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Analyze Investments PTA0505

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Analyze Investments PTA0505

  1. 1. Personal Finance How To Analyze Investment Like the Pros
  2. 2. TABLE OF CONTENTS By The Editors Of Personal Finance The Hard Facts 1 Collecting Data 2 The Ratios 8 Technical Indicators 20 Selected List Of Company And Industry Information 23 KCI Communications, Inc., 7600A Leesburg Pike, West Bldg., Suite 300, Falls Church VA 22043. Subscription and customer services: P.O. Box 4106, McLean, VA 22103, 800-832-2330. It is a violation of the United States copyright laws for any person or entity to reproduce, copy or use this document, in part or in whole, without the express permission of the publisher. All rights are expressly reserved. ©2008 KCI Communications, Inc. Printed in the United States of America. PTA1207-TG. The information contained in this report has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed.
  3. 3. The Hard Facts Without financial facts and figures, professional analysts couldn’t make informed decisions. Financial analysis demonstrates how past conditions and events came to pass; more important numbers exhibit what could happen in the future. The real purpose of this analysis is to identify proba- ble outcomes if certain actions are undertaken. For exam- ple, if past sales growth averaged 10 percent annually during a 10-year period and if the management team remains intact, we might logically expect the trend to continue. What numbers do the pros use? Most analysts use the raw information presented by accountants concerning sales, margins, expenses, profits and taxes. Unfortunately, the numbers themselves tell only part of the story. The trick is to know what the numbers mean and to relate them to each other and to industry norms. Financial analysis is designed to determine a company’s relative strengths and weaknesses—whether the firm is financially sound and profitable relative to other firms in its industry and whether its position is improving or deteriorat- ing over time. Analysts need this information to estimate the riskiness of the endeavor under consideration and to determine if the firm is worthy of an investment. Of course, the numbers aren’t the whole story. There are psychological factors that affect the stock market. Some ana- lysts say the stock market is 15 percent numbers and 85 percent psychology, following the postulate that all invest- ment issues are human related. That’s why savvy analysts use intuition and psychology to supplement the numbers. But without a solid grasp of how the pros use numbers, you’ll never be in the major leagues of investing. The tech- niques contained herein and in Personal Finance will help you become a confident investor. www.pfnewsletter.com 1
  4. 4. Collecting Data The first concern of the analyst is finding reliable infor- mation. Where do you look? The most commonly employed information, and the most dependable, is historical. Of the various reports corporations issue, the annual report is by far the most important. The Annual Report Financial Statements Principally, the annual report provides two types of infor- mation: a description of the firm’s operating results during the past year and a discussion of new developments that will affect future operations. The report includes four basic financial statements: the income statement, the balance sheet, the funds flow statement and the statement of changes in owners’ equity. Taken together, these state- ments depict the firm’s operations and financial position. In order to evaluate the merits of an investment, investors look for information that tracks the business and try to under- stand the flow of funds into and out of the firm. This process involves reviewing a great deal of formal or informal data rele- vant to the specific purpose of the analysis. Almost all of the data needed is found in the following financial statements. 1. Balance Sheet The balance sheet describes the categories and amounts of assets utilized by the business and the offsetting liabilities incurred by lenders and owners. Sometimes called the statement of Balance Sheet financial condition, or statement of Assets = Liabilities + Owner Equity financial position, it must always Assets Liabilities “balance.” Why? Because the total Current assets $50 Current liabilities $26 assets invested in the business at Fixed assets 125 Long-term liabilities 97 any point in time, by definition, are Other assets 2 Owners’ equity 54 Total assets $177 Total liabilities $177 matched precisely by the liabilities and net worth and owners’ equity position. 2 How To Analyze Investments Like the Pros
  5. 5. The balance sheet is sometimes reduced to a simple accounting equation: assets = liabilities + owner equity (see box on p. 2). Ultimately, all transactions appear within this basic equation. The balance sheet assigns values to equipment and other assets, describes amounts owed on both short- and long-term horizons, lists funds available for continued operation of the business, and determines the value of the stockholders’ equity. Keep in mind that balance sheets can become obsolete very quickly. Like your monthly bank statement, they reflect conditions on the compilation date. The major categories of assets are: current assets (items that turn over in a short period of time, such as cash, mar- ketable securities, accounts receivable and inventories); fixed assets (buildings, land, mineral resources, heavy machinery, vehicles, etc., all of which are used over the long haul); and other assets (deposits and intangibles like copy- rights and patents). Major liabilities include: current liabilities (obligations to distributors, tax authorities, employees and lenders due within one year); long-term liabilities (an assortment of debt instru- ments like mortgages and bonds); and owners’ equity (funds contributed by various classes of owners of the business as well as accumulated earnings Income Statement retained in the business). Revenues - Expense = Profits 2. Income Statement Sales $4,000 Costs and expenses 2,400 The income statement describes the Writeoffs 100 dollar value of goods and services sold, Depreciation 100 gross profit, funds expended to make profits happen, including writeoffs and Earnings before interest and taxes $1,400 taxes, and how much net profit or loss Interest expense 25 resulted. The income statement is some- Earnings before taxes 1,375 times referred to as the operating state- Taxes 475 ment, earnings statement or profit-and- loss statement. Net Income $900 www.pfnewsletter.com 3
  6. 6. Where the balance sheet reflects the financial condition on a specific date, income statements tell what happened over a period of time, usually one year. The net profit earned by a business enterprise is found by deducting expenses from revenues, or in equation form: revenues - expenses = profits (see box p. 3). 3. Funds Flow Statement The funds flow statement, or the statement of changes in financial position, provides the basis for an aggressive analy- sis that focuses on the changes in financial condition result- ing from management decisions made during a given time period. It’s derived from data appearing in other statements and answers the following questions: Where did the compa- ny get its funds during the year? What did the firm do with these funds? Is the firm’s financial position stronger or weaker, as measured by changes in net working capital (cur- rent assets minus current liabilities)? This statement is prepared by comparing ending and beginning balance sheets and is combined with information from income statements. As noted, from this greatly simpli- Funds Flow Statement fied example (see box), the compa- Changes in ny’s current assets declined during Balance Sheets 12-31-05 12-31-04 + or - the year. You can also see that the Current assets $50 $55 –5 firm used available funds to finance Fixed assets 125 110 +15 long-term liabilities, because fixed Other assets 2 0 +2 Total assets $177 $165 +12 assets were up from $110 to $125, with a corresponding jump in long- Current liabilities $26 $16 +10 term debt. It’s just this sort of Long-term liabilities 97 59 +38 snooping, combined with a vigilant Owners’ equity 54 90 –36 reading of all text, that puts the Total liabilities $177 $165 +12 spotlight on patterns. and net worth Sources of funds are designated by a "+" and uses by a “-.” Is the firm’s financial position stronger or weaker, as measured by changes in net working capital? It’s weaker. Working capital declined by $15 (current assets down by $5 and current liabilities up by $10). 4 How To Analyze Investments Like the Pros
  7. 7. 4. Statement Of Changes In Owners’ Equity The statement of changes in owners’ equity or financial position gives more details concerning the change in owner- ship accounts, or net worth, as recorded by the beginning and ending balance sheets. Getting a closer look at the funds flow statement allows you to make a more detailed analysis. For example, you can determine whether debt or a new equity issue financed company growth. From Data Collection To Ratio Analysis The statements discussed provide much useful informa- tion. However, the collection of data is just a starting point. Once reliable information is assembled, an investor can con- duct ratio analysis on the firm and then compare the infor- mation to data of firms within the industry. Ratio usefulness lies in the ability to turn a series of num- bers into a powerful display highlighting the elements that affect operating performance. While there are many ways to compare numbers, ratio analysis is accomplished simply by dividing one number into the other. Ratios Financial ratios are designed to exhibit relationships among financial statement accounts, putting numbers into perspec- tive. Unfortunately, it’s not always clear whether higher or lower values for any given ratio are desirable. When unsure, look at the trends for the industry. The more enlightened you are, the more success you will have as an investor. Ratios have a number of advantages: • They clarify the relationship between numbers that are difficult to see and comprehend by themselves. • Ratios focus on trends that may be impossible to spot in a column of numbers. • Ratios make numerical reporting easier to follow and more interesting, especially when comparing firms with- in an industry. www.pfnewsletter.com 5
  8. 8. Here are some of the ways investment analysts put ratios to work: • Monitoring growth of a company • Assessing profitability and understanding trends • Appraising return on investment • Watching expense-related items • Determining breakeven levels • Comparing and contrasting operating periods • Comparing and contrasting planning with actual results • Comparing and contrasting current expenses to historical costs • Observing collections and receivables trends • Comparing and contrasting a firm with competitors • Comparing and contrasting entire industries • Comparing and contrasting executive performance • Monitoring performance under different interest rate scenarios • Observing employee productivity • Monitoring employee turnover • Measuring management’s efficiency • Measuring the average size of orders • Clarifying financial statements • Evaluating returns to shareholders Before undertaking an analysis, you need to know: • What is the exact nature of the analysis? What are you attempting to accomplish? • Which specific factors and trends are likely to be helpful in ana- lyzing the stock? What is the order of importance? • Where will your data come from? How old is the data? • How reliable is the data? What confirmation do you have? Never accept data from brokers or company officials at face value. Question everything. 6 How To Analyze Investments Like the Pros
  9. 9. • How precise do the answers need to be? Will additional research be worth the effort? • How important are qualitative judgments in the con- text of the problem? How much of a role does psychol- ogy play? Limitations Of Ratio Analysis As with any investigation, there are drawbacks to ratios: • Today, conglomerates operate businesses in many industries, which makes it difficult to obtain meaningful statistics. For example, General Motors operates numer- ous businesses, from automobiles to finance to insur- ance to locomotive construction. • Inflation badly misrepresents balance sheets because financial statements are based on historical costs. Profits are affected because inventory values rise with inflation. • Some firms employ “smoke and mirrors” to make financial statements look better. Cash accounts can be skewed by including money from long-term debt with cash, improving year-end “quick” and “current” ratios. After analysis is endorsed by accountants and results printed, debt can be paid off. • Different accounting practices can mislead. Firms within similar industries may use contrasting deprecia- tion schedules. • Ratios consider past activity. History is worth recogniz- ing, but the future is always uncertain. Never assume that obsolete printed material has any application in today’s world, even if it’s only a few months old. Regardless of its limitations, ratios allow investors to focus on problems. More important, they provide the tools to determine if company managers recognize transforma- tions in their industry, adapt to changes, and if they’re con- trolling finances properly. www.pfnewsletter.com 7
  10. 10. The Ratios Ratios are the foundation of what analysts call “funda- mental analysis.” In traditional ratio analysis, very few addi- tional information sources beyond the balance sheet and income statement are used. However, don’t confine your digging to these two statements. There are many advan- tages to looking beyond the two traditional financial state- ments for useful input numbers. Which Ratios to Monitor Ratio compilation and analysis is a clerical process. It requires determination in the collection of data, accuracy in calculation and perseverance in comparison with industry averages. There’s no relationship between the size of a firm and the number of ratios requiring review. It depends entirely on your style and the comfort level you need to feel safe with your investment. Beware of pseudo ratios that can’t logically be compared. For example, the ratio of stockholders’ equity to sales prob- ably expresses no useful relationship. Unique or custom ratios may or may not provide significant information. Problems arise when attempting to compare unusual ratios to industry norms that don’t exist. Ratios may be categorized into these groups: asset man- agement ratios, profitability ratios, liquidity ratios and market value ratios. When making comparisons, keep in mind that numbers must be consistent from one period to another. Extraordinary items should be removed from cur- rent and past data. Remember that new information could make previous data invalid. Asset Management Ratios Sales Growth Ratio Without grease for the wheels, a company won’t run for long. Sales provide the grease; nothing happens until 8 How To Analyze Investments Like the Pros
  11. 11. somebody sells something. This ratio measures just how well the company is doing with its sales. Over time you can determine if insufficient growth origi- nates from within the company (lack of attention to marketing or customer preferences) or from without (competitors, tech- nological change or a recession). Whatever the cause, failure to grow sows the seeds for future difficulties. This ratio is calculated by examining current year sales with revenues from the previous year. The ratio equation is: Sales Growth = (Net Sales This Year - Net Sales Last Year)/Net Sales Last Year Net Sales Last Year On the income statement on p. 12, we note net sales of $1.29 million. This equation requires you to examine the previous year’s income statement (not shown) and net sales from the period monitored. Net sales were up 29 percent during the previous year, indicating rapid growth. The analyst must compare this fig- ure with industry averages and chart the growth over several years to look for erratic patterns. Sales Per Employee When companies originate, employees wear many hats. As firms grow, they hire specialists to fill positions, suppos- edly to improve efficiency. In reality, labor costs sometimes increase faster than revenues as companies transfer former part-time jobs to full-time specialists earning salary and ben- efits. The risk of expanding too fast is real for all companies, not just small and medium-sized firms. You should watch this ratio closely, especially in fast- growing high-tech industries. An increase in this ratio is usually a sign of improving efficiency, while a decrease may mean that the firm is experiencing diminishing returns or anticipated sales have not materialized. Another compari- son is between employees and production. For example, contrasting General Motors and Ford employees needed per unit of automobiles produced. www.pfnewsletter.com 9
  12. 12. Sample Balance Sheet XYZ Company Statement of Financial Position, Dec. 31, 2006 Assets Current Assets Cash and marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Other current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $428,000 Fixed Assets Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Buildings, less depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Machinery/equipment, minus depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Total Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 Other Assets Intangibles (goodwill, patents, trademarks) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,000 Tangible other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Total Other Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,000 Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $510,000 Liabilities and Stockholders' Equity Current Liabilities Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Current portion long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500 Other current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — Total Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $147,500 Long-Term Liabilities Notes and mortgages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000 Lease obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Total Long-Term Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000 Stockholders' Equity Capital stock, par value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .0.01 Authorized shares, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000,000 Issued and outstanding, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000,000 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000 Total Stockholders' Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000 Total Liabilities and Stockholders' Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $510,000 10 How To Analyze Investments Like the Pros
  13. 13. For this equation, we must dig to determine the number of employees. After reading the annual report, we discover that the firm has only 30 employees (not displayed). Sales Per Employee: 1,290,000/30 = $43,000 The $43,000 means nothing until we compare it with other firms within the industry and track the figure over several years. Total Expense Ratio This ratio indicates managerial success in controlling expenses. The lower the number the better. Total Expense Ratio = Total Operating Expenses/Net Sales Interest Expense Ratio Some companies depend on borrowed money to finance long-term growth, even daily operations. Still others rely on equity capital and cash flow from profits. This ratio studies the interest cost relative to the sales of the company. You should give this ratio close scrutiny, watching closely when borrowing is significant and comparing with similar firms. Interest Expense Ratio = Interest Expense/Net Sales Turnover Of Assets Sometimes called the investment turnover ratio, asset turnover ratios measure how many times the company’s assets are employed in the year to create sales. This is a compelling indicator of management efficiency and performance. Turnover Of Assets = Net Sales/Total Assets Lower ratios indicate insufficient sales or the need to elimi- nate unproductive assets. High ratios point to an ability to cre- ate and process sales at low cost. Follow this ratio with a trendline chart; downward trends signal declining efficiency. Inventory Turnover This ratio assesses how well management controls inventory. An increasing inventory may show manage- ment commitment to increase sales, or accumulation of www.pfnewsletter.com 11
  14. 14. XYZ Company Income Statement goods languishing on shelves. Year Ended Dec. 31, 2006 When comparing businesses, Revenues net sales may be the better Gross sales . . . . . . . . . . . . . . . . . . . . . . . . . . .$1,300,000 yardstick because cost of Less returns and allowances . . . . . . . . . . . . . . . . . .10,000 goods sold varies consider- Net Sales . . . . . . . . . . . . . . . . . . . . .$1,290,000 ably between firms. Cost of Goods Sold The average inventory is Beginning inventory . . . . . . . . . . . . . . . . . . . . . .$300,000 determined by adding opening Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .800,000 and closing figures and divid- Cost of goods available for sale . . . . . . . . . . . .$1,100,000 ing by two. We’ve simplified Less ending inventory . . . . . . . . . . . . . . . . . . . . . .300,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . .800,000 our example so that both fig- Gross Profit . . . . . . . . . . . . . . . . . . . . .$490,000 ures are $300,000. Operating Expenses Inventory Turnover = Cost Of Goods Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$160,000 Sold/Average Inventory Marketing expenses . . . . . . . . . . . . . . . . . . . . . . . .75,000 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .5,000 Profitability Ratios Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . .12,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . .10,500 Profits are very important. Bad-debts expense . . . . . . . . . . . . . . . . . . . . . . . . .20,000 Unless the company has Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . .14,000 Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25,000 unlimited resources, operat- Additional expenses . . . . . . . . . . . . . . . . . . . . . . . .50,000 ing unprofitably over a peri- Total Operating Expenses . . . . . . . . . . .$406,000 od of time will deplete capital Income From Operations . . . . . . . . . . . . . . . . . . . .$84,000 to the point that nothing is Net Profit Before Taxes . . . . . . . . . . . . . . . . . . . . . .84,000 left to pay employees or buy Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12,000 Net Profit After Taxes . . . . . . . . . . . . . .$72,000 raw materials. Continuous break-even operations provide no cushion for contingencies. What’s worse, without profits, rational investors will not invest nor will lenders supply the funds needed for growth and expansion. Gross Margin Low margin means that too much is being paid for merchandise, or selling prices are too low, or both. A value of zero means that the goods are sold for the same price paid for them. Negative values are possible if selling prices are below cost overall. Such evidence would indi- cate extreme competition. 12 How To Analyze Investments Like the Pros
  15. 15. Margin is closely related to pricing. Remember that margin is lower where the customer can pick and choose among many suppliers and higher where choices are limited. A high margin would probably indicate this firm has few competitors. Determine this ratio by dividing gross profit by net sales. Gross Margin = Gross Profit/Net Sales Break-Even Margin This is simply the total operating expenses divided by net sales, a number that even the most inexperienced investor should monitor. Management attempts to increase profits by increasing margins, though price increases may fail because customers could seek substitutes or forgo the prod- uct entirely. Margins are also affected by purchasing raw materials. Increasing raw material order quantities from sup- pliers could lower prices and operating expenses. Break-Even Margin = Total Operating Expenses/Net Sales Operating Margin Operating margin is considered a better indicator of man- agement skill and operating efficiency than net profit margin. This ratio is important to investors interested in the underly- ing profitability of the business. Even firms with excessive debt expense can be proven competitive using this ratio. Operating Margin = (Net Profit Before Taxes + Interest + Depreciation)/Net Sales Profit Growth This ratio measures success in transferring revenue growth to bottom-line profit growth. The ratio is the difference between this year’s and last year's after-tax net profit, divided by last year’s after-taxes net profit. It’s best to plot this data for several preceding years on a trendline to see if profits fluctuate significantly from year to year. This ratio requires us to examine the previous year’s income statement (not displayed). Profit Growth = (This Year’s After-Taxes Net Profit - Last Year’s After-Taxes Net Profit) /Last Year’s After-Taxes Net Profit www.pfnewsletter.com 13
  16. 16. Return On Sales This is a key profitability ratio, also known as net prof- it margin. This ratio measures the difference between what a company takes in and what it spends in conduct- ing its business. Lower returns are predictable when many rival companies flirt with the same customers. Conversely, high returns are common for firms offering propri- etary products. Yearly trends are significant because they demonstrate how well a company’s overall business strategy is working. It’s best that you diagram returns for several years on a trendline chart to evaluate patterns. Return On Sales = Net Profit After Taxes/Net Sales Return On Gross Profit This ratio compares net profit to gross profit instead of to sales. It’s useful to investors, lenders and anyone who may need to compare the efficiency of two firms in similar or total- ly different businesses. You want to know how successful a company is at converting gross profits into net profits. Firms with high returns on gross profit display at least two common characteristics: They’re in good lines of business and competitors are scarce. Return On Gross Profit = Net Profit After Taxes/Gross Profit Return On Assets This ratio indicates how successful management is in utilizing assets to make profits. It really measures the firm’s earning power of its asset investments. Averages for this ratio vary greatly by line of business. Obviously, steel manufacturers require more assets than a sales-oriented business. Some analysts remove intangible assets from the equation and average beginning and ending asset totals. To simplify our analy- sis we’ll use ending total assets taken from the balance sheet. Return on Assets = Net Profit After Taxes/Total Assets 14 How To Analyze Investments Like the Pros
  17. 17. Return On Net Worth Sometimes called return on equity, this is the best known of the return-on-investment ratios. Pay particular attention to this ratio because it reports how much the company is earning from dollars invested. The national averages for this ratio vary from 5 to more than 20 percent depending on the business. Lower returns may limit investment, restrict growth and ultimately the dividend-paying ability. Many variations for this ratio exist, with the resulting numbers differing significantly. Return On Net Worth = Net Profit After Taxes/Stockholders’ Equity Some firms obtain money entirely from equity investors, or from profits resulting from business. Money obtained this way doesn’t have to be repaid, and there’s no interest cost. Other firms obtain needed cash by borrowing from banks, or by issu- ing debt instruments such as bonds. Company survival may hinge on its ability to meet such obligations. Business success results from maximizing the use of other people’s money. Liquidity Ratios Current Ratio This ratio is computed by dividing current assets by current liabilities. Sometimes called the liquidity ratio, this ratio is perhaps the best-known measure of financial strength on a specific date. When companies get into financial difficulty, they pay debts slowly. When tough times appear, the current ratio will fall and could spell trouble for the firm. Industry averages aren’t etched in stone, but a popular rule of thumb for this ratio is 2 percent or better. Many consider this number the minimum necessary for reliable cash flow, though some lines of business operate at lower figures. Current Ratio = Current Assets/Current Liabilities Quick Ratio Quick assets are current assets less inventory, divided by cur- rent liabilities. Sometimes called the acid test, this ratio is perhaps www.pfnewsletter.com 15
  18. 18. the best measure of liquidity on a specific date. Why? Because it considers only those assets that can be converted to cash quickly. Typically, inventories are the least liquid asset. Quick Ratio = (Current Assets - Inventory)/Current Liabilities Current Debt To Stockholders’ Equity This measure of financial strength compares what’s cur- rently owed to what’s owned. Since current liabilities are due now, this ratio is another important indicator of com- pany solvency. Current Debt To Equity = Current Liabilities/Stockholders’ Equity Debt To Stockholders’ Equity This ratio is total liabilities divided by the stockholders’ equity. It compares the total of what’s owed to what’s owned. When the ratio exceeds 100 percent, it indicates that the investment capital provided by lenders exceeds that provided by the stockholders. Debt To Equity = Total Liabilities/Stockholders’ Equity Debt To Assets Also called the debt ratio, this ratio compares what’s owed to the value of assets employed by the business. The total liabilities are divided by total assets. While debt varies greatly from firm to firm, this ratio monitors success in using debt to build the business. If the ratio climbs over time, a likely interpretation is that borrow- ing is financing losses. Debt To Assets = Total Liabilities/Total Assets Inventory To Current Assets Ratios involving inventory are measures of managerial effi- ciency. This ratio is a good indicator of asset allocation and liq- uidity because it makes the comparison to other assets instead of sales. There’s no correct value for this ratio, but if it moves out of its known range it should be viewed as a red flag. Inventory To Current Assets = Inventory/Current Assets 16 How To Analyze Investments Like the Pros
  19. 19. Judgment Day Ratio The judgment day is when all possible circumstances sour. This is the most critical of the solvency ratios and assumes that inventory, accounts receivable, prepaid expens- es and other current assets are illiquid. Only cash is available to meet obligations. Examine this ratio closely to determine if a firm is operating too close to the abyss. Develop a trendline and follow this ratio over time. Judgment Day Ratio = Cash/Current Liabilities Cash To Total Liabilities Cash is the ultimate asset—in fact, it’s the only asset that others will pay you to hold. Unfortunately, comparative information on levels of cash held by corporations isn’t easi- ly obtained. Sometimes you can make many permutations to uncover actual cash amounts. Cash To Total Liabilities = Cash/Total Liabilities Market Value Ratios Investment analysis means looking at anything about a firm that could impact its ability to meet financial obliga- tions and provide a growing stream of earnings and divi- dends. After all, if you’re nearing retirement and counting on dividend income to supplement Social Security, you don’t want any surprises. Market value ratios, sometimes called investment ratios, examine a company’s progress from a bottom-line position. When market values flounder, investors “bail out” quickly, forcing down the price of the security. Book Value Per Share The stockholders’ equity is divided by the number of shares of stock outstanding. When new stock is sold from time to time, this ratio tracks the dilative effects of such sales. Book Value Per Share = Stockholders’ Equity/Shares Outstanding www.pfnewsletter.com 17
  20. 20. Dividend Rate Dividend rates are important but only provide limited information for evaluating holdings. They communicate only one fact—the amount of the payout. These numbers are frequently located on the balance sheet, in the stock- holders’ equity section. Dividend Rate = Dividend Dollar Totals Disbursed/Shares Outstanding For this simplified example, no dividends are included. If they were, the total amount of the dividend would be divided by 22 million shares, the number of shares of stock outstanding. Dividend Yield The dividend yield relates dividend payout to the stock price. High yields are characteristic of mature industries, like utilities. Low-yielding stocks indicate growth companies. Dividend Yield = Dividend Dollar Amount/Current Stock Price In this simplified example, dividend amount is not includ- ed. Suppose the stock price is $45 and the yearly dividends add to $3.15. The yield would be 7 percent. Price-To-Earnings Ratio Price-to-earnings (P/E) ratios are oft-quoted by analysts and represent per share market price of a company’s stock divided by after-taxes net profit per share. When investors are optimistic, as they were for most of the latter 1990s, they’re willing to pay more for anticipated future earnings. When a company’s future is viewed pessimistically, or the industry is boring, the ratio is likely to be low. P/Es change with stock price movement, so to arrive at the current P/E, divide the stock’s current price by earn- ings for the most recent four quarters for a trailing P/E. Or, if you’re forecasting the future, divide the current price by the company’s estimated earnings for the next four quarters. One way to foretell growth is to examine historical patterns. 18 How To Analyze Investments Like the Pros
  21. 21. Many analysts maintain that low P/E stocks are positive (bullish indicators) while high P/E stocks are signs of an impending correction. It’s a good habit to develop trendline charts of the P/Es for stocks that interest you. P/E = Stock Price/Net Profit After Taxes Per Share Price-To-Earnings-To-Growth The price-to-earnings-to-growth (PEG) ratio, otherwise known as the PEG ratio, is a way to measure a stock’s value relative to its growth rate. The PEG ratio is calculated by dividing a company’s P/E ratio by its five-year expected earnings growth rate. A PEG ratio under 1 suggests a com- pany is undervalued relative to its growth rate, while a num- ber above 1 suggests it’s overvalued. Like other ratios the PEG ratio shouldn’t be used in a vacuum. Consequently, you should compare PEG ratios that appear especially high or low to other competitors in the industry as well as the market as a whole to get a sense if the stock is truly under or overvalued relative to its peers and the entire stock market. PEG = P/E ratio/5-Year Earnings Growth Estimates Price-To-Book Price-to-book is the per share market price of a compa- ny’s stock divided by stockholders’ equity per share. This ratio is a fairly good indicator of how investors view the future. The higher the ratio, the more optimistic are buyers. Note that book value does not accurately report the market value of assets because values are derived from historical costs. Price-To-Book = Stock Price/Stockholders’ Equity Per Share Price-To-Sales Here’s another way to evaluate the company’s market price, this time relating it to sales. The idea is to put a price on a business that correlates to annual sales. Price-To-Sales = Stock Price/Net Sales Per Share www.pfnewsletter.com 19
  22. 22. Technical Indicators The preceding chapters were primarily concerned with fundamental analysis or the firm foundation theory. The fundamental investor matches value to price. Fundamentalists believe that investment prices reflect all available information relevant to determining value. Any new information is quickly digested by the investing public and accurately reflected by posted prices. Technical analysis is the castle-in-the-air theory. That is, technicians don’t concentrate on a stock’s value, but on investors’ moods. Technicians pay little attention to what the company does, concentrating on how the stock price performs. Technicians employ indicators, charts and computer programs to track trends in stocks and bonds and the general market. They use these indicators to predict price movements. Fundamental analysis focuses on the intrinsic value of specific firms. Analysts crunch numbers, conduct ratio analy- sis and probe factors like sales trends, profits, product analy- sis, potential markets and managers. By examining the foun- dation of the firm, future prices can be forecasted. Technicians focus on the company’s stock price and volume traded as pictured on daily, weekly and monthly charts. By looking at a stock’s pricing activity, future prices can be forecasted. Other Technical Indicators Dow Theory is the oldest and most widely used of the technical theories. As with other technical procedures, it’s based on trends indicated by price movements. Named after Charles Dow, this theory contends that the stock market is made up of two types of “waves.” These waves are pri- mary—a bull or bear market cycle of several years’ duration and a secondary wave lasting from weeks to months. Dow believed his theory applied to the general market and that individual stock selections would rise or fall with the averages much of the time. 20 How To Analyze Investments Like the Pros
  23. 23. Speculative influence is reflected in the ratio of activity between Nasdaq and American Stock Exchange (AMEX) stocks to New York Stock Exchange (NYSE) volume. The theory is that when activity and prices of Nasdaq and AMEX stocks begin to move more rapidly than the blue chip issues, speculation is multiplying. That’s the time for conservative, rational investors to move to the sidelines. The Odd-Lot Index reveals how smaller investors view the market. The smaller investor is presumably less informed and so tends to follow established and predictable patterns. Concentrating on trades of fewer than 100 shares, the index alerts its followers when fry investors deviate from regular actions. Moving averages (see box) compare current stock or mutual fund prices to averages tracked over a period of time. As a new price is added to the list, the oldest price falls off. All prices are “aver- aged” by dividing the sum total by the number of days The Moving Average or weeks monitored. A solitary number is meaningless unless it’s com- pared to something else. Analysis depends on compar- Investors invest in the mar- ison. For example, unless you know the average of ket as long as the moving stock prices for the past six months, you won't know average is above the S&P whether trends are increasing or decreasing. And that's usually what you need to know. 500 average, the Wilshire The best way to focus on trends over time is with 5000 average or whatever the moving average. Moving averages allow you to index is monitored. examine the direction of a stock or mutual fund by comparing its price to movements over time. A moving A most-active stock list average is updated periodically by dropping the first is published in many daily number and adding the most recent number. newspapers, giving highs, For example, a 52-week moving average is deter- mined by adding the stock or mutual fund's closing price lows, last prices and changes for the current week to the closing prices of the previous in the volume leaders on the 51 weeks and then dividing by 52. Over time, this mov- NYSE and Nasdaq ing average indicates the trend of prices. In most cases, analysts compare individual invest- exchanges. Many investors ment moving averages with a regular market average watch these lists closely and like the S&P 500. For example, as long as the S&P either buy the issues after 500 is above its moving average, the outlook is bull- ish. Conversely, when the S&P 500 falls below its they’ve appeared on the list moving average for three or four weeks, the outlook for three consecutive days or is bearish. short them. www.pfnewsletter.com 21
  24. 24. Similar to the most active list is the daily list of new highs or lows. These are the stocks that hit new highs or lows for the year during the previous day’s trading session. Technicians believe that when more stocks are making new highs than lows, bullish times will result. Advances vs. declines is a simple measure of the number of stocks having advanced in price and the number that have declined. Widely followed and quoted, this is thought to illustrate the general direction of the market. Volume, the number of shares traded daily, is an important indication of where the market is headed. Buyer enthusiasm to climb aboard rising markets frequently push prices higher. Momentum measures the velocity of an index, comparing current numbers to an index or a moving average. How To Evaluate A Mutual Fund Interested in mutual fund investing? Before you invest in a mutual fund, obtain answers to these questions: • What was the annual return of the fund for the past 10 years? Did the fund outperform the S&P 500 during that time frame? • Was growth apparent each year? How did the fund perform in the bear markets of ‘87, ‘90, ‘94 and the fall of ‘98? • Did the fund outperform other funds with similar objectives? • Is the current portfolio manager the person who built the fund? If not, how long has the present manager directed the fund? There’s no substitute for experience (especially when your money is in jeopardy). • Does the fund have a load? Do your best to stay away from loaded funds, especially when there are so many good no-load funds. Is the expense ratio—the sum of all administrative and management fees divided by the NAV—below 1.5 percent? Avoid funds with ratios above that. 22 How To Analyze Investments Like the Pros
  25. 25. Selected List Of Company And Industry Information Your local library should have some or all of the follow- ing publications investment experts use to evaluate stocks and industries. Key Industry Overviews • Standard & Poor’s Industry Surveys—New York: Standard & Poor’s Corp. Quarterly updates. • Value Line Investment Survey—New York: Value Line. Looseleaf with weekly updates. • Morningstar Mutual Funds—Monthly updates. A run- down and rating of mutual funds. Corporate Profiles And Summary Information 10-Ks and Annual Reports to shareholders. All of these public filings can be found on the “Edgar” database provid- ed by the Securities & Exchange Commission. The Internet address is www.sec.gov. • Hoover’s Handbook—Profiles of more than 500 major corporations. • Moody’s Manuals—Bank & Finance. Industrial. International. OTC Industrial. Public Utility. Transportation. New York: Moody’s Investors Service. • Standard & Poor’s Bond Guide—New York: Standard & Poor’s Corp. Monthly. • Standard & Poor’s Stock Guide—New York: Standard & Poor’s Corp. Monthly. • Standard & Poor’s Stock Reports—New York: Standard & Poor’s Corp. Weekly updates. www.pfnewsletter.com 23
  26. 26. Internet A great Web site that provides everything from 15- minute delayed stock quotes to price charts to financial ratios is Yahoo Finance. The Web site is http://finance.yahoo.com. Investors get analysts’ upgrades and downgrades, earnings estimates and industry compar- isons for financial ratios. A new financial site that's set to rival Yahoo! Finance is Google Finance (finance.google.com). Market Indexes Tracking the market is a complicated undertaking. For example, if you asked your broker “How’s the market doing today?” chances are you’d receive information on the Dow Industrials. But with only 30 stocks, they’re a very narrow representation of how the broad-based market is doing. Other, more broadly based, widely followed and quoted market measures are: • The S&P 500 includes the best stocks in industry, technology, transportation and utilities listed on the NYSE, AMEX and the Nasdaq. • The Wilshire 5000 consists of all US equities, real estate investment trusts and limited partnerships—more than 5,800 securities. • The NYSE Composite includes about 2,500 common stocks listed on the NYSE. • The Value Line Composite is an average of all 1,700 stocks followed by Value Line. • The Nasdaq Composite measures all domestic stocks traded on the Nasdaq, about 4,600 issues. • The Russell 3000 contains 3,000 large US companies, or more than 90 percent of the US equity market. • The Russell 2000 features the 2,000 smallest stocks in the Russell 3000. 24 How To Analyze Investments Like the Pros
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