1。

Income–dividendyields

Thereareonlytworeasonstobuyashare:forincomeorforgrowth。

Whichisbest?

Investorsoftenconsidercapitalgrowthalonewhentheylookbackatthesharestheywishedtheydbought。

Butinfact,incomeisfarmoreimportant。

OverthepasttenyearstheFTSE100hasbeenallbutflat。

Butthroughoutthelastdecade,barringoneortwoblips,suchastherecentBPdebacle,bigbluechipshavecarriedonpumpingoutdividends。

Indeed,asGMOsJamesMontiernotes,inEurope,80%to100%ofthetotalreturnsachievedsince1970havecomefromdividends。

Forinvestors,therefore,yields(theannualdividendasapercentageofthecurrentshareprice)matter。

Andthegoodnewsisthat,fornowatleast,theFTSE100isofferingayieldofaround3。

5%,whichpipsthereturnonlong-termgilts。

Andplentyofsolidbluechipsoffermore。

Beforedivinginalwayscheckdividendcover–thenumberoftimestheannualdividendcouldbepaidoutofprofitsaftertax。

Again,thenewshereisgood。

OnaverageFTSE100companiesarecoveringtheirdividendsatleasttwice。

2。

Growth–price/earningsratio

Thenextcheckisafirmsprice-to-earningsratio(p/e)。

Asaroughguidethistellsyouhowlongthemarketexpectstowaittogetitsmoneyback,ignoringinflation。

Soap/eof,say,15suggeststhatifearningsdontgrow,youwillwaitaround15yearstorecoupyourinitialinvestment。

Thelowerthep/eandthestrongerthecompany,thebetterthechanceofbaggingabargain。

Onewayoftestingwhetheralowp/eratiorepresentsvalueornotistheprice-to-earnings-growth(PEG)ratio。

Thiscomparesthep/etoafirmsearningsgrowthrate。

Ifthisyearsearningsare£100mandnextyearsareexpectedtobe£110m,theexpectedearningsgrowthrateis10%。

Ifthefirmsp/eiseighttimesthenthePEGratiois0。

8(8/10)。

APEGbelowonesuggeststhatthefirmischeap。

AhighPEG,ontheotherhand–say,twoormore–impliesthatafirmsearningsgrowthisbeingofferedtooexpensively。

3。

Assets–price-to-bookratio

Ifyouwerebuyingabusinessyoudwantalistofitsassets(thestuffitowns)anditsliabilities(theamountsitowes)sothatyoucouldworkoutwhatitsnetassetsareworth。

Theprincipleissimilartotryingtoworkoutyournetequityinaproperty–ifahouseisvaluedat£350,000butcarriesa£50,000mortgage,itsnetvaluetothehomeowneris£300,000。

Forinvestors,price-to-bookratios(p/b)compareacompanysmarketvaluewiththebookvalueofitsbalance-sheetnetassets。

Soifafirmsmarketcapitalisationis£100manditsbalancesheetnetassetsare£150m,thep/bis0。

67。

Thatmeansthesharesareavailableatadiscounttonetassetvalue(NAV)–agoodsigninthehuntforabargain。

Itsnotaperfecttest,balancesheetsoftenexcludeintangibleassets,suchasbrandsandpeople。

Soinsectorssuchassoftwaredevelopment,thebalancesheetmaybelargelymeaningless。

Butitsstillausefulcheck,particularlyforasset-richsectors,suchasinvestmenttrustsandpropertycompanies。

Awell-knownmodificationisTobinsQ。

Thiscomparesafirms(orsectors,orevenawholeeconomys)marketcapitalisationtothecostofreplacingitsassetsattodaysprices。

Thelatterinvolvesafairbitofguesswork,butinprincipleiftheratioislessthanone,firmsarepricedcheaplyandmaybevulnerabletotakeover。

OnceTobinsQclimbsmuchaboveone,existingfirmsstarttolookoverpriced。

Inasectorthissetsthescenefornewrivalstoenterandundercutanyincumbents(assuminglowbarrierstoentry)。

4。

Cash–pricetofreecashflow

Dividendscanbecancelled,earningsmanipulatedandassetsmis-statedbydirectors。

Butcashflowishardertomessaroundwith。

Soagoodtestforvalueisthefirmsmarketcapitalisationagainstoneyearsfreecashflow。

Thatsthecashfromafirmsoperations,subtractingnon-discretionaryspendingoninterestpayments,tax,andtheamountneededtoreplaceexistingfixedassets。

Thelowertheratio,thebetter。

Whattobuy

Severalbluechipslookgoodonthesecriteria–herearetwoofthebest。

ThefirstisMelrose(MRO),whichseeksoutunderperformingindustrialfirmsandlookstoturnthemaround。

Thedividendyieldfor2010is3。

7%,covered2。

3times。

Thep/eis11。

2andthePEG0。

4。

AnotherdecentbetissupermarketTesco(TSCO)。

Whilegrowthisslowing,thebrandissolidandoffersaforwardyieldof3。

5%,covered2。

3times,withap/eslightlybelowtheFTSEaverageat12。

8andaPEGof1。

2。

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