Download PDF
Before we get right into the numbers I want to bring up an important point that I feel new investors often ignore when looking up financial numbers of a company. There’s an abundance of financial data found online for free and as a new investor you need to be conscious of how reliable the information is no matter how easy it might be to access. For example: take a stock from the Dow 30 stocks (listed in the Dow Jones Industrial Average) and compare the numbers, ratio and data between a number of financial websites (MSN, Yahoo, Globeinvestor, Google Finance). What do you notice? Are all the figures the same? Are they different? Why?
I have a bias towards using financial statements because of my prior education in business. I understand that for a new investor financial statements are extremely intimidating, but they were for anyone who struggled through boring accounting lectures, case studies that challenged your sanity and equally brutal exams. There comes a time for every DIY investor where you either completely trust the corporation you’re investing in (to not cook the books) or to crunch the numbers yourself as part of an investor’s due diligence. There’s nothing wrong with using a financial website to get a general sense of what’s going on in a company, but I have not and do not place absolute trust in the numbers that they display. How old is that data, is the P/E up to date with the latest quarter, has the site taken into account the latest dividend increase or earnings projections? The only question you should consider answering for yourself is “Can I trust these numbers?”
I believe that, as a new investor, you should work off financial statements in order to get used to looking at numbers, knowing what they mean and learning to calculate them on your own. Confidence is key to an investor. While you might struggle initially and become frustrated, over time you’ll begin to develop the confidence and a better understanding of what you’re doing, looking at and interpreting to make better informed decisions. Have you ever noticed how many investors place confidence in analyst recommendations or why? Because the individual investor doesn’t want to do the hard work themselves and instead places trust in a stranger working for a financial institution that is being paid to sell you an opinion. No analyst is going to protect you from a bad investment. If you’re serious about investing, want to invest on your own and grow as an investor then growing pains are a part of the process that you’re going to have to get through. As an independent investor you have to protect yourself from risk.
There are lots of things an individual investor can do to try and minimize discrepancies found in financial statements. The first is ensuring that there’s a high level of professional responsibility by management and an expectation within the corporate culture of a company for accountability. This can be something as simple as a good mission statement, tone in an annual letter to shareholders by a CEO or financial officer or a long established history of trust with investors.
What you want to do is compare results from previous years to the latest published reports and begin asking yourself, “Do these numbers match, are there figures that appear/disappear for no apparent reason, does something clearly not make sense here?” If not, then start to ask more questions. Don’t be afraid to contact the investor relations department, to poke around, ask for clarification on facts. If you have a financial advisor you should be asking them the significance of a discrepancy and if they dismiss your concerns, fire them! You can even pick up an introductory accounting book or take a community college course for a few hundred dollars if you’re that serious. The point is to start taking responsibility for your investment decisions instead of relying on others to create an opinion for you.
The Numbers:
I previously listed the following list of quantitative information that I concentrate on for investments in my DivG portfolio and promised to provide insight into how I interpret and use them in my stock analysis.
To review these include:
- ROE
- Book Value Growth
- Price-to-Book
- Dividends (growth, payout & yield)
- Free Cashflow
- Price-to-Earnings (trailing & forward)
- Revenue/Expense growth
- Liquidity Ratios
- Debt to equity
- Basic EPS & Diluted EPS
A lot of financial websites provide a decent definition of return on equity and how it’s calculated. ROE is a company’s net income (in $) divided by its total shareholder’s equity (in $) and gives you a number that can be expressed as a percentage. As an investor I expect a return on my investment and ROE is one of the more important figures I look at to see how committed and able a company is at returning value to me.
ROE measures a company’s ability to generate profits from the money invested by shareholders. If company ABC sells 100 shares for $1 each and makes $10 of net income that year, then $10/$100 = 0.10 or 10%. That means ABC generated a return of 10% on the money invested by shareholders (me) and measuring this over time gives you a good indication of the ability of management and the company to generate returns to you. While there are companies that range from 5% to 30% depending on the specific industry, what I tend to look for is consistency around a ROE of 12%. The reason for this can be found in my post on the Rule of 72.
BV Growth:
Book value is important not just for value investors but for any investor. BV is calculated by taking tangible assets (hard assets you can hold in your hand) and subtracting intangible assets (goodwill, patents) and total liabilities. BV growth is important to me as a shareholder because it represents a share of the business from which a return can be created. I try to explain this to friends as thinking of BV growth as a component of ROA (return on assets). I want to know not only what a company can do with the equity I invest (ROE), but also what a company can do to generate returns with its tangible assets and re-invested capital. If I’m analyzing a manufacturing company that has considerable assets in machinery for production, I’m keenly interested in what return those assets generate for the business and how the addition of new assets grows the book value without the company taking on too much debt. I want to see BV continuously increasing each year at a consistent rate that matches my expectations for the growth of the company.
P/B:
Price to book is the price per share of a company dividend by its book value (its value of net assets). This is important because it gives me a sense of how expensive a stock is based on its net assets if I had to replace the business tomorrow. If the company had to meet all its liabilities and function only on its assets for returns, what would be the value per share that I as a shareholder could buy it for? Deep value investors often look to this ratio as an indication of buying a company for cents on the dollar. A stock with a book value of $10 trading at a price per share of $8 has a P/B of 0.8. Some industries trade at a substantial premium of price to book due to the use of assets to generate returns. The key to remember is to put the ratio into the proper context by comparing to industry peers and a company’s historical P/B average to gain a sense of relative value (is it cheap or expensive & why).
Dividends:
Dividends are important for reasons I’ve outlined here. I view dividends as excess tangible returns in my hand that I receive as a return on the value of equity I’ve placed into the company. I can then use those excess returns to either re-invest back into more equity of the company, shares of other companies for my portfolio or for my own personal use. BV growth and dividend growth should grow in line with each other consistently over time and the dividend payout (dividend per share divided by EPS) gives me a sense of how much of the net income from a company is being directed to shareholders in contrast to growing the company organically. For a company in a mature phase of operation I would expect a higher dividend than a company attempting to grow its business quickly. For a growing business I want to see a lower payout because I don’t want them taking on unnecessarily expensive debt in order to grow the company.
Free Cashflow:
I’ve discussed this here.
P/E:
Price to earnings is the price per share dividend by EPS and an indication of how much other investors are willing to pay for a company’s current earnings and future earnings potential. I look at trailing (past 12 months) and forward earnings (future 12 months) to get a sense of where the company has been (past economic environment) and where I anticipate the earnings to be at a point in the future. I often forecast forward earnings based on past earnings growth, guidance by management and compare that to a company’s historical valuations.
Revenue/Expense Growth:
Revenues and expense growth give me a good grasp of how quickly expenses are growing and being managed by the business in contrast to rising or flat revenues. Here I concentrate on margins (expanding or contracting) and use it to evaluate management’s focus on maintaining profitability. A business can grow revenue at 5% per year, but if expenses are growing at 15% per year then as I shareholder I become immediately concerned that the trend is unsustainable and will look to management to get a handle on the problem.
Liquidity Ratios:
Liquidity ratios are important for any business because they measure the ability of management and various departments to meet short and medium term cash obligations during operation of the business.
Current Ratio:
Current ratio is a ratio that is determined by taking the total current assets on a company’s balance sheet and dividing that number by the total current liabilities. Current assets are all items in the asset portion of the balance sheet that will be converted to cash within one operating cycle (year) of a company. Current liabilities are all items in the liability section that will require payment, via cash, within the same time period. The current ratio for most companies should be 2:1 indicating the company has twice the needed convertible cash on their balance sheet to pay for the liabilities coming due over the next twelve months.
Quick Ratio:
The quick ratio is determined by taking the total of all liquid assets (cash + receivables) and dividing that number by the total current liabilities. This ratio helps to demonstrate a company’s ability to pay its obligations over a short period of time. The general guideline here is 1:1, indicating the company has enough cash on hand to meet short-term needs without having to sell or liquidate hard assets and inventory. Again, this figure will depend on the industry
If the current or quick ratios are too high compared to the industry average this might indicate that management isn’t effectively using their available cash investments. Likewise, if either ratio is too low the company may be in danger of not meeting its monetary obligations and this can cause a company to use expensive short-term financing from a bank or raising money through the equity markets (share dilution).
Working Capital:
Working Capital is the difference, in dollars, between current assets and current liabilities. The current ratio gives an indication of what proportion of cash is available to pay liabilities and working capital is the dollar amount of that difference.
Debt to equity:
The debt to equity ratio of a company is used to assess the extent the company is leveraged to debt. Total liabilities are divided by total liabilities + shareholder’s equity. Companies in industries such as utilities, telecommunications or manufacturing will often have a debt to equity ratio over 1.0 (more debt than equity) due to the capital intensive nature of their operations. These companies may need to borrow money to purchase assets, equipment or infrastructure, but the debt to equity should be manageable or constant at a level where operating cashflow is able to meet debt repayment obligations.
Basic EPS vs. Diluted EPS:
Basic earnings per share is a simple number that considers only net income, preferred dividends and a weight-average number of common shares of a company and each financial statement released by a company (annually or quarterly) will have this breakdown.
Diluted earnings per share is calculated under a “worst-case” scenario of assumptions where the company identifies all the dilutive securities they have that will negatively effects EPS if they were to be converted. These include convertible preferred shares (preferred shares that could be converted to common shares), stock options or warrants. For sake of easy calculation I use basic EPS in my analysis of equities.
See Also:
Part IV:
Part I:
Part II:
Subscribe or purchase full stock analysis posts!
Click here to see how future posts can be delivered directly to you
0 comments:
Post a Comment