Excerpt from EDGAR by Gene Walden
Key Measures of Financial Strength
There are several simple formulas you can use to analyze a companys financial strength. In this chapter, well provide you with a close look at many of the ratios and measures Wall Street analysts use to evaluate a company. You can use the same measures in your own research while reviewing a companys income statement, balance sheet and other financial tables available in their 10-K and annual reports. Well refer back to many of these ratios in later chapters as we discuss the 10-K and other financial reports. Here some of the leading ratios and measures:
Return on Equity
Return on equity is considered to be one of the most important measures of a company's financial strength. It helps you determine how much shareholders are making for their investment dollars, and whether they are making more for their investment dollars this year than they did in previous years. Here is the formula for determining return on equity (ROE):
Net income for the year (after taxes) ¸ Shareholders' equity (from the start of the year) = Return on equity
Not everyone calculates ROE using shareholders equity from the start of the year. Some analysts (including the well-known ValueLine Investment Survey) calculate the ROE using shareholders equity at the end of the year. But that does not represent a true return on equity. As a business you start with a certain amount of money and capital investment in the company (the equity) and you spend the next 12 months generating revenue and income using that equity. The ROE is supposed to demonstrate the return shareholders earned on their investment that year. Thats why its important to use the equity the company starts the year with rather than what it ends the year with.
Example: If ABC Corporation has a net income of $10 million for the year 2002, and shareholders' equity of $70 million at the start the 2002, to calculate ROE, you would divide the $10 net income by the $70 million shareholder equity. The return on equity is 14 percenta pretty healthy return.
While ROEs tend to vary dramatically by industry, here is a very rough guideline: over 40 percent would be considered an excellent ROE, 15 to 30 percent would be about average, and under 10 percent would be considered mediocre to poor.
To get a better perspective on the ROE, see how it compares with the previous year's return, how it compares with the return of other companies in the same industry and how it compares with current interest rates on corporate bonds. In its 2001 annual report, Johnson & Johnson included its return on shareholder equity in its 3-year financial table (see Figure 3-1). Its ROE was 27.0 in 1999, 26.5 in 2000 and 25.4 in 2001. A dropping ROE is not a particularly good sign, but even at 25.4 percent, thats a very good ROE.
Lets see how that compares to the ROE for General Motors. In GMs annual report, the company does not list its ROE, so we have to calculate it ourselves. The following figures were extracted from a financial table in GMs 10-K report:
GENERAL MOTORS CORPORATION AND SUBSIDIARIES
Years Ended December 31
2001 2000 1999 1998 1997
---- ---- ---- ---- ----
(dollars in millions except per share amounts)
Net income $601 $4,452 $6,002 $2,956 $6,698
Stockholders' equity $19,707 $30,175 $20,644 $15,052 $17,584
In 2000, GM earned net income of $4,452 million. It began the year with stockholders equity of $20,644 million (the equity listed under 1999). Lets use the formula to calculate GMs ROE:
$4,452 million (net income) ¸ $20,644 million (stockholders equity at the start of the year) = 0.21 (21%) (Return on Equity)
A return on equity of 21 percent is considered very healthy.
But the following year, 2001, GMs net income plummeted, and so did its ROE. The company posted net income of $601 million (compared with $4,452 million the previous year), on shareholder equity of $30,175 million. Follow the formula again, and you come up with an ROE of just 2 percenta very low return for the shareholders investment.
Gross profit margin on sales
Has the company been able to widen its margin between costs and revenues, or is competition in its industry forcing it to keep prices down and costs up. To calculate the gross profit margin on goods sold, follow this formula:
Sales - Cost of goods sold = Gross profit margin
(Be aware that "cost of goods sold" does not include marketing, selling, administrative or research and development costs. It merely refers to the actual costs of producing the products.)
Heres an example: If ABC had sales of $50 million and its cost of goods sold was $30 million, its gross profit margin on sales would be $20 million.
Johnson & Johnson spells out its gross profit margin in its Consolidated Statements of Earnings (see Figure 3-4). It had sales of $33,004 and cost of goods sold of $9,536. Subtract the $9536 from the $33,004 to get a gross profit margin of $23,468. Youll also notice in the table that the companys gross profit margin increased from 1999 to 2000 and from 2000 to 2001. Thats a positive sign for the company.
Gross profit margin ratio
In and of itself, the gross profit margin provides only a one-dimensional view of the companys profits. Its difficult to make a valid comparison from one company to another based on the profit margin because the size of the company makes such a dramatic difference in the profit margin.
To get a better perspective of the companys profitability (as compared with others in its industry), you can quickly calculate the companys gross profit margin ratio. To calculate gross profit margin ratio, divide profit margin by gross sales. Heres the formula:
- Cost of goods sold
Gross Profit Margin ÷ Sales = Gross Profit Margin Ratio
With our ABC Company example, divide the $20 million profit margin by the $50 million in gross sales. That would give you a very respectable gross profit margin ratio of 40 percent. Again, to get a true reading, compare this ratio to the previous year's gross margin ratio and, if possible, to the gross margin ratios of other companies in the industry.
Lets calculate Johnson & Johnsons gross profit margin ratio:
- 9,536 (cost of goods sold)
23,468 ÷ 33,004 (sales) = 0.71 (71%)
A 71 percent gross profit margin ratio is outstanding, although gross profit margins in the medical products field tend to be higher than average because the cost of their goods is relatively cheap. But they do spend sizable sums on research and development that is not included in "costs of goods sold."
Lets look at the gross profit margin of companies in two other industries. Heres Wal-Marts numbers for its fiscal year 2002:
$217,799 million (net sales)
-171,562 million (cost of sales)
46,237÷ 217,799 = 21.2%
As the figures indicate, Wal-Mart had a 21.2% gross operating margin ratio. As expected, that is far below Johnson & Johnsons because Wal-Mart faces the high cost of purchasing and transporting the goods for its stores with a relatively low margin for its retail sales. But the company does make up for its lower margins with very high sales volume.
Lets look at a heavy manufacturing company. Boeing Corp., the leading aircraft manufacturer, posts its operating margin ratio in its financial highlights table in its annual report. According to its table, the ratio varied from about 5.5 to 6.7 percent over the most recent three years. What the low numbers indicate is that Boeing has a high cost of goods and production to produce its aircraft and related products, and a relatively low margin of profit on each product sold.
That is why it is important to compare a companys profit margin ratio to other companies in the same type of industry, rather than with companies in unrelated industries where the economic dynamics may be entirely different.
But what do you do for a service company that doesnt sell any products, and, therefore, does not have a "cost of goods sold? For service companies, you will usually see a line for "operating expenses." You can use that to calculate gross profit margin.
Book value (per common share)
Theoretically, book value tells you what one share of common stock would be worth if all of the company's assets were liquidated and the proceeds returned to the stockholders. The assets would include the company's real estate, patents, brand names, and all other assets, minus debts and other liabilities. Most of the time, however, a company is worth far more than its book value because it has more than just valued assets. It also has a corporate infrastructure in place to produce and sell goods or services, and, presumably, has some name recognition or marketing ties that should help guarantee the future success of the company. That all goes into a companys total valuewhich is what youre paying for when you buy the stockbut goodwill and future prospects are not included in calculating a companys book value. Book value only takes into account the companys actual assets.
But the book value (or book value per share) does give you another factor to consider in evaluating a stock. You can compare the book value with the actual stock price (the book value will be lower in the vast majority of cases), and you can compare it to the book values of other companies in the same industry. Generally, the closer a book value is to the actual stock price the better the value to the shareholders. It may also be helpful to compare it to the book values of preceding years to see ifand how fastthe book value is increasing. That gives you another good indicator of the companys overall growth.
Here is the formula to use in calculating book value per share:
Total common shareholders' equity
- Intangible assets (goodwill, copyrights, patents, etc.)
Balance ÷ # of shares of stock outstanding = Book value per share
You may find that it is easier to come up with book value per shareand a number of other ratiosby going to one of the many online financial sites that offer basic stock information absolutely free. (You can find many of the top sites by clicking on "RESEACH CENTRAL" on the home page of this web site, AllStarStocks.com.)
Lets go over some of the other key measures and ratios::
Price-to-book value ratio
Instead of comparing a stock's current price to the company's earnings, you can compare the price to the worth of the company's assetsits book value. To compute the ratio, divide the stock's price by the book value per share. Heres an example:
ABC Company has a $20 stock price and a $5 book value per share. Heres how you calculate its price-to-book ratio:
$20 Current stock price÷$5 Book value per share = 4.0 price-book ratio
A stock that is selling over its book value indicates that investors think highly of the company and therefore have put a high value on its assets. A stock selling at or below its book value indicates that investors have low expectations for the company and do not prize its assets. Investors who specialize in buying undervalued stocks peruse stocks selling at or below book value because they think they are getting a bargain if they can buy the stock for less than the company's assets are worth. Such stocks might also be takeover bait because another company or a raider may smell the same bargain, acquire the company, and sell off its pieces for more than their current price. Most of the time, however, these stocks do not recover. For comparative reference, a price-to-boo ratio of under four is very good, 5 to 10 is about average, 11 to 20 is a bit below average, and over 20 is cause for some concern.
Other Vital Ratios
Here are some other important financial measures you may want to use to analyze a companys investment value:
Cash Flow. The cash flow helps measure the companys ability to generate cash. A positive cash flow means the company has more cash coming in than going out, while a negative cash flow means the company has more money going out than coming in. Some analysts consider this to be a companys most important measure of financial health. The more cash flow a company can generate, the easier it can pay its bills, dole out dividends to shareholders, and invest in new assets. To calculate cash flow, start with net income after taxes and add all other non-cash charges, such as depreciation, depletion and amortization.
Net income after taxes ÷ Depreciation and other non-cash charges =
= Cash Flow
Cash Flow per Share. Divide the cash flow by the number of shares outstanding. Compare within industries. Generally speaking, the higher the better, and a growing cash flow per share is also a positive sign. But to get a better reading, you need to take one more step and calculate the "price-to-cash-flow-per-share ratio." To calculate that, divide the current stock price by cash flow per share. The lower the price-to-cash-flow-per-share the better. Compare with companies in the same industry.
Current Ratio. A measure of the companys financial strength, the current ratio is calculated by dividing the total current assets by total current liabilities. This ratio is more applicable to product-oriented rather than to service-oriented companies. A healthy ratio for a company that keeps inventories is 2 to 1 or higher. A ratio of 1.0 is also okay, but if its under 1.0, it indicates that current liabilities have become greater than current assets, which is a riskier short-term financial position.
Total current assets ¸ Total current liabilities = Current Ratio
Debt-to-assets ratio. Used to help measure a companys reliance on leveraging, it is also known as the "debt ratio." The debt ratio is calculated by dividing total long-term and short-term liabilities by total assets. The lower the better (the more conservative the company). Higher leveraging can increase companys returns, but it also puts the company at higher risk in bad times. While the ratio level tends to vary by the industry, the debt should make up no more than about two-thirds to three-quarters of the companys assetsa debt-to-assets ratio of 66 to 75 percent.
Total long-term liabilities plus total short-term liabilities ¸ total assets = Debt-to-assets ratio
Debt-to-equity ratio. Also known as the leverage ratio, it helps measure the companys financial strength by comparing its debt financing to equity ownership. To calculate, divide long-term debt for the most recent fiscal quarter by total shareholder equity for the same period. Lower is better. For a loose reference, less than 0.1 would be considered excellent, 0.1 to 0.9 would be considered good, 1.0 to 2.0 would be considered fair, 2.1 to 4.0 would be considered below average, and more than 4 would be considered to be poor.
Diluted shares. The number of shares of common stock that would be outstanding if all convertible securities were converted to common stock. (Diluted earnings per share is the companys net income divided by its total number of diluted shares.)
Dividend Yield (%). As a shareholder, dividend yield measures the percentage that the dividend payment based on the price of the stock. Its similar to an interest rate. For instance, if you pay $100 for a share of stock that pays a $1 dividend, your dividend yield is 1 percent ($1 divided by $100). Calculate by dividing the annual dividend payment by the current price of the stock. If ABC Corp. pays a $1 dividend, and its stock is trading at $50, here is the calculation: $1 ¸ $50 = .0.02 (2 percent). So the company has a dividend yield of 2 percent.
Annual dividend payment ¸ stock price = Dividend Yield
Earnings per share. The net income divided by the number of common stock shares outstanding. A company with one million shares outstanding, and net income of $2 million, would have earnings per share of $2.
Inventory turnover ratio. How quickly does the company sell off its products? The inventory turnover ratio, which measures the number of times inventory is turned over (or is sold) each year, helps you compare the sales success of companies in the same industry. Calculate by dividing cost of goods sold by inventory. A high ratio is preferable, and indicates that the company is selling out its goods quickly, while a low ratio means products are not moving. But there are vast differences in inventory turnover ratios from one industry to another.
Cost of goods sold ¸ inventory = Inventory Turnover Ratio
Net-sales-to-working capital ratio. How efficiently is the company using its working capital? This ratio gives you a broad idea. To calculate, divide net sales by net working capital (see working capital, below in this section). A very low ratio means you may not be getting enough out of your working capital, while a very high ratio could put you at risk of a cash shortfall if sales suddenly sink.
Operating Margin. One measure of a companys profitability, the operating margin measures the percent of revenues remaining after paying all operating expenses. It is calculated by dividing operating income by total revenue. It is expressed as a percentage. This tends to vary by industry, but for a very rough guideline, over 50 percent would be considered excellent, 20 to 40 percent would be good, and under 10 percent would be poor.
Operating income ¸ Total revenue = Operating Margin
Price-to-Cash-Flow-per-Share Ratio. To calculate this, divide the current stock price by cash flow per share. Compare within industriesgenerally the lower the better. (See Cash Flow and Cash Flow per Share.)
Price-to-Sales ratio. Refers to the stock price divided by the sales per share. This measure has gained growing importance, particularly with stocks that have little or no earnings. With no earningsand no price-earnings ratiothe price-to-sales ratio can you a comparative reference point in valuing a stock. As a very loose point of reference, you might consider a price-to-sales ratio of under 4 to be excellent, 5 to 8 is above average, 8 to 12 is about average, 13 to 18 is a little higher than normal, and over 18 is dangerously high. Heres the formula:
Total revenue ¸ shares outstanding = revenue per share
Stock price ¸ revenue per share = Price-to-Sales Ratio
Quick ratio. Also known as the "acid test ratio," the quick ratio is a good measure of the companys current liquidity and ability to meet short-term obligations. To calculate, divide the companys current assetsits cash, short-term investments, and accounts receivable (but not its inventory)by its current liabilities. Inventory is not included because its not liquidit takes time to convert inventory to cash. The higher the better, but a quick ratio of 0.5 to 1.0 is considered satisfactory.
Current assets (not including inventory) ¸ Current liabilities = Quick Ratio
Return on Assets. Another measure of a companys profitability, return on assets is calculated by dividing the companys income after taxes by its total assets. It is expressed as a percentage. For rough reference, over 30 percent is considered excellent, 15 to 20 percent is very good, 10 to 15 percent is about average, 5 to 10 percent is a little below average, and under five percent is generally considered very poor.
Net income (after taxes) ¸ Total assets = Return on Assets
Return on Investment (ROI). Determined by dividing the net income by assets, the ROI helps measure how effectively management is using its assets to make money. A more telling calculation sometimes used by analysts to determine ROI is to divide operational earnings by assets. Operational earnings refers to earnings from the companys main operations, and would not include earnings received from unrelated investments. That gives you a truer picture of how effectively the management is running the companys core operations. An ROI of more than 20 percent is excellent, 10 to 20 percent is good, and under 10 is mediocre to poor.
Net Income ¸ Total assets = Return on Investment
Sales-to-receivables ratio. Is the company collecting on its sales? This ratio, which measures the number of times a company turns over its accounts receivables each period, helps illustrate how effective a company is at collecting its debts. Calculate by dividing net sales (from the income statement) by net receivables (from the balance sheet). A higher ratio is better, indicating efficient collection of debts. However, this ratio can vary dramatically by industry, so it is best used to compare companies in the same industry.
Working capital. A measure of the companys cash flow, working capital is calculated by subtracting current liabilities from current assets (such as cash, accounts receivable, short-term investments and inventory). The higher the working capital, the more financially secure the company.
Current liabilities - Current assets = Working Capital
The P/EWall Streets Favorite Ratio
Without a doubt, the price-earnings ratio is Wall Streets most commonly-used measure of a stock's value. All other ratios and formulas pale in comparison to the price-to-earnings ratiogenerally referred to, simply, as the "PE."
Literally translated, the price-earnings ratio means the stock price divided by the earnings per share. For example, a $10 stock with annual earnings of $1 per share would have a PE of 10 ($10 divided by $1). Normally the PE is based on the most recent (trailing) four quarters of earnings. A stock with no earnings or losses would not have a PE.
Price of the stock ¸ Earnings per share = Price-to-Earnings Ratio (PE)
PEs are a lot like golf scoresthe lower the better. Thats why on Wall Street, a low stock price doesnt necessarily mean the stock is cheap. In fact, in value terms, a $100 stock could be cheaper than a $3 stock. It all depends on the price-earnings ratio.
Many professionals and individual investors decide which stocks to buy and sell based largely on the PE. (The PEs are listed every day in the stock tables of most major newspapers, as well as at nearly any Internet financial site.) Investors often watch the PEs as closely as the stock price itself. In the late 1990s, when investors ignored the PE and bought tech stocks with astronomical PEs, they ultimately paid the price when tech stocks crashed. But investors who owned stocks with reasonable PE ratios (primarily outside the tech sector) escaped the market crash relatively unscathed. Thats why the PE is a measure every serious investor should understand.
Which of the following stocks would be cheaper in Wall Street terms?
- A $30 stock with earnings of $1 per share (a PE of 30)?
- A $100 stock with earnings of $10 a share (a PE of 10)?
In value terms, the $100 stock would be cheaper than the $30 stock, because the PE of the $100 stock is one-third that of the $30 stock.
Most established blue chip stocks have PEs in the range of 10 to 30. The average PE for a stock on the Dow Jones Industrial Average over the past 50 years has been about 13, although over the past 10 years that figure has climbed to about 18. In fact, the average PE jumped to over 20 during the bull market run of the late 1990s, and hit a peak just before the market started its downward slide.
In comparing PEs, think of buying a stock in much the same way as you would think of buying a business. If you can buy a business for $10 that earns $1 a year (10 PE), that would seem to be a much better value than to buy a business for $30 with that same $1 of earnings (30 PE).
So why doesn't everyone buy stocks with the lowest possible PE? Because some companies really are worth more than others. Great companies with fast earnings growth command a premium over slow-growing companies, as well they should.
For a stock to be fairly priced, its PE should roughly reflect its earnings growth rate. If earnings are growing at 30 to 40 percent, then the PE should be in the 30 to 50 range. If it is growing at 15 percent per year, the PE should be closer to from 15 to 20.
Picking stocks based on PEs can be tricky. Some industries command higher PEs than others. Tobacco and military stocks, for instance, often have very low PEs, while technology and medical stocks tend to support fairly high ratios.
The best point of comparison may be the stocks own historical PEs. If a stock has had a 20 PE through most of its history, and its earnings are continuing to grow at the same pace, then you would probably be safe to buy the stock when its PE is around 20 or less. If the PE has climbed closer to 30and the earnings growth has remained the sameyou might be better served to look for other opportunities and wait for the PE of that stock to drop back down before buying.
The PE, however, is just one factor to use in judging a stock. Never buy a stock based on its PE alone. But for stocks that meet your other standards, the PE can help you sift out the bargains, and decide when to buy and when to sell.
Low PE Stocks
Some investors focus exclusively on low PE stocks, often with good success. In fact, studies have shown that low PE stocks, as a group, tend to outperform the overall market. But thats not to say there is no risk to low PE stocks. Keep in mind, those stocks have a low PE for a reason. It might be because their earnings growth has been slow, or the company is facing legal problems, or its prospects for future growth are considered poor. But, for whatever reason, Wall Street has put a low value on that stock. Fortunately for low PE investors, Wall Street makes plenty of mistakes. Thats why low PE investors continue their search for the diamonds in the roughlow PE companies with solid growth and strong future prospects that Wall Street has overlooked.
There is one big problem with investing exclusively in low PE stocks, according to money manager Lee Kopp. People who only buy low PE stocks will never own the great companies. "Theyre missing out on some great opportunities," says Kopp. "They have their heads in the sand." The great stocks always command a premium. Youll never find the fastest growing, most dynamic companies in the bargain bin. For short-term investments, low PE stocks can provide some surprising returns. Just dont build your entire portfolio around them. If you keep an eye out for low PE stocks, you may be able to catch some big gains on the turnaround. Or as Minneapolis businessman Dennis Kleve puts it: "Im not cheap. I just want a good deal."
Where can you find low PE stocks? Price-earnings ratios are listed in the stock tables of the Wall Street Journal, Investors Business Daily, and most major newspapers, as well as on most online investment sites (see my list of favorites, Chapter X). An easier way to find cheap stocks is through the Value Line Investment Survey (which should be available at your public library). Value Line publishes a list of the lowest PE stocks in each of its weekly updates. A number of online investment sites also allow you to do special screens to identify low PE and high PE stocks.
High PE Sectors
It is not unusual for the price-earnings ratios of an entire sector to become irrationally high from time to time. If you own stocks in an overpriced sector, you can save yourself some heavy losses by unloading those stocks before they begin to plummet.
There have been several times in recent history when PEs of certain sectors became dangerously high. Those times are usually easy to recognize, because the rationale for the high prices from the experts on Wall Street is almost always the same: "This time its different. These stocks can support exorbitantly high PEs because (fill in the blank)." Sometimes the claim is that the dynamics of valuing stocks has changed; sometimes its because a particular sector has "unlimited" potential. There have been many rationales for exorbitant PEs, but none have held up over time. Stocks with high PEs have always come back to earth.
Here is a brief history lesson. The most recent example was the Internet stock phenomenon. Stocks of little-known companies were carrying PEs of 100 to 200 (and beyond). In fact, many Internet stocks had no earnings at all and no prospect for achieving earnings any time in the foreseeable future. Yet, the hype surrounding the Internet sector was so pervasive that investors poured billions of dollars into those stocks. And the higher those stocks climbed, the faster the money poured into the market. But when the bubble burst, it took down hundreds of Internet companies along with the millions of investors who had staked much of their retirement dollars on those stocks.
But the Internet meltdown was just one example in a long history of market madness. In the early 1980s, high-tech start-up stocks and biotech stocks were the rage with investors who believed that there could be no end to their spectacular growth. It mattered little that many of those companies still had no earnings, or very small earnings, and no track record. Investors still were bidding up the prices. PEs climbed into the 50 to 100 range. And the rationalizations from Wall Streets experts began: "These stocks are different from the blue chips. They can support higher PEs because of their potential for rapid growth." When the rapid growth never materialized, investors lost interest in the sector and prices fell through the floor. Stocks trading as high as $30 or $40 per share were suddenly going begging at $6 or $8.
In the late 1980s, Japanese stocks roared to record levels. Many stocks carried PEs as high as 100 to 200levels that were virtually unheard of in the history of the stock market. Unfazed investors continued to buy, while Japanese brokers continued to tout the stocks. "This time its different," they said. "This is the great Japanese financial empire, an empire that is taking over the worlds financial markets, the worlds manufacturing markets, and the worlds high technology markets. These stocks can support the higher PEs because they are part of this great Japanese economic machine." But suddenly the machine ground to a halt, the bottom fell out of the Japanese economy, and hundreds of stocks dropped to a fraction of their former highs. Some 15 years later, Japans Nikkei Stock Exchange was trading at less than one-third of its peak level of the late 1980s.
In 1991, medical stocks suddenly caught fire. Merck climbed 80 percent. Pfizer went from $40 to $84 a share. Stryker went from $16 to $50. Across the board, medical stocks were climbing far faster than the market averages. PEs were moving into the 40 to 70 range. And once again, the rationalizations from Wall Street analysts began: "This time its different. The worlds population is aging, and the need for medical products will continue to expand. Thats why these stocks can support high PEs." But once the frenzy wore off in 1992, those stocks began to slide, continuing to decline for about two years to the point where great stocks with great earnings such as Merck and Bristol-Myers Squibb were actually carrying PEs in the low teens. They went from overpriced to under-priceduntil Wall Street finally rediscovered them in 1995 and pushed their prices back up to fair market value.
If you own stocks of a sector with PEs that seem way out of whack, be prepared to lighten your position. Your sell signal will be those wise words from Wall Street: "But this time its different." Get out, take your profit, and move on. Invoke the Greater Fools Theory to your own benefit and let the next guy take the fall. Or as General George Patton once put it: "The object of war is not to die for your country but to make the other bastard die for his."