The analyst is taught to view a company in terms of some rather specific elements, some of which are measurable and some of which are judgmen- tal. Among those factors that enter into the analysis of the company are . . .
• The financial structure and performance of the company.
• The economic context in which the company operates.
• The nature of the securities market in which the company must be evaluated.
• The nature of the industry in which the company operates, and the market for its products and services.
• The management of the company. Corporate governance has become a major issue. A survey of investors by McKinsey and Company reported that 80 percent of global investors said they would pay a premium for a company that was visibly well governed. But 63 percent said that gov- ernance considerations might lead them to avoid certain individual companies.
• The company’s own projection of its plan for growth.
According to the Chartered Financial Analysts Federation, the interna- tional organization of portfolio managers, securities analysts, investment
advisors, and other investment professionals, the key types of information they need are . . .
• Information about off-balance sheet assets or liabilities
• Explanations of extraordinary, unusual, or non-recurring charges
• Information about pension and other retirement or post-employment benefit plans
• Contingencies, such as litigation or potential exposure to legal action
• Explanations of revenue recognition criteria
They are fully cognizant and wary of the fraud hidden in the off- balance sheet chicanery of the companies that were caught in the financial scandals. CFAF believes that all assets, regardless of how they’re financed, as well as liabilities, should be accounted for on the balance sheet, and that GAAP(Generally Accepted Accounting Principles)should require it.
Revenue recognition, they point out, is especially critical. Revenue can only be recognized, according to SEC Staff Accounting Bulletin 101, when it is “realized or realizable and earned”.
Valuable factors that define the character of the company may include . . .
• Customer satisfaction
• Product or service quality
• Effectiveness of internal and external information systems
• Marketing prowess
• Market share
• Intellectual capital
• Employee training
• Employee morale
• On time deliveries
• Outsourcings and labor policies
• The changing nature of its industry
• Company integrity, as informed by compliance with Sarbanes-Oxley and SEC regulation
Perhaps the best delineation of the fundamental aspects of security analysis is found in the superb and sustaining work Security Analysis,by Benjamin Graham and David L. Dodd (fifth edition, by Sidney Cottle,
Analysis and Analysts 129
Roger F. Murray and Frank E. Block). Benjamin Graham has long been considered to be the dean of analysts, not only for his success as an analyst, but by virtue of the fact that his book was one of the first, and certainly the most masterful, to set forth the basic elements of security analysis. It remains a standard today, and forms the precepts used by successful investors, such as Warren Buffett. Even if Graham’s precepts are honored in the breach, they are still a standard that guides all analysts.
Basically, Graham believed that no company should be considered as an investment vehicle unless . . .
• The company is prominent and conservatively financed. Current assets should be at least two times current liabilities, and debts should be not more than 110% of net current assets.
• The company has been a consistent dividend payer. The more conser- vative investor would want to see dividends going back twenty years.
• There has been no deficit in the last five years.
• The price-earnings multiple is low. In a soft market, and with high interest rates, he suggests a maximum price of eight times current earn- ings per share.
• The stock is selling at one half of its previous high.
• The stock is selling at a price that is no more than two thirds of net tan- gible assets.
Obviously, these are very stringent factors, developed in a different time, in a different market and economic environment. Under many condi- tions, these principles would eliminate all but the smallest segment of pub- licly traded companies. And while very little argument can be taken with any of the points he makes, it can certainly be argued that the spectrum of investment possibilities is much greater than companies that fall within his parameters. An example would be a company in an emerging industry with a current ratio of 1.8 but long term debt of 15% of net current assets, and strong earnings gain. Dodd and Graham’s credit standards may be too tight for this company, but the company may still be a good investment prospect.
During the early years of the high tech companies, it might have been diffi- cult to apply Graham and Dodd’s principles, but those principles would have saved a lot of investors had they been followed in the tech industry’s later years, before the bubble burst.
The realities of the stock market today, the range of reasons for invest- ments, and new analytical concepts, all dictate some rather more flexible
considerations in analyzing a company. In the arena of new companies, with initial public offerings, there are many that, based on fundamentals, are sound investments by any standards.
Another variable today is that with the growing number of investors, new ranges and parameters of risk substantially change security analysis.
For example, the value of a stock to an investor with long-term, low-risk goals is different than it is for an investor willing to put investment capital at greater risk to achieve rapid, high returns. Looking at the changing spec- trum of risk tolerance, we see new analytical guidelines.
Growing in popularity are new—or newly articulated—concepts of economic value added(EVA). It’s an attempt to express two concepts—net profit and rate of return—in a single number. A similar program—market value added—uses the same approach but with different elements. Whether these programs have any merit will be determined only in the long run.