Investing Tools for
Investors Looking to Excel
10/21/02
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Investing Tools for
Investors Looking to Excel |
How to dissect the balance sheet, income statement, and cash flow analysis to spot problems and prospects that may not be broadly recognized or in the stock price. Fundamental Analysis Fundamental Analysis probes the Balance Sheet, the Income Statement, and the Statement of Sources and Uses of Working Capital. The Balance Sheet is a point in time view of Assets and Liabilities and Shareholder's Equity (derived by subtracting liabilities from assets). The Income Statement shows the results of operations including revenues, less the cost of goods sold, operating expenses, non cash charges, interest expenses, and taxes. The Statement of Sources and Uses of Working Capital looks at the sources of funds and uses of funds. This statement is critical to look at how a company is sourcing its working capital requirements and capital expenditures. Fundamental Analysis evaluates the Balance Sheet, Income Statement, and Sources and Uses of Working Capital in order to assess the following;
Liquidity Ratios- Current Ratio- ratio of Current Assets (assets maturing within one year of statement date) divided by Current Liabilities (liabilities maturing within one year of the statement date). Current Assets generally consist of Cash, Marketable Investments maturing within one year, Current Receivables, and Inventory. Current Liabilities consist of Accounts Payable, Current Debt, and Deferred Income. Quick Ratio- ratio of Current Assets minus Inventory divided by Current Liabilities. This is a better measure of liquidity since the true nature of liquidity under duress is difficult to determine. Forced liquidations can lead to very disappointing realizations. A quick ratio over one is desirable. Receivables Turnover- Sales for the Period divided by Average Receivables (Beginning Receivables minus Ending Inventories divided by two). The trend in this ratio is extremely important to determine credit quality of the customers and whether the company is meeting its deliverables. There are times companies will book sales even if customers have not accepted or received delivery. Inventory Turnover- Sales for the Period divided by Average Inventory (Beginning Inventory minus Ending Inventories divided by two). The trend in this ratio is extremely important to determine whether a company is stuffing the channel or is stuck with depreciating inventory. Comment- While it is desirable to have a Current Ratio over 2 times and Quick Ratio over 1 times, there are industries where this is not true. Utilities and truckers receive quick payments (fast turnover of receivables, little inventory) and have slow payables since they receive generous terms of trade, so that they can have ratios of 1 or less and still be completely liquid and solvent. Long Term Assets consist principally of Property, Plant, and Equipment and Capitalized Software Development Costs. Both these items are not recorded as an expense but capitalized when put into service or as the software is completed. These long term assets are then depreciated or amortized over their expected economic life and hence recorded as an expense. Uneconomic or obsolete property or capitalized software which doesn't work or has been outflanked by competition should be written off. Companies are, at times, hesitant to startle Wall Street with these write-off and write-downs. Often, these unproductive assets build until the auditors blow the whistle and force write-offs. Total Asset Turnover - Total Asset Turnover (Sales for the Period divided by Average Total Assets for the period) and its trend can unearth dead assets if the ratio is deteriorating and there is no valid explanation. What to Look For! It is important to look for the trend in these numbers. For instance, rapid sales accompanied by radical slowing in inventory and receivables turnover, may indicate channel stuffing, bad credit quality of customers or erroneous and premature booking of sales before customer acceptance. Companies anxious to hit extremely aggressive Wall Street expectations may ease credit policies, or get customers to accept too much product in return for easy credit. This robs from future quarters and suggests growth is not all it's cracked up to be. This can mean a real disaster in the making. Once Wall Street Analysts are bilked, it's tough to get Wall Street sponsorship back. Companies with substantial amounts of In-Process inventory as opposed to Finished or Raw Inventory may have a lower quality of liquidity. If the economy slows, the company may get caught with substantial amounts of unsold in-process inventory, for which prices have plummeted. Asset Quality- In addition to turnover of receivables and inventory, one should look for capitalized expenses. Capitalization involves booking as a asset rather than an expense costs of products or assets where revenues are expected to be realized over time. In an attempt to match revenues and expenses, it is deemed appropriate to not expense software development for which there is no current revenue possibility, even if there is a demonstrable ultimate market once completed. Once the software is finished and saleable, the company will begin to amortize (expense) the capitalized cost over the time of its expected economic usefulness. Capitalization of certain expenses can lead to assets of dubious quality and liquidity where ultimate realization is subject to realistic concern. Computer companies capitalize software development. Retailers capitalize so-called pre-opening expenses. So do restaurants. Companies capitalize software development they undertake. However, there are times when the software doesn't work and must be abandoned and written off. These assets may be of very dubious quality. These assets may be written off, leading to so-called "one time" write-offs. Some companies engage in "one time" write-off as a normal course of business. Channel Stuffing- Companies desperate to meet sales and earnings targets can stuff the channel by giving tremendous financing terms to their retail outlets or other sales channels like Value Added Resellers (VARS). Sunbeam's and Compaq's stock prices crashed when the game couldn't be pushed anymore. The receivables and inventory turns gave this away. Wall Street didn't see this deterioration in turnover so their customers took severe losses. Keep in mind, channel stuffing robs from subsequent quarters to feed the current quarter. When management gets into this mode one of two things happen. One, sales unexpectedly explode and take down all the product from the channel. Two, the whistle is blown and the stock implodes. Generally, it is the latter that occurs. Earnings Quality Creating Earnings- Companies that have earned or been accorded (there's a big difference) high P/E's can use this inexpensive currency to buy earnings. Wall Street does not like dilutive deals where the acquiring companies earnings forecasts are reduced because the consequence of the acquisition will be lower earnings per share or cash flow per share for some period until "synergies" kick in. This happens because the company exchanges its lower P/E stock to buy high P/E stock with the result that shares outstanding increase by more than the earnings, thus diluting existing shareholders. Dilutive deals must have credible long term logic to justify disadvantaging existing shareholders in the near term. Accretive deals are loved by Wall Street because they increase earnings forecasts and, in theory at least, increase the earning per share for existing shareholders. These deals involve exchanging high P/E stock for lower P/E stock. In essence the company is acquiring more earnings than it is required to issue new stock, thus elevating forecasted EPS. The problem with these accretive deals is that the creation of earnings per share through acquisition may be masking a problem with organic growth with the existing businesses prior to the acquisitions. Wall Street, in too many cases, arrives way late to realizations about deteriorating fundamentals with companies it follows. So, while a company has a high P/E, it can use this acquisition currency to mask deterioration. The list of the Snapples, Oxford Health, and Cendants who disappointed the world is long. These accretive deals can mask problems that Wall Street might have spotted with more detailed analysis of ratios and trends. Further, Wall Street enjoys huge revenues from advising corporate clients on acquisitions and would be loath to bad mouth accretive deals they derive income from. Wall Street has shown little urge to slay the golden goose. Cendant, Tyco, and Cisco are prominent examples of accretive acquirers. Cendant has come a cropper already with the blowup of CUC due to accounting irregularities. Tyco and Cisco are going strong and have not yet hit any speed bumps. While deals can be very beneficial, one should be somewhat circumspect about possible underlying troubles. Other Earnings Issues- Habitual write-offs described as unusual suggest possible problems with acquisitions, software development run amok, a buildup in obsolete inventory, property, plant and equipment that needs to be replaced but is being slowly depreciated, or a business that needs huge amounts of reengineering from a capital and human resource perspective. When the reality of these circumstances is recognized, companies will try to categorize them as Unusual Items. If these unusual items occur almost every quarter, it is apparent management has been managing earnings by sustaining bloated and unrealizable asset values. New management often will write-down assets, particularly inventory, goodwill, and property, plant and equipment in order to improve future earning by lowering future cost of goods sold, amortization and depreciation. Future earnings increases and supposed turnarounds can have more to do with previous write-offs than improvements in the business. In effect, these write-offs, while appropriate, are also reducing future costs and making new management look extremely strong. Beware the big difference between strong management, and CEOs and CFO's with the knowledge of the latitude that accounting permits. Take a look at Sunbeam to see this in action. Top line revenue growth that is much lower than bottom line growth can be a source of future problems. This could suggest improper timing in expense recognition or it could suggest gross margin improvement which is a result of huge write-downs in prior quarters. It is important to diligently look at the trend in gross and operating margins, to assess price competitiveness and the general cost of managing the business. If a company has to spend more to get its product into the market, at the same time gross margins are deteriorating, it could suggest deteriorating fundamentals. Another negative is the merging of deteriorating unit volume growth and deteriorating pricing power, suggesting an industry with way too much capacity unless there is a huge pickup in demand. Many businesses exhibit these characteristics before serious declines in business fundamentals and stock price. The DRAM companies, PC manufacturers, restaurants, metal manufacturers, and manufacturers of computer memory have all demonstrated these issues. The stocks have suffered accordingly. Leverage Leverage relates to the amount of debt incurred in relation to shareholder's equity, and suggests the amount of risk (losses) a business can withstand before it is incapable of covering its obligations. Highly leveraged businesses with substantial cyclicality and earnings variability can have their status as a going concern severely jeopardized in downturns. The ratios most looked at with respect to leverage are the following;
Free Cash Flow- Net Income plus non-cash charges (depreciation and amortization) less capital expenditures and capitalized software to sustain business in its current mode without new strategic initiatives. For instance, very positive cash flow is misleading if a company has old assets and bad business engineering and antiquated software that might make it uncompetitive with its industry in the near future. It must spend to avoid obsoleting itself. These expenditures will be capitalized for accounting purposes but should be deducted from cash flow to assess the true health of the business. Free cash flow is a way to compare apples to oranges. Further, it is from this free cash flow that debt is really reduced or that money for strategic initiatives is derived. A criticism of technology (espoused by Peter Lynch, amongst others) is that the technology industry never really generates free cash flow since it is constantly reinventing itself to avoid being outflanked. All cash flow must be plowed back into the business and much of the capitalized cost on the balance sheet may involve old useless technology which should have accelerated write-offs or rates of amortization. You must look at the particulars of each company to draw the appropriate conclusion. This can be a difficult exercise. The bigger and more diversified the company, the more arduous the task in determining the true situation. Ratios vary by industry and revolve around the nature of the assets, their liquidity, the speed they turnover, and the degree to which they are special purpose. The consistency or variability of profitability has a very important bearing on debt capacity. Banks, because their assets are viewed as liquid and collectible, are leveraged at over 20 times (total liabilities to equity). Software companies, in many cases, have no debt. Drug companies, because they have substantial free cash flow, in many cases, have no debt. Some companies believe judicious leverage augments Return of Equity and hence Earnings Per Share (Net Income divided by shares outstanding), as long as the Return on Assets exceeds the incremental cost of debt. However, there is a risk adjustment process where the market will markdown the Price Earnings Ratio (P/E) if the risk from debt appears to be thwarting needed initiatives or creating undue risk. It is important to be cognizant of the risks of highly leveraged financial conditions, particularly in cyclical businesses. If there is a positive, it is that a highly leveraged business in cyclical downturn, with no debt capacity or ability to sell equity, may have no choice but to sell to a competitor creating the opportunity for a quick pop in the troubled company's stock. This last possibility is not an investment strategy so much as a fortuitous. Debt Service Coverage While static ratios of leverage are instructional on one level, true debt capacity is a function of the ability to service or retire debt, which, in turn is a function of income, since long term debt is repaid from cash flow, not asset liquidation. Specifically, since net income and cash flow are the source of most debt service (interest and principal repayments), it is important to look at the following ratios;
The term structure of a company's debt can go a long to determining financial condition. If a company is financing both working capital (receivables and inventory ) needs and fixed assets and software development with short term debt, any downturn can cause problems if the banks are not willing keep lending facilities intact. Most lending facilities have financial covenants relating to financial ratios, and earnings levels. Breaching these covenants can cause immediate debt acceleration, unless the bank provides forbearance. While banks will typically grant forbearance, they will exact a price in terms of higher rates, etc. Debt should have terms and maturities coincident with asset turnover and/ or expected useful lives. Mismatching can cause big problems in the event of a cyclical downturns or a credit crunch, which we haven't experienced in almost two decades in our domestic economy. However, we only have to look at the problems of emerging economies in October, 1997 to see the problems a company might encounter under similar circumstances. Profitability Profits are simply Revenues for the period, less cost of goods sold, selling, general, and administrative expenses, depreciation and amortization and interest and taxes. To normalize for different degrees of leverage, fixed assets, tax rates, levels of capitalized expenses (like pre-opening costs, software development costs, etc.) and goodwill (excess of costs over net assets acquired) created in Purchase accounting, the financial community likes to look at Cash Flow. Cash Flow is net income plus all non-cash charges. Further, analysts like to look at Free Cash Flow. Analysts will look at Earnings Per Share, which is Net Income After Taxes divided by Average common shares outstanding for the period. Since many industries today do not generate accounting profits, analysts must also look at Cash Flow. Cable TV, many types of telecommunications, particularly Internet Access Providers, some broadcasters (particularly Radio), providers of Broadband Communications utilizing fiber optics, many types of real estate (they refer to cash flow as Funds from Operations or FFO), and certain types of oil exploration do not generate accounting profits. These companies also employ substantial amounts of leverage. The combination of heavy depreciation and interest causes accounting losses even if cash flow is sufficient to service debt and the business is viewed as healthy. These businesses are valued on Cash Flow Multiples. They will range from 6 times Cash Flow on the low end to well over 20 times Cash Flow on the high end. Sales, Net Income and Cash Flow are best viewed on a per share basis. This facilitates industry comparisons and represents the key element of any valuation metric. These per share valuation measurements consist of the following:
In analyzing a company it is important to judge these statistics relative to the industry and relative to the company's historical range for such statistics. Sales per Share is used to edit out the effects of leverage and show future potential. Let's say two retailers in the same area have Price to Sales ratios of .25 and .50 respectively. However, both companies have the same P/E. What this indicates is that one company has higher margins, is more efficient, and better managed. However, if the company with the lower Price to Sales ratio were to reengineer its business to meet the margins of its competitor, its profits and stock price might double. This is why relatively under-performing companies can change management and strategy and get a big boost to the stock price because of an expectation business performance and efficiency will be enhanced. Value players are constantly looking for these opportunities particularly where new management might galvanize the process. Analysts will also look at Shareholder's Equity divided by shares outstanding, both on a gross basis and after deducting intangibles. This leads to the following ratios;
Value is identified when a company is selling at a discount to its historical ratios and to other public companies in the same industry based on all of the ratios above. Further companies with significantly appreciated assets that have been mostly depreciated and are far more valuable than accounting presentation shows. Additionally, if there appear to be ways to improve the performance with certain initiatives with quick paybacks (new computer system or opening a new sales channel or a strategic alliance with a company who has something the subject company lacks), the stock might be even more of a value. Growth This is the historical and forecasted rate of revenue and earning growth for the company. While companies do not provide revenue and profit projections for public consumption, Wall Street Firms (the so-called Sell Side of the Street) do provide such coverage for firms they do cover. Companies do not publish forecasts because of the fear of law suits and the problem caused by accounting convention and SEC convention causing the company to reconcile their actual results with prior forecasts. While companies do not forecast for public disclosure, they do work with the Sell Side of Wall Street to guide forecasts into what they believe to be a highly achievable area. Wall Street tremendously values certainty and a company that consistently meets or beats the Sell Side revenue and earnings forecasts will be accorded higher multiples than competitors who are unreliable in delivering financial results on target. While Wall Street forecasts earnings, it also forecasts a sustainable growth rate for revenues and earnings. This is particularly important since Wall Street loves a high level of sustainable growth, consistent delivery of earning right on target, and Price/Earnings multiples that are less than sustainable growth. This is the GARP concept (Growth at a Reasonable Price). The ideal is to find investments that grow at high, but consistent levels, that trade at a P/E discount to their growth, the market, and their industry and where there is no reason for concern about their accounting. Also, the financial and operating ratios, and asset turnover statistics and trends should show no deterioration, in fact, improvement. Computer screens can help identify candidates for you. Keep Your Eye Out for Trouble- You May See It Before Wall Street
Critique of Fundamental Analysis- Some of the best performing stocks of the 90's have been stocks of companies with no earnings, no tangible net worth, negative current ratios, no prospect of profitability, and tremendous uncertainty about whether their business model is valid and will lead to profits that would validate stock prices. So, why use fundamental analysis at all? Why not just use momentum price investing techniques and technical analysis and spare yourself digging for worthless pieces of information like the business of the company and whether it has made money or ever will make money. Here are the companies that don't make money, except for the shareholder's who ignored the fundamentals and bought the stocks anyway.
These companies all shared a feeling that they were the industry of the future and that a multitude of Cisco's and Microsoft's would emerge from these optimistic visions of the future. The jury is still out on that view. Biotecs have definitely stumbled. While knowing the fundamentals is a strong plus, an obsession with it, at the same time the fundamentalist is ignoring revenue growth, price momentum, secular change and technical analysis is a formula for serious underperformance. In other words, stocks may be cheap for very good reasons, and some stocks can be very expensive for very good reasons, as well. |
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