Beginners often wonder when a stock has finally become a buy signal. Identifying these kinds of things is a good first start.
So I created a 3 part “Green Light Approach” that you can use on any stock. It will help you pick good stocks at great prices. I call this an interactive guide because you CAN’T passively read this! Sometimes the best way to learn is to dive right in!
Are you ready to get started?
Each part has a scenario that you can learn from. There’s an easy chart that shows you if that ratio is green, yellow, or red.
Finally, I challenge you to work out an example. If you challenge yourself and work out the example, you will learn the process. You can then apply the Green Light Approach to find a buy signal for any company in the stock market. 3 green lights means you’re good to go!
If you scroll to the bottom of this post, you’ll see some stock market industry leaders and their Green Light Approach scores for 2013. It’s a great place to get started for your own ideas.
At the end of this challenge you will know the basics to analyzing stocks and finding them at good prices. This will put MORE MONEY in your pocket, and make more money WORK FOR you!
First Buy Signal: Dividends
Dividends are your share of the company’s profits. You want stocks that are paying you dividends. They are your reward for holding long term.
The best part about dividends is that they compound. You earn a percentage of your investment with the first dividend. Then the next dividend is earned on the first dividend plus your investment. The next dividend is earned on the first + the second + the original.
You can see how this can add up quickly. Investing in companies that don’t pay dividends makes you rely on stock prices to rise. This can be great for a while, but as soon as the price stops increasing you’re left with nothing.
During the internet bubble of 1999, a lot of technology stocks soared to new highs. Many new “experts” were claiming that dividends didn’t matter anymore. They would say: With so many stocks climbing higher, why buy the boring dividend stocks?
Shareholders who bought into this lie were taught the hard way.
Take Sprint (S) for example. The company stopped paying a dividend in 1999, yet the stock climbed to a peak of $71.22 on November 19. People thought it would go up forever.
The stock never got that high again. By 2001, the stock had crashed to $20. Today it trades at $6.05.
Solid companies treat their shareholders right and pay them a dividend. Companies that don’t, like Sprint (S), probably didn’t deserve the high stock price.
A company like McDonalds (MCD) has paid a dividend for over 40 years. You could’ve bought them in 1999 for $46.50 while collecting around 3% in dividends all this time. The stock now trades at $100.18.
You can find the dividend yield (%) of a company on any financial website, next to the ticker. It’s calculated pretty simply.
Dividend yield (%) = [Dividend] / [Share Price]
If you can find a company with a dividend yield greater than 2%, then you’ve found your first green light. With the Green Light Approach, you just need green lights in the other 2 categories.
Example #1: Dividends
For this example, I want to take you back to the end of the millennium. That’s right, I’m talking about December 31, 1999. I will present some facts, then pick a stock. Remember from part 1 of Stock Market 101: Dividend Yield = [Dividend] / [Share Price].
Proctor and Gamble (PG) is trading at $54.75. They have paid a dividend of $1.14. The company doesn’t have any exciting new products, instead they produce regular household items. It seems like Proctor and Gamble (PG) shareholders are missing out compared to the extraordinary returns of technology stocks around them.
On the contrary, Microsoft (MSFT) has been a world dominating stock. The company is trading at $58.37. Their products are used in almost every PC, and it seems like everyone in the country has one. The stock is seen as a leader of the “new” internet economy. Microsoft (MSFT) has already given early shareholders 1,000% gains. But, the company doesn’t pay a dividend and doesn’t plan to soon. Analysts argue that the profits are better reinvested in the company instead of paid back to shareholders.
Use this information to calculate the Dividend Yield of each, then make a decision. After that, check your answer below.
Example #1: Check your Answer
Proctor and Gamble (PG)
Share price at $54.75. Dividend paid was $1.14.
Dividend Yield = [$1.14] / [$54.75] = 0.02 = 2%
Share price at $58.37. No dividend paid.
Dividend Yield = 0 / [58.37] = 0%
From what we know up to this point, Proctor and Gamble (PG) is the clear better choice here. Their share price didn’t climb as high as the technology stocks did at the time, but they also didn’t fall as far when the bubble popped in 2000.
In fact, Microsoft hasn’t recovered from its once glorious highs made in 1999. Meanwhile, Proctor and Gamble (PG) has been steadily rising while shareholders have accumulated dividends.
Just one year later, Microsoft had fallen to $21.68. Today it’s trading at $31.39. That’s a loss of 46.2%. $10,000 in Microsoft in 1999 would be only $5,380 today.
Proctor and Gamble only dropped to $35.62 one year later. The company’s recovery has been much more solid, as the price is now at $80.41. The stock has gained 46.9% since its 1999 highs, all the while paying dividends to its shareholders.
I hope this simple example teaches you the importance of dividends. Not getting paid a dividend may seem ok at first.. until you’ve invested into a company with a loss and have nothing else to show for it.
…Did You Know?
It took the stock market 25 years to recover after the Great Depression crash [Tweet This].
Second Buy Signal: P/E Ratio
P/E Ratio is the most basic assessment of a stock. It’s also the most widely used and recognized financial ratio.
P/E tells you how expensive a stock is relative to its profits.
You want to look for stocks with low P/E ratios. The lower the ratio, the less you are paying for a company’s earnings. The higher the ratio, the more you are paying.
The stock market fluctuates between bear and bull markets often. Fear takes over during a bear market, while greed consumes a bull market. During times of extreme greed, people make poorer decisions with stocks and forget basic fundamentals.
Look at the previous example of Sprint (S) again. Because of the speculative craze of the time, people were ignoring basic fundamentals.
The stock had warning signs long before the dividend cut.
During Sprint’s peak on April 7th 2006, the stock was at $26.40. The company had EPS (earnings per share) of $0.45, which gave the stock a P/E of 58.7.
As you will see below, this P/E was very high and unreasonable. But people found excuses to ignore the obvious, and paid the price when the stock plummeted to $1.96 just two years later.
To calculate P/E ratio of any company, use the following equation. EPS and share price can easily be found on any finance website.
P/E Ratio = [Share Price] / [Earnings Per Share]
Example #2: P/E Ratio
The date is March 10, 2000. From only what is presented below, you have to pick one of the 2 stocks. Which one would you choose? Remember: P/E Ratio = [Share Price] / [EPS].
Cisco (CSCO) is trading at $68.18. The stock keeps reaching record highs, but critics claim the stock is overvalued. However, this isn’t stopping the stock from pushing higher. People see Cisco as changing the world as we see it. Technology companies like Cisco are seeing hope of massive growth and big profits from their innovative products. The stock had an EPS of $0.36 for the year.
Target (TGT) is trading at $30.04. Not many people are buying these type of stocks, as brick and mortar stores are considered the old way to do business. With everyone making their fortunes in the internet and dot com start ups, plays like Target seem old fashioned and behind the times. The stock had an EPS of $1.38 for the year.
Calculate their P/E Ratios and make a decision. Then check your answer below.
Example #2: Check your Answer
Share price at $68.18. EPS was $0.36.
P/E Ratio = [$68.18] / [$0.36] = 189.4
Share price at $30.04. EPS was $1.38.
P/E Ratio = [$30.04] / [$1.38] = 21.7
So many investors disregarded basic fundamentals during the dot com bubble. A P/E ratio like 189.4 is NEVER sustainable and will crash back down eventually. It always does.
A little over a year later Cisco (CSCO) crashed down to $13.62. Imagine those who couldn’t take the blood bath any longer and sold then. That’s a loss of 80%! $10,000 disappears to $2,000 almost instantly! The stock has never recovered, and trades at $25.50 today.
Target actually rose to $39.16 in the same time period. While the majority of the public was freaking out about the market crash, Target was silently growing and growing. Today the stock is at $71.62 and paying a nice dividend. It pays to be patient. It pays to be smart.
By the way, that Target gain is 138%. But it happened over 14 years. These kind of gains take time. With the dividends reinvested and compounded, the return becomes much greater than 138%.
So why does this happen?
The P/E ratio can help us identify stocks that are undervalued or overvalued. When a stock becomes extremely overvalued, the chances of it staying overvalued for a long period of time rapidly decrease. An undervalued stock is much more likely to appreciate over time.
The P/E ratio can be a valuable tool in keeping you away from bubbles and market frenzy. People who ignore P/E ratio often think they can sell the stock later because the stock will keep going higher. Oftentimes it does, but no one can know when the top is. If everyone did, then you wouldn’t be hearing stories of investors and hedge fund managers who go suicidal when these bubbles pop.
…Did You Know?
A $10,000 investment in Walmart (WMT) in 1978 would be worth $9,914,500 today, without including dividends.
Third Buy Signal: Debt to Equity
So you now know how to get cash from your investments with a dividend. And you know how to find undervalued stocks with the P/E ratio.
Now I am going to show you how to stay safe.
Leveraged companies are risky companies. When you are investing for the long term, you want to avoid debt as much as possible.
Many companies borrow money to finance growth, and you will find these numbers in the liabilities column of a company’s balance sheet. These numbers mean nothing to you unless you have a ratio to relate them all.
That’s where the debt to equity ratio comes in. Debt to Equity shows you how much debt a company has in regards to its assets.
The lower the debt to equity ratio, the better.
During the housing bubble of 2007, construction companies like Alcoa (AA) were heating up in the stock market. Many of these stocks looked very attractive and even had good P/E ratios.
However, what most investors didn’t realize was that most of this growth was being fueled by debt. Behind the scenes, this company along with many others were filling up their balance sheet with excessive liabilities.
While this might be fine for a while, eventually the over leverage will catch up to a company like Alcoa (AA). It did.
The crash hit Alcoa (AA) very hard. During its peak on July 13th 2007, the company was trading at $47.35. The company had $38.8 million in liabilities and only $16 million in shareholder’s equity at the time.
This gave the company a very high debt to equity ratio of 2.4. The party didn’t last forever, as by February 27th 2009, the stock was down to $6.23. Today it still only trades at $8.14, which is pitiful compared to where it once was.
Learn to calculate Debt to Equity ratio so this doesn’t happen to you. You can find assets and liabilities in the balance sheet section of Yahoo Finance.
Debt to Equity = [Total Liabilities] / [Shareholder’s Equity]
Shareholder’s Equity = [Total Assets] – [Total Liabilities]
Note: Financial companies such as banks are exceptions to this rule. Because of the nature of the banking business, they carry much larger debt to equity ratios. This is also true for the auto industry. It’s a very capital intensive industry. When calculating Debt to Equity for financial companies, divide the number by 10 THEN compare to chart above.
Example #3: Debt to Equity
This last decision may be easier to make in hindsight, but the truth of the numbers are still so powerful. Without ruining the answer I’ll say that even years before one of these companies went bankrupt, there were major red flags warning of trouble ahead.
The date for this last example is March 1, 2005. Remember that: Debt to Equity Ratio = [Total Liabilities] / [Shareholder’s Equity].
General Motors (GM) had $460,422 million in total liabilities and $14,597 million in shareholder’s equity. The stock was trading at $34.39. Keep in mind that the U.S. economy was booming during this time with the housing bubble.
At the same time, Volkswagen (VLKAY) had $145,547 million in total liabilities and $31,450 million in shareholder’s equity. The stock was trading at $9.50. While U.S. companies were thriving at this time, brands like Volkswagen’s Audi were underperforming the big players of BMW and Lexus.
Calculate the Debt to Equity Ratio and make your decision. See the answer below.
Example #3: Check your Answer
General Motors (GM)
Share price at $34.39.
Total Liabilities: $460,422 million. Shareholder’s Equity: $14,597 million.
Debt to Equity = [$460,422] / [$14,597] = 31.5
Now, divide by 10 = 3.15
Share price at $9.50.
Total Liabilities: $145,547 million. Shareholder’s Equity: $31,450 million.
Debt to Equity = [$145,547] / [$31,450] = 4.6
Now, divide by 10 = 0.46
Remember that we are dividing by 10 because of the capital intensiveness of the auto industry.
As you may know, GM went bankrupt in 2009. While the bondholders got a little bit back, the shareholders got nothing. Even though the government bailed them out, this didn’t help at all with getting the shareholders any of their money back.
The truth is that most bankruptcies can be spotted years in advance. Even in 2005 General Motors had a huge amount of debt to equity. The U.S. auto industry was failing, and anyone who paid attention to the balance sheet could’ve seen that beforehand.
While this tragedy was taking place, Volkswagen’s stock has continued to advance and the company has continued to take market share. Volkswagen’s Audi has exploded in popularity in the U.S., and the future looks brighter than ever.
Volkswagen (VLKAY) is at $44.58 today, a whooping 369% gain! This goes to show you that you don’t have to settle for subpar companies. While some companies struggle to get back on their feet, other companies are thriving and growing.
These numbers and ratios are all common knowledge and easily accessible. There’s no big secret to winning in the stock market. Wall Street just doesn’t want you to know that.
Notice how for all 3 examples, the stocks with the great stories all lost. A big mistake investors make is to get swept up by the story, instead of listening to the numbers. Any stock can have a story be twisted to sound good. Numbers can’t be changed. Numbers never lie.
…Did You Know?
Just because a company starts paying a dividend doesn’t mean it’s done growing. Walmart (WMT) grew 1,300% after starting to pay a dividend [Tweet This].
Go Out and Profit!
You now have 3 simple buy signal indicators you can use on any stock.
I hope you’ve learned something and have been inspired to do more.
Remember that most investors don’t take the time to learn these basics that I’ve taught your here. They’re always looking for the quick fix shortcut. Anyone who takes the time to understand how businesses work and report their financials can do very well for them self in the market.