Picking shares for a portfolio has a lot to do with unseens

PF University It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of the Stock Exchange".

It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of the Stock Exchange". So wrote John Maynard Keynes. Tongue in cheek, perhaps, but his quotation raises an interesting point. Risk and volatility come as a package. That is not to say that a volatile share cannot make a good investment. But the fact that a share goes up does not necessarily make it a good long-term investment, or does it? There are some forces you should keep in mind when analysing price movements, because if you don't understand these basics you might as well take your portfolio to a casino.

The first question you should ask is: "What price should a company's share be"? In theory, the correct price, or "fair value", can be calculated by estimating how much profit the company is likely to earn in the future, then applying an appropriate discount - for example, inflation adjustment - to determine how much future earnings are worth. Divide that figure by the number of ordinary shares outstanding, and you have a price, a textbook starting point. The reality is quite different.

A company's earnings (revenues minus expenses) are published in its financial statements and are normally audited (approved) by a reputable firm of accountants. However, because companies can "manage" their earnings in certain legitimate ways, try to look at the earnings before interest, tax, depreciation and amortisation (EBITDA) This will give you a better picture of the core business. Cash flow is another important factor, particularly in the financial environment we find ourselves in today. A strong positive cash flow will have a significant upside influence on the share price. Does the company pay a dividend? Most investors prefer companies that do; in fact, some pension funds can invest only in dividend-paying companies. Look for the dividend yield: this is the annual dividend per ordinary share divided by the current price per share. Generally speaking, the higher the yield the better, but you also need to take into consideration earnings outlook, cash flow and external influences such as interest rates, the economic cycle and foreign exchange-rate movements.

The asset value of a company is another important constituent in valuation. You may read "ABC Fund is on a 15 per cent discount to NAV", meaning you can buy shares in the fund at 15 per cent less than the correct prevailing value. This is what we like: value for money. There are also external factors to consider. For instance, if a large investment bank issues a "sell" recommendation on a company, you will be one of the last to know unless you are a client of that company.

Then there is the general economic outlook; information about inflation, economic growth, unemployment, consumer spending and interest rates. For example, if unemployment is rising, people become frightened of losing their jobs, so they will spend less, which is not a good thing for retailers. If at the same time consumers are reducing heir debt, this will not be good for banks, who will be receiving less interest payments from customers.

Finally, a useful tip. The "Efficient Market Hypothesis" contends that investors cannot make money trading on news reports and other public information, because the information is already reflected in the share price as soon as it is known. The tip, therefore, is to do your homework in order to profit from identifying matters that are not reflected in the current share price. John McGaw is a financial adviser based in Dubai. Contact him at [e-mail]