Security Analysis Lite Gary Ge MYP Year 5 Personal Project
Table of Contents Section 1 Introduction .......................................................................................................................................... 3 Section 2 Fundamental Analysis ....................................................................................................................... 5 Section 3 Qualitative Analysis ........................................................................................................................ 10 Section 4 Value Investing .................................................................................................................................. 14 Section 5 The Financial Report and Balance Sheet ................................................................................. 20 Section 6 The Income Statements ................................................................................................................. 24 Section 7 Conclusion .......................................................................................................................................... 27 Section 8 Bibliography ....................................................................................................................................... 28
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Section 1 - Introduction ________________________________________________________________________________
INTRODUCTION The investing decision is predominantly focused on two crucial questions: What is the investment’s potential earning power and what is the risk involved? Investing is all about beating the market, and value investors have developed a method to beat the annual returns of the Standard & Poor’s 500 (a stock market index based on 500 of America’s top publicly traded companies) a long time ago. The art of value investing is a proven strategy that has allowed for many successful track records, with famous value investors such as Warren Buffett, Benjamin Graham, David Dodd, and Charlie Munger leaving their indelible mark in nancial history. Value investing is all about buying a dollar for fty cents. Whenever you are purchasing a large or small share of a corporation or business, you always want the intrinsic value (inherent or underlying value) to be higher than the current market price. Before moving on, however, I must emphasize that there exists no foolproof, infallible method that predicts success when it comes to picking stocks. Hence, investing is more of an art, rather than a science because: 1. It is impossible to account for all of the factors that affect the health of a company. Consequently, it is impossible to construct a single algorithm that guarantees fortunes and headlines. It is quite simple to assemble data for fundamental analysis, but deciding which gures are relevant is a whole other exercise. 2. There is a plethora of information that simply cannot be assigned a value due to being intangible. Quantitative information such as the company’s prots are easy to nd, but information such as a company’s staff, competitive edge, and reputation is impossible to quantify. Hence, stock-picking is a subjective, and even intuitive practice. 3. Human (often irrational) elements constantly mingle with the forces of the market. Therefore, it is impossible to have an absolute prediction on the outcome of a stock. Emotions are subject to rapid changes and unpredictability, and when condence transforms into fear, the stock market becomes a place where one should tread carefully. Investing and stock-picking is all about the practical application of theories, means that these theories merely provide a best guess on which stocks to purchase. Sometimes, two seemingly contradicting theories can be successful at the same time, making it important for one to select the correct theory that suits their own personal outlook, time frame, risk tolerance, and the amount of time and effort they are willing to devote to investing. If you master the art of stock-picking, the stock market is an excellent place to increase your wealth. For example, had you investing in Microsoft at its Initial Public Offering (IPO) in 1986, an initial investment of $10,000 would have transformed itself into $3.5 million in today’s money. The 3
Section 1 - Introduction ________________________________________________________________________________ stock market is a thrilling place, which is why people are constantly hunting for the next Microsoft.
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Section 2 - Fundamental Analysis ________________________________________________________________________________
FUNDAMENTAL ANALYSIS Fundamental Analysis Topics Introduction The Greater Fool Theory Applying Theory to Practice
INTRODUCTION Evaluating a stock through fundamental analysis is a relatively simple and straightforward process - it merely takes a little time and energy. Fundamental analysis is used to determine a company’s intrinsic value, or what the stock is really worth, as opposed to its value on the marketplace. If the stock’s intrinsic value is worth more than its current market price, then it makes sense to add the stock to your portfolio (investments held by an individual). There are many ways to determine intrinsic value, but they all follow the fundamental tenet that a company is worth the sum of its discounted cash ows. In plain English, this simply means that a company is worth the sum of its future prots. In performing fundamental analysis, it is imperative that all future prots be discounted to account for the time value of money, or the force by which the $1 you receive in a year’s time is worth less than $1 you receive today. To understand the fundamental concept of intrinsic value equaling all future prots, we must rst understand the purpose of a business: It is to maximize the wealth and provide value to the owner(s). For example, if you have a small business, its value sources from the money you can withdraw from the company year after year, and not from the growth of the stock itself. However, you may only take from the company if there are leftovers after paying for supplies and salaries, reinvesting in new equipment, etc. A business is all about generating prots (revenue minus expenses), and it is this idea that forms the basis of intrinsic value.
THE GREATER FOOL THEORY One assumption of the discounted cash ow theory is that humans behave rationally on the market, and no one in the right mind would purchase a business for more than its future discounted cash ows. Because stocks represents ownership in a corporation and indicates that a part of the corporation’s assets and earnings be claimed for the holder, this assumption 5
Section 2 - Fundamental Analysis ________________________________________________________________________________ also applied to the stock market. Then why is it that stocks exhibit as much volatility as they do? It makes little sense that a stock’s price will uctuate so much when intrinsic value does not change by the minute. The fact of the matter is, people do not view stocks as representations of discounted cash ows, but rather, trading vehicles. Cash ows are disregarded when people are able to sell the stock to somebody else later for more than what they paid for. This phenomenon has subsequently been labeled as the greater fool theory. With this theory, prots are not determined by the company’s worth, but rather, the speculation on whether or not you are able to sell the stock to another investor (the fool). Conversely, these traders have argued that investors rely too heavily upon fundamentals, and therefore, fail to observe the market’s trends and tendencies. Here, we are able to distinguish the disparity between a technical and fundamental investor. Again, it is important to establish that each approach has its own merits and downfalls, but in general, fundamentals are for the long-run while technical analysis is most suited to short-term strategies.
APPLYING THEORY TO PRACTICE Theoretically, calculating discounting cash ows is a seemingly straightforward task. However, apply it to real life and it becomes an exercise of great difculty. The biggest challenge with the discounting cash ow theory is predicting the following year’s prots, so image how difcult it is to predict the prots of, say, the subsequent 10 years? What if the company goes bankrupt? What if the company survives the ups-and-downs of an entire century? With a plethora of uncertainties and possibilities, it is no mystery as to why there are so many different models for calculating discounting cash ows. Unfortunately, all models still fall prey to the complications posed by the uncertainties of the future. On the following page is a sample of a model used to calculate the value of a company. Take a look at how fundamental analysis works when put into practice.
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Section 2 - Fundamental Analysis ________________________________________________________________________________ FIGURE 1 Assumptions: - Discount Rate 8% - Growth Rate First 5 Years 15% - Growth Rate After First 5 Years 5% - Figures are in USD Millions
Prediction of 5 Years of Cash Flows Year 1
Year 2
Year 3
Year 4
Year 5
Prior-Year Cash Flow1
$100
$115
$132.25
$152.09
$174.90
Growth Rate2
15%
15%
15%
15%
15%
Cash Flow3
$115
$132.25
$152.09
$174.90
$201.14
Discount Factor4
0.93
0.86
0.79
0.74
0.68
Discount Value Per Year5
$106.95
$113.74
$120.15
$129.43
$136.77
Sum of PV of Cash Flow
$607.03
FIGURE 2 Calculating Residual Value Cash Flow in Year 5 Growth Rate
$201.14 5%
Cash Flow in Year 6
$211.20
Capitalization Rate6
3%
Value at End of Year 5 Discount Factor At End of Year 5 PV/Residual Value7 Intrinsic Value of the Company
$7,039.75 0.68 $4,787.03 5,394.06
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Section 2 - Fundamental Analysis ________________________________________________________________________________ When projecting this far into the future, one can begin to appreciate the obvious difculties of accounting for the different rates at which a company will grow as it enters different phrases. In this particular model, there are two steps used to address this problem: 1. Determine the sum of the discounted future cash ows of the next ve years. 2. Determine the residual value, or the sum of future cash ows of the following years starting from year six. In this example, the company is projected to grow 15% annually for the rst ve years and 5% annually in the subsequent years. Firstly, we must obtain the sum of the yearly cash ows of the rst ve years, each one of which have been discounted to the year zero, or the present value (PV). Once the total PV of the initial ve years has been calculated, we must then determine the value of the cash ows coming from the sixth and subsequent years, assuming that the growth rate is 5% per annum. The sum of the aforementioned cash ows is then discounted back to year ve and then year zero. It is added with the PV of the cash ows from the rst ve years, and we end up with an estimation of the intrinsic worth of the company. If the estimation is greater than the current market capitalization, then the stock may be a strong buy. Market capitalization is the total value of all of the shares outstanding (total shares) multiplied by the market price of one share. Here are some notes about each component of this model: 1. Prior-Year Cash Flow: The theoretical amount, or total prots, that shareholders could have taken from the company the previous year. 2. Growth Rate: The rate at which the earnings of company owners’ are expected to grow during the next ve years (or to perpetuity). 3. Cash Flow: The theoretical amount that shareholders would receive if the company gave out all of its earnings/prots. 4. Discount Factor: The number that brings the future cash ows back to its present value. 5. Discount Per Year: The multiple of cash ow and the discount factor. 6. Capitalization Rate: The discount rate (the denominator) in the formula for a constantly growing perpetuity. 7. PV/Residual Value: The present value of the company in year ve. The previous example of cash ow analysis has been rather simple, but it answers the following question: How much cash will the investment generate each year and what are the cash consequences? 8
Section 2 - Fundamental Analysis ________________________________________________________________________________ Unfortunately, measuring cash ow is no easy task, which is why Wall Street technicians spend much of their time pondering and analyzing cash ows. In reality, the only real cash ow from a public company is its dividend (the distribution of a portion of a company’s earnings to its shareholders), and the dividend discount model (DDM) values a company according to its future dividends. However, the amount paid in dividends varies, and is decided by the board of directors. Most secure and stable companies offer dividends to its shareholders. Due to unimpressive share prices, they attempt to compensate for this with dividends. Companies with rapid-growth don’t usually offer dividends at all, as all their prots are reinvested to sustain the higher-than-average growth rate. Some companies simply just don’t offer anything. If the former is the case, then other valuation methods include net income, free cash ow, EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization), and many other nancial measures. Different methods have their own pros and cons, but all are used to estimate a company’s intrinsic value. The point is that cash ow can be represented differently in different situations. No matter what model you may choose to use, the underlying theory behind them is universal.
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Section 3 - Qualitative Analysis ________________________________________________________________________________
QUALITATIVE ANALYSIS Qualitative Analysis Topics Management Know the Company Industry/Competition Brand Name
MANAGEMENT The evaluation of a company’s worth is not merely limited to crunching numbers and predicting cash ows. Whilst stock-picking, one must also examine a company’s more general and subjective qualities. Strong management is imperative for success at any rm. It is the people at the top who are the ones who make strategic decisions, serving as perhaps the most important factor in determining a company’s success. By asking who, where, what, when, why, an investor can evaluate the quality and strength of the management. Who? Who are the people running the company? You should nd out who the CEO, CFO, COO, and CIO are. Where? Research and nd out the educational and employment backgrounds of these people; where do they come from? Once you have this information, determine whether or not their management styles are suitable for running a company in its respective industry. For example, something that may raise a brow or two would be a management team comprising people from different industries. Additionally, if the CEO of a newly-formed company previously worked in the industry, you must then deduce whether or not they have the right qualities to lead the company to success. What and When? Find out what the management philosophy is; what style of management do these people want to use to run this company? For example, some managers may be more exible in their 10
Section 3 - Qualitative Analysis ________________________________________________________________________________ management style and allow for more openness and transparency. On the other hand, some managers are more rigid and adhere to policy and established logic when making decisions. You can determine the management style by looking at the company’s past actions or by reading the management, discussion & analysis (MD&A) section of the company’s annual report. Question yourself whether or not you like their management philosophy, and whether or not it works for the company, given its size, nature of business, and industry. Next, nd out when the current team took over the rm. Long tenures by managers typically mean that they are successful and protable. Had they not been successful, shareholders and the board of directors would have booted them already. In fancy MBA terms, this is known as “restricting the management,” or changing the management due to poor results. If a company is constantly changing its managers, it may be prudent to invest your money elsewhere. However, it is not to say that restricting management automatically entails that the company is doomed and soon to go bankrupt. Conversely, management restructuring may also be a sign to invest, as it shows that the struggling company is making an effort to improve its future Why? Look into the reasons as to why these people decided to become managers. Investigate their employment history and look for a strong reason to justify their management position. Again, ask yourself if the manager has the qualities to run a successful business. Finally, nd out if they have been hired because of past success or achievement or if they simply landed the job through questionable methods such as inheritance.
KNOW THE COMPANY The second part while conducting qualitative analysis is knowing what the company’s product(s) and/or service(s) are. Basically, how does the company make its money? What is the company’s business model (how does the company plan to make a prot)? In the end, whether or not a company’s efforts will prove protable is central to the investment-decision. Too often do people claim that their stock will be largely protable, but when asked what the company actually does, they seem to have a blurry vision of the company’s future. As obvious as this may seem, if you are unsure as to how the company generates return, then you can never be sure that the stock will be protable. 11
Section 3 - Qualitative Analysis ________________________________________________________________________________ For example, the biggest lessons learnt from the dotcom bust of the late ‘90s is that a failure to understand a business model can lead to serious consequences. Much of the traders investing in dotcom companies had no idea how they generated revenue, or why their shares were priced so high. The stark reality was that these companies were making no money at all, but were rumored to have massive growth potential. This subsequently led to overpriced stocks due to overenthusiastic buying thanks to herd mentality, which led to an ensuing market cash. Most people lost money during this bubble burst (the rapid expansion and collapse of a market), but famous investor Warren Buffett lost nothing, as he simply did not invest in high-tech stocks due to his lack of understanding. One must have a strong understanding on how a company actually makes money in order to assess whether or not management is doing well in regards to the decision-making process.
INDUSTRY/COMPETITION In this section, we must analyze different characteristics of the industry, such as its growth potential. An average company in a thriving industry can provide decent returns, while an average company in a poor industry will most likely prove to be a poor investment. Sound judgement is required in determining an industry’s stage of growth, and has one asking themselves whether or not the demand for an industry will continue to grow. However, what may seem obvious is often overlooked. For example, there is obviously greater growth prospects for a technology company versus an appliance repair company. It’s also important to consider a company’s relative market share. For example, Microsoft dominates the operating systems market. Anyone who tries to enter this industry faces monumental obstacles as Microsoft can take advantage of economics of scale (cost efciencies that corporations acquire through expansion). Near-monopolies do not always remain at the top, but investing in a company who tries to take on an industry giant has its obvious risks and implications. Consequently, barriers that make entering an industry difcult provides already established companies with qualitative advantages. For example, entering the restaurant industry takes little skill level and capital. On the other hand, entry into the automobile and pharmaceutical industries have massive barriers (large capital expenditures, exclusive distribution channels, government regulation, patents, etc.).
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Section 3 - Qualitative Analysis ________________________________________________________________________________ BRAND NAME Brand name reects years of product development and marketing. Valuable brand names such as Coca-Cola and consumer goods giant Procter & Gamble both have an estimated intangible value worth billions of dollars. It’s important to diversify one’s portfolio with different brands to reduce risk, as optimal performance in brand can compensate for less desirable performances in other brands. Additionally, some investors choose to ignore companies that are branded around a single individual, as bad news related to that person may hamper the performance of the company, even if the news has nothing to do with the company’s operations.
CONCLUSION In conclusion, qualitative analysis is just as important as fundamental analysis. These methods may be simple, but are imperative when evaluated the potential of an investment. You don’t need a PhD in nance, and identifying a good company is not only limited to investors on Wall Street who have access to company information.
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Section 4 - Value Investing ________________________________________________________________________________
QUALITATIVE ANALYSIS Value Investing Topics Value versus Junk What is a Stock? Contradictions Finding Undervalued Stocks Screening for Value Stocks Basic Value Investing Ratios Net-Net Insider Purchasing ACtivity The Margin of Safety The Art of Value Investing
VALUE VERSUS JUNK In the 1930s, two professors working at Columbia University, Benjamin Graham and David Dodd, established the framework for today’s value investing. Value investing is one of the best ways to pick stocks, and has been widely used ever since. Although the method is very effective, the underlying concept is rather simple: to nd companies trading under their inherent worth. Value investing requires investors to examine a stock’s fundamentals - its earnings, dividends, book value (the value of a company after subtracting its intangible assets and liabilities from its assets), and cash ow (the movement of cash) - to determine whether or not the stock is undervalued, given its quality. A incorrectly valued stock is prone to increases in share price when the market corrects its error in valuation. However, this does not mean that value investing is the act of buying a stock simply because it has declined in price and therefore seems cheap. With value investing, it is imperative to establish the difference between an undervalued company versus one that has simply declined in price. Investors must do adequate research before they can select high-quality, underpriced stocks. For example, if Company XYZ has been trading at $50 per share, but suddenly drops to $30 per share, it does not mean that the company has automatically become a bargain. This is merely a sign that the company is worth less than it previously was, and the decline in price could be a result of several factors, such as the market responding to a fundamental issue within the company’s management/operations. For a stock to actually qualify as a value stock, the issuer must display good fundamentals that imply that the 14
Section 4 - Value Investing ________________________________________________________________________________ intrinsic value is worth more than $30. Hence, we can see that value investing compares current share prices to the intrinsic value and completely disregards historic share values.
WHAT IS A STOCK? When valuing investing, stocks should be viewed as nancial instruments which represent ownership of a company. Hence, the prots that result from value investing come from investing in quality companies, and not through trading. Because value investing is about determining a company’s intrinsic value and underlying assets, there is no need to pay any regards to external factors affecting a company, such as market volatility or day-to-day price uctuations, as they are not built-in to the company, and therefore, have no effect on the value of the company in the long-run.
CONTRADICTIONS The efcient market hypothesis (EMH) states that current market prices will always reect all relevant information related to a company. This means that intrinsic value is essentially non-existent. However, value investing tenet dictates the complete opposite, with value investors believing the EMH to exist only in a dreamworld, as the whole point of value investing is to search for inefciencies (when the market assigns an incorrect price to a stock). Value investors also disagree with the idea that high beta (volatility) will always equate to a risky investment. For example, if an investor believes that Company ABC has an intrinsic value of $20 per share, but is currently being traded at only $15, then they will automatically assume that Company ABC is a strong buy. However, let’s say that the stocks at Company ABC drop to $10 per share, then a decrease in price means a rise in beta. In this case, as long as the company retains its intrinsic value of $20 per share, then the decrease of value makes the stock an even bigger bargain. The better the bargain, the smaller the risk. Hence, high beta does not deter value investors, because as long as they have faith in the stock’s intrinsic value, an increase in beta may just be a good thing. FINDING UNDERVALUED STOCKS To begin your search for undervalued stocks, start by completing the following steps: 1. Generate a list of stocks that meet the basic screening criterions introduced in the following section. Some websites lter stocks according to certain specications. 15
Section 4 - Value Investing ________________________________________________________________________________ 2. Conduct in-depth analysis of these companies by examining the stock’s nancial data (use databases such as Edgars and Sedar, or quarterly reports/press releases from the company’s ofcial website). 3. Use major nancial websites (ie. NYSE, Nasdaq) to nd out about the company’s basic information such as stock price, shares outstanding (share volume), earnings per share, and news regarding the company and industry. 4. Find out who the majority owners are, and recent insider purchasing activity(s). 5. Heed to Benjamin Graham’s rule that an undervalued stock is always priced at less than two-thirds of its intrinsic value.
SCREENING FOR VALUE STOCKS Qualitative aspects of value stocks: 1. Where are value stocks found? Everywhere. They can be found in the NYSE, NASDAQ, AMEX, over the counter, on the FTSE, Nikkei, etc. 2. Which industries are value stocks located in? Virtually every industry has its own value stocks. However, they are more likely to be found in industries that have faced recent turbulence, or were recently subject to overreaction from the market due to some news affecting the industry. For example, cyclical industries, industries sensitive to the business cycle, where revenues are higher or lower depending upon economic prosperity or hardship, allows for companies to be undervalued for certain periods of times. 3. Can value stocks be those that have just reached all-time lows? Yes. Value companies can be companies that have hit an all-time low (ie. 12-month low or half of a 12-month high), although it is still important to remember that cheapness is only a useful metric when compared alongside its intrinsic value. The following numbers/guidelines are used by value investors whilst picking stocks. Be mindful that there are merely guidelines, and not concrete rules. 1. Current price per share should be no greater than two-thirds of the intrinsic worth. 2. The company’s price-earnings ratio (P/E ratio) should be in the lower 10% of all equity securities (stocks). 3. Price/Earnings to Growth (PEG ratio) should be less than one. 4. Stock price should be no more than the tangible book value. 5. Total debt should be no greater than total equity (D/E ratio < 1). 6. Current assets should be equal to at least twice the current liabilities. 7. Dividend yield should be greater than two-thirds of the long-term AAA (high credit quality) bond yield. 16
Section 4 - Value Investing ________________________________________________________________________________ 8. Compounded over the previous decade, earning growth should be at least 7% per annum.
BASIC VALUE INVESTING RATIOS P/E Ratio Recall to the time when you heard someone say that a stock is selling at something “times earnings.” This is the P, or the current price of the stock. E is the company’s annual earnings per share (EPS). For value investors, the P/E ratio should be as low as possible, with the most desirable ratios being single digits. The quotient from calculating P/E is called the earnings multiple. P/E Ratio = Market Value per Share/Earnings per Share (EPS) Before we continue, please note that value investing does not simply involve the act of investing in low P/E stocks, albeit low P/E ratios (relative to other companies within the same industry) are often indications of an undervalued stock. For example, if the average P/E ratio of an industry is 25, then a company with a P/E ratio of 15 within the same industry should warrant further investigation. PEG Ratio PEG is used to measure the intrinsic value of a company. It is a metric used to see how cheap a stock is, while at the same time, taking into account the projected growth of earnings. Usually, if the PEG ratio is less than 1 (PEG < 1), then there is an undervaluation of the company. PEG Ratio = Price-to-Earnings (P/E) Ratio/Annual Earnings Per Share Growth Earnings Yield Earnings yield is the inverse of earnings multiple. For example, a stock with an earnings multiple of 25 would have an earnings yield of 1/25 or 0.04, or more commonly represented as 4%. Because value investors search for stocks with low earnings multiple, the inverse of that would simply mean that they are also searching for high earnings yield. Earnings yield is used by investors to determine whether or not a stock is able to generate a large amount of earnings in relation to the individual share price.
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Section 4 - Value Investing ________________________________________________________________________________ NET-NET Another widely-accepted method of picking value stocks is the net-net method. This method proposes that if a company is selling at less than two-thirds of its current assets, then there is no need to perform further analysis. The logic behind this concept is not complex: if a company is selling at such a low level, the shareholder will not only get all the permanent assets of the company for free (ie. property, equipment, etc.), but also receives the company’s intangible assets (ie. goodwill). Unfortunately, such companies rarely exist.
INSIDER PURCHASING ACTIVITY Insiders comprise a company’s senior managers, directors, and shareholders who own at least 10% of the company’s total shares. These people will have exclusive access to information and knowledge about the company they manage, so if they are purchasing the company’s stocks, its safe to assume that they have faith in the company’s future. Also, investors who have bought at least 10% of the company’s shares wouldn’t have done so if they thought that the company had no prot potential. If these investors are further adding to what they own, then they obviously see great prot potential in the company. However, if an insider does sell some of their stocks, it does not always mean that they are anticipating poor company performance. They may simply just need the cash for personal reasons. However, if mass sell-offs are occurring by insiders, then it is reasonable to conduct further in-depth analysis of the reasons behind the sales. Within two business days of purchasing stocks, insiders are required to report to the Securities and Exchange Commission (SEC). Hence, you will be able to nd insider purchasing activity free on the SEC website and major nancial websites. THE MARGIN OF SAFETY The use of a margin of safety is an easy and effective way to prevent loss. Because we are all humans, it is prudent to leave room for error in case our calculations of intrinsic value are too optimistic. For example, an investor calculates the intrinsic value of a company to be $20 per share. However, in order to prevent the investor from paying too much for an accidental junk stock, he uses a margin of safety by deciding that the intrinsic value of the company to be $14 per share.
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Section 4 - Value Investing ________________________________________________________________________________ THE ART OF VALUE INVESTING To sum this section up, let’s go over value investing as an art. Value investing is all about being condent that the stock(s) you’ve selected is inherently worth more than its current share price through in-depth research and analysis of the company. Value stocks are not to be identied simply because they have a few good ratios, or because there has been a dip in the price. When selecting value stocks, think about the company’s prot potential and future prospects: 1. 2. 3. 4. 5. 6.
Can revenues be increased through raising prices? Can revenues be increased through increasing sales? Can revenues be increased through lowering expenses? Can revenues be increased through selling or terminating unprotable operations? Can revenues be increased through expanding the company? Who are the company competing against and how strong are they?
In answers these questions, one must not help but realize that value investing is in some ways, and art. Good investment choices cannot be determined simply by plugging numbers into a software. So to increase the odds of selecting the best stocks, only invest in stocks that you fully understand (this is the approach used by Warren Buffett). Companies like these are most likely ones that are in industries that you’ve worked in. Peter Lynch, another prominent investor, believes that an individual investor can outperform institutions by buying into companies that they know about before Wall Street sees their prot potential. Finally, another strategy is to simply buy shares of companies who offer products/services that have been in demand for a long time and are likely to continue with the amount of demand. This strategy does not simply revolve around doing math and looking at stock quotes, but requires critical-thinking and deduction. It is obviously not possible to predict innovating new products/services that may cause current ones to become obsolete, but this can be compensated by researching into company history and how they has adapted to change over the years. It’s also prudent to analyze management styles and the effectiveness of corporate governance to determine the company’s adaptability.
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Section 5 - The Financial Report and Balance Sheet ________________________________________________________________________________
THE FINANCIAL REPORT AND BALANCE SHEET The Financial Report and Balance Sheet Topics Financial Reports The Balance Sheet The Fundamental Account Equation
FINANCIAL REPORTS Financial reports are the performance results that a company publishes annually and quarterly. The U.S. Securities and Exchange Commission (SEC) requires that these reports be led, and one can consequently nd these on the SEC website or the company’s corporate or investor relations website. The nancial report informs the reader of the products/services that the company offers, and forwards an idea of how the company sees itself. For example, if we read Amazon’s annual report, we learn that the company is more than just a website that sells books. Financial reports also contain appraisals of their recent accomplishment, changes in leadership, risk factors, intellectual property, any regulatory changes, etc. Investing requires that you understand a company’s business model, and this information can be obtained from the company’s annual report. However, if you still have no idea what the company does after completing this research, it is probably a good idea to shy away from the stock. Besides this kind of information, nancial reports also offer nancial data that are useful to investors (ie. revenues, operating expenses, net income, total assets, total debt, etc.). These numbers often come in tandem with their corresponding historical values, make data compare easy. Comparing current and historical data is used to determine the effectiveness of growth prospects and to create forecasts. Financial reports is also imperative for analyzing a company’s weaknesses. Phrases that suggest things such as rapidly evolving business models or highly volatile stock prices could potentially turn investors off if they feel that it poses a threat to the earning power of the rm.
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Section 5 - The Financial Report and Balance Sheet ________________________________________________________________________________ THE FUNDAMENTAL ACCOUNTING EQUATION Assets (A) = Liabilities (L) + Owners’ Equity (OE) What you own (assets) equals to the total of what you borrowed (liabilities) and what you have invested (equity) to pay for it. All nancial transactions must adhere to this balancing concept. Assets Assets are the resources that the company current owns for the future benet of the rm. These include: - Cash - Inventory - Accounts Receivable - Equipment - Real estate Accounts receivable is the money that customers, such as individuals or corporations, owe to the company for products and services that have already be delivered/used but have yet to be paid for. On the balance sheet, accounts receivable is recorded as an asset, as it represents a legal obligation by the customer to repay their short-term debts. Liabilities Liabilities are nancial obligations that include repaying borrowed money, debts, and other obligations in order to continue providing goods or services to other entities in the future. Liabilities include the following: - Amounts Owed to Suppliers - Accounts Payable - Prepaid Accounts or Advances from Customers to Deliver Goods and Services - Taxes Owed - Wages Owed to Employees Owners’ Equity Owners’ equity (OE) is the total value of the owners’ investment in the company. Investments may be in the form of cash, other assets, or the reinvestment of earnings into the company. OE includes the following: 21
Section 5 - The Financial Report and Balance Sheet ________________________________________________________________________________ - Common Stock - Investment by Owners - Additional Paid-In Capital - Investment by Owners - Retained Earnings - Reinvestment of Earnings by Owners
THE BALANCE SHEET The balance sheet of a company consists of two sections: the company’s assets, and the company’s liabilities and owners’ equity. The balance sheet shows these values as of a specic date, and provides a snapshot of a company’s holdings at a given time. When examining the balance sheet, the current ratio is an important ratio used to compare the company’s total current assets to its total current liabilities. Current assets will be consumed within a year and current liabilities must also be repaid within the same amount of time. The higher the ratio, the more attractive it is to value investors (preferably greater than 2 to 1), as this indicates that the company can easily cover its obligations, and also displays a high amount of liquidity. However, one must compare the current ratio to those of most recent years and the one’s of competitors to establish the ratio’s signicance. From the balance sheet, investors should also calculate net current asset value per share (NCAVPS). NCAVPS is obtained by subtracting the current liabilities from the current assets. You then divide this quotient with the number of shares outstanding to get the NCAVPS. A low NCAVPS is one of many indications that an value investor should continue with their analysis. NCAVPS = (Current Assets - Total Liabilities)/# Shares Outstanding Balance sheets are also used to determine the long-term nancial conditions of a company. Long-term liabilities are any nancial obligations which have maturity dates greater than a year (ie. mortgages, bonds). Long-term assets include real estate and factories, which are included under the “xed assets” or “property, plant and equipment” section. “Intangible assets” also fall under the category of long-term assets. These include things such as copyrights, trademarks, and patents (intellectual property). Another important gure to heed to is the debt-to-assets ratio, as any company whose debt exceeded 50% of assets should simply be avoided. The number is obtained by dividing the total liabilities by total assets. The lower the ratio, the more investors are justied to continue with further investigation. Total Debt To Total Assets = (Short Term Debt + Long Term Debt)/Total Assets 22
Section 5 - The Financial Report and Balance Sheet ________________________________________________________________________________ Additionally, the book value per share and price-to-book ratio (P/B ratio) are also important numbers to get from the balance sheet. Book value, or net worth, is calculated by subtracting a company’s liabilities from its assets. The book value per share, as its names suggests, is calculated by dividing the book value by the number of shares outstanding. Companies with share prices below its book value per share are a green light for investors to continuing conducting their analysis. For example, if Company XYZ has a net worth of $100 million, and has 20,000 shares outstanding, it’s book value per share would be $100,000,000/$20,000, or $5,000. If the stock of Company XYZ trades at $4,000, then it is reasonable to continue with your research. Book Value Per Share = (Assets - Liabilities)/Total Outstanding Shares The price-to-book ratio is obtained by comparing the stock price to the book value. ($4,000/$5,000 = 0.8) P/B Ratio = Stock Price/(Total Assets-Intangible Assets and Liabilities) There are many more nancial ratios that can be calculated with the help of the balance sheet, but these are just the most basic ones.
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Section 6 - The Income Statement ________________________________________________________________________________
THE INCOME STATEMENT The Income Statements Topics The Income Statement Calculating Protability
THE INCOME STATEMENT The income statement shows the “ow” of activity and transactions over a specic period of time. In the income statement, there are revenues generated from sales and expenses relating to those revenues. When you subtract the expenses from the revenues, the difference is income. Revenue - Expenses = Income When examining the company’s income statement, it is better to look at the company’s annual report rather than its quarterly report, as businesses are often subject to the uctuations of business cycles. Also, by comparing the most recent gures to preceding ones, one can get an idea if or if not the sales of a company are improving over time. Increase in sales is an obvious indication of a growing company. The next thing to look for on an income statement is the cost of goods sold (COG). COGS includes all the costs that are directly linked to the productions of the goods/services sold/ offered by a company. This amount includes things such as the cost of materials and direct labor costs. It does not include indirect costs such as money spent on distribution and the company’s sales force. COGS can also be referred to as “cost of sales.” Cost of Goods Sold = Beginning Inventory + New Purchases - Ending Inventory Another thing to look for is the gross margin. If a business has a negative gross margin, it either means that costs are out of control, or the pricing structure of the industry simply does not afford protability for Company XYZ. Gross margin = Sales - The “Direct” Cost of the Goods or Services Sold The operating prot is the earnings before interest and taxes (EBIT). The further we progress through the income statement, the more and more expenses are deducted. At the operating level of prot measurement, all corporate expenses directly related to generating 24
Section 6 - The Income Statement ________________________________________________________________________________ revenue are deducted. Additionally, since most companies will use accrual accounting, costs such as depreciation or amortization must also be accounted for. Accountants will also divide the cost of equipment, tools, building, and any other xed assets by their estimated operational years, and deduct that from the operating prots. The result is earnings before interest, taxes, deprecation, and amortization (EBITDA). Another important terminology from the income statement is net income. Below the operational level of prot, items not directly linked to operations are deducted to calculate income. Firstly, any form of interest for the period is deducted, which include things such as corporate borrowings used to nancing a company. Accountants do not include interest in the operating income because companies are funded differently and use varying proportions of bank borrowings and investors’ money. Dividends are also not deducted, too, as owners pay dividends out of the net income at the bottom of the statement. By separating interest expenses, the operating income only reects the costs required to operate the company, and not what is needed to nance it. Tax expenses are also separate from the operating income because it is simply a non-operating expense. Additionally, different tax strategies result in vastly different tax expenses, and those strategies are often the result of a skilled tax accountant rather than the actual operating results. Tax expenses are put below operating results as a separate deduction, and we end up with the net income as the nal income measurement. This is what the company ultimately made, and is the conventional metric used to measure success or failure. The nal lines of an income statement contain the company’s basic earnings per share (EPS) and the diluted earnings per share (EPS). Basic EPS is calculated by dividing the net income by the number of shares outstanding. This number is used by investors to look for growth in EPS. Diluted EPS is the earnings per share if all of the company’s convertible securities were converted to regular shares. Convertible securities include stock options, convertible bonds, preferred stocks, warrants, etc. Convertibles are ideal for investors who seek greater potential for appreciation than bonds (a debt investment) provide, and higher income than common stocks offer. Convertibles will also most likely offer a lower coupon (interest rate) than a normal bond, but the fact that it can be converted to a common stock adds value for the owner; it is essentially a bond with a stock. If these nancial instruments were to be converted, it would mean that there would be an increase in outstanding shares. Consequently, all shareholders would have smaller relative shares, and therefore, smaller splits of the prot. Diluted EPS is therefore, always lower than basic EPS, but value investors wish for the difference to be minimal. 25
Section 6 - The Income Statement ________________________________________________________________________________ Finally, the income statement will also tell the reader the changes in outstanding shares over time. Growth companies such as Amazon will typically increase their shares outstanding every year, while value companies will have a decreasing number of shares. A decrease in the number of shares is indicative of share buyback programs, which means that the management has condence in the company’s future prospects. This also means that the EPS will increase, as the number of shares have decreased. Conversely, if the number of shares outstanding has increased, it entails that the company is issuing more stock options, therefore diluting your earnings. This is usually done simply to nance a company through stock offerings.
CALCULATING PROFITABILITY Prot margin is the most rudimentary metric used to determine protability. There are two types of prot margins, both of which act as indicators of company performance. Net prot margin (after tax) is calculated by dividing the net prot by sales. Gross prot margin (before tax) is calculated by dividing the gross prots by sales. These prot margins are represented as a percentage. A low prot margins means that either a company's COGS are too high, or the market simply doesn’t support the company’s operations. Also, remember that there is no magic number for a “satisfactory” prot margin, as these gures are all industry-specic. Prot margins are also an indication of whether or not companies may succeed in the future. To further calculate protability, one should also compare prot margins to the ones of previous years to make sure that the company is growing. It is also important to compare the company’s prot margins to its competitors in order to gain a perspective of these numbers (companies with greater prot margins than their competitors ensure more consistent and growing prots). Finally, value investors nd it valuable to compare the stocks they are interest in to others like it that have recently been acquired. The price a stock sells during an acquisition is usually a true reection of its actual worth, as acquisitions are handled by seasoned and knowledgable investors.
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Section 7 - Conclusion ________________________________________________________________________________
CONCLUSION Value investing is all about buying a dollar for ď&#x20AC; fty cents. Instead of paying the full price for a stock, value investors are able to enjoy signiď&#x20AC; cant discounts on their purchases by inquiring into the wisdom of market prices. This allows them to utilize high margins of safety and while enjoying high returns by keeping their stocks until they rise to or exceed their true value. If you are a bargain hunter, a person willing to do legwork, and someone with a lot of patience, then value investing is the strategy for you. Happy investing!
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Section 8 - Bibliography ________________________________________________________________________________
BIBLIOGRAPHY
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