The answer to the question: “How do I buy stocks?” is twofold. First, the company has to comply with my 3 revealing ratio’s for selecting undervalued stocks. Second, I must conclude my overall stock investment analysis of the company with a buy rating. I will limit myself on this page to the first part of the answer: the 3 revealing ratio’s for selecting fundamentally undervalued stocks.
3 Revealing Ratio’s for Selecting Fundamentally Undervalued Stocks
Because there are several thousands of companies in the energy and mining sectors to choose from, I have composited a set of revealing ratio’s for selecting fundamentally undervalued stocks to limit the amount of companies which potentially could be included into my stock portfolio. By complying with these ratio’s I make sure I can only choose between financially healthy stocks, as the selection process is based purely on the analysis of the company’s balance sheet.
Current Assets / Current Liabilities = (Minimum) 1.5
This calculation is also known as the current ratio1.
The current ratio informs us if the company can pay back their current liabilities (short term debt and payables) with their current assets (cash, receivables and inventory). A ratio under 1 implies that the company is unable to pay off its current liabilities with their current assets. The current liabilities are all the company’s liabilities which are due within twelve months – the current assets are all the company’s assets which are reasonably expected to be converted into cash within twelve months.
Companies with a current ratio under 1 often turn to the capital markets in order to raise additional funds or sell assets in order to pay back their debts and to have sufficient cash for their future working capital needs. They often also need to arrange additional funds to finance their expansion plans. The consequence is often a decrease in their share price in anticipation of arranging the required financing. That’s why I avoid company’s with a low current ratio for my stock portfolio. If a company from my portfolio has a current ratio which decreases to under 1.5 over time, I will not hesitate to liquidate this position as soon as I have noticed this – unless I have concluded that the decrease to under 1.5 is only temporarily.
I would like to point out that this first calculation relates only to selecting undervalued stocks in the energy and mining sectors. To find out how I adjust this calculation to select stocks from other sectors, I refer you to the first note at the bottom of this page.
Tangible Book Value / Total Tangible Assets = (Minimum) 0.4
The tangible book value1 is calculated as: Total Equity – Goodwill – Intangibles
The total tangible assets is being calculated as: Total Assets – Goodwill – Intangibles
Most companies in the energy and mining sectors are mineral exploration companies which do not generate any profit. That’s why I do not like to see too much debt on the exploration companies’ balance sheets. For the mineral exploration companies from my stock portfolio, the outcome of the revealing ratio #2 is almost always more than 0.9 – but must be at least 0.8. However, when an exploration company brings a project into production it’s logical that this company’s debt level is increasing. Heck, it has to finance the costs to develop the project into a producing asset. Also, more developed companies – which already have one or more producing assets – normally have a much higher relative debt level compared to exploration companies. As long as these producing assets generate profits – or, at least are expected to generate profits in the near term, this higher debt level shouldn’t be any problem. For producing mineral resource stocks, I have set a minimum value of 0.4 for share buying tip #2. With such a ratio a company normally can still arrange extra leverage to its balance sheet, when they suddenly need to after being confronted with some kind of unforeseen problem.
Tangible Book Value / Market Capitalization = (Minimum) 2
The market capitalization1 (or market cap) is calculated as: Shares Outstanding x Current Market Price per Share
My revealing ratio #3 is my interpretation of a decent margin of safety. If you are not familiar with the margin of safety principle, I encourage you to read “The Intelligent Investor”, a book written by Mr. Benjamin Graham. According to the living legend himself – Mr. Warren Buffet – this is by far the best book on investing ever written. In short, the margin of safety principle recommends investors to only buy shares which are undervalued in the current stock market, i.e. only buy them when you can get them at a discount.
Of course, the tangible book value already provides a margin of safety on it’s own, when compared to the normal book value, as it subtracts the goodwill and intangibles. But the share buying tip #3 demands that I only buy shares of companies, which can be bought at a discount of at least 50% to it’s tangible book value. This discounted value is then only just the entry point for my initial buy order in a certain stock, as I tend to buy more of a company’s stock when the share price decreases even further.
In short, I can conclude that the companies which comply with my 3 revealing ratio’s:
- have enough liquid assets to be able to pay their current liabilities;
- have a strong balance sheet with a low debt level and a cushion for unexpected rough times;
- are valued at a current market price which clearly undervalues the assets mentioned on their latest balance sheet.
Note: When I am selecting undervalued stocks who operate in other sectors than the mining- & oil and gas companies, I change the calculation for my first share buying tip into the quick ratio, which value should also be at least 1.5. The difference between the current ratio and the quick ratio is that for calculating the quick ratio you should first subtract the inventory value from the current assets, before dividing that outcome by the current liabilities. Inventory is excluded because in most sectors it will take months, or even years, to turn the inventory into cash – this is rarely the case with the ‘inventory’ of the energy and mining sectors. In addition, as I have explained in my stock market analysis, you can imagine that I feel quite comfortable with companies who hold mineral inventory – especially inventory from the most scarce minerals.
Note: Although a company must comply with my revealing ratio’s before I will add it’s stock to my portfolio, I would like to note that if a company’s stock is already a part of my stock portfolio, I take advantage of every exciting press release of that company to add more shares to my portfolio – as long as the share price still complies with all 3 ratio’s. In addition, the contents of that press release must have an extra positive impact to my overall stock investment analysis or to the outcome of the sums of my 3 revealing ratio’s for selecting fundamentally undervalued stocks.
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