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.
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
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
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
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
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
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
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.
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.
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
• 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
• 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-
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-
• 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.
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
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.
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.
This ratio assesses how well management controls
inventory. An increasing inventory may show manage-
ment commitment to increase sales, or accumulation of
XYZ Company Income Statement goods languishing on shelves.
Year Ended Dec. 31, 2006 When comparing businesses,
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.
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
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
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
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 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
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
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-
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
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
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.
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 assets are current assets less inventory, divided by cur-
rent liabilities. Sometimes called the acid test, this ratio is perhaps
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-
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
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
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
The dividend yield relates dividend payout to the
stock price. High yields are characteristic of mature
industries, like utilities. Low-yielding stocks indicate
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 (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
18 How To Analyze Investments Like the Pros
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
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 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
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
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
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.
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
• 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
22 How To Analyze Investments Like the Pros
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
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
• 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.
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).
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