The Smart Way to Pick Investments, Manage Your
Portfolio, and Maximize Profits
MICHAEL C. THOMSETT
AMACOM
Winning
with
Stocks
American Management Association
New York • Atlanta • Brussels • Chicago • Mexico City • San Francisco Shanghai • Tokyo • Toronto • Washington, D.C.
T h e S m a r t W a y t o
P i c k I n v e s t m e n t s , M a n a g e Yo u r P o r t f o l i o , a n d M a x i m i z e P r o f i t s
Michael C. Thomsett
Winning
Stocks with
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Library of Congress Cataloging-in-Publication Data Thomsett, Michael C.
Winning with stocks : the smart way to pick investments, manage your portfolio, and maximize profits / Michael C. Thomsett.
p. cm.
Includes index.
ISBN-13: 978-0-8144-0986-2 ISBN-10: 0-8144-0986-5
1. Investments. 2. Stocks. 3. Speculation. I. Title.
HG6041.T46 2008 332.63'22—dc22
2008017989 Michael C. Thomsett.
All rights reserved.
Printed in the United States of America.
This publication may not be reproduced, stored in a retrieval system, or transmitted in whole or in part, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of AMACOM, a division of American Management Association, 1601 Broadway, New York, NY 10019.
Printing number
10 9 8 7 6 5 4 3 2 1
Preface: Creating YourComprehensive Program vii Chapter1 AShortHistory ofthe StockMarket 1
Chapter2 TheBottomLine 23
Chapter3 YieldandYield History 47
Chapter4 The ‘‘Practical’’ DowTheory 65 Chapter5 A FewValuableFundamentals 91
Chapter6 Identifying the Risk 119
Chapter7 The Egg-and-BasketIdea 137
Chapter8 Liquidityin the Market 151
Chapter9 Volatilityand Leverage 165
Chapter10 Alternativesto DirectOwnership of Stocks 181
Chapter11 MarketTiming 197
Chapter12 Applying YourComprehensive Program 209
Glossary 227
Index 237
v
Creating Your Comprehensive Program
T
he market.Theideaof peopletrading moneyin and out of stocks, whether $100 or$10 billion, is exciting. It representsthe epitome of the free market and of capitalism. While many people criticize the free economy, it has becometrulyglobal in recentyears, andthe movement and exchange of capital fuels the world’s economy. It always has and it always will. But the changes brought about by improvedinformation technology, the Internet, andthe openingof many borders sincethe end ofthe ColdWar haveallexpanded the market so that today it is easy for anyone to invest virtually any- where—instantly.This miracle brings with it many new risks. While in the past information was expensive, difficult to find, and untimely, today thereistoomuch information. Themodern challenge is deciding which information is useful, and which isnot. This book concen- trates on specific investment tools that help you to develop the meansto controlyour individualportfolio, research, and decision- making process. These tools work together in forming your pro- gram for creating and managing profits. Advice in the financial pressis either too broad and general,focuses on one small part of thetotalpicture,ordistortsand exaggeratestheimportance ofmar- ket developments. This book puts together a program for the in- vii
formed study of stocks, toimprove youroverallperformancein an ever-changing marketenvironment.
The stock market in the United States is themostpopular in- vestment market in theworld, usednotonly bymillions ofindividu- als,but also byinstitutional investors:mutualfunds,pensionplans, insurance companies. Just abouteveryonewhoinvests, hasa retire- mentplan,or works for a large companyisinthemarket.But how much do they really know about picking stocks? That is the big question answered byWinning with Stocks.
An irony of howpeople invest is that—especiallyin the stock market—rumor, gossip, and opinion aregiven greater weight than research. This is a widespread flaw, with ‘‘the crowd’’ more often wrong than right(giving riseto contrarianstrategies), andwith the market characterized more by emotion than by logic. It has been saidthat if themarket wereaperson, he orshewould probably be in therapy.
Stocks can be selected by sector, reputation, or price. Some peoplelikethe fundamentals (financial information),others prefer technical analysis (chartingpatterns,pricetrends, and volume/price study).Bothfundamental andtechnicalschools offervaluableideas.
In Winning with Stocks, the reader is going to find a short listofthemostvaluableindicators (fundamental andtechnical) for picking stocks. On the fundamental side are ratios designed to quantify financial andworkingcapital strength (current ratio,debt ratio)and profitability (revenuetrend, net return). Technical indica- tors include price history, trading volatility, and trading range trends. Combination indicatorsinclude dividend yield,earnings per share, andtheall-importantprice/earnings (P/E)ratio. Theauthor provides suggestionsaboutpickingstocksusing theselimitednum- beroftests.
This book isaimedat thenovice or investor/trader with limited experience. Theintentionofthis book isto explain themarket in a spectrumofrisksand opportunities,sothat thereader willbeable tomakean informed decision about how tomake profitswhilelim- iting risksin the stock market.
Winning
with
Stocks
A S H O R T H I S T O R Y O F T H E S T O C K M A R K E T
T
he stock market isafascinatingcultural and financialplacewith a rich history. Before the telephone, communication was virtually impossible beyondthewalls ofthe exchange or, in the case of the AmericanStockExchange (AMEX),outon the street,becausethe exchange could not afford a building, thus its nickname, ‘‘the curb.’’ In those days, the PhiladelphiaStockExchange (PHX)was at great disadvantage because traders in New York knew days ahead of otherswhat goodswerearrivingby ship. Sothe PHX set upaseries ofmenon hillswith mirrorsandtelescopes, andmes- sages were conveyed from New York to Philadelphia in less than onehour.Because trading in the old dayswas limitedto the exchange, only brokersand dealerswereabletotrade;themarketsimplywas not available to the average person, an idea that is unthinkable today. Major advances included the telegraph, ticker tape, tele- phone, and of course, the computer. All of these changes have vastlyimprovedtheability of peopleto communicateandtotrade.
This chapter introduces you to many of themost commonerrors 1
investorsmake; byknowing these you are betterequippedtoavoid falling intothe common market traps. Thisis followed by a brief history ofthemarket itself, which isnotonly fascinating andinter- esting, but also demonstrates how we arrived at the system we havetoday.
The modern market is cheap, efficient, and well regulated.
Today, morethanever before, themarket has becometruly demo- cratic. Anyone with a few hundred dollars can buy shares of any listed companythrough a free online brokerageaccount,paylittle or nothingforopening that account, andtrade for onlyafewdol- lars.You nolonger needtorely onexpensive stockbrokers offering advice you really don’t need. You can find your own research through books, the Internet, investment clubs, and association membership. In today’s market, anyone willing to research for themselves and to study themarket has a better chance than ever beforeto createandmanageastockportfolio.
Evenso,caveat emptorcontinues toapplyin the stock market as it does elsewhere.You cannot trust other people tomake deci- sions for you, tellyou whereto invest,or ensure profitability. One reasonfor studying thelong history of themarket isto cometoan understandingofthemany problemsinherent in any venuewherea lotofmoney changeshands. Greed dominatesthemarket, andthat fact isunavoidable. Themarket attractsnotonlymillions ofhonest, hardworkingpeoplewhowant to build security for themselvesand theirfamilies,but also avariety of con artistsand outright thieves.
Unfortunately, many of these ‘‘market lowlifes’’ exist and thrive among all of usand often function as advisers,financial planners, analysts, stockbrokers, and online marketing companies offering
‘‘free’’advice on how toget rich—theyare everywhere.
The experiencemostpeoplearegoing tohavein themarket will belargely positive,basednoton anyassurance of safety bygovern- ment regulators,butbythe simple fact thateveryoneisincontrolof theirowndestiny. Thisincludes yourportfolio. If you arerealistic, willing towork andlearn how themarketfunctions, and you under- standthat profit potential always comes with risk, thereisnothing to prevent youfrom enjoying the amazing ‘‘freedom to invest and profit’’thatyoucan havein the U.S. stock market.
A Starting Point: Avoiding the Mistakes of the Past A historyusually beginsat the oldestpoint andmoves forward.Be- foregoingback in time, however, it makes senseto begin at the end to exposethemostcommonerrors peoplemakewhen theyinvest in the stock market. Knowing thehistory ofthemarket is valuableand important,butevenbefore you readabout that, it is equallyimpor- tant to know what mistakes other people often make. History re- peatsitself. Everyonehasheardthis before, and it makes sense to know that mostpeopleare proneto fall intothe sametrapsasthose who have gone before. Thus, studying common errors is valuable intelligence,becauseit helps you toavoidthose same problems.
One cynicalpoint of view about thiswas expressed by George Bernard Shaw, whomused,‘‘Ifhistoryrepeatsitself, andtheunex- pected always happens, how incapable must Man be of learning from experience.’’ This point of view is actually quite common in themarket,but it is fatalisticandassumesthat no one canovercome the errors of the past. If this istrue, then you might as well turn overyour moneytoa mutualfundandhopethat itsmanagement is better than average. Contrarytothatcynicalpointof view, it is pos- sible for hardworking people to make informed decisions and to beat market averages, simply by observing (a) what others have donetolosemoney,(b)themistakesthat recur in themarket, and (c) how specific indicators do, in fact, lead you to profits consis- tently.
Among themistakes investorsmake are eightof the most im- portant, listed below andalso summarizedinTable 1-1.
M i s t a k e 1 : I n v e s t i n g w i t h M o r e R i s k T h a n Y o u C a n A f f o r d
Risk—the chancethatyou will loserather than gain—isan in- herent attribute in all investments; there are no risk-free invest- ments.Afullyinsured, guaranteed savingsaccountcontainstherisk that incomewill notbeat the combinationofinflation andtaxes,so even that representsaspecificrisk.
In the stock market, risk usuallyreferstomarket risk,or therisk
TA B L E 1 - 1 . E I G H T C O M M O N I N V E S T O R M I S T A K E S
Mistake1: Investing with more risk than you can afford Mistake2: Chasing income but forgetting cash flow Mistake3: Limiting your investing horizon
Mistake4: Overlooking the essential research Mistake5: Buying and selling at the wrong time
Mistake6: Assuming the entry price is the starting point Mistake7: Believing higher-priced stocks are always expensive Mistake8: Worrying too much and being impatient
associated specificallywith the price pershare of stock. If youbuy 100 sharesat$50 pershareand pay $5,000andthe stock’smarket valuethen fallsto $45,you lose $500. A worthwhile exercise isto begin by defining your risk tolerance,or your ability to take risks and toafford possiblelosses. Stock risk is oftenspotted byway of volatility, the tendency for prices to move around. High-volatility stocks are often erratic and havea broad trading range, and low- volatility stockstendtotradewithin a narrowerpricerange.
Once you haveidentifiedwhat you can affordin terms ofrisk, it is easier tomatch your risk tolerance to companies whose stock historiesarea good fit. Many people—including those who define their risk tolerancein advance—invest in inappropriateways, tak- ing risksthey cannot afford. Thisis perhapsthemostcommon mis- takeinvestorsmake.Forexample, manyinvestors definethemselves as conservative and ‘‘in it for the long term,’’ and then trade like speculators.
M i s t a k e2 : C h a s i n g I n c o m e b u t F o r g e t t i n g C a s h F l o w The emphasis of income in the market is easy to understand.
Everyonewantsto buy bargain-priced stocksand cash inon a big price run-up. To a lesser degree,dividends are also a formof in- come but the dividendrateisat times overlooked. Investorstendto
focus exclusively onprofitpotentialbutoverlook the equallyimpor- tantcashflow,or theavailability of cash whenyou needit.
Forexample, if you invest instock thatdoesnot goupinvalue, you mightdeterminethatyou needtokeep your moneytiedup for several months. This might be especially true in cyclical stocks, whose economic cycle is tied to the calendar or to the economy.
However, if it turns out thatyou needthose funds beforethe cycle goes into an uptrend, you have to sell shares at a loss. This cash flow risk means that you cannot afford to hold onto positions as long as necessary to create profits. Because you have to take out funds forotherpurposes, thetiming is poorforsome ofthoselong- term investments.
M i s t a k e 3 : L i m i t i n g Y o u r I n v e s t i n g H o r i z o n
It is easyto becomemyopicin the stock market. Once youfind something that works, thetendencyisto stick with it.Forexample, if you buy shares of an energy company and make a profit, you mightbelievethat this sector isa‘‘surething.’’But if your timing is poor, thatdoesnot necessarilyapply. Thisiswhymostpeople sug- gest thatyoudiversify your investmentcapital amongseveraldiffer- entstocks,sectors, andmarkets.
These different marketsmayinclude non-stock areaslike bond mutual funds, realestate,optionsand futures,or precious metals.
You can also diversify by buyingshares of equity mutual funds or exchange-traded funds (ETFs). Effective diversification protects you from abroad overall loss duetoafailurein a single company orsector. Thosewhoseinvesting horizon islimitedtendto be close- mindedtothe conceptof diversification,so theyareat greater risk.
Aslong asinvestmentcapital remainsin too fewstocks or markets, the risk remains. The more capital focused in singular stocks or sectors, thegreater therisk.
M i s t a k e 4 : O v e r l o o k i n g t h e E s s e n t i a l R e s e a r c h
Thereareactually four distinctschools ofthought about stock market research. First, those who believe in fundamental analysis rely on the financial reportsissued by companiesandtheir auditors
or reports filed with the Securities and Exchange Commission (SEC), which regulates publiclytraded corporations.Afundamen- tal investor readsthe balance sheet andincome statement aswell as narrative sections of reports and then develops a series of useful ratioteststo compare companiesandto follow trendsthat appear within the companyitself.
The second school of thought istechnical analysis, which fo- cuses on pricemovement of astock and chart patterns. Technical analysts believe that specific chart patterns and short-term trends anticipate future pricemovement, andthat the shape ofthetrading rangeitself (the distance between high andlowprices over aperiod of time) defines volatility (safety) and anticipates near-term price movement.
The third is a combination, and this is the most sensible ap- proach.Byusing aspects of bothfundamental andtechnical analy- sis, information isgathered from differentsourcesand based on a differentseries ofassumptions,you makeinformed decisions.
Fourth isthelargest group ofall, containing investorswho buy and sell stock with no valid information whatsoever. They watch pricemovement, go on investmentchat linesand exchangeinforma- tion or simplyread what others have written, and make decisions impulsively, often with very flawed information. For example, in 2007, a comment on a Yahoo! (YHOO)message boardabout one ofthenational home builders predictedthat the stock would plum- met andthe companywouldgo broke,specifically becausewith in- creased foreclosures, the company had to compete for a limited market. In other words, home buyers would choose foreclosed homes rather than buying a new home from the builder. This is insane. Therearereally onlyasmall number of foreclosed proper- ties at any given time, and the market for purchasing foreclosed homes is vastly different from the market for newly constructed properties. Evenso, thisistypicalofthenonsensethatcanbe found onInternet message boards—illogical,emotional, andat times self- serving(forexample, if someone buys stock andthe price falls, they may perform a pump and dump, going online and talking up the stock hopingotherswillbuy shares, apracticethat isillegal).
The point aboutcomparingschools ofinvestigation isthis:You
should plan togain insightfrom whatevervaluable source youcan find, includingboth fundamental andtechnical analysis.But when itcomesto opinions of people youdonot know, unsolicitedadvice, or rumor andgossip,you willdowell toavoidmaking any decisions based on those sources. They arethemost common andthe least reliable.
M i s t a k e 5 : B u y i n g a n d S e l l i n g a t t h e W r o n g T i m e Themost famous maxim about investing is ‘‘Buy low and sell high.’’ As trite as this might sound, it is important to remember becausemany people do exactlythe opposite. It isuseful torealize how most people view what goes on in short-term price trends.
Theyassume,quite often, that whatever hashappenedmost recently isgoing to continuehappening in the future. Of course, thisisillog- ical, but the market is ruled by two primary emotions: greed and fear. Infact,you willbewisetoreplace ‘‘Buylow and sell high’’with adifferent maxim: ‘‘Bullsand bears canboth makemoney,but the market isruled by pigsand chickens.’’
On the greed side, as prices rise it is easy to believe that the trendwill keepgoing in the same direction.Anyone owningstock holds ontoitexpectingfurtherpricegrowth and, infact, theyrefuse to sell and miss outon more profit. So the prudent idea oftaking profits—even when the valuehas doubled—ismore often ignored thanfollowed.An investor who doesnot already ownstock will re- spond to price run-ups by buying shares, hoping to get inon the bonanza. Thisworks sometimes,but it isalsointeresting to observe thatbuying activityin astock is often at itsgreatest at themoment thatprices peak andadowntrend begins.
On the fearside, as prices fall it is just as easyto believethat the wholemarket isgoing to crash. In thismode, investorsarelikelyto sell when prices fall, hoping toavoid further declines. That is pru- dent in some cases,but mostofthetimeasteep declineactuallyis anopportunityto buy sharesat acheap price.Whenfeardominates an investor’smind, it isimpossibletothinkclearly.
When greedand feardominate,peopletendto buyhigh and sell low—the exact opposite ofwhat they should be doing.For theas- tute, calm investor who is able to step back from these common
emotional gut reactions, recognizing the timing opportunities of price run-up and steep decline are great opportunities in the market.
M i s t a k e6 : A s s u m i n g t h e E n t r y P r i c e I s t h e S t a r t i n g P o i n t
Thismistakeisworth keeping in mind,becauseit is so common.
Stockpricesare constantlyrising and falling as buyersand sellers vie for control and exchange the momentum with one another.
Pricesriseandinvestors sell totake profits, which weakens demand and drives prices down; then investors buy at a bargain price, in- creasingdemandand forcingpricesup. Thereare dozens of possi- bleinfluences onstockprices, andtheyare continuallymovingback and forth in response.
The common assumption among investorsistotreat theirpur- chase price per share as a starting point, when in fact it is simply thelatestentryin the price continuum.Forexample,someone buys stock at$50 pershareandimmediatelytheir assumption isthat the stock is going to move upward. When it moves down instead or, moretypically,floats upand down to prices onbothsides of $50 pershare, theinvestor is disappointed. The stock was supposedto rise, notfallorfloat.
This bringsupan importantconcept: In the stock market, tim- ingcounts. Short-andlong-termpricemomentumdefinehow and why pricetrends comeandgoasthey do. So if you happen to buy shares at the top of a price momentum swing, you are probably going to paytoomuch;andif you happen to buyat the bottomofa momentumswing, you will time your purchase well, at least until themomentumswings back in the otherdirection.
M i s t a k e7 : B e l i e v i n g H i g h e r - P r i c e d S t o c k s A r e A l w ay s E x p e n s i v e
The math of the stock market is often confusing and easy to misread. Apopularbeliefisthat a$25 stock isworth halfasmuch asa$50 stock. Thisisa misleading assumption. The price pershare
is not the definitive valuation point.For example, a company with 20millionsharesat$25 pershareisworthexactlythe sameas one with 10 million shares at $50 per share. In order to determine a company’s ‘‘value’’ or whether its stock is a bargain, you need to look at other criteria, such as the price-to-earnings ratio (P/E ratio), which isalso calledthemultiple. The price ofashare of stock is divided by earnings pershare, andtheanswer tells you how many times earnings the stock is trading. A low P/E implies the stock is cheap, and asthe P/E gets quitehigh, it becomes a higher-risk investment.Astock tradingbetween aP/E of 8and 20isreasonably priced,forexample,comparedtoastock with aP/E of 65.
Themathproblems ofthemarket arenot limitedtomispercep- tionsabout themeaningofthe price per share. Thewaythatdaily changes arereported can be misleading aswell. For example, the financial news programsliketoreport the daily price changein the number of points. So two stocks,each risingby four points, have had a very good day. But they are not necessarily the same. For example, a stock selling at $20 per share rising four points has grown by 20 percent, which is veryimpressive. But anotherstock, selling at$200 pershare, has onlyrisen2 percenton the same day.
Although thereporting might bethe same—bothstocksrose four points—the $20 stock had 10 times more movement invalue be- causeits share priceislower.
M i s t a k e 8 : W o r r y i n g T o o M u c h a n d B e i n g I m p a t i e n t Anold saying tellsusthat‘‘themarketclimbsa wallofworry.’’
Thisrefersto investor attitudes about all markets, including those whose prices arerising.Yes, theyarerising today,but what about tomorrow? Experiencedinvestorsunderstandthat whenyou getso overconfident thatyoustopworrying, you have setyourselfup for a fall. Smart investors worry continually. Asmarkets move down, theyworryabout more downwardmovement.Asmarketsmoveup, theyworryabout a reversal.
The solution is patience. Inexperienced investors caneasilyget hooked on the action of the market, wanting to make a decision every day, take profits, and exposethemselvesto ever greateroppor-
tunities.But in themarket,change doesnot always occurevery day for every stock.Anexperiencedinvestor knowsthat, as yet another old saying goes,‘‘themarket rewards patience.’’ Thisis practicedin many forms, including waiting out short-term price movement (a speculative pointof view)toholdingstockover many years (a more conservative ‘‘value investing’’ point of view agreeing with people likeWarren Buffett).
Your individual historyasan investor isgoing to depend on how wellyouobservethese common mistakesandavoidrepeating them.
But in addition to every person’sindividual history, the overall mar- ket isan interesting,colorful, and varied placewhere commercehas taken place for hundreds of years. Everyinvestor will appreciatea brief overviewofthe stock market’s historyto demonstratehow it hasarrivedwhereit istoday. However, in addition towatchingout for the common mistakes other investors have made, it is equally important toask therightquestions before proceeding with anyin- vestmentplan.
Your Most Important Questions
If people are doomed torepeat the past, then there isno point in trying toanticipatethe future.A less cynicalpointof view isthatby understanding themistakes ofthe past,you arelikelytoknow what to avoid. By taking that idea to the next level, if you understand what questions youshould beaskingyourself,you willprobably be better equipped to create, manage, andlater modify yourportfolio toreducelosses and improve the chances for profit in anymarket condition.
The fivemost importantquestions everyinvestorshouldask in- cludethe following, which arealso summarizedinTable 1-2.
Q u e s t i o n1 : H o w M u c h R i s k , a n d W h a t K i n d , I s A p p r o p r i a t e f o r M e ?
Riskcomesinseveralforms, andin the stock marketawareness of risk is essential.You cannot simply buy shares of stockbecause
T A B L E 1 - 2 . F I V E Q U E S T I O N S E V E R Y I N V E S T O R S H O U L D A S K
Question1: How much risk, and what kind, is appropriate for me?
Question2: How much do I need to invest today to reach my future goals?
Question3: What affect will inflation and taxes have on my profits?
Question4: What strategies are available and which should I use?
Question5: Should I hire a financial planner or make my own decisions?
someone else does orbecause you hear a rumor; you needto evalu- atemarket andliquidityrisk aswell.
Market risk refersto price volatility. Therisk that astock’s price will remainflat for a long period of time or worse, decline, isthe mostobviousand best-known riskfor stockholders. It is overcome throughdiversification andthe selectionof conservative stocksand by avoiding high-P/E stocks, those higher-risk and more volatile sectors, andunknown, newcompanies.
Liquidityrisk means cash will notbeavailablewhenyou needit or, asan alternative definition, thereisno buyer availablewhenyou want to sell. In the exchangemarket,you can always finda buyer forshares,but the pricemight not bewhat you wantor expect. In some other markets,such asrealestatelimited partnerships,youdo notenjoyapublic exchangearenafor units youbuy,sothe onlyway to sellsharesiswith adeep discount.
Q u e s t i o n 2 : H o w M u c h D o I N e e d t o I n v e s t T o d ay t o R e a c h M y F u t u r e G o a l s ?
If you listen to financial advisers, you will hear that you need much moremoneytoretirethanyou thought,orforcollege educa- tion,paying off your home,or any other futuregoal.But the esti- mated future needs analysis often assumes a low return on investmentsandunrealisticallyhigh inflation.Your investmentport- foliowill notexperiencethe full inflationaryrateaslong as youdon’t haveto buya new homeandnewcarevery year;a greater inflation- ary risk is found in the declining value of the dollar, and that is where you need to build your portfolio defensively. But when you
consider the dollar amount needed, remember a few points that most financial planners forget tomention:First,you should struc- ture your mortgage so that you own your home free and clear by retirement. This requires careful preplanning and acceleration of payments, aswell as the disciplineto allowequity togrow and to not refinance.
Second, whenyou retire you haveto considerother sources of incomeincludingIRA,company-paidretirement, and socialsecur- ity. In addition, many people retire and reduce their income but continue to work, so don’t assume that your income stream will moveto zero justbecause youdecidetoretire.
Andthird, anyadvice you receive from afinancialexpert hasto be taken with one point in mind: The more you invest, the more commission the financialplanner receives. (Thisassumes you work with acommission-based planner, as opposedto onewhoworks for aconsultingfee.)
Q u e s t i o n3 : W h a t A f f e c t W i l l I n f l a t i o n a n d Ta x e s H av e O n M y P r o f i t s ?
Oneinvisible factor—overlooked by almost everyone—isthe double effectofinflation andtaxes. Even though therate ofinflation may be small, the combinedimpactofthese factorsis significanton your actual investment return. In other words, it isnot enough to break even and it is inadequate to settle for a conservative, safe, but very low return—especially if the after-inflation and after-tax outcomeisnegative.
To calculatethe effectof inflation andtaxes,firstfind the cur- rent rate ofinflation.You may use the published Consumer Price Index (CPI) reported by the Bureau of Labor Statistics (www.bls .gov/cpi,or develop yourownpersonal inflation assumption based on whatyoubelieveinflation isgoing to be for the comingyear. The rate you use,expressedasapercentage, is divided by yourestimated rate ofafter-tax income. To findthis subtractyoureffective tax rate from 100 percent. This effective rate is theactual percentage you pay in taxes, or your total tax liability divided by your taxablein- come. Be suretoinclude bothfederal and state tax liabilities. The formula:
I
100RB
where Irate of inflation
Reffective tax rate (federal and state) Bbreak-even return
Forexample, ifthe current rate ofinflation is 3 percentperyear and your effectivetax rate (federal and state combined) is 34 percent, yourbreak-even return is:
3
100344.5%
Thisrevealsthatyou needto earn4.5 percentonyour investments just to breakeven andmaintainyourpurchasingpower. If youearn less than4.5 percent, you are losing money on an after-taxbasis.
(This calculation is distorted somewhat by tax-free investment in- come such as qualified dividendsand bylower tax rates oncapital gains.But the exercise doesillustratethe point that asimplerate of return is not always beneficial when taxes andinflation are calcu- lated.)Break-even returnsare shown inTable 1-3.
Q u e s t i o n4 : W h a t S t r a t e g i e s A r e Av a i l a b l e a n d W h i c h S h o u l d I U s e ?
Ifanything, themodern-dayaccess via the Internet to free ad- vice,strategies, and ideasisan embarrassment ofriches.1Thereis somuchout therethat it is quite difficult to distinguishbetween the good and the bad. So although there is a lot of free information availabletoday comparedto evenone decade earlier,youstill need to do your homework inorder toknow how to proceed andwhich advicetotake or reject.
Strategiesinvolvethe very beginningdecision to employ funda- mentalor technical analysis, acombinationofthetwo,or to proceed based only on current newsand information. Failing to use some type of system andat least afew indicatorsandtrendsisa mistake.
TA B L E 1 - 3 . B R E A K - E V E N R AT E S
Effective I N F L A T I O N R A T E
Tax Rate 1% 2% 3% 4% 5% 6%
14% 1.2% 2.3% 3.5% 4.7% 5.8% 7.0%
16% 1.2 2.4 3.6 4.8 6.0 7.1
18% 1.2 2.4 3.7 4.9 6.1 7.3
20% 1.3 2.5 3.8 5.0 6.3 7.5
22% 1.3 2.6 3.8 5.1 6.4 7.7
24% 1.3% 2.6% 3.9% 5.3% 6.6% 7.9%
26% 1.4 2.7 4.1 5.4 6.8 8.1
28% 1.4 2.8 4.2 5.6 6.9 8.3
30% 1.4 2.9 4.3 5.7 7.1 8.6
32% 1.5 2.9 4.4 5.9 7.4 8.8
34% 1.5% 3.0% 4.5% 6.1% 7.6% 9.1%
36% 1.6 3.1 4.7 6.3 7.8 9.4
38% 1.6 3.2 4.8 6.5 8.1 9.7
40% 1.7 3.3 5.0 6.7 8.3 10.0
42% 1.7 3.4 5.2 6.9 8.6 10.3
As to how and when you invest, numerous strategies can be used.None ensure profits,but many can addto yourself-discipline.
Forexample,youcan use dollarcost averaging(also calledthe con- stantdollarplan)to placethe sameamountofmoneyintothemar- ket on a periodic basis. Even when share prices rise or fall, dollar cost averaging involvesregular investments,often into one stockor mutualfund everyweekor month.
Youcan alsoaverageup or average down, which may bethought of asthe opposite of dollarcost averaging. Under this system,you buyadditional shares of stock whenever the share price falls. As a result, your average price is always somewhere between original priceand currentprice.Youcan alsoaverageup, meaningyoubuy more shares when the share price rises. Under this system, your average priceisalwayshigher than the original investmentprice but lower thancurrent marketprice.Neitherofthese systems should be used blindly; you willdo better to pick investments based on analy-
sis, andit isalwaysa mistaketo blindly put moremoneyinto stocks orfundsthat arenotperforming well.
Diversification is also a strategy, and it explains why mutual fundsare so popular.By definition, afundholdsadiversified port- folio,so youcanputveryminimalcapital amountsintoafundand enjoy broad diversification. However, it is wise to compare costs before picking afund. A no-load fund hasno sales fee, whereasa load fund charges on average 8.5 percent ofall money you invest.
Other fees may also apply, including an advertising fee (called a 12b.1 fee), back-loads (sales charges taken when you withdraw), and a management fee to compensate the managers who decide what stocks or bondsto buy.An alternativetomutual fundsisthe exchange-traded fund, or ETF, which needs little or no manage- ment. The ETF holds a basket of stocks identified in advance by sector,country,or product and shares can betraded on the open exchange just like stocks, rather than requiring you to buy or sell directlythrough afund’smanagement.
You can find out moreabout mutualfunds bygoing tothein- dustryassociation Web site, the Investment Company Institute, at http://www.ici.org.Youcan alsouseafreemutualfund costcalcula- tor to compare one fundtoanother, available on the SECWeb site, athttp://www.sec.gov/investor/tools/mfcc/mfcc-int.htm.
Q u e s t i o n 5 : S h o u l d I H i r e a F i n a n c i a l P l a n n e r o r M a k e M y O w n D e c i s i o n s ?
Most noviceinvestorsaretimidabout themarket, andmaynot bewilling to simply jumpin without some experience. It seemsan obvious choicetohireafinancialplanneror towork with abroker- age firmoffering‘‘fullservice’’inexchange for a highcost totrade.
This is ill-advised. The first consideration is that no onewill help you to succeedin themarket aswell as you will help yourself.Finan- cialplannersand brokersare commission-compensated salespeople in most instances, so there is an unavoidable conflict of interest.
They makemoney only if you take their advice, and you will dis- cover that this advice usually is to buy products that compensate them.Forexample, aplanner will invariablyrecommenda loadmu-
tual fund, meaning only about $92 out of every $100 you invest goesintothe fund;therest goes forcommissions.Anotherexample:
Afinancialplanner will rarely, if ever, recommendthatyou acceler- ate payments on your mortgage, even though this is sensible for many people. Thereisno commissionpaid for givingsuch advice.
Some financialplannersworkfor afee. Thismeans youpay by thehour. However, it is possiblethat the planner also getsacom- mission if you invest in any ofthe productshe orsherecommends.
Whilethis is double compensation and clearlyaconflict,someget aroundthisissue by forming acorporationorseparate partnership.
So youpaythe consultationfeetothe planner andthe commission goestothe planner’s corporation.
Ultimately, you should plan to strike out on your own, make your own decisions, and take completeresponsibility for your in- vestment portfolio choices. As a transition between your starting point asa noviceandaseasonedinvestor,you may considerjoining an investmentclub. Thisisa group ofindividualsliving in the same area who pool their resourcesandmoneyto pick investments. The history of investmentclubsisimpressive, andthisisa great wayto gain real-world experience as an investor. To find out moreabout formingorjoining a local investmentclub,contact theNational As- sociation of Investors Corporation (NAIC) at http://www.better- investing.org. You can also find support for your investment pro- gramfrom theAmerican Associationof IndividualInvestors (AAII) athttp://www.aaii.com.
The overall market can be intimidating at first, but once you step back and look at the bigpicture,you will begin to see in it a more personalized perspective. Your experience and knowledge growsas youbegin toinvest, andif you ask therightquestionsand avoid the pitfalls commonly made, you will be far ahead of the crowd. This process isaided byknowing at least a briefhistory of themarket itself.
A Brief History of the U.S. Stock Market
The ‘‘stock market’’isnot actuallyasingle place,but rather a net- work of physical and electronic places including buildings, com-
puter centers, and home computers. The origin of the term goes back manyhundreds of yearswhen dealerstraded shares of stock inperson andwherethemarket was, infact, aphysicalplace.
Many peoplethinkof ‘‘WallStreet’’asthe centerofthe financial universe, andin manyrespects, that istrue. The originofthename goes back to the early seventeenth century and referred not to a wall,but toa group of people, theWalloons (German-speaking Bel- gians).New Amsterdam(the original name ofNew YorkCity)was originally founded bytheWalloons;theywereinstrumental in turn- ing thearea intoa world port andtrade center. The financialcenter was called ‘‘deWaalStraat,’’ or the street wheretheWalloons con- ducted business. The settlement was bordered on thenorth by an actual12-foot wall,built asadefenseagainst NativeAmericans, and the British kept the reference to the wall and the street as ‘‘Wall Street.’’ Today, the term ‘‘Wall Street’’ refersgenerally toallbusi- ness, investment, and commerceandnotjust toadefensivewallor evensimplytothe streetofthe samename.
Twomajorstockexchangesgrew up during the eighteenthcen- tury,formalizing tradeas volume pickedupin theNew World. The first and oldestexchangein the United Stateswasthe Philadelphia StockExchange,founded in1790. In1792, a group of merchants in New Yorkorganizedand formedwhat laterbecameknown asthe New York Stock Exchange. Competition between the two ex- changeswas fierceandthe Philadelphiaorganizers quickly set upa system oftelescopes andmirrors by which they could flashsignals from New York harbor to Philadelphia in as little as 10 minutes.
Thisamazingsystem remained ineffect until thetelegraph wasin- ventedin1846.
The innovation of the communication system istypical of the American Stock Exchange history. The New York, Philadelphia, andAmerican exchanges have always been on the cutting edge of advances, making themost outof thetelegraph, ticker, telephone, television, and computer. Eachofthesetechnological improvements has created huge leaps in exchange business and in the execution speed oftransactions.
It wasnot alwaysthat way. Beforethetelephone,for example, it was virtuallyimpossible forpeopleto buyand sellshares of stock
directly. They hadtowork through abroker whowould go physi- callytoanexchangeandtransact for them,oftenfor sohigh afee that it wasnot realistic for anyone outside ofthe brokerage commu- nitytotryandmakemoneyin the stock market.
Thehistory ofthe stock market is,sadly, a history ofgreedand of many individuals taking advantage of peopleand robbing them of their life savings. In addition tothe bigpanics and crashes that have typified the history of the market, a few corrupt individuals alsohave profitedin this environment. Mostpeopletodayremember Kenneth Laywho, as chief executive officerof Enron,bankrupted the companyanditsauditor, Arthur Andersen, asaconsequence of his creative ‘‘incentive pay’’and falsifiedaccounting records. That was very recent. But the colorful history of Wall Street has seen many other characters of similar questionable integrity. Thewell- known market crash of October 1929 led to the formation of the SEC and passage of several important pieces of federal legislation, requiring listed companies to conduct independent audits, meet specific reporting and listing standards, and limiting the kinds of leveraged trading activitythat has so oftencreated market crashes in the past. Morerecently, after the ‘‘Enron’’ period,Congressin- creasedthe SEC’s enforcement budget and enacted numerousre- formsthrough the Sarbanes–OxleyActof 2002.
In the past, perhaps the most infamous market con man was Charles Ponzi. The ‘‘PonziScheme’’isnamedafter himbecausehe operatedthe shamso effectively.AnItalian immigrant whoarrived in 1903, Ponzi had a background of minor rackets and schemes meant to takemoney from people.By 1920,Ponzi had developed the basic idea of his famous scheme: He told would-be investors that iftheygavehimcash, heguaranteeda50 percent return in45 days,100 percent in90 days. Fewpeople bothered to ask how he would achieve this because the rate of return was so good, and magic thinking took over from more practical, healthy suspicion.
Ponzi ended upwith more subscribers and true believers than he could handle. Those who did inquire were told that the idea was based on management of a foreign postal coupon exchange, but fewpeoplewantedtoask anyin-depthquestions,especially because Ponzi’s earlyinvestorswere, indeed,doubling their money every 90
days.Word spread. The schemewasingenious,simple, andwould inevitably fail. As investor numbers increased, Ponzi paid off his initial investorsandword continuedto spreadat an acceleratedrate.
He finallyhadtohireagentstohandlethe volume of people showing uptohand over money.ByFebruary 1920,Ponzi wastaking inover
$5,000 perday.By March, the daily volumehadgrown to $30,000, andinMayit reached $420,000.
So great was the hysteria that people mortgaged their homes and cleaned out theirsavingstotake part in the Ponzi investment.
Mostdidnotcollect their winnings,butchoseto plow theirprofits back intothe plan. Ultimately, the pyramid collapsed becauseit was built onever-higher debt.Finally,Ponzi wasno longer ableto pay offinvestorsandhewas sent to prison andthendeportedto Italy.
The Ponzischeme demonstrateshow many peoplethink. Ifget- ting richsoundstoo easy, it is probably somekind ofascheme,but peoplewant to believe. Theyallow theirown greedto overruletheir judgment, and like the Ponzi investors they end up losing thou- sands,perhapsmillions.
On a larger scale, marketshaverisen and fallenover time, and landmarkdatesin market historyare often the bigcrashes. Today, the Internet hasmadethe stock market more efficient thanever and hasalsomade stockbrokers virtually obsolete. Traders do not need to telephone a broker and pay exorbitant fees to execute trades;
they candoit themselves from theirown home or office computer.
Unfortunately, thislow-costconveniencealsohasmadeiteasierfor con artiststo findtheirvictims, andhasmademarketcrashes faster andmore devastating thanever.Withover26millioncomputersin usearoundtheworld, the stock market today doesnotexistonlyin aphysicalsensein lowerManhattan;it istrulya worldwidemarket.
The New York Stock Exchange (NYSE), only one of many ex- changesaroundtheworld, transactionsmorethan$2trillionevery tradingday.
The big marketcrashesinU.S.historyareworthsummarizing, asthese definethehistory ofthe stock market,often resultingfrom economic recessions or from the abuses of individuals. The nine worst, based on declines in the Dow Jones Industrial Average (DJIA), were:
1. April17,1930to July 8,1932 (loss: 86%) 2. March10,1939to March31,1908 (loss: 49%) 3. January 1,1906toNovember15,1907 (loss: 49%) 4. September3,1929toNovember13,1929 (loss: 48%) 5. November3,1919toAugust24,1921 (loss: 47%) 6. June 17,1901toNovember9,1903 (loss: 46%) 7. September12,1939toApril4,1942 (loss: 40%) 8.November21,1916to December19,1917 (loss: 40%)
9. January 15,2002to October9,2002 (the DJIA lost 38% ofits value)
This list provides perspective to the modern versions of stock marketcrashes.Notethat the 1987 crashof over500 points didnot even make the list, and the very brief decline in value following 9/11was sominor it wasnotevenconsideredacrash.
Thisall raisesan importantquestion:Why do crashesand pan- icshappen? Someimportant thingstoremember about themarket:
1. Price levels always come back from declines, although it often takes time. This works in both directions, as history reveals. No pricetrendsmoveinone directionforever. However,over time,val- ues oflisted companies,overall, haveincreased. Capital isnotfinite, and capitalismcreateswealth. The stock market isanextraordinary form of freedom, where you canplace capital at risk andwatch it appreciate over time. The occasionalprice plungesinvariablyreturn to previouslevels. Thekey isthat if you pickstocksintelligently, a market-wide price decline doesnotpermanentlyaffect the value of your investment. Even whenprices fall, theywill riseagain.
2. The market overreacts to everything. In fact, crashes them- selves are forms of severe overreaction. In asensible, logical, and stableworld priceswould simplyrisegradually over time.Forexam- ple, look at therealestate market. Inspite of the price and credit bubble ofrecentyears, thehistory ofrealestate showsthat in most regions,prices steadilyincrease over time. Evenduring the bubble, the problemswereisolated toafewstates where past abuseswere
mostsevereandwhere priceshadrun up beyondreason. Soif you exclude California, Arizona, andFloridafrom thenational averages, even during the 2004–2007 bubble years, the overall price ofreal estatein the United Statesremained very steadywithpricestrend- ing upand down within normalcycles.
The stock market isanexciting, high-risk market.Youcandou- ble your moneyin a matterofhours or weeks,butyoucan alsolose half ofit in the sametimeif you taketoohigh a risk. That would be unlikely in the real estate market. The stock market tends to rise and fall inextreme degrees because ofitsliquidityand ease oftrad- ing, and because ofthetendency for individuals, analysts, andinsti- tutional investorstotakeall newsand exaggerateit,bothpositively andnegatively.
3. No matter how much analysis you perform, the market con- tains many unknown factors and is impossible to anticipate.Thisis the simplereality. Even so, many ‘‘systems’’ can be found to beat themarket.None ofthem workconsistently,butyoucanvastlyim- prove yourodds by performingyourown analysisandmakingsmart choices. It istheunknownfactor that adds somuchvalueto stocks.
Muchoftoday’s priceand pricemovementoccursin anticipationof thingsthat havenotyetoccurred,such as future earnings,possible mergersand acquisitions, laborstrikes,development ofnew prod- uctsandnew markets, and changesin the competition.No one can anticipatewhat isgoing tohappen nextyearoreven next week and this uncertainty adds to both risk and to potential reward in the market.
History demonstrates extreme price swingsin themarket.Fol- lowingsome price crashes, it hastaken many years for themarket valuetoreturn to previouslevels.Butfor themostpart, themarket tends to recover quickly, especially in stocks whose fundamental valueis strong and does not change. Such a companymay see its stockprice plummet with therest of themarket.But the stronger the company, the faster its pricewill reboundafter acrash.
Youcan alsolearn a lotfrom historyabout the difficulty of find- ingeasymoney. Thelong history of con gamesand swindles,both byindividualsandinsiders,servesasan important lesson. Thereis
no easy money! Many peoplewill appeal to greed and rob unsus- pecting investors of their life savings, but everyone should know better. Iftherewere easy pathstoriches,strangerswouldnotbe so willing to sharetheirsecretswith you. Soanytime someone offers tohelp youdouble your money, keep onehand onyour wallet and never give out information. One thing that is sure in the market:
Giving money toanyonemakingsuchpromisesisasurething, on thelosingside.
Note
1 From theFrench,L’Embarras des richesses1726 playtr. by JohnOzell in1738, meaning an abundance of somethingbeyondwhat isneeded.
T H E B O T T O M L I N E
M
ostexpertsagreethatcorporate earnings (expressedas earnings per share,orEPS)are one ofthekey factorsinstudyingstocks. Thisis especially true when tracked over time, as part of a growing and emerging trend. Looking atEPS by itself reveals nothing, because earnings vary based on thenumberof shares outstanding.This chapter explains EPS and market price in the context of how you can use the information to study a company’s perform- ance. This requires developing historical trends as well as projec- tions ofthe future. EPS should be studied foreachcompanyin this manner, andthegrowthcurve should be studiedand compared to otherstocksin the sameindustry orsector.
Priceisaseparate butequallyimportantfactor, although it has nothingdirectly to do with the fundamentals. The price per share of stock reflects the current perception of value, which factors in expectations about futuregrowth. It isa common mistaketo view marketprice as being associated with financial information but, in fact,priceisperception.
One ofthemore popular market measurementsisthe price-to- earnings (P/E) ratio. Although higher P/E most often is seen as reflecting higher market popularity, long-term studies reveal that 23
lower-P/E stocks outperform market averages. Many investors need to reexamine their opinion of P/E. This chapter also warns that the older the earnings information, the less reliable the P/E because outdated earnings pershareare beingcomparedto current marketprices.
The Corporate Income Statement
What exactly doesit mean when acompanyreportsitsearnings? If you ask this questionof others,yousoondiscover thatpeoplehave vastly different perceptions about what earnings represent. Some believe earningsarethe sameasrevenue or thatearningsand profits arealways the same number. In fact, the definition of earningsis more complex than this.
Thewaythat companies report profit andloss makes earnings somewhat more elusive than most people would like. Figure 2-1 summarizes and defines the various segments oftheincome state- ment,ending with netearnings.
A few important points to makeabout reading financial state- ments:
1. Dollar amounts are usually reported in millions of dollars, unless otherwise qualified.Forexample,$1,000wouldactuallyrep- resent $1 million or $1 billion. This is commonly used shorthand for the purpose ofreporting to stockholders.
2. Whilethe formatoftheincome statementfollowsa general consistency, theterminologyisnot alwaysidentical. Itvaries byin- dustryand bytype ofactivity.Forexample, many companies divide general expenses into two groups: general and administrative (G&A)and sellingexpenses. Thetopline, revenues, may begiven a different name ordefined bytype.Forexample, acompanymaking a lotofrevenue from interest incomemay breakout aseparateline to distinguish interestfromother revenues.
3. Thereporting method for companies isat times not as de- tailedas you mightexpect. Even in theannual report, wherea lotof detail is desirable, some companies provide only a highly summa-
F I G U R E 2 . 1 . T H E I N C O M E S T AT E M E N T
Gross revenue xxx,xxx,xxx Less: returns and allowances x,xxx Net revenue xxx,xxx,xxx
Cost of goods sold:
Beginning inventory xx,xxx,xxx Materials purchased xxx,xxx,xxx Direct labor xx,xxx,xxx Other direct costs x,xxx,xxx Subtotal xxx,xxx,xxx Less: ending inventory xx,xxx,xxx
Cost of goods sold xxx,xxx,xxx Gross profit xx,xxx,xxx General expenses xx,xxx,xxx Operating profit xx,xxx,xxx Plus: other income x,xxx,xxx Less: other expenses ( x,xxx,xxx ) Pre-tax profit xx,xxx,xxx Federal income taxes x,xxx,xxx After-tax net profit xx,xxx,xxx
rized financial report. So even with the uniformity of reporting under accountingstandards, it isnot always easytomake company- to-company comparisons.
4. Companies sometimes have to ‘‘restate’’ past reports. This occurswhen mistakesweremadeandlater haveto be fixed,or when an operating unit is sold. In theinterest of consistency and accu-
racy,past reportsare changedtoreflectcurrent reports.Forexam- ple, if a company has been overstating net profits and the latest year’sauditsreflect that,previousnetprofit reportswillbealtered.
And if a company sells one of itsmajor operating units, previous reports arerestated to showprofits without that unit. In this way, youcan look at all lines oftheincome statementfor many yearsand get an accurate picture ofhow trendshavemoved over time.
5. Income statementsare summaries ofactivity for avery spe- cific period of time, usually thelatest fiscal quarter or fiscal year.
‘‘Fiscal’’ simplymeansthereportingperiod chosenbythe company.
Whilemost individualsusethe calendaryearfor reporting and pay- ing taxes,corporations canelect tohavetheirfiscalyearend on any month.Based on theindustry, thereare strategicreasons forpick- ingone fiscalyearover another.When a report is provided for the latest quarter, it is compared to the same quarter in the previous fiscalyear,sothat the comparison ismeaningful.Afullyear’sreport isusually shown in two columns:the currentyear andthe previous year.
In Figure 2-1, the specificlinesandtheir meaningsare:
Gross revenueisthe dollarvalue of sales, unadjusted, made dur- ing aspecific period, usuallyafullfiscalyearor thelatestquarter.
Returns and allowances are adjustments to revenue for dis- counts, merchandisereturns, rebates, andrefunds.
Net revenue isthenetof gross revenue, minusreturns and al- lowances.
Cost of goods soldis broadly definedas costs directlyassociated with thegenerationofrevenue.Forexample, when acompany buys merchandiseit is bought at wholesaleand soldat marked-up value or retail. Merchandiseisadirectcost,becausetheamountofreve- nue and the cost of merchandise are related. In comparison, ex- penses like rent, telephone, or clerical salaries will remain at the samelevel whether revenuerises orfalls.
With the costofgoods sold,several lineitems occur. Theinven- tory, or goods kept on hand in warehouses or stores, or in plants
where manufacturing and assembly take place, is adjusted within cost of goods sold. The net change between beginning inventory (cost value at the beginning of the period) and ending inventory (costvalueat the end ofthe period)is one formofadjustment. The directcost isincreased bymaterials purchased during the year,di- rect labor(the costofmanufactureandassembly,forexample), and other lineitemslike freight and othercostsneededtoget merchan- dise sold.
Thetotal of all direct costs, including increase or decrease in inventorylevels, isthe costofgoods sold. Thisis deducted from net revenue.
Gross profit is theremaining value of net revenues minus the costofgoods sold.
General expensesincludes alloverhead and other expensesthe company pays each year. This includes nondirect salaries and wages,payroll taxes, retirementbenefits, insurance, rent, telephone, office supplies, advertising, and dozens of other categories. The maindistinctionbetweencostsand expensesiswhether it isrelated to productionofrevenue. Paymentofrent isrequiredwhether reve- nuerises orfalls,soit isanexpense. Purchases ofmerchandise for resaleis clearlyadirect cost;it risesas the volume of salesgrows, and fallsifandwhensales decline.
Operating profitisthenetof earnings (profit) strictly from op- erating the company. Inother words, ifthe company did not need to spendmoney on nonoperatingexpenses orpaytaxes, thiswould bethe ‘‘bottom line.’’But therearemoreadjustments.
Other incomeisa nonoperating item. It includesgains fromsell- ing capital assets or operating units,foreignexchange gains, win- nings from lawsuits, andinterest.
Other expenses include nonoperating losses, such as losses on the sale of capital assets, legal judgments paid, foreign exchange losses, andinterestexpenses.
Pre-tax profitrepresents earnings frombothoperating andnon- operating activities beforeadjustingfor tax liabilities.
Federal income taxesincludestheallowanceadded for the cur- rentyear’stax liability based on taxable corporateincome.
After-tax net profit is the bottom line; the net earnings of the companyafter allsources ofincome,costs, and expensesaretaken intoaccount.
The Attributes of Earnings
Knowing thegeneraldefinitionsused on theincome statement isa wise starting point. If you are not sure what ‘‘earnings’’ really means, it isimpossibletomake valid comparisons betweencompa- nies orbetweenquarters oryears. Definition isthe startingpoint in knowing how to evaluateacompanybeforebuyingstock.
Earnings contain specificattributes based on the industryand the company. It isunrealisticto expect any company’snet returnto rise every year and indefinitely into the future. The dollar value shouldriseas sales rise,but thenet return—the percentage ofnet earnings divided byrevenue—shouldremainconsistent.
The formulafor net return is summarizedin Figure 2-2.
Forexample, threelisted corporationsreportvastly different net returns overfive years. Table 2-1 showstheseresults.
It is always interesting to comparenet return on two different levels: first, the trend within the company, and second, outcomes betweencompanies. Thesethree corporationsareincompletely dif- ferent industries, so a standard for net return cannot be applied equallyto each. Rather, outcomes should be compared between a company and its direct competitors, those corporations operating in the same business.
This comparison isinteresting, however,because asaprelimi-
F I G U R E 2 . 2 . N E T R E T U R N
net earnings revenue
= net return
T A B L E 2 - 1 . N E T R E T U R N C O M PA R I S O N S
In Millions of Dollars
Company Year Revenue Net Profit Net Return
AT&T 2006 $ 63,055 $ 7,356 11.7%
2005 43,862 4,786 10.9
2004 40,787 4,979 12.2
2003 40,843 5,971 14.6
2002 43,138 7,473 17.3
Citigroup 2006 $146,558 $21,249 14.5%
2005 120,318 19,806 16.5
2004 108,276 17,046 15.7
2003 94,713 17,853 18.8
2002 92,556 13,448 14.5
IBM 2006 $ 91,424 $ 9,416 10.3%
2005 91,134 7,994 8.8
2004 96,293 8,448 8.8
2003 89,131 7,613 8.5
2002 81,186 5,334 6.6
Source: Standard & Poor’s Stock Reports
narymethod forpickingcompaniesasinvestments, itdemonstrates severalbasic but importantpositive points, including:
1. The companieswere profitable eachyear in theanalysis.
2. Changes fromyear to year arenot highly volatile, meaning that year-to-year revenue, net income, andnet return are somewhat predictable.
3. Revenue is shown for each of the companies during the five years.
A more specific analysis shows that resultsareactuallymixed, even though revenueroseineachcase.AT&T (T) experienced sig- nificant increases in revenue, although itsnet income declined for the firstfourofthe five years. Thisis further reflectedin net return,
which also declinedthroughout the period. This doesnot mean the company is heading into bankruptcy, but it does raise questions.
Whyisnet returndeclining in aperiodwhen revenuerose? It usu- allymeansthatexpensesarerisingor that,dueto competition,costs (andthus,profit margin)are squeezed. Ineithercase, thetrendis worthfurtherstudy.
Citigroup (C) experienced substantial risein both revenueand net income. Itsnet returnbegan and endedthe periodat14.5 per- cent, with higher net return in between. This probablyreflects the changing financial marketsin 2003 through 2005, morethan any management issues orcompetitive changeswithin the company. In 2007,Citigroup’s fortunesweremore dismal.
IBM (IBM)also experienced strong growthboth in revenueand net income. Itsnet return rose stronglythrough the five years, indi- cating improving margins as well as continued controls over ex- penselevels.AlthoughIBM’snet return islower than thetwo other companiesin this study, itdoesnot reflect a negative. Everyindus- tryis different, andthis simplyindicatesthat thegrossmargins for IBMare different thanfor AT&Tand Citigroup.Forexample,IBM manufacturesand sellshardware soit hasinventory costsaswell as direct labor. Incomparison,both AT&Tand Citigroup focusmore onservicesand, in the case of Citigroup, interest income. Themar- ginfrom thiskind ofactivityisinvariablyhigher than forcorpora- tions selling products. This makes the point that comparisons between industries are not valid. A valid comparison would be to contrastIBMto other information technology (IT)hardwaremanu- facturersand Citigroupto otherfinancial institutions.
Tracking Earnings Per Share Over Time
Thenet incomereported byacompanyisadollarvalue but analysis often takes place in shorthand. Even the dollarvalues leave off six zeroes byreporting in millions of dollars. Earnings (net income)are commonlyreported not by dollar value but by earnings per share (EPS).
Thereisa good reasonfor this. If one companyhas 10million
shares outstanding and another has 20 million, an identical dollar value of net incomehas vastly differentsignificance on aper-share basis—regardless ofthe percentage ofnet return. EPSisalso sig- nificant because corporate shares outstanding may change over time. In an idealsituation, issuing more shares translatestohigher EPS because the infusion of new capital enables the company to growover time.
It isalsoimportant torecognizea trendamong largelisted com- paniesto buyandretireits ownshares on themarket, andthe effect thishas onEPS.When acompany buysits ownsharesit isapositive sign that management believesthe stock isa bargain at its current price.When itbuysthose shares, the companyretiresthemperma- nently. Soif earningsare exactlythe same fromone year tothenext, but the company buysa large portionofits outstandingsharesand retiresthem, thiswillincreaseEPS.
The calculationof EPSinvolves dividing earnings bythenum- berof outstandingshares. Earnings coverone fullyear,sothe cal- culation needs to be adjusted if and when the number of shares changes.For example, ifthe company bought(andretired) shares during the year, thenumberofaverage shares outstanding hasto be adjusted tomakethe calculation accurate. Andif the companyis- suednewshares during the year, that alsohasto betaken intoac- count incalculatingEPS.
A word on modifying the outstanding shares: The calculation hastoincludea weightingfor themonths specificnumbers of shares were outstanding.For example, ifacompany started the year with 9million shares and bought andretired 150,000 shares at the be- ginningofthethirdmonthofits fiscalyear, it wouldhaveto calcu- latetheaverage sharesas follows:
2months,9millionshares outstanding 10months,8.85millionshares outstanding average shares outstanding:
2/129.00 million 1.50 10/128.85 million 7.37
total 8.87 million shares
Thisisthenumberof shares outstanding to beusedincalculat- ingEPS. The calculation involves dividingearnings bythenumber of shares outstanding. This formula is summarizedin Figure 2-3.
Forexample, returning tothe previous example ofAT&T,Citi- group, and IBM, earnings per share is a revealing analytical tool.
Thereal meaningof earningsismore significant when analyzed on aper-share basisthanon the dollarvalue ofnet return, as shown in Table 2-2.
The EPS for AT&Thas declined over the five yearsinquestion, so on this basis performancehas been disappointing. Citigroup, in comparison,experiencedasteadyriseinEPS, and IBM’s perform- ance was even stronger. From an investor’s point of view, which attemptsto place value on therevenueand earningstrend, anEPS analysis over at leastfive yearsisthe bestprocedureto follow.
You mightexpect price performance totrack EPS,or in other words, as EPS improves, the stock’s price range should climb as well. Thisisa reasonableassumption, although outside conditions affectpricerangeaswell. Thegeneralconditionofthemarketfor a particular industrywill keep prices downeven as EPSrises,orvice versa. However, it isinteresting to studythe priceranges for a pe- riod oftime comparedto EPS.Asummaryis shown inTable 2-3.
The comparison revealsthat you cannot rely solely on EPSto predict marketshare. Over a longperiod oftime,priceswill rise for corporationswhose earningsand EPSrise,but in the short term it ismore elusive. In the case ofAT&T, thelowpricerose during the five years while the high price in the range fell. This makes sense whenyou also observethe declineinEPS over the same period. The
F I G U R E 2 . 3 . E A R N I N G S P E R S H A R E ( E P S )
net earnings shares outstanding
= EPS
