Fundamental Analysis Techniques
Efficiency Ratios
IF ONE GROUP of managers was able to squeeze more money out its assets or capital than another, you'd go with the first one, right? Of course. That's why accountants and stock analysts long ago began looking for a reliable way to measure management efficiency. Return on equity (ROE) and return on assets (ROA) are what they came up with.
Both ratios are an effort to measure how much earnings a company extracts from its resources. Return on equity is calculated by taking income (before any non-recurring items) and dividing it by the company's common equity or book value. Expressed as a percentage, it tells you what return the company is making on the equity capital it has deployed. Return on assets is income divided by total assets. It gives you a sense of how much the company makes from all the assets it has on the books -- from its factories to its inventories.
As measures of pure efficiency, these ratios aren't particularly accurate. For one thing (as we've mentioned repeatedly), earnings can be manipulated. It's also true that the asset values expressed on balance sheets are (for various reasons) not entirely reflective of what a company is really worth. Microsoft or an investment bank like Goldman Sachs, as they say, rely on thousands of intellectual assets that walk out the front door every day.
But ROE and ROA are still effective tools for comparing stocks. Since all
Fundamental Analysis Techniques
Margins
LIKE ROE and ROA, calculating a company's margins is a way of getting at management efficiency. But instead of measuring how much managers earn from assets or capital employed, this ratio measures how much a company squeezes from its total revenue (sales).
Sounds a lot like earnings, right? Well, margins are really just earnings expressed as a ratio -- a percentage of sales. The advantage is that a percentage can be used to compare the profitability of different companies while an absolute number cannot. An example should help. In the spring of 1999, Sears had net income of about $1.1 billion on annual sales of about $41.2 billion. Wal-Mart, meanwhile, was earning about $4.7 billion on sales of $143 billion. Comparing $4.7 billion with $1.1 billion wouldn't tell you much about which company was more efficient. But if you divide the earnings by the sales, you'll see that Wal-Mart was returning 3.3% on sales while Sears was returning just 2.7%. The difference doesn't sound like much but it was worth about $839 million to Wal-Mart shareholders. And it's one of the reasons Wal-Mart was trading at about twice the multiple of Sears.
Analysts look at various types of margins -- gross, operating, pretax or net. Each uses an earnings number that is further down the Income Statement (see Price/Cash Flow for more on how the Income Statement works). What's the difference? As you move down the statement, different types of expenses are factored in. The various margin calculations let you refine what you're looking at.
- Gross margins show what a company earns after all the costs of producing what it sells are factored in. That leaves out a lot -- marketing expenses, administrative costs, taxes, etc. -- but it tells you how profitable the basic business is. Consider that Wal-Mart's gross margin was about 22% in the spring of '99. Sears' was 34%.
- Operating margins figure in those selling and administrative costs, which for most companies are a large and important part of doing business. But they come before interest expenses on debt and the noncash cost of depreciation on equipment. The earnings number used in this ratio is sometimes called cash flow or earnings before interest, taxes, depreciation and amortization (EBITDA). It measures how much cash the business throws off and some consider it a more reliable measure of profitability since it is harder to manipulate than net earnings.
- Pretax margins take into account all noncash depreciation on equipment and buildings, as well as the cost of financing debt. But they come before taxes and they don't include one-time (so called "extraordinary") expenses like the cost of shutting a factory or writing off some other investment.
- Net margins measure the bottom line -- profitability after all expenses. This is what shareholders collect (theoretically) and so closely watch.
Margins are particularly helpful since they can be used both to compare profitability among many companies (as we demonstrated with Wal-Mart and Sears above) and to look for financial trouble at a single outfit. Viewing how a company's margins grow or shrink over time can tell you a lot about how its fortunes are changing. Between early 1995 and January of 1999, for instance, Dell Computer's net margin doubled from 4.3% to 8% even as the cost of a PC declined markedly. What does that tell you? Dell was driving down prices and manufacturing more efficiently. Rival Compaq Computer, meanwhile, went disastrously in the opposite direction -- 8% to -8% -- as the company ran into trouble digesting several acquisitions and began to lose money. That helps explain why Compaq's shares rose about 250% during that time while Dell's roared ahead almost 8,000%
Fundamental Analysis Techniques
Inventories
IF YOU ASKED the average company president what he (hey, don't blame us for the averages) thinks of inventory, he'd likely sigh and tell you it's a necessary evil. Manufacturers have warehouses filled with raw materials, component parts and finished goods to help fill orders. Retailers have stock waiting to be sold. For every moment any of it sits idle on the shelves, it costs the company money to store and finance. That's why managers strive with all they've got to have as little inventory on hand as possible.
Certain types of companies (manufacturers, retailers) by nature must carry more inventory than others (software makers, advertising companies). So as an investor you want to look for two things here: First, does one company in a given industry carry more inventory as a percentage of sales than its rivals? Second, are its inventory levels rising dramatically for some unexplained reason?
You can't look at inventory in isolation. After all, if a company's inventory level increased 20% but sales grew at a rate of 30%, then the increase in inventory should be expected. The warning sign is if inventory spikes despite normal growth in sales. In 1997, for instance, the stock of high-flying apparel maker Tommy Hilfiger got nailed when its inventories suddenly rose 50% spooking Wall Street analysts, who figured the popular men's wear maker had lost its edge among teenage boys. Tommy eventually righted the situation (it had more to do with inventory management than fashion sense) and the stock recovered. But a lot of investors lost money along the way.
A helpful number to look at is the inventory-turnover ratio. It's annual sales divided by inventory and it reflects the number of times inventory is used and replaced throughout a year. Low inventory turnover is a sign of inefficient inventory management. For example, if a company had $20 million in sales last year but $60 million in inventory, then inventory turnover would be 0.3, an unusually low number. That means it would take three years to sell all the inventory. That's obviously not good.
There's no rule of thumb when it comes to turnover. It's best to make comparisons. If a retailer had a turnover of 4, for example, and its closest competitor had turnover of 6, it would indicate that the company with higher turnover is more efficient and less likely to get caught with a lot of unsold goods.
Fundamental Analysis Techniques
Current Assets/Liabilities
These statistics are always worth a look to take a company's short-term temperature. Current assets are things like cash and cash equivalents, accounts receivable (money owed the company by customers) and inventories. They are defined as anything that could be sold quickly to raise money. Current liabilities are what the company owes in short order -- mostly accounts payable and short-term debt.
The thing to look for here is a big change from period to period. If the current assets number grows quickly, it could mean the company is accumulating cash -- a good thing. Or it is having trouble collecting accounts receivable from customers -- a bad thing. Precipitous growth in current liabilities is rarely a good thing, but it might be explainable due to some short-term corporate goal.
If you see a spike in either category, it's worth further explanation. Check the analyst research, news reports or get the financial statements and read the notes. Management is required to explain changes in the company's financial condition.
Fundamental Analysis Techniques
Beta
HOW MUCH volatility can you expect from a given stock? That's well worth knowing if you want to avoid being shocked into panic selling after buying it. Some stocks trend upward with all the consistency of a firefly. Others are much more steady. Beta is what academics call the calculation used to quantify that volatility.
The beta figure compares the stock's volatility to that of the S&P 500 index using the returns over the past five years. If a stock has a beta of 1, for instance, it means that over the past 60 months its price has gained 10% every time the S&P 500 has moved up 10%. It has also declined 10% on average when the S&P declines the same amount. In other words, the price tends to move in synch with the S&P, and it is considered a relatively steady stock.
The more risky a stock is, the more its beta moves upward. A figure of 2.5 means a gain or loss of 25% every time the S&P gains or loses just 10%. Likewise, a beta of 0.7 means the stock moves just 7% when the index moves in either direction. A low-beta stock will protect you in a general downturn, a high Beta means the potential for outsize rewards in an upturn.
That's how it is supposed to work, anyway. Unfortunately, past behavior offers no guarantees about the future. If a company's prospects change for better or worse, then its beta is likely change, too. So use the figure as a guide to a stock's tendencies, not as a crystal ball.
Fundamental Analysis Techniques
Short Interest
LEAVE IT to Wall Street to figure out a way to profit from a falling stock. It's called "selling short" and it's becoming increasingly popular among individual investors. It works like this: Say an investor analyzes Intel and decides that all signs point to a decline in the stock price rather than an increase. Intel is trading at $60 a share, so the investor borrows shares of the stock at that price and immediately sells them. After the stock falls to maybe $40 a share, he buys it back on the open market to repay his debt. But since the price is lower, he pockets the difference -- in this case $20 a share. (Of course, if the price goes up from his original price, the investor loses big time.)
There are entire companies devoted to selling stocks short and they make it their job to seek out companies that are in trouble. They pore over financial statements looking for weaknesses. But sometimes they merely think a company is too highly priced for its own good.
Happily, the stock exchanges track "short interest" in a stock and report it each month so other investors can see what the short-sellers are up to. We track the short-interest ratio (short interest/average daily volume of the stock) on our Investor Snapshots, and it is always worth a look.
A high (or rising) level of short interest means that many people think the stock will go down, which should always be treated as a red flag. Your best course is to check the current research and news reports to see what analysts are thinking. But high short interest doesn't necessarily mean you should avoid the stock. After all, short sellers are very often wrong.
The short-interest ratio tells you how many days -- given the stock's average trading volume -- it would take short sellers to cover their positions (i.e. buy stock) if good news sent the price higher and ruined their negative bets. The higher the ratio, the longer they would have to buy -- a phenomenon known as a "short squeeze" -- and that can actually buoy a stock. Some people bet on a short squeeze, which is just as risky as shorting the stock in the first place. Our advice is this: Use the short-interest ratio as a barometer for market sentiment only -- particularly when it comes to volatile growth stocks. When it comes to gambling, you're better off in Vegas.
Fundamental Analysis Techniques
Price/Cash Flow
LIKE THE PSR, this ratio is another response to investor distrust of net earnings. Many stock analysts think it gives a better picture of a company's true earning power than does the net income figure. The problem is, there are several ways to define cash flow and it is always a little tricky to calculate. And to understand how it works, you first need a quick lesson in how earnings and expenses are recorded.
So here goes. Accounting rules require that a company lay out its profits or losses in a standard table called the Income Statement. At the top of the table is a figure for total sales (revenue). Expenses of various types are subtracted as you move down the page. The "bottom line" is net income.
Some of those expenses represent the direct cost of producing a company's goods or services. Others -- like depreciation on equipment -- are costs, but don't involve a cash outlay of any sort. Still others -- like taxes and financing costs -- are more administrative in nature. The farther down the income statement you go, the more a company's accountants can fiddle with assumptions to make their net earnings look better. So analysts look for a number -- called cash flow -- that is higher up the statement and that backs out everything but the real cost of doing business.
As we've said, there are any number of cash-flow formulas that add and subtract various types of expenses. Cable-television companies, for instance, carry a lot of debt to finance the ongoing construction of their networks. So when comparing them, analysts tend to use a cash-flow formula that backs out the cost of that debt. Why? They want to know how much money the companies generate from their networks, not how much their debt costs. That they examine separately.
Our view, however, is that most companies should be compared with the impact of their financing costs showing. What qualifies as a low number? Anything below 20 is worth a look. But, as always, you have to compare a company to its industry.
Fundamental Analysis Techniques
Price/Sales Ratio
THE ONCE-OBSCURE price/sales ratio has become an increasingly popular method of valuation for a few reasons. First, quantitative investor James O'Shaughnessy demonstrated convincingly in his book, "What Works on Wall Street," (McGraw-Hill, 1998), that stocks with low PSRs outperformed stocks with low P/E multiples. Second, as we mentioned in the section on P/Es, many investors don't trust net earnings, since they are often manipulated through writeoffs and other accounting shenanigans. Sales are much harder to "manage." Finally, the explosion in Internet stocks forced investors to look for ways to value companies with lots of potential, but no earnings.
As the name implies, the price/sales ratio is the company's price divided by its sales (or revenue). But because the sales number is rarely expressed as a per-share figure, it's easier to divide a company's total market value by its total sales for the last 12 months. (Market value = stock price x shares outstanding.)
Generally speaking, a company trading at a PSR of less than 1 should attract your attention. Think about it: If a company has sales of $1 billion but a market value of $900 million, it has a PSR of 0.9. That means you can buy $1 of its sales for only 90 cents. There may be plenty else wrong with the company to justify such a low price (like maybe it's losing money), but that's not always the case. It might just be an overlooked bargain.
O'Shaughnessy found that PSRs work best for large-cap companies, perhaps because their market values tend to be much closer to their massive sales to begin with. The ratio is less appropriate for service companies like banks or insurers that don't really have sales. Most value investors set their PSR hurdle at 2 and below when looking for undervalued situations. But, as always, we'd counsel that you compare a company's PSR value to its competitors and its own history.
Fundamental Analysis Techniques
Price/Book Value
BOOK VALUE is a company's assets minus its liabilities. It's accounting jargon for what would be left over for shareholders if the company were sold and its debt retired. The price/book ratio measures what the market is paying for those net assets (also known as shareholder equity). The lower the number, the better.
Price/book was a lot more popular in the age of smokestacks and steel. That's because it works best with a company that has a lot of hard assets like factories or ore reserves. It is also good at reflecting the value of banks and insurance companies that have a lot of financial assets.
But in today's economy many of the hottest companies rely heavily on intellectual assets that have relatively low book values, which give them artificially high price/book ratios. The other drawback to book value is that it often reflects what an asset was worth when it was bought, not the current market value. So it is an imprecise measure even in the best case.
But the price/book ratio does have its strengths. First of all, like the P/E ratio it is simple to compute and easy to understand, making it a good way to compare stocks across a broad array of old-line industries. It also gives you a quick look at how the market is valuing assets vs. earnings. Finally, because assets are assets in any country, book-value comparisons work around the world. That's not true of a P/E ratio since earnings are strongly affected by different sets of accounting rules.
