I want a stock that is set up to possibly double in seven years, which requires it to have average returns of over 10% annually.
• Nine percent to 10% is near historically what the indexes like the S&P 500 have earned over time, so I am looking for equities that will meet or beat these returns.
• To get a margin of safety, I like to find stocks that are discounted by 45% or greater for most stocks and 20% or greater for strong franchise companies. This reduces risk for an investor.
• To get an intrinsic value per share, I use the GuruFocus DCF calculator.

I keep a watch list of stocks with alerts set in with my brokerage site so I get an email when any of the companies I follow hit the target price I am looking for.

Apple example:

Here is the data for calculation for Apple based on tangible book value plus earnings with growth factored in at 20% per year. The growth piece can be changed if you anticipate growth is slowing. Apple's growth is slowing, so you can reduce the 20% if you feel it is more reflective of future growth.

When calculated the formula says that Apple should be worth $213 with these numbers. On the GuruFocus site, you can change the the info in the box above as far as years, growth and rates.

This will change the results if you reduce the growth, but you will still get over 20% margin of safety.

5. Dividends are an area I, sadly, was not comprehending when I started out. To get such small amounts did not seem relevant to me, but the key thing here is dividend growth.

Some companies grow their dividends annually to the tune of 10% and even up to 25% or more. Over time this can have a powerful compounding effect, particularly when dividends are reinvested into the existing company or another dividend growth company.

For example here are some companies and their dividend growth records over 20 years as of May 5, 2010. One has to keep in mind over this period we had the dotcom crash and subprime crash, but still the return on the initial investment from the dividends is impressive regardless of the volatility that their shares price may have had.

Company dividend yield rounded on initial investment after 20 years at May 2010 (from dividendsvalue.com):

• McDonald's Corporation (MCD): 52%.
• IBM (IBM): 32%.
• Walgreens (WBA): 29%.
• Canadian National Railway (CNR-T, CNI-N): 29%.
• Colgate-Palmolive (CL): 25%.
• Lowe's Hardware (LOW): 21%.

Although it takes time when I look at these results over 20 years it is amazing and these companies have grown dividends beyond 2010. The length of time you have to let the dividend grow and the selection of company that will grow dividends at a good pace is important here.

Although McDonald's used to grow their dividend up to 25% in the past, they are now are growing dividends at less than 10% as their business growth slows and the dividend has a higher payout ratio to their earnings. Past performance does not indicate future performance.

Newer dividend growth companies like Microsoft (MSFT) or Qualcomm (QCOM) might be able to provide the big dividend growth over the next 20 years. To pick such companies, I like to look at a few qualities:

• How are the companies revenues growing; I want to see strong and consistent growth.
• Whether the company initiated a dividend program and appear to be committed to growing dividends.
• Payout ratio: What percentage of their earnings are they paying to dividends? Lower percentages give more room to grow the dividends, particularly when revenues are growing.
• Estimation of the company's future dominance or performance in their market.

Value investing with solid dividend growth companies can work very well. During a market crash, share prices will drop and dividend yields increase. This opportunity provides a higher starting yield for the growth to make your compounding even more effective.

In the "About Me" section I gave the example of Toronto Dominion (TD-N or TSX:TD) which fell significantly in the 2007 and 2008 sub prime crisis. Due to the price drop, their PE, PEG, and dividend were all great and their balance sheet strong. From that time the stock price tripled and the 6% dividend has increased from about $1.20 per year at the beginning of 2009 to an estimated $2 for 2015. The $2 is around 12% of the low stock price in 2009. I did not buy because I was waiting for the chart pattern, and it is a lesson I will never forget.

The Toronto Dominion example is one where I should have had a high conviction and invested heavily at those levels since I believed they would stay in business and their fundamentals were outstanding. I wait for opportunities like that to come again such as it did when Apple (AAPL) dropped 45% in 2013 after Steve Jobs' death. The fundamental ratios were great and I still saw lots of iPhones and other Apple products being used happily by consumers. This time I did buy, but still should have put more into it and it would have paid off greatly.

Apple example:

Again, looking at Apple I believe one should look at four key things: payout ratio (here it is low at 0.22), dividend growth, and yield. The fourth one is revenue growth, which we see has been average 20% in the past three years.

6. Qualitative evaluation:Â This is the subjective part of the evaluation. Philip Fisher in his book "Common Stocks and Uncommon Profits" calls this scuttle butt. Sometimes when everything is looking good fundamentally, there can be a situation that is not part of the fundamentals such as accounting fraud, end of patents, new competition, new technology or other things that may impact the business.

An example of this is the iPhone taking market share from Blackberry, or the camera phone impacting a company like Kodak.

Many of the gurus I write about can go talk to CEOs and people from the company. I can send emails to investor relations but another way is through news and Seeking Alpha. This is where you can evaluate the risks that do not show up on financial statements and consider if the risk is worth the reward.

One time I found a company with great valuation from a screen. When I checked the company on Seeking Alpha, I learned through comments on articles that the price had depreciated due to the company having their patents expiring. As I did not know much about the company and upon this news I decided not to invest, even though the previous five evaluations were outstanding.

This is an area that I have to place my own judgement on and figure out what is relevant and what is not. When Steve Jobs died, Apple was punished with its stock going down 45%. In my opinion, there was still a lot of loyalty to the Apple products and with significant undervaluation from the stock decline made this a good investment. Still there were many articles saying the loss of Jobs was the end of Apple. I had to use my own judgement and ignore this.

In the end this area is an investor needs their own judgement after reading the intangible info. I want to find good value and fundamentals as a result of market overreaction to an event, so I may read a lot of stuff that is contrary to my thoughts. I need to evaluate the others opinion and determine if it is important or just noise. In this case, Apple's stock came back and is a front runner again. They were able to add shareholder value and the market eventually realized the value in the company.

7. Technical analysis - After all the previous tests are passed, then I do like to look at the charts. I look at this for stocks that pass the first six tests but I have less certainty. For stocks like Canadian banks and blue chips that are selling at a discount, I do not need to look for this. There are many ways to play the charts and they do tell you something about the group mentality. I will not go into detail here, but will refer to technical analysis when writing about equities I am considering. If buying or selling comes in at certain levels, you know that the collective group of investors like or dislike a certain price.

Example of a small cap stock (also as TGA on the NYSE). See in the graph above how you can see from 2004 there is a support floor for around the $2.50 price. If it drops below the $2.40 mark, technical analysis would indicate it could drop to the pre-2004 levels.

Watching this is more short term. Warren Buffet has said "In the short term, the market is a popularity contest; in the long term it is a weighing machine." This means that the fundamentals will likely win out in the long term, but in the short term popularity gives volatility that can be seen in the charts.

My system of investing is to value assets, cash flow and earnings. I will buy when they are out of favor because the fundamentals look good. This helps me reduce my risk and contrarian, going against the crowd. This is how we take the volatility of the popularity contest and work it in our favor.

Disclosure: I am long AAPL, TD and TGA.