From Ken Little,
Your Guide to Stocks.
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Fundamental analysis is the process of looking at a business at the
basic or fundamental financial level. This type of analysis examines key ratios
of a business to determine its financial health and gives you an idea of the
value its stock.
Many
investors use fundamental analysis alone or in combination with other tools to
evaluate stocks for investment purposes. The goal is to determine the current
worth and, more importantly, how the market values the stock.
This
article focuses on the key tools of fundamental analysis and what they tell
you. Even if you don’t plan to do in-depth fundamental analysis yourself, it
will help you follow stocks more closely if you understand the key ratios and
terms.
It’s all about earnings. When you come to the bottom line, that’s what
investors want to know.
How much money is the company making and how much is it going to make
in the future.
Earnings
are profits. It may be complicated to calculate, but that’s what buying a
company is about. Increasing earnings generally leads to a higher stock price
and, in some cases, a regular dividend.
When
earnings fall short, the market may hammer the stock. Every quarter, companies
report earnings. Analysts follow major companies closely and if they fall short
of projected earnings, sound the alarm. For more information on earnings, see
my article: It’s the
Earnings.
While
earnings are important, by themselves they don’t tell you anything about how
the market values the stock. To begin building a picture of how the stock is
valued you need to use some fundamental analysis tools. These ratios are easy
to calculate, but you can find most of them already done on sites like cnn.money.com
or MSN
MoneyCentral.com.
These are the most popular tools of fundamental analysis. They focus on
earnings, growth, and value in the market. For convenience, I have broken them
into separate articles. Each article discusses related ratios. There are links
in each article to the other articles and back to this article.
The
articles are:
2.
Price to
Earnings Ratio – P/E
3.
Projected
Earning Growth – PEG
8.
Book Value
No single number from this list is a magic bullet that will give you a buy or
sell recommendation by itself, however as you begin developing a picture of
what you want in a stock, these numbers will become
benchmarks to measure the worth of potential investments.
From Ken Little,
What traits do excellent businesses have in common? To put the question
another way, what are some of the important factors that separate a good stock
from just another stock?
For this
exercise, I’m going to look at three non-financial characteristics of
businesses. The financial analysis is important, but if a business doesn’t
possess these important market attributes, it is unlikely it can sustain a
leadership position.
Will anyone want their product or service tomorrow? It makes little
difference if the company has the hottest product on the market today if it is
a passing fad or yesterday’s technology.
VCRs
were once the hottest thing in video technology, but now retailers are
practically giving the machines away. A major video store has announced they
will no longer carry new releases on video tape – everything they stock will be
in DVD format.
Great
companies have products and services that people want year after year because
of their universal appear or because the company keeps the products fresh with
shifting consumer concerns.
There is
not a railroad or steel maker in the 30 stocks that Dow Jones Industrial
Average, yet those two industries created immense wealth for their owners in
the not too distant past.
Strong competitive advantages, often called the deep moat, protect
great companies from competitors.
These can be high costs of entry, such as in heavy manufacturing (think
cars and airplanes); or name recognition like McDonald’s and Coca Cola; or
low-price leader, such as Wal-Mart.
These
advantages (and superior companies usually have more than one) make it
difficult for competitors to grab market share. Dell Computer’s efficient
operations let it build a commodity product (the personal computer) cheaper
than its competitors did. It was able to grab and hold on to significant market
share.
Southwest
Airlines is another example of a company that did the same thing as its
competitors, but did it better and cheaper.
One of the most important characteristics of a great company is market
leadership. Market leaders can set the agenda for their industry.
However,
beware of the complacent giants that grow fat and slow in their leadership
roles. They will eventually go the way of all companies that rest on past
accomplishments and disappear into merger oblivion.
Market
leaders set the pace for the industry and use their size to protect their
position. They are able to hire top talent and have the resources to keep
pushing their advantage.
Market
leaders that pause to catch their breath are often passed and they never regain
their leadership standing again. IBM is a good example of a company that could
have owned the personal computer market, but let it slip away.
These are three non-financial characteristics of great companies. The
numbers will usually follow any company that has a durable product or service,
a significant competitive advantage and holds a market leadership position.
From Joshua Kennon,
Each autumn, I read Benjamin Graham's Intelligent Investor. Its
principles are timeless, unquestionably accurate, and contain a sound
intellectual framework for investing that has been tested by decades of
experience. As I considered the content of my weekly article, I decided to
focus on the seven tests prescribed by Graham in Chapter 14, Stock Selection
for the Defensive Investor. Each of these will serve as a filter to weed
out the speculative stocks from a conservative portfolio. Note that these
guidelines only apply to passive investors seeking to put together a portfolio
of solid companies for long-term appreciation; an investor that is capable of financial
statement analysis, interpreting accounting decisions,
and valuing an asset based on discounted cash flows may take exception to any
of the following as long as he is confident his analysis is both conservative
and promises safety of principal.
In the world of investing, there is some safety attributable to the
size of an enterprise. A smaller company is generally subject to wider
fluctuations in earnings. Graham recommended [in 1970] that an industrial
company should have at least $100 million of annual sales, and a public utility
company should have no less than $50 million in total assets. Adjusted for
inflation, the numbers would work out to approximately $465 million and $232
million respectively.
According to Graham, a stock should have a current
ratio of at least two. Long-term
debt should not exceed working
capital. For public utilities the debt should not exceed twice the stock
equity at book
value. This should act as a strong buffer against the possibility of
bankruptcy or default.
The company should not have reported a loss over the past ten years.
Companies that can maintain at least some level of earnings are, on the whole,
more stable.
The company should have a history of paying dividends on its common
stock for at least the past twenty years. This should provide some assurance
that future dividends are likely to be paid. For more information on the
dividend policy, read Determining
Dividend Payout: When Should Companies Pay Dividends?.
To help ensure a company's profits keep pace with inflation, net
income should have increased by one-third or greater on a per-share basis
over course of the past ten years using three-year averages at the beginning and
end.
For inclusion into a conservative portfolio, the current price of a
stock should not exceed fifteen times its average earnings for the past three
years. This acts as a safeguard against overpaying for a security.
Quoting Graham, "Current price should not be more than 1 1/2 times
the book value last reported. However, a multiplier of earnings below 15 could
justify a correspondingly higher multiplier of assets. As a rule of thumb we
suggest that the product of the multiplier times the ratio of price to book
value should not exceed 22.5 (this figure corresponds to 15 times earnings and
1 1/2 times book value. It would admit an issue selling at only 9 times
earnings and 2.5 times asset value, etc.)"
You can find more information and a book review of The
Intelligent Investor in the top picks section.
From Ken Little,
One of the challenges of evaluating stocks is establishing an “apples
to apples” comparison. What I mean by this is setting up a comparison that is
meaningful so that the results help you make an investment decision.
Comparing
the price of two stocks is meaningless as I point out in my article “Why
Per-Share Price is Not Important.”
Similarly,
comparing the earnings of one company to another really doesn’t make any sense,
if you think about it. Using the raw numbers ignores the fact that the two
companies undoubtedly have a different number of outstanding shares.
For
example, companies A and B both earn $100, but company A has 10 shares
outstanding, while company B has 50 shares outstanding. Which company’s stock
do you want to own?
It makes
more sense to look at earnings per share (EPS) for use as a comparison tool.
You calculate earnings per share by taking the net earnings and divide
by the outstanding shares.
EPS =
Net Earnings / Outstanding Shares
Using
our example above, Company A had earnings of $100 and 10 shares outstanding,
which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and
50 shares outstanding, which equals an EPS of 2 ($100 / 50 = 2).
So, you
should go buy Company A with an EPS of 10, right? Maybe, but
not just on the basis of its EPS. The EPS is helpful in comparing one
company to another, assuming they are in the same industry, but it doesn’t tell
you whether it’s a good stock to buy or what the market thinks of it. For that
information, we need to look at some ratios.
Before
we move on, you should note that there are three types of EPS numbers:
From Ken Little,
If there is one number that people look at than more any other it is
the Price to Earning Ratio (P/E). The P/E is one of those numbers that
investors throw around with great authority as if it told the whole story. Of
course, it doesn’t tell the whole story (if it did, we wouldn’t need all the
other numbers.)
The P/E
looks at the relationship between the stock price and the company’s earnings.
The P/E is the most popular metric of stock analysis, although it is far from
the only one you should consider.
You
calculate the P/E by taking the share price and dividing it by the company’s EPS.
P/E =
Stock Price / EPS
For
example, a company with a share price of $40 and an EPS of 8 would have a P/E
of 5 ($40 / 8 = 5).
What does P/E tell you? The P/E gives
you an idea of what the market is willing to pay for the company’s earnings.
The higher the P/E the more the market is willing to pay for the company’s
earnings. Some investors read a high P/E as an overpriced stock and that may be
the case, however it can also indicate the market has high hopes for this
stock’s future and has bid up the price.
Conversely,
a low P/E may indicate a “vote of no confidence” by the market or it could mean
this is a sleeper that the market has overlooked. Known as value stocks, many
investors made their fortunes spotting these “diamonds in the rough” before the
rest of the market discovered their true worth.
What is
the “right” P/E? There is no correct answer to this question, because part of
the answer depends on your willingness to pay for earnings. The more you are
willing to pay, which means you believe the company has good long term
prospects over and above its current position, the higher the “right” P/E is
for that particular stock in your decision-making process. Another investor may
not see the same value and think your “right” P/E is all wrong.
From Ken Little,
In my article on Price to Earnings
Ratio or P/E , I noted that this number gave you
an idea of what value the market place on a company’s earnings.
The P/E
is the most popular way to compare the relative value of stocks based on
earnings because you calculate it by taking the current price of the stock and
divide it by the Earnings Per Share (EPS). This tells
you whether a stock’s price is high or low relative to its earnings.
Some
investors may consider a company with a high P/E overpriced and they may be
correct. A high P/E may be a signal that traders have pushed a stock’s price
beyond the point where any reasonable near term growth is probable.
However,
a high P/E may also be a strong vote of confidence that the company still has
strong growth prospects in the future, which should mean an even higher stock
price.
Because
the market is usually more concerned about the future than the present, it is
always looking for some way to project out.
Another ratio you can use will help you look at future earnings growth
is called the PEG ratio. The PEG factors in projected earnings growth rates to
the P/E for another number to remember.
You
calculate the PEG by taking the P/E and dividing it by the projected growth in
earnings.
PEG =
P/E / (projected growth in earnings)
For
example, a stock with a P/E of 30 and projected earning growth next year of 15%
would have a PEG of 2 (30 / 15 = 2).
What
does the “2” mean? Like all ratios, it simply shows you a relationship. In this
case, the lower the number the less you pay for each unit of future earnings
growth. So even a stock with a high P/E, but high projected
earning growth may be a good value.
Looking
at the opposite situation; a low P/E stock with low or no projected earnings
growth, you see that what looks like a value may not work out that way. For
example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8.
This could prove to be an expensive investment.
A few
important things to remember about PEG:
If you give some management teams a couple of boards, some
glue, and a ball of string, they can build a profitable growing business, while
other teams can’t make a profit with several billion dollars worth of assets.
Return on Equity (ROE) is one measure of how efficiently a company
uses its assets to produce earnings. You calculate ROE by dividing Net Income by Book Value. A healthy
company may produce an ROE in the 13% to 15% range. Like all metrics, compare
companies in the same industry to get a better picture.
While ROE is a useful measure, it does have some flaws that can
give you a false picture, so never rely on it alone. For example, if a company
carries a large debt and raises funds through borrowing rather than issuing
stock it will reduce its book value. A lower book value means you’re dividing by
a smaller number so the ROE is artificially higher. There are other situations
such as taking write-downs, stock buy backs, or any other accounting slight of
hand that reduces book value, which will produce a higher ROE without improving
profits.
It may also be more meaningful to look at the ROE over a period of
the past five years, rather than one year to average out any abnormal numbers.
Given that you must look at the total picture, ROE is a useful
tool in identifying companies with a competitive advantage. All other things
roughly equal, the company that can consistently squeeze out more profits with
their assets, will be a better investment in the long run.
From Ken Little,
With interest rates on the rise, you may want to pay more attention to
debt when evaluating a stock for investment. Companies that a
carry heavy debt load may be at risk in an environment of rising interest
rates.
There
are several measurements you can use to gauge whether a company may be carrying
too much debt. Both come off the balance sheet if you want to do the math
yourself or you can find the ratios on several online services.
The two
ratios are part of a set of metrics that help you determine the financial
health of a company when you are evaluating its stock for investment. We need
two definitions before we move on:
Long-tern debt, such as mortgages would not be included,
however that portion of payments due in the next 12 months would be included.
The first ratio is the Quick Ratio. This ratio gives
you an idea how easily the company can pay its current obligations – that is
those bills due in the next 12 months.
The Quick Ratio is cash, marketable securities and accounts receivable
divided by current liabilities (those due in the next 12 months). However, not all
Current Assets are included in this ratio - excluded are accounts receivable
and inventory. Basically, you are saying if all income stopped tomorrow and the
company sold off its readily convertible assets, could it meet its current
obligations?
A Quick Ratio of 1.00 means the company has just
enough current assets to cover current obligations. Something higher than 1.00
indicates there are more current assets than current obligations.
It is important to compare companies with others in
the same sector because different industries operate with ratios that may vary
from one sector to another. Some industries such as utilities,
for example carry much more debt than other industries and should only be
compared to other utilities.
The second ratio is the Current Ratio. The Current Ratio is very
similar to the Quick Ratio, but broadens the comparison to include all Current
Liabilities and all Current Assets. It measures the same financial strength as
the Quick Ratio that is a company’s ability to meet its short-term obligations.
Some analysts like the Current Ratio better because
it is more “real world” in that a company would convert every available asset
to stay afloat if needed. The Current Ratio measures that better than the Quick
Ratio.
Like the Quick Ratio, 1.00 or better is good, and
likewise you should always compare companies in the same sector.
Theses two ratios, which you can find on any Web site that offer
quotes, tell you a great deal, about how a company may or may not weather tough
times. Low numbers in these ratios should be a red flag when you are evaluating
a stock.
See Part
Two in this series on debt and evaluating stocks.
From Ken Little,
Should you invest in companies that carry large amounts of debt? That
is a question every investor should ask when evaluating stocks.
Unfortunately,
the answer isn’t as easy as “yes or no.” The correct answer is “it depends.”
The problem is that some industries typically require more debt than others do.
For
these industries, a higher debt load is normal. For example, utilities often
borrow large sums of money when building new power plants. It may take several
years to build the plant, which means no revenue and lots of debt.
However, the useful life of power plants spans many years and when the
debt on the plant is repaid the facility can become a real cash cow for the
utility.
For
other industries, a large debt load may signal something seriously wrong.
Of course, any company might pickup a big note if it just bought a
building or a competitor.
There
are several tools you can use to determine whether a company is exposing itself
to too much debt.
The
first is the Debt to Equity Ratio. This ratio tells you what portion of debt
and equity is used to finance a company’s assets.
The formula is Total Liabilities / Shareholder Equity = Debt to Equity
Ratio.
A ratio
of 1 or more indicates the company is using more debt than equity to finance
assets. A high number (when compared to peers in the same industry) may mean
the company is at risk in a market where interest rates are on the rise.
If a
company has debt, it has interest expenses. There is a metric called Interest
Coverage that will give you a good idea if a company is having trouble paying
the interest charges on its debt.
The
formula is: EBITDA / Interest Expense = Interest Coverage.
EBITDA
is Earnings Before Interest, Taxes, Depreciation and
Amortization and measures the operating performance of a company before
accounting conventions and non-operational charges (such as taxes and
interest).
The resulting ratio tells you whether a company is having trouble
producing enough cash to meet its interest expense. A ratio of 1.5 or higher is
where companies want to be. A lower ratio may indicate that the company has
trouble covering interest expenses as well as other costs.
Debt is not a bad thing when used responsibly. It can help businesses
grow and expand. However, misuse of debt can result in a burden that drags down
a company’s earnings.
From Ken Little,
It all comes down to the bottom line.
Well,
there’s more than one way to read that sentence and both would be correct. In
this article, I am introducing the concept of stock evaluation or how you
decide if a company’s stock price accurately reflects its worth.
If you
can’t determine a stock’s value, how will you know whether the current price is
high, low, or about right? Fortunately, there are many resources to help you
evaluate stocks, although you must be careful since some of these sources may
be less than objective in their analysis
However, let’s stick with the basics first. For most investors, stock
evaluation revolves around the company’s earnings. Everything else either adds
to or takes away from the earnings report. Earnings simply are the company’s
profit – how much money did it make in any given period.
This is
not to say that small or rapidly growing companies with negative earnings have
no value or that their earnings’ reports are meaningless – quite the contrary.
All earnings reports have meaning in the proper context.
Investors expect established companies like Coca Cola to have positive
earnings. If Coke reports lower earnings for a quarter, the
stock will likely drop unless there is a reason that explains this as a
one-time event. Young companies, on the other hand, may go for years
with negative earnings and still enjoy the favor of
the market if investors believe in the future of the company.
So, in
addition to the actual earnings, is the expectation of earnings. A company may
report positive earnings for a quarter, but fall short of expectations and see
its stock tumble.
Earnings
(or growth towards positive earnings) tell you how healthy a company is and if
it may pay dividends or grow through capital appreciation (higher stock price).
The basic measurement of earnings is “earnings per share” or EPS. This
measurement divides the earnings by the number of outstanding shares. For
example, if a company earned $12 million in the third quarter and had 8 million
shares outstanding, the EPS would be $1.50 ($12 million / 8 million).
The
reason you reduce earnings to a per share basis is to facilitate comparison
with another company and to show how to divide the profit. Two companies that
each had $12 million in earnings would look the same with just those raw
numbers. However, if one company had 8 million shares outstanding and the other
company had 4 million shares outstanding, which stockholders will profit the
most.
You can use the earnings per share measurement in three time intervals:
Only the trailing EPS is actual. The current
and forward EPS are estimates.
When you
hear news commentators talk about “earnings season,” they are referring to the
quarterly earnings reports companies have to file with the SEC.
You can
look at these reports online via the SEC site called Edgar.
Companies
that fail to meet earnings expectations usually make the business news with
reports of a falling stock price.
Investors use many other tools in evaluating stocks, but it
all begins and usually ends with earnings.
From Ken Little,
How is your portfolio or stock doing? Have you calculated its return
lately, and, more importantly, have you calculated its return in a meaningful
way?
There
are several calculations that will give you an idea of how an investment is
doing. Some are more complicated than others are, but none are beyond the reach
of the average investor and a calculator.
Here are
several calculations you can use to help you understand how your investments
are doing.
This is a simple calculation, but it reminds us that we need to include
dividends (where appropriate) when figuring the return of a stock. Here is the
formula:
(Value
of investment at the end of the year – Value of investment at beginning of the
year) + Dividends / Value of investment at beginning of the year = Total Return
For you
bought a stock for $7,543 and it is now worth $8,876, you have an unrealized
gain of $1,333.
You also received dividends during this time of $350. What is the total
return?
($8,876
- $7,543) + $350 / $7,543 = Total Return
$1,333 + $350 / $7,543 = Total Return
$1,683 / $7,543 = Total Return
0.2231 or 22.31% = Total Return
You can
use this calculation for any time period, which is a weakness since it doesn’t
take into account the time value of money.
Simple return is similar to total return,
however it is used to calculate your return on an investment after you have
sold it.
Here is
the formula:
Net
Proceeds + Dividends / Cost Basis - 1
Let’s
run through an example. Suppose you bought a stock for $3,000 and paid a $12
commission. Your cost basis is $3,012. You sell the stock for $4,000 and there
is another $12 commission, so your net proceeds are $3,988. Dividends amounted
to $126.
$3,988 +
$126 / $3,012 - 1 = Simple Return
$4,114 / $3,012 – 1 = Simple Return
1.36 – 1 = Simple Return
0.36 or 36% = Simple Return
Like the
Total Return calculation, the Simple Return tells you nothing about how long
the investment was held. If you want to see after-tax
returns, simply substitute “net proceeds after taxes” for the first variable
and use an after tax dividend number.
For investment held more than one year, you may want to look at this
more sophisticated, but not much more complicated calculation.
The
Compound Annual Growth Rate shows you the time value of money in your
investment. A 40 percent return over two years is great, but a 40 percent
return over ten years leaves much to be desired.
I devote
a whole article on this important calculation. You can find it by clicking here.
Simple or slightly more complicated calculations can give you a better
fix on how your investments are doing.