Once you have the information in hand, the next step is to decide exactly what information you will want to review. Future chapters provide you with detailed examples for all of the tests and ratios that you can perform on financial statements. The following is a review of the primary points of interest. These may be used to quick-check a company and, perhaps, to eliminate a company from your list of possible investments. For exam- ple, you may set some basic rules for yourself. You may decide to not in- vest in companies that have never shown a profit; those whose P/E ratio is too high; companies that do not pay dividends; or companies whose bonds are rated below investment grade. These are only examples of some of the elimination points you could employ. Here is a quick-check- list you can use to review the numbers as reported on the financial state- ments, without needing a detailed review:
1. Comparison of sales, costs, expenses, and profits. The most basic and obvious test is the test of earnings. Look at the statement of opera- tions, not just for this year but for previous years as well. If the company has many divisions, look for breakdowns by operating unit (this is usually located in the footnotes). Also study the impor- tant attributes making up sales growth or decline. For example, in the retail sector, study the year-to-year changes in retail space and numbers of stores opened or closed. Are sales growing? And if so, are profits growing as well? The big danger signal is found when sales are flat or declining, but expenses keep rising; that is a sign of a poorly managed company. Even when sales are rising, if profits are falling at the same time, there could be problems.
The sign of a well-controlled, well-managed company is one in which sales increase each year—not erratically but steadily—
and costs remain at the same approximate percentage of sales. At the same time, expenses may be expected to rise somewhat during periods of growth, but not at the same rate as sales. Net profits should remain at approximately the same percentage of sales each year, while the dollar amount of net profits rises. That is the basic operating standard.
2. Dividends declared and paid. Corporations declare and pay divi- dends and those that raise their dividends each year also tend to be well-managed companies. This does not mean a company that does not pay dividends is not well managed; the dividend test is only one of many basic tests worth applying. You may also decide to limit your search to corporations that have in- creased their dividend every year. An excellent subscription service for those interested in tracking
dividend records is Dividend Achievers (http://www.dividendachievers.com), a ser- vice published by Mergent Corporation. A quarterly publication lists those companies that have increased dividends for at least 10 years.
Corporations with erratic earnings and large net losses cannot always afford to pay dividends because their cash flow tends to suffer along with the volatile earnings outcomes. A volatile operating record is a sign of problems, but companies with less fundamental volatility tend to also have better cash flow; consistent profits;
and a better, more consistent dividend record.
3. DRIPS program offered. Rather than cash, many corporations allow stockholders to take dividends in additional partial shares.
This is the most efficient way to reinvest dividends and achieve a compound rate of return. These dividend reinvestment pro- grams (DRIPs) are valuable for anyone in- terested in accumulating value rather than receiving cash.
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fundamental volatility the degree of change from one year to the next in reported sales, costs, expenses, and earnings, as well as inconsis- tency in other fundamental trends, dividend payments, and ratio tests.
dividend reinvestment programs (DRIPs)
services provided by many corpora- tions allowing stockholders to take dividends in additional partial shares instead of cash dividends.
For example, if current share price is $75 per share and the quarterly divi- dend is $25, a DRIPs plan would allow the stock- holder to acquire an additional one- third share.
For a complete listing of corporations offering DRIPs programs, check http://www.wall-street .com/directlist.html.
Valuable Resource
4. Price/Earnings (PE) ratio. One of the most pop- ular and interesting tests of a stock is the price/earnings ratio (PE ratio). This is a compari- son between the current price of a share of stock to the latest known earnings per share (EPS). The ratio is interesting because it com- pares a technical indicator (price) to a funda- mental indicator (earnings per share). As a general observation, when the PE is very high, it indicates greater risk. As the multiple of earn- ings grows in the price, there is an increasing chance that the market has overvalued the stock. A midrange PE is usually found between 11 and 20, although opinions about “best” PE level vary.
Many variations of price comparison are used by analysts, and these are explained in de- tail in Chapter 9.
5. Capitalization and debt ratio. Easily overlooked in the test of basic strength or weakness of a company is the capitalization mix. A company’s total capitalization is the total of shareholders’
equity plus long-term debt. By definition, long- term debt usually includes contracts, notes, and bonds that take more than one year to repay.
The debt ratio is the percentage that long-term debt represents of total capitalization. This is ex- plored more in Chapter 7; but be aware of the essential importance of a debt ratio trend: As debt begins to represent more and more of total capitalization, the trend becomes worse. It means there will be less operating profit in the future to fund operations and dividend pay- ments because more cash will have to be used to repay debts and to maintain interest payments on those debts.
price/
earnings ratio (PE ratio) an important ratio comparing the current price per share to the latest known earnings per share (EPS).
The PE multiple summarizes the market’s percep- tion about the number of times’
earnings the stock should be worth, and it is a combination of both technical (price) and funda- mental (earnings) information.
earnings per share (EPS) an important fundamental indi- cator, reflecting net earnings each year per outstand- ing share. The earnings are divided by the shares outstand- ing to arrive at the EPS, which is reported in dollars and cents.
6. Product or service and business sector. What kinds of products or services are marketed and sold by the company? Are those products experimented, untested, and new? If so, the potential market will be unknown, which presents both risk and opportunity. Are the products currently going through a series of lawsuits? (For example, pharmaceutical com- panies may have exposure to expensive suits, threatening their profitability and capital safety.) Are the products or services poten- tially obsolete? When Polaroid filed for bank- ruptcy a few years ago, some people were surprised—but when you consider their product, it made sense. The “instant” camera was revolutionary in its day, but digital tech- nology made the Polaroid camera obsolete.
The company had not kept up with change.
A critical analysis of what the com- pany sells should include a comparative cri- tique of how competitive it remains. Using the digital camera example, who is master- ing that market today? With Hewlett- Packard, Xerox, and dozens of foreign
corporations taking a market share, what is likely to happen to Kodak in the future? While Kodak has entered the market, they continue to consider old-style film their primary product. So what does this mean to you as a long-term investor? These are important questions to ask, and a comparative study of the cor- porations within a single industry can be revealing.
7. Company position within the sector. Each sector has a clear leader or two or three companies all vying for the lead in market share. The lead company may be quite large and well capitalized, but can it hold its lead indefinitely? What about second-tier corporations, the up and coming ones hungry for larger market share? These may be better long-term growth candidates, depending on the
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total
capitalization the combination of long-term debt and shareholders’
equity; the source of financing to fund corporate operations, con- sisting of debt and equity capital.
debt ratio the portion of total capitalization represented by debt, as opposed to equity sources;
when debt levels rise and corpora- tions become less able to continue dividend pay- ments or fund future operations.
sector, the marketing strategy employed by each company, and the various capitalization sizes of companies. Some corporations try to offer everything to the market, whereas other competitors may specialize narrowly. This also affects future growth capabilities. The smaller corporations within a single sector may be undercapitalized to compete with the larger, stronger companies over the long term.
As a quick checklist, this is by no means a definitive fundamental analysis program; it is a starting point only. You do need to perform a de- tailed review, as you will find in coming chapters. As you review corpo- rate financial reports, ask yourself some of the very basic questions as a means for deciding whether it is worth your time to investigate further.
Here are three crucial questions you should ask:
1. Has the company ever reported a profit? It is virtually impossible to make judgments about a company on the basis of fundamental analysis if that company has never reported a profit. So many fundamental tests are comparative trends based on profitability.
So many questions about management’s effectiveness are also based on how well they maintain net profit from year to year;
how growth affects profits; and how expansion of operating units diversifies the company’s profits. If there has never been a profit, none of those essential tests can even be performed.
It is amazing that during the dot.com Internet craze, so many companies without track records started up and attracted investors. Prices rose without fail over months and months, and investors continued pouring money into ever higher-priced stock. Many of those companies had never reported a profit. In fact, it was uncertain in some cases what those companies even sold. One important test of management’s ability is the demon- strated ability to establish a reasonable level of profit and then to repeat that year after year, even as revenues grow.
2. Can you follow a trend, or not? Some corporations report a very erratic history of revenues, costs, expenses and profits. As a conse- quence, it is impossible to determine the long-term trend, because one has not been established. Other companies, by comparison, report steadily growing sales, consistent cost and expense levels, and predictable profits. This is a sign of good management. As an investor, you want to be able to estimate the direction the com- pany is moving and predict its rate of growth.
High levels of fundamental volatility are a warning sign that management may be tinkering with its accounting policies or, at the very least, is not able to control expenses. Management is supposed to create a strategic marketing plan, track it from month to month, and generate revenues. At the same time, they are supposed to control costs and expenses. When this is done properly, the result is low volatility in the numbers. When man- agement does not know how to control its forecasts and internal expenses, the result is high fundamental volatility.
3. Are you looking for good investments or do you just like the com- pany? So many investors pick companies because they like the product without considering the relative value of the company as an investment. Many people hate Wal-Mart because they employ a smart, but ruthless marketing strategy. They offer lower prices than small local shops and, as a consequence, a lot of small busi- nesses cannot compete. So as a potential investor, you need to make a distinction between personal feelings and investment value. It is a fact that, based on numerous fundamental tests, Wal-Mart is an excellent growth investment; Sears, by compari- son, has been losing market share over many years. So you might like shopping at Sears and hate Wal-Mart. But that would not be a sound reason to buy Sears stock, which is fundamentally weak, and to reject Wal-Mart stock, which is fundamentally strong.
The same case applies to the selection of soft drinks, food companies, tobacco giants, computer software manufacturers, or recreation industry companies. If you do decide to invest on moral terms or on personal preferences for products, be aware of the underlying reasons for your choices. If you want to employ fundamental tests, it is important that you put aside personal preferences based on products or marketing strategies. The two do not mix well.