5 Signs Of A Decent-Looking Share

Published in Investing on 1 August 2012

Financial ratios say it all. Here's what to look for.

How do you spot a share that will go on doing the business for years? It's a question that perplexes many investors, who often rely on intuition, newspaper tips and friends for suggestions on where to park their cash.

Yet ironically, with the arrival of free online databases carrying a wealth of financial information, it's never been easier to do the fundamentals of investment selection, reviewing key metrics and winnowing down a shortlist.

Granted, you may have to hop between databases to get the complete picture: not every free online resource carries every metric. But given the time and the inclination, it's possible to progress a long way.

So here, then, are five things to look out for:

1) Growing revenues

The first thing you want to see are increasing revenues. Simply put, if sales aren't climbing over time, it's difficult for profits or dividends to grow much, either. They might in the short term -- but you won't see the long-term growth that you want.

Nor, frankly, do investors want stellar growth, either, of the sort experienced by -- say -- SuperGroup (LSE: SGP). SuperGroup saw soaring sales on the back of its Superdry fashion label, to be sure. But what can come into fashion can just a quickly go out of fashion. Throw in operational and logistical problems, and the prospect of disaster beckons.

In my book, steady-as-you-go revenue growth is much more appealing. High-tech chip designer ARM Holdings (LSE: ARM), with a five-year revenue growth of 15%, looks good on this metric. So too does advertising WPP (LSE: WPP) on 12%, and Associated British Foods (LSE: ABF) on 12%. In each case, there are no obvious cyclical factors to take into account -- as there in with, say, miners -- so the five-year figures will be reasonably representative.

2) Earnings growth

After revenue growth, I like to see earnings growth -- otherwise, those new sales will have come at the expense of margins, and the business is effectively ‘buying' growth.

Again, some businesses will be able to point to shoot-the-lights-out earnings growth. Tullow Oil (LSE: TLW), for instance, has posted an impressive five-year earning growth of 128%. My approach is to once again eliminate the outliers, and set myself more modest aspirations.

So how do ARM, WPP and Associated British Foods fare on earnings growth, then? Quite respectably, as it happens. ARM saw earnings growth of 42%, WPP can point to 18%, and sugar-to-Primark Associated British Foods posted 16%. All three, then, get a green light from me.

3) P/E

But how expensive is it to buy a share -- literally -- of such earnings? Today, the FTSE 100 (UKX) is on an overall price-to-earnings (P/E) ratio of 10.7, and for me alarm bells ring when a share is on a P/E that is significantly above or below that market average.

Too high a P/E, and the share is too expensive. Too low a P/E, and I begin to worry about sustainability: why has the market marked down the company's earnings to such a low level? Insurer Aviva (LSE: AV), on a forecast P/E of just half the market average, is one such example of a share that is worth carefully evaluating before taking the plunge -- especially in the wake of recent boardroom turmoil.

So how do our three shares fare on this metric? ARM, I'm sorry to report, is on a P/E of 53. For me, that's far too much to pay. Great if it becomes unexpectedly cheaper, but failing that, it's for the chop. Associated British Foods at 18 is expensive, but -- just -- affordable. WPP, on 12, is fine.

4) Yield

As an income-focused investor, I like a stream of dividends flowing in. Dividends, I find, are the most sincere form of profitability. What's more, while growth-oriented shares offer the prospect of a decent gain at some point in the future, dividend shares give you that growth in small chunks, enabling you to spend or re-invest them as you wish.

So how do our three shares fare on forecast yield, then? As might be expected, on a P/E of 54, ARM offers only a miserly 0.8% yield. Associated British Foods is better, at 2.2%, but still a fair bit less than the FTSE 100's average dividend yield of 3.8%. WPP, on the other hand, comes in at 3.5% -- lower than the average, to be sure, but within the bounds of acceptability.

5) Dividend growth

Finally, we turn to dividend growth. The logic? Yield provides a snap shot at a moment in time, so let's see how payouts to shareholders have grown -- or not -- over a longer timescale.

Even though we're no longer really interested in ARM Holdings, it's worth noting that the company has increased its dividend by a healthy 12% per annum over the past five years -- albeit from a low base of 2p per share, to 3.48p.

Associated British Foods' dividend growth is far more miserly: just 6% -- ahead of inflation, but not significantly. WPP? Once again, the £10 billion market cap adverting giant turns in a creditable performance, posting a 17% growth.

Foolish bottom line

So would I rush out and purchase WPP, the single share to make it successfully through all five filters? No, of course not. Further research is required -- debt levels, exposure to pension commitments, currency issues, dominant shareholders who might de-list it and so on.

And, of course, I'll want to check all the figures above -- sourced from Bloomberg -- against the figures in the company's accounts. Database data can and does contain errors, and databases can find it difficult to deal with circumstances such as special dividends.

Finally, one investor well used to evaluating the prospects of shares, of course, is Neil Woodford, who looks after two of the country's largest investment funds and runs more money for private investors than any other City manager. Why not let him do the donkey work for you?

A free special report from The Motley Fool -- "8 Shares Held By Britain's Super Investor" -- profiles eight of his largest holdings, and explains the investing logic behind them.

Is he worth listening to? Well, on a dividend re‑invested basis over the 15 years to 31 December 2011, Mr Woodford has delivered a spanking 347% return, versus the FTSE All‑Share's distinctly more modest 42% performance. Which to my mind, speaks for itself.

So why not download the report? It's free, so what have you got to lose?

Want to learn more about shares, but not sure where to start? Download our latest guide -- "What Every New Investor Needs To Know" -- it's free. The Motley Fool is helping Britain invest. Better.

More investing ideas from Malcolm Wheatley:

> Malcolm holds shares in Aviva, but not in any other company mentioned here.

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

rober00 01 Aug 2012 , 5:04pm

Malcolm I think you should have mentioned one other ingrediant too, namely dividend cover.

If this is too low (which depends on the sector I know) then all else could still lead to loss.

goodlifer 02 Aug 2012 , 10:37am

We're looking for blue or bluish chips which (a) pay reasonabley decent dividends, and (b) hopefully go up 30% or more over the next few years.
In these we reinvest our dividend payments every month, together with any spare cash we may happen to have.

FWIW our checklist, items in no special order.
1) Would I be happy to work for this firm, if need be, or for one of the family to do so?

2) Does it fit in with the rest of our portfolio?
For reasonable diversification we like to have at least fifteen differnt holdings.
In practice there seems to be no upper limit. the more the merrier.
We don't like any holding to make up more than about 7% of our portfolio,- less if possible.

3) Yield
Ideally not below 4 or 5%,
Check dividend cover, history and forecasts

4) Price Earnings Ratio.
Never - well, hardly ever - more than ten times earnings, ideally seven times or less.
Check earnings' history and forecasts

5) Check stockholders' equity.
More than half, and you may be onto a very good thing.

Inevitably one has to compromise - find a share that ticks all boxes, it'll probably go down the tube before the ink's dry on the contract note.
One of the reasons why we diversif.y

Inevitably one has to compromise - find a share that ticks all boxes, it'll probably go down the tube before the ink's dry on the contract note.
One of the reasons why we diversify.

goodlifer 02 Aug 2012 , 6:50pm

Why not let him - the Blessed Neil - do the donkey work for you?

One reason is he doesn't always tell us what he's actually paid for his choices.
One of the most important things we need to know.

I'm afraid your report is quite a good read but not all that helpful - for all the superlatives you lavish on your hero, most of its content is blindingly obvious.

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