I’ve been buying shares — with varying degrees of success — for 35 years. My first trades, made in 1986-87 as a teenage novice, had very mixed results. And a few times during my investing career, I’ve made the odd awful investment that wiped out my stake. Slowly, I learnt that investing isn’t like gambling or speculating. It’s about buying into quality companies at fair prices and then holding on for years. Today, my process for picking cheap shares is well-established — and has produced good results for more than a decade. Here’s how it works.
I check the company’s history and geography
I often begin by looking at a company’s recent history and its past, because longevity can be a strength in business. For example, did you know that Royal Mail Group dates back to 1516 and is therefore 506 years old? Or that drinks giant Diageo‘s origins date back to 1627? Likewise, if a company has a recently scandalous history, then I’m highly unlikely to buy its shares.
Next I check the debt burden
One of the first things I do before looking at the underlying value of a business and its shares is to look at the company’s debt burden. History has taught me that crushing debt brings down many otherwise sound firms. For example, if a company’s shares have a total market value of £1bn and the business carries £2bn of net debt (such as loans, bonds and pensions deficits), then I’m highly unlikely to invest in it.
Then I look at fundamentals
Once I’ve established that a business has a decent pedigree, only then do I start to evaluate its fundamentals. For me, these three key numbers are key:
1. The price-to-earnings ratio (P/E)
This divides a company’s share price by the firm’s full-year earnings per share (EPS). For example, a share priced at £1 with EPS of 12.5p has a P/E of 8. While P/E ratios vary widely between companies and sectors, the lower a P/E, the cheaper a share may be. For example, Lloyds Banking Group has a P/E of 5.87, which looks attractive to me as a veteran value investor.
2. The earnings yield
The earnings yield is simply the reciprocal (reverse) of the price-to-earnings ratio, so it’s earnings per share divided by the share price. For the above £1 share, an EPS of 12.5p translates into an earnings yield of 12.5%. Generally speaking, the higher the earnings yield, the cheaper a share appears to me. The current Lloyds P/E of 5.87 translates into an earnings yield above 17%, so I see these as cheap shares today.
3. The dividend yield
Lastly, I check a company’s dividend yield, which is its full-year cash dividend per share divided by its share price. For example, a share priced at £1 offering a yearly dividend of 5p has a 5% a year dividend yield. In another real-life example, Lloyds shares have a dividend yield of 4.56% a year. That beats the wider FTSE 100 index’s cash yield of around 4% a year.
Finally, I apply what I call my ‘test of reasonableness’. If I don’t easily understand a company’s business model and how it makes money, then I just don’t buy these cheap shares. This final comprehension test has saved me from making many mistakes over the decades!
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Cliffdarcy has no position in any of the shares mentioned. The Motley Fool UK has recommended Diageo and Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services, such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool, we believe that considering a diverse range of insights makes us better investors.