| Getting to Know the Numbers |
GETTING THE INVESTMENT PROCESS STARTED
There are many strategies for making money in the stock market. All typically require information about a company’s performance compared to previous periods, peer groups, etc. Market Guide provides that information in a very logical and easy way that helps you perform an analytic review of a prospective investment no matter what your style or strategy.
This section begins with simple pricing information; the stock price, year high and year low, and beta. The current stock price, viewed in the context of its high and low price over the past 52 weeks, gives an approximate indication of whether the company is currently in or out of favor with the market.
Beta is a measure of the volatility (riskiness) of a company’s stock price relative to the overall volatility of the stock market. A stock that is approximately as volatile as the stock market will have a beta of 1.00. Stocks that are more volatile than the stock market will have a beta greater than 1.00, whereas stocks less volatile than the market will have a beta of less than 1.00. Aggressive investors looking for growth companies should be willing to buy stocks with higher beta values. Income oriented, or risk averse investors should look for lower beta stocks. The beta value used here is measured over a five year time frame.
Next are some per share items widely used by investors to assess the attractiveness of the subject company’s shares: Earnings Per Share, P/E Ratio, and Cash Flow Per Share. The Earnings Per Share (EPS) and the Price Earnings (P/E) Ratio are amongst the most important and closely watched measures of corporate value. The P/E Ratio shows you the multiple you’re paying for each dollar of earnings of the company. All things being equal, one would prefer a company with a lower P/E than a higher P/E. However, the old adage, "You get what you pay for " applies to stocks as well. You should be willing to pay a premium P/E multiple for a rapidly growing company because you expect its future earnings rate to be higher. A good rule of thumb is that a stock is attractive if its P/E ratio is lower than its long term compound growth rate in EPS. (These growth rates can be found in the next section of this report.) Conversely, if the company’s outlook is more uncertain due to factors such as competition, a lawsuit, or a cyclical downturn, then you may wish to discount your valuation expectations by insisting on a lower P/E multiple.
It is useful to review and analyze some ratios in a historical context. Below the P/E Ratio we provide the five year high and low range of the P/E Ratio. This is meaningful for many companies as it gives you a sense of how the company will be valued in recessionary times when the company may have low earnings (and high P/Es) or in boom times when the company may have higher earnings (and lower P/Es). For many companies, especially the newer technology and higher growth companies, you may see very high P/E’s. High P/E ratios in the latter case may reflect a young company that has just started making money, or has made very little money while selling at a high price because of the promise of significant future earnings growth. If a company doesn’t have five years worth of history, or it wasn’t profitable for at least four out of the five years, the table will give a "not meaningful" (NM) value for the high and low P/E value.
The annual dividend rate is the total dividends you could expect to receive if you held the stock for a year. It is based on the current quarterly dividend payment rate projected forward for four quarters. The dividend yield is the indicated annual dividend rate expressed as a percentage of the price of the stock, and could be compared to the coupon yield on a bond.
The last dividend declared is the quarterly dividends per share paid or to be paid to shareholders. That dividend payment was applicable to owners of the stock on the ex-dividend date and was paid out to shareholders on the payment date. These dates are important to the investor for a variety of reasons. One is that stock prices generally drop by the dividend amount on the ex-date, and that may be a consideration in your timing of the purchase or sale of your stock. Secondly, the pay date will tell you when the money will show up in your account and needs to be reinvested. Most companies pay cash dividends quarterly, so you can use the last ex-dividend date and the last dividend payment date to project the future dividend ex-dates and pay-dates. Dividend yield should also be compared to its historical average to determine whether the stock is overvalued (low yield) or undervalued (high yield) relative to historical average yield.
The shares outstanding indicate the amount of shares issued by the company less any shares that the company has bought back and holds in the corporate treasury. Some of the shares that the company has issued may be closely held by officers, directors, and others owning more than 5% of the shares outstanding in the company. These investors are generally long-term investors who are not actively trading their stock holdings. The float indicates the number of shares held by everybody other than officers, directors and 5% or more owners. In many smaller companies where management has a big stake in the company, the float is very important for the same reasons as the daily trading volume. If there is little float, there’s generally very little trading volume and anybody wishing to buy or sell the stock may impact the price significantly.
Daily trading volume is particularly important to institutions who need to take large positions and investors who wish to trade their holdings. It can also be an indicator of the risk of potential price volatility. If trading volume is low and a large investor wants to acquire or sell a position, then he/she will be faced with buying or selling shares over time, or risking a material impact on the price of the stock. Since unexpected developments can precipitate the need to quickly buy or sell, this measure of liquidity helps to identify risk.
The Last Split Date and the Last Split Factor tell you when the company last split its stock and what the split ratio was. It may help you reconcile what happened in your account in terms of the number of shares you hold. Generally a company that is interested in having a sizable following amongst individual investors will try and keep its price in an affordable price range. As the company does well and the share price increases, management will split the stock and bring the share price back to more affordable levels.
It is useful to know the number of institutions that own a position in this company. Even a small number of institutions indicates that the company has been noticed by institutions. If it is not widely held, the stock may rise as it gets better known and more institutions decide to buy in. If it is very widely held, any significant disappointment by the company may result in the risk of significant institutional selling of the shares.
Many believe it is best to own a company that is between 5 and 20 percent owned by institutions, suggesting there is some institutional interest and some knowledge of the company. If the company's shares are heavily owned by institutions, (i.e. 65%-70% or more) and the company were to report disappointing news, the stock might be vulnerable to a severe correction in price as institutions sell their shares.
If the P/E Ratio of a company is less than its industry average P/E, the company is selling at a discount valuation to its peers. Similarly, if a company’s price to book value ratio is lower than it’s industry’s price to book, it is a positive indicator. Price to tangible book is similar to price to book, except that we have subtracted the value of intangibles such as goodwill from book value. If price to book is lower (better value) while return on equity is higher (higher profitability) and total debt to equity is comparable to (better or equal financial strength) that company's peers, then you may have a genuinely undervalued stock. (Another way of looking at the preceding statement is that the better profitability (return on equity) is genuine and neither due to low equity base or a highly leveraged balance sheet (risky).)
Price-to-Sales is generally used to evaluate companies that don’t have earnings and don’t pay dividends. For these companies, you may consider that high multiples of sales and high growth rates suggest optimistic investor future earnings expectations. Free Cash Flow is the excess cash generated by a company's operations after capital expenditures and dividends paid. Free Cash flow is the engine for future growth, so its useful to see how much you are paying for the amount of free cash flow generated. Some investors prefer to look at price to free cash flow ratios rather that P/E ratios. This is particularly true of cash generating ventures such as selected types of energy companies. Energy companies generate huge cash flows from oil and gas production, which they typically plow back into exploration to find new reserves of oil and gas.
Return on Equity is the return generated on every dollar invested by shareholders in the company. A high Return on Equity implies proprietary products, high growth markets, a strong performance by the company’s management, and /or a business with high barriers to entry. However, Return on Equity should always be viewed in conjunction with Financial Strength ratios to make sure the high ROE is not merely a function of a highly leveraged capital structure (Total Debt to Equity).
Long-Term Debt/Equity is a measure of “permanent” financial leverage. Many companies use short term debt in their capital structure, and we suggest using total debt/equity as a measure of financial leverage as well. The more debt in a company's capital structure, the greater the financial leverage risk. If a company’s return on assets is higher than the interest rate that it pays on debt, then it is better to use some debt in the capital structure, paying the interest rate on it, while the excess return on assets accrues to shareholders and increases earnings per share. However, if the return on assets falls below the rate of interest on borrowed funds, the shortfall comes out of earnings that would otherwise have gone to the shareholders. Thus the term "leverage".
If earnings are growing faster than sales, it implies that profit margins are expanding. Healthy and expanding profit margins are an important indication that the company is well managed and has control of product pricing and costs. In other words, it has pricing power. A company cannot have above average or increasing profit margins unless it has a unique technology, a dominant market share, or is lowering costs faster than its competition. These things allow successful long-term growth with an appreciating share price. An extremely competitive environment might cause the company to experience decreasing margins because it has to constantly lower selling prices to match the competition. The dividend growth rate is important to income-oriented investors. If you are relying on the income from dividends, you would want the dividend growth rate to equal or exceed the anticipated inflation rate so that the purchasing power of this income stream is maintained. Furthermore, a company with a modest yield but a high dividend growth rate may, in the future, prove to be an excellent source of future income.
It is also useful to compare the growth rate of earnings with the growth rate of dividends. The dividend growth rate may not be sustainable unless the earnings growth rate equals or exceeds the dividend growth rate. (If dividends are growing faster than earnings, the dividend payments will eventually consume much of earnings and inhibit the company’s ability to grow.)
The Retention Rate indicates how much of every dollar of earnings is kept by the company after paying dividends to shareholders. The company might use this money for investment in new plant and equipment, development of a new product, acquisition of another company, or repurchase of stock. This is a useful indicator of future earnings growth. Assuming the company will earn its present ROE on a larger capital base, the retention rate when multiplied by the return on equity (ROE) may approximate the future earnings growth rate.
If there are multiple classes of stock, you will see them mentioned here too. It is always important to look for them because, in addition to the earlier discussion, you may sometimes find that other classes of stock may be more attractive than the one you were initially looking at. In addition, there may be some attractive convertible debt or convertible preferred stock outstanding that this section will alert you to. Convertible securities often provide some current income while also giving you some upside participation in the appreciation potential of the underlying common stock. This paragraph also tells you the date and underwriter of the last public underwriting of the company. It is good to see a recognized and respected firm as the lead underwriter for the company. If you are dealing with small companies, investigate unrecognized underwriters. If you are a knowledgeable investor, you will probably recognize some underwriters as ones with more liberal standards and you may choose to closely investigate these companies. This paragraph also tells you how much debt the company has, and gives you an indication of the breakdown between fixed rate and variable rate debt and the interest rates on that debt. For a company with a lot of debt, it is important to review this. If a company has a large amount of variable rate debt and interest rates rise, its earnings will likely be unfavorably impacted more severely by the increased interest expense.
Also focus on fully diluted earnings per share. If the company has stock options, warrants, rights, and/or convertible securities outstanding, the dilution caused by the additional common shares represented are reflected in fully-diluted earnings per share. Fully-diluted earnings per share comparisons over time eliminate the variability caused by option and warrant exercises and convertible security conversions. As options, warrants, rights, and convertible securities are converted into common stock, the difference between primary and fully diluted EPS diminishes.
It is generally not desirable to have receivables increasing faster than the revenues. Similarly, it is always useful to see that Accounts Payable are kept under control. A sign that a company may be in financial stress is a dramatic increase in accounts payable.
The next thing to review is the asset composition. Long-term investments may indicate assets unrelated to the company's basic business. Fixed assets could be either understated or overstated but usually relate to operations. They might include land and buildings, machinery and equipment, and other long term assets.
You want to look for a company which has greater current and long term assets compared to their liabilities. If current assets are less than current liabilities, the company could have an increased risk of insolvency (see the discussion of Current Ratio under the Financial Strength Ratio heading). Long-term debts and capitalized leases are straightforward. They are the money the company has borrowed to buy plant and equipment or use in its business. Other long-term liabilities generally include items such as deferred taxes. Companies with significant other long-term liabilities should be looked into more closely.
The Statement of Cash Flow is divided into three sections. The Operating section tells you how the company’s basic business performed. The Investing Section will highlight capital expenditures, purchase of investment securities, and acquisitions. This is how the company has invested its money for the future. The Financing Section shows if the company borrowed money, or if the company issued or repurchased shares. The Net Change in Cash is equal to the net effects of what the company generates in operations, spends to invest for the future, how it finances itself, and the impact of foreign currency adjustments.
You want to see a company in which Net Income plus Depreciation are greater than Capital Expenditures plus Dividend Payments. This is the definition of Free Cash Flow. If a company has Free Cash Flow, then it can finance its growth and finance its dividend payments from internal sources. If a company doesn’t have a positive Free Cash Flow, it may have to sell equity which will dilute your holdings, borrow money, sell assets, or use its working capital more efficiently. The cash flow statement provides insight into which of these sources funded the company's activities in the period(s) in question.
Some of the items to look for in the statement of cash flows include:
Finally, the exchange rate effect is the impact of fluctuation in foreign currency exchange rates in the Statement of Cash Flows on the resulting Net Change in Cash. Currency translation will impact companies with significant foreign operations or companies with significant import and export activities, and represents an additional business risk of the company. A company engaged in significant foreign business may see its growth in local currency enhanced or offset by rising or deteriorating exchange rates of that local currency into home currency (i.e. the U.S. dollar). Be wary of large, volatile changes in this adjustment factor relative to Net Income or the Net Change in Cash.
BUSINESS SUMMARY
The brief has three components. The first part describes the underlying business of the company. The second part compares the year-to-date price performance to the same period a year ago. The third part discusses reasons for the increase or decrease in recently reported revenues and income. This quick introduction to a company gives you the background that makes the rest of the report more meaningful. One important aspect to look for in the discussion of results is whether there are any one-time events, such as a gain on the sale of a division or a write off, affecting the announced results, or whether the changes in the results are part of an on-going, sustainable trend.
EARNINGS ANNOUNCEMENT
This section is not always present. It is shown only when a company has recently announced its earnings but has not yet filed its detailed financial statements. Market Guide believes that the latest information must be made available to its clients. From earnings announcement press releases, Market Guide collects the latest revenue, net income, Earnings Per Share (EPS) and shares outstanding values. All relevant ratios such as trailing twelve month EPS or Net Profit Margin affected by preliminary earnings announcements reflect these latest reported numbers, and are identified as such by an asterisk.
RATIOS & STATISTICS AT A GLANCE
The date at the top of this section is the pricing date. These statistics are always calculated on a trailing twelve month basis using the latest available quarterly information and the preliminary earnings announcement, if available.
SHARE RELATED INFORMATION
Market Capitalization is the price multiplied by the number of shares outstanding, and gives you a sense of the market’s appraisal of the value of the company. Market value permits the company to be classified as large cap, mid cap, or small cap. Investors generally regard large companies to be safer to invest in than small companies, although several studies indicate that while riskier, small companies as a group tend to outperform large companies over long periods of time.
INSIDER AND INSTITUTIONAL TRADING ACTIVITY
Insiders owning a significant piece of the company is generally a positive sign (to see what insiders own please refer to the Equity section of the report). It often indicates that management’s and shareholder's objectives are closely aligned, and that the officers and directors will diligently attempt to maximize shareholder value. However, when insiders own a very large and controlling percentage of the company, they may not feel responsible to outside shareholders. This is particularly visible in companies with multiple classes of stock, with insiders/management retaining voting control over the company. In this case, outside shareholders will have little influence on corporate policies and decisions, and management’s interests may not be aligned with public holders. To avoid this risk, look for companies where there is only one class of stock owned by everyone, where management and directors own a meaningful amount of stock, and in which management is partially compensated with stock options.
COMPANY TO INDUSTRY COMPARISON
An undervalued, profitable, growing and financially strong company is generally a good investment. However, the absolute levels of these ratios vary dramatically from one industry to another. For example, utility companies have high dividend yields and low earnings growth rates, while technology companies may exhibit rapid earnings growth and pay no dividends. Cyclical companies generally have higher debt levels, while some companies relying on intellectual property or proprietary technology need little infrastructure and often operate with very little or no debt. To make it easier for you to evaluate a company we provide selected financial ratios in each of four key groups: Valuation, Profitability, Financial Strength and Growth in comparison with their industry peer group. These ratios should be reviewed for both their absolute levels, relative to the company's stock valuation, and relative to the company's peers.
VALUATION RATIOS
The valuation ratios determine whether the company is inexpensive or costly on an absolute basis. The goal is to find companies that are bargains relative to their growth rates, financial strength and profitability characteristics!
PROFITABILITY RATIOS
The Net Profit Margin is expressed as a percentage and is net profit divided by total revenue. It does not include extraordinary items, discontinued operations, and a variety of other non-recurring items. It gives you a sense for how profitable the company’s basic business is, after all expenses and taxes have been paid. The higher the value, the better.
FINANCIAL STRENGTH RATIOS
The current ratio is the ratio of current assets to current liabilities. The higher the number, generally, the better it is. Any number that’s close to or below one means that the company has more current liabilities than current assets and may, therefore, shortly need to raise funds in some way in order to pay off those liabilities and restore working capital to fund short term business needs such as inventory or work in process. It is a very negative sign for a company to have a current ratio of less than 1:1.
COMPANY GROWTH RATES
Valuation is most closely linked to growth. Three of the most important financial numbers are sales, earnings per share, and dividends per share. Sales are important because without a sustained increase in sales, one cannot expect a sustained increase in earnings and cash flow. Without a sustained increase in earnings and cash flow, the company can’t sustain an increase in dividend payments to shareholders. We provide three year periods for growth statistics because a three year period is long enough to capture sustainability and short enough to capture the largest number of companies with qualifying data. It’s useful to review whether sales and earnings are increasing at an increasing rate. Again, take a look at the company's growth rates relative to its industry. You would expect to pay more for a high growth company and less for a slower growth company. However, sometimes you can catch higher growth at a discount! If you see a very high and apparently unsustainable growth rate, check the historical quarterly sections and selected financial statements to see if these were computed off a very small or depressed base year level. Don't forget to view these growth statistics in conjunction with the company's financial strength ratios.
EQUITY INFORMATION
The Equity section tells you how many shares are authorized, issued and outstanding. It also indicates any significant institutional and insider control. As previously discussed, it is generally a positive sign to have insiders own a meaningful amount of the same class of shares held by the public. This means that they have a major stake in the company and that their interests are very closely aligned with shareholders, so that you can count on management to act in the best interests of all shareholders of the company.
FOOTNOTES
The Footnote section describes anything that the investor may need to be alerted to, such as whether there has been a major acquisition, write-off, divestiture, or changes in accounting practices. The footnotes may sometimes reference a period that is part of the Market Guide database, but is not shown in this report. This is still valuable because it alerts you to an important factor that affected the company in a prior period.
HISTORICAL QUARTERLY RESULTS
This table displays up to four years of quarterly revenue and earnings per share numbers. These numbers are reported in local currency for foreign companies so that these values are not distorted by fluctuating exchange rates. By looking down the columns, you can track any seasonality in the business. By looking across the rows, you get a sense of how the company has grown from year to year. The key here is to find a company that has achieved steady growth in revenues and earnings per share over the period covered. A steady grower may have a lot less risk than a company with an erratic sales or earnings record. You might expect a higher P/E multiple for the shares of consistent growth companies. The stability of earnings and the ability to produce positive earnings year after year, quarter after quarter are important factors to look for in a company.
SELECTED INCOME STATEMENT
This statement gives you key income statement items for the last two fiscal years, the year-to-date period and the same year-to-date period a year earlier. Again, it is important to see if the revenues are increasing, and it is desirable to see earnings increasing faster than revenues. The Selected Income Statement provides an opportunity to focus on operating versus non-operating factors contributing to earnings. Look for operating expense increases below the rate of revenue growth, and less contribution to income before taxes from non-operating sources. At the bottom is earnings per share excluding extraordinary items, which is the earnings per share that you see referenced elsewhere in this report. The extraordinary items could be a discontinued operation, a restatement due to a change in an accounting policy or some other factor that doesn’t appropriately reflect the ongoing operations of the company. If there are any discontinued operations or extraordinary items, you will see them listed and the resulting earnings per share that includes these items.
SELECTED BALANCE SHEET ITEMS
This statement provides insight into key balance sheet items for the subject company. It is always important to see how much cash and short-term investments a company has. If a company is losing money, it is important to know if it has sufficient cash to sustain itself until reaching profitability. Large cash and marketable security positions may indicate upcoming financial difficulty if accompanied by ballooning payables and shrinking receivables, or they may indicate a cash flow rich business or a conservatively run company. If a company possesses a large amount of cash and marketable securities, it may also be an acquisition or takeover candidate by another company wishing to acquire the target company with the target's own cash and borrowing power.
SELECTED STATEMENT OF CASH FLOW ITEMS
The Statement of Cash Flows is considered by some investors to be the most important statement due to its insight into the financial activities of the company. This statement tells you exactly where the company generated its cash from and how it was used. It always pays to key off the largest numbers, especially when looking at the Statement of Cash Flows. That will give you a good sense of what might make a difference and where you need to focus your attention.
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