Chapter I
An introduction to the stock market
What we’re going to cover
This first section is an introduction to investing and the NAIC. We will look at companies, what a stock is, stock markets, buying and selling shares in a company and so on. Many of you are probably already familiar with many of these terms and concepts, so this chapter is a review.
The National Association of Investors Corporation
The NAIC is a not-for-profit organization base in Madison Heights, MI. NAIC has about 750,000 members and 40,000 investment clubs. Investment clubs will be discussed in detail later. The goal of the NAIC is to teach individuals and groups how to invest in common stock.
NAIC was founded in 1951. The organization grew out of an investment club formed before World War II. Members of the club—on active military service in Europe and Asia—corresponded with each other. Military censors, who read all mail, became interested in the concept of an investment club and many of them wrote to club members asking for guidance in forming a club! This activity was one of the drivers for starting a national organization.
NAIC has four guiding principles that many have shown lead to success when investing in common stock; these principles are
1. Invest regularly
2. Reinvest all your earnings
3. Choose from among growing companies
4. Diversity to reduce (optimize) risk
Invest regularly
If you invest regularly, the implication is that you’re saving. That is, you’re setting aside a portion of your periodic income and not spending it. I can’t think of a single approach to successful investing that doesn’t involve saving.
With the change in retirement plans away from defined benefit (pension) to defined contribution (401(k) or (403(b)) people nowadays have the opportunity to save and invest regularly. You can have a portion of your salary deducted automatically and invested in various financial instruments—usually a mutual fund. We’ll touch on mutual funds later.
NAIC suggests that for those who save regularly, a portion of those savings should be directed to common stock. If you own a single share of stock in a company, often the company will let you buy additional shares at no or minimum additional fees. Currently, there are about 800 companies with such programs. These purchases—optional cash payments—are an excellent way to invest regularly.
There are many benefits to following this suggestion. If you diligently follow the NAIC approach while investing in public companies, you will also gain financial education. You will learn and become empowered, relying on yourself and not on others. You will no longer be scared by the professional explanations you hear; you will learn the language of finance. You will see what it takes to succeed.
Reinvest all your earnings
Be committed. If a farmer wants to have lots and lots of chickens, he can’t go around eating eggs. Companies often make periodic payments to shareholders (dividends). NAIC suggests that, where possible, these payments should be invested right back into the company. Many companies have programs called DRIPs (Dividend Reinvestment Plans). For many, DRIPs have proven to be a spectacular way to amass wealth.
Reinvesting allows you to benefit from one of the most remarkable forces on the planet: compounding. There are people who have been in DRIPs for twenty and thirty years. They have seen the dividend they receive grow steadily over time. The dividend they now receive on the original share they bought is now much larger than their original investment. That’s my kind of investment.
The last two activities have been kind of passive. You save, you invest, and you reinvest. Now you have to make a choice. It’s kind of a no brainer to select a company that’s growing. However, NAIC supports the idea that you look for a company that’s growing faster than the economy overall. In fact, select a company that doesn’t give a hoot about the ups and downs of the economy—a company that just keeps motoring along like the Energizer Bunny!
When we get into using tools such as the Stock Selection Guide and the Stock Comparison Guide, you will see that these companies tend to be leaders in their industry; the often do something different—they are winners. Actually, nine times out of ten, credit is due to a visionary, diligent, disciplined management.
Diversify to reduce (optimize) your risk
“It seemed like a good idea at the time.” We’ve all used that expression. No matter how discerning you become in the stock selection process, there will always be problems.
NAIC has a rule of five—it’s empirical—based on experience. The rule states that for five companies you purchase that just look great, one will perform much better than expected; three will behave as anticipated and one will be a disaster. Many people have “rule of five” stories to talk about.
Investing in common stock has risks. Some companies go belly up. That’s a good thing. It means there’s a better company out there that pushed them out of business. You have to keep studying and learning so you can spot this “better company” in the future. As you develop in investing acumen, you learn to spot the gems and avoid the duds!
If you have time on your hands, risk is a good thing. Risk implies variability of returns. In the stock market that means that prices jump all over the place. Keep in mind, while prices can be volatile, on the average, they trend upwards. Once you gain experience and learn about the companies in which you invest, you can use risk to your advantage. You will learn when the market overreacts to temporary setbacks by pushing the stock price down—it creates a buying opportunity for you: a patient long-term investor. In all your dealings with the market, keep one thing in mind: patience is genius in disguise.
Many people throughout the country—in fact around the world—have amassed large portfolios and mitigated financial worries by following these guiding principles.
Today, the NAIC has over 100 chapters all across the US. These chapters consist of over two thousand volunteers dedicated to teaching people the basic concepts that should lead to successful investing. Chapters run various programs on the NAIC tools, computer programs. Chapters also sponsor Investor Fairs® where people get to meet directly with companies.
The national organization publishes a monthly magazine, Better Investing, and other materials available to members. NAIC runs a number of national investor programs including the National Congress, held in the fall, CompuFest, held in the early summer, and InvestFest, held in the spring—both of which are educational programs. Detailed information about upcoming local and national events can be found on the Web Site (better-investing.org).
If you are interested in either joining or learning more about NAIC, literature is included with this text. End of promotion J!
What is a stock and what is a company?
A good question. It’s hard to answer this question without addressing the issue of “what is a company”? So, let’s start there.
Let’s say you had a great idea and decided to form a company. Well, there are three basic ways that one can establish a company: (i) form a sole proprietorship, (ii) create a partnership or (iii) establish a corporation.
Sole Proprietorship
In a sole proprietorship, an individual owns the company. That person often works in the company. Profits from the company become income for the owner—increasing his or her tax burden. A sole proprietorship is a popular form for a business; however, there are liability issues that force individuals to set up a different type of company. If problems occur, say legal problems, the sole proprietor holds the liability.
Partnership
A partnership is a similar in many respects to a sole proprietorship. A person might start a partnership if she didn’t have enough money to finance the business herself—she could get partners to help fund the business. Another reason might be that other people have particular expertise that is important to the success of the business. A partnership is when two or more people have an ownership interest in a company. An agreement is created that determines the form of the partnership and the degree to which each partner owns the entity. Profits and losses then pass to the partners in proportion to the ownership interest of each in the partnership. A disadvantage of a partnership is that the partners share liability. Let’s say that the partnership is granted a line of credit from a bank. If one of the partners borrows against the line of credit and absconds with the money, the remaining partners are liable for the debt!
Corporation
Finally, a corporation is a legal fiction—it’s like creating a new person except this “person” can’t vote; can’t drive a car; can’t be a space shuttle astronaut—well, you get the picture. However, a corporation does pay taxes, can employ people, enter into contracts, can own property and can even own other corporations. You can view a corporation as similar to a partnership except it’s a slightly different legal construct. One great thing about a corporation is the issue of liability. The owner of a corporation isn’t liable if the corporation does something (there are some exceptions, but these exceptions usually center around inappropriate acts on the part of the owner). This liability issue is an important reason why many businesses are structured as corporations.
A corporation can be created in any state. A charter is usually written that defines what the corporation is, what it does, and who the owners are. The charter defines how the ownership of the corporation will be designated. Shares in the corporation are created and these are divided up among the owners of the corporation. This process is described next.
The people who invest money (capital) in the corporation in return for an ownership interest are stockholders. They own part of the stock of the company. This ownership interested is defined in a document called a stock certificate. This document describes what portion of the company is owned by the person (or entity) named on that certificate. The corporate charter states how the company will be divvied up! It stipulates shares of ownership—shares. For example, if the charter stipulates that the corporation will have one hundred shares and that each of a hundred people received one of these shares in return for their investment, then each person owns one percent of the corporation. The shares of ownership in the capital stock of the corporation are divvied up among the owners in proportion to the amount they invested. To summarize, investments made into the corporation by people or entities (other corporations for example) are represented by shares (shares of ownership); these shares in total are called “Capital Stock” of the corporation.
Shareholders
Let’s start off with the following question—shares vs. stocks: what’s the difference in these terms? They are often used interchangeably. (I amazed that the spell checker told me I got interchangeably correct on the first shot!) The capital stock is the total money invested in a business—a corporation. When you buy shares of a corporation, you own a portion of the capital stock of that corporation. Hence the term “My stocks did well yesterday,” would be translated as “the shares I own in the capital stock of some corporations did well yesterday.” It could also mean “my stock certificates did well (increased in value) yesterday.” This definition will be touched on—from slightly different angles—again and again!
So, shareholders are the owners of a corporation; a single share (in the stock of a company) gives the owner certain rights. For example, corporations hold an annual meeting—the shareholders meeting. At this meeting a “board of directors” is elected. The board of directors represents the shareholders and oversees the corporation. This board appoints officers to run the company. Examples of officers include a CEO (Chief Executive Officer), a CFO (Chief Financial Officer), and various vice presidents of the corporation. Officers of the corporation and members of the board of directors are often referred to as “insiders,” as these people have “inside information” which is generally not available to the public at large.
So, let’s say you decide to form a company and you incorporate it—you create a corporation. If you have enough money to fund the operations of the company, you are the sole owner of the corporation—in other words you own all the stock in this corporation: 100% of the shares belong to you. Most people aren’t that lucky and they require others to help them fund the company. There are two ways to get the funds that you need: borrow them or “buy” them!
Bonds and Liabilities
A bond is a form of a liability—something that you owe. Let’s say you don’t have the financial wherewithal to finance your company, but you do know people who have money. You go to those people and say “If you lend me ten thousand dollars, I will pay you 2½% of that $10,000 at the end of each quarter for twenty years. I will also return the $10,000 to you at the end of twenty years.” If you both agree to these terms, then you have certain obligations to the lender. You have to pay the lender $250 at the end of each quarter—forty payments in all over the life of this “note”; giving a total payment of $10,000. You also agree to pay back the $10,000 at the end of year twenty. That’s one way of raising money. You can write a note, issue a bond. That is, you can create a fixed obligation that you pay over time.
There is a type of bond called a “zero coupon bond.”. This bond has a face value, let’s say $1,000; a lifetime—ten years, for instance, but does not pay interest. In this case, the purchaser of this bond might discount the face value—let’s say buy it for $150—in lieu of receiving interest payments.
Now, the bonds may be callable. You might be allowed to pay them off early, if you have the funds. The bonds could also be convertible. You could have a provision in your agreement with the lender that allows the bonds to be converted into a fixed number of shares of common stock. We’ll talk about this point later when we touch on the topic of dilution.
Other means of financing
Let’s say you don’t like the idea of being indebted. You know your business will be successful, but you’re also going to have a lot of expenses for the first few years. The idea of having to make interest payments every quarter could stifle the growth of your company—these payments are a form of risk. So, you now have to think up some other creative way to raise the funds you need.
Well, if you can’t borrow the money, you decide to sell these rich guys something that they might value—part of your company. This approach can take a bit of convincing. You have to sit and show them your business plan, let them know why you think that this idea has every chance of success. You describe the risks inherent in what you’re doing, but you also let them know that you have ways of at least addressing these risks. The people who invest in your company will undoubtedly want to have over half of the shares—they want to control the company. It’s their investment, so they want to protect it until they feel comfortable that the company will not only survive but thrive.
This private round of financing helps get the company off the ground. If this stage is successful, a number of things can happen, but very often the investors want shares of the company made available to the public at large. Going public allows broadening of the ownership interest and a potential windfall for the initial investors. This point will be discussed later.
Going public
A company might go through a number of rounds of private financing—stages in which wealthy investors put money into the company to fuel its growth. If the company is very successful, it eventually reaches a stage when it requires substantial funding. At this point the company might “go public.” In private financing, the shares of the company are held by a few individuals. These shares are “illiquid”: it’s not easy to sell them and convert them into cash. For one thing, there may not be a lot of buyers. If there are buyers, they might differ on what they think the company is worth. Bringing a company public—selling it to the public at large—can help alleviate a lot of these issues.
Let’s say business is booming and the future looks even brighter. The company might decide it’s time to share the wealth. Management approaches an investment bank and asks them to “bring the company public.” Documents are filed with the SEC (Securities and Exchange Commission), a statutory body with regulatory oversight on stock markets. Permission to bring the company public is sought and obtained. A prospectus is written that details two years of financials, goals for the future and various risks that might be faced. This prospectus is often called a red herring! The prospectus is made available to anyone who wants to read it. The bank then facilitates a “road show” where the company visits large institutional investors and makes a presentation about the value of investing in the new company. A ticker symbol is assigned to the company—a ticker symbol is a group of letters, a shorthand way of writing the company name. A day is chosen to bring the company public—to have an initial public offering, an IPO. A price range for the shares has been established. On the day of the IPO, the shares are transferred somewhere in the price range from the investment bank (or banks) to institutional investors and the public. The shares can then be traded! That is, the owners of the shares can sell to others through a mechanism to be discussed.
The number of shares a company can issue is given in the company charter—kind of like the constitution for the company. The charter stipulates the number of shares a company is authorized to issue. When shares are sold to the public at large, they are called issued shares; shares held by people and institutions are referred to as “issued and outstanding”: they are, in principle, available for trade. Companies seldom issue all the shares that the charter authorizes. Before more shares are issued, the board of directors must get permission from shareholders—the people who own the issued shares. Finally, sometimes a company will buy back its own shares. Now, I’m talking about the company itself making the purchase (remember a corporation is like a legal person in some respects) not employees of the company. If a company buys back its own shares, these shares are still called “issued,” but they are not outstanding.
Let’s say a charter authorizes a company to issue 10,000,000 shares of common stock. If the company sells 5,000,000 shares to the public through an investment bank, there are now 5 million shares of that company issued and outstanding. If the company decides to buy back 1,000,000 shares, it does so like any other purchaser. The company goes to a broker and makes purchases on the open market. Once the shares are bought, there are still 5 million shares issued but only 4 million shares outstanding.
Brokers and Exchanges
Brokers
Before we talk about exchanges, let me just tell you what a broker is. If you’ve ever bought or sold a house, you know already. A broker is someone who brings a buyer and seller together and facilitates a transaction between them. A stockbroker is someone who facilitates the buying and selling of shares and receives a commission for the transaction by way of compensation. A stockbroker is not a financial adviser (though some are certified as such), or a securities analyst.
Stock Exchanges and Markets: an overview | The “stock market” is used collectively to mean all markets: the NYSE, AMEX, the NASDAQ and so on. |
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Once a company has been brought public, the company is listed on an exchange or a market. The two big ones are the New York Stock Exchange, NYSE, and the NASDAQ.
Before we talk about the various exchanges or markets, let’s keep in mind what they are. A stock market is a place where one person sells shares to another. The market works just like any other market in that the buyer wants the lowest price and the seller the highest. By aggregating (bringing together) this trading activity, in principle both parties should be happy. If you have a lot of people selling and buying, you’ll have a range of opinions on an appropriate price for the stock. Hence, the chance of finding a seller and a buyer who agree on a price is likely to increase.
Another thing to keep in mind is that once a stock is listed, it’s sort of out of the hands of the company. Bill Gates cannot produce a list of all the shareholders. For one reason, as thousands of shares of Microsoft change hands each day, the names on that list (and the number of shares each person owns) changes continuously. | Keep in mind that the market capitalization changes day-to-day, even minute-to-minute. |
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The market does perform one important task: it offers a value for each listed company. For example, if the most recent trade of a company, ABC, is $50 per share and there are 100 million shares outstanding, the “market” is setting a price of $5 billion on the ABC Company ($50 per share by 100 million shares). This number, $5 billion in the current example, is called the market capitalization of ABC Company. In this regard, the stock market is like a public opinion poll for the value of each listed company.
NAIC methodology doesn’t put too much store in what the public thinks; we focus more on the fundamentals that are believed to drive the valuation. One technique, the Portfolio Management Guide, provides one way in which an astute investor can take advantage of insanity in the market place.
NYSE: The NYSE is one of the oldest stock exchanges in the world. It’s a classical exchange—and auction market. Companies listed on the NYSE (the big board) have a ticker symbol of up to three letters. For example, AT&T has a ticker symbol “T”; the ticker symbol for America Online is AOL. If a ticker symbol has more than three letters, it represents a company that is not listed on the NYSE. The NYSE charges fees to companies that want to be listed. The NYSE is one of the most expensive places to list a company. The exchange also has more stringent requirements that other exchanges or markets. For example, the NYSE requires that the company be profitable! As a result, start up companies, or companies in emerging industries are not generally found on the NYSE.
The NYSE has a trading floor where buys and sells occur. There are two major classes of people on the exchange, brokers (well traders) and specialists. These people “buy” a seat on the exchange. There are a limited number of seats (around 1400) and the price of each seat is based on demand. The role of the broker is essentially as described earlier. A specialist is something different.
Each company traded on the exchange has a specialist assigned to it. All trades for that company route through the specialist. The role of the specialist is illustrated in movies such as Greed. You have a person—the specialist—standing in the middle of a crowd of traders. These traders have buy and sell orders at various prices. The specialist works to ensure orderly trading in the stock; this specialist determines the current buy and sell prices. In the unlikely event that there are sellers for a company and no buyers, the specialist purchases the stock for his or her own account. Naturally, if there were sellers and no buyers you’d expect the price to drop: it does. The specialist ensures that the shares are purchased at steadily decreasing prices. He or she buys the shares in the order in which the sell-order is received. The exchange has guidelines for this activity.
Specialists have to have the resources to make many purchases in the unlikely event of a marked “crash.” In October of 1987, specialists on the floor of the NYSE ensured that anyone who wanted to sell shares was able to do so. The NASDAQ, discussed next, did not have such a mechanism in place.
I have just described the ideal scenario. In reality, with over a billion trades in a given day many of the activities I’ve just described are handled electronically.
NASDAQ: the NASDAQ has a different structure. The NASDAQ was started about thirty years ago by the umbrella organization for brokers: the National Association of Securities Dealers. NASDAQ is actually an acronym: the National Association of Securities Dealers Automated Quotation National Market System. So, this market is often abbreviated as NASD, NASDAQ or NMS. NASDAQ is a market rather than an exchange. There are no specialists on the NASDAQ, there is no trading floor—there is no exchange. The NASDAQ has a series of “market makers.” A company such as Microsoft (MSFT) might have many market makers assigned to it. The market makers are responsible for ensuring orderly trading in the shares of a company; they ensure that the prices move in an orderly fashion. The market makers set the price based on supply/demand criteria. In this way, they function in a role similar to a specialist.
Market makers often have an inventory of shares; specialists have their accounts too. Market makers (or other brokers) could sell from this inventory.
Companies on the NASDAQ have a ticker symbol of four or five letters. Remember NYSE companies have one to three letters. Requirements to list on the NASDAQ are less stringent that those on the NYSE. Companies do not have to be profitable; however, there are minimum requirements for assets. This topic is discussed later.
The differences between the NYSE and the NASDAQ aren’t too important. In fact, the structure of these two means of buying and selling share is merging.
Other Exchanges: Aside from the NYSE, there are regional exchanges in Philadelphia, Chicago, San Francisco, etc. These exchanges, as measured in number of trades per day, are smaller than the NYSE. They function in a similar role. There are also electronic exchanges. These electronic exchanges are becoming responsible for an increasing number of trades in a given day.
What happens when I place a trade?
Nowadays there are a number of ways you can buy or sell a company; however, no matter how the trade is initiated, the ensuing sequence of events is the same.
Let’s say you are sitting at your computer and you want to buy 500 shares of Microsoft (MSFT). What you have to do is to give instructions to your broker. In this example, the instructions are being given electronically; however, if you called the broker or visited her office, the same information would be required.
You need to know the ticker symbol. If you don’t have it, there are a few places to look. The Wall Street Journal (WSJ) is an excellent resource. I’ll talk about the WSJ later. You can also go on-line. A list of on-line resources is provided in the first Appendix.
The following pieces of information will be required:
1. Is the order a buy or sell
2. Is the order a market, stop or limit order
3. What is the time limit: Good till canceled, Day only, immediate
4. How do you want the transaction to proceed? Do you have a minimum quantity? Do you want all or none?
You have to be able to respond to all these questions.
Answering the first question is easy: you know if you want to buy or sell. The next question is a bit trickier. If you select a market order, you’re telling the broker to buy the shares of Microsoft as soon as possible at whatever price they are trading. Many people don’t want a market order, they prefer a limit order. In other words, they like to specify the price.
Let’s say you got interested in Microsoft at $70 per share. You have tracked the company looking it up in your copy of the WSJ and you noticed that the share price has bounced around from $68 to $74 over the past few ways. You have $35,000 lying around and you want to buy 500 shares at $70 per share. You place a limit order. You specify that you want the purchase to be made at $70 per share or lower. If you’re selling shares and you place a limit order at $70, you are requesting that the order be executed at $70 per share or higher. Buying low and selling high are generally good things!
Ok, so you have specified the company name (via a ticker symbol), you have stated you want to buy shares in the company; you have asked that the trade be a limit order at a price of $70 per share: next you have to specify the time limit.
You have a number of choices here. You can ask that the order be filled immediately (fill or kill). An order is killed if it is halted before it can be confirmed or executed. You can say that the order should be executed some time today (day only). Finally, you can stipulate that order is “good till canceled.” (GTC) An order that’s GTC will generally hang around for two to three months waiting for the price to come to your limit order. When it hits the price, chances are it will execute.
I say “chances are” because there’s one more piece to the puzzle. You have to let the broker know if you’re willing to let the trade be broken up into smaller pieces. A lot is 100 shares. Trades are normally executed in lots. An odd lot is a number that isn’t evenly divisible by one hundred. For example 62 shares is an odd lot as is 148. The more shares you try to trade, the tougher it becomes to execute the event in one fell swoop. As orders are placed, they are “queued up.” Those at the head of the queue have the right to be executed first.
If your order to buy 500 shares at $70 is facing acceptable sell orders in the queue that ask for trades of 100 shares, 400 shares, 300 shares, 10,000 shares, it might be tough to match things up. In most cases, it is never a problem. So stipulating “all or none” (AON) doesn’t present a difficulty. If you don’t do this, the order might execute in segments. You might see the 500 be filled in three events: 200 shares, 100 shares and 200 shares. If you have a flat fee per trade, you might incur three commissions for this trade. If you specified “all or none” and the trade was actually split you, you would likely only incur a single commission.
Let’s say you wanted to buy 6,000 shares of a company that has an average daily volume of 100,000 shares. You might want to specify a minimum quantity of 1,000, 2,000 or 3,000 shares. This scenario could happen when you place a GTC limit order for 6,000 shares—all or none—that never executes, even if the limit price is reached repeatedly. Maybe the orders just can’t be matched up.
By the way, this hypothetical queue of orders doesn’t wait until the order at the head is executed. If a match between buy and sell cannot be achieved, the next order in the queue is examined. There’s a certain supermarket I know that should invoke that policy at their deli counter!
Generally speaking, a market order with no stipulation on the number of shares has the best chance of executing. If you place a limit order with a minimum quantity or all or none, then making it good till canceled will likely increase the probability that the trade is executed.
If your limit order for 500 shares of Microsoft is executed, you’re now an owner of the company. If you so request, you will be issued a stock certificate. You will then become a shareholder of record. Often, a brokerage company requires payment of a small fee for issuance of a stock certificate—the fee is around $25, but it depends upon the brokerage company policy. If you decide to become a shareholder of record, this fact is recorded by a person called the transfer agent. The transfer agent keeps records for the company. If you elect not to receive the stock certificate, then the certificate (actually an electronic certificate nowadays) is held by the broker and the shares are held in street name. The broker in some respects acts as the transfer agent and keeps track of who owns what. If the company wants to talk to the shareholders—announce a stock split, issue a report—this action is carried out through the broker. In street name, you still own those shares, but they’re held by the broker for you.
What’s a spread?
Let’s say you want to by those 500 shares of Microsoft at $70 per share. Chances are your order will be matched with someone who is selling 500 shares at some price lower than $70: maybe $69½ or $69¾ per share. The broker, or other middleman, arranges trades to buy shares at, say, $69½ per share, and sell them to you at, perhaps, $70 per share. This difference between the buy and sell price (the bid and the ask price) is the “spread.” So the transaction is profitable for three reasons: the seller pays a commission, the buyer pays a commission and the middlemen get to keep the spread. Actually, the spread I used, 50¢, is high nowadays. Spreads are often lower than this—depending on the company in question.
If the company is very liquid, then the spread is lower. Liquid means a lot of trades per day. If the company doesn’t have many trades per day—that is, it is illiquid— then the spread between the bid and the ask price is likely to be higher.
What’s a stock split?
Stock price appreciation correlates with earnings. If a company performs very well—increases earnings steadily from year to year—then the stock price is also likely to appreciate.
When companies go public, the IPO price is often placed in the teens. If the company is a great growth company—growing at 30 to 40% each year—it won’t take long for the price of a share to exceed $100. High priced shares are not necessarily a concern for institutional investors—pension funds, etc.—where trades of $500,000 are not uncommon. However, a high priced share can cause problems for the small investor. Here’s why.
People still buy shares in round lots of one hundred. If the price of a single share is $100, the trade would cost $10,000 (100 shares times $100 per share) plus a commission (often $5 to $30). The average portfolio (collection of stocks) is under $40,000, so $10,000 worth of a single stock reduces the overall diversity of the portfolio. Companies have stock splits to alleviate such problems.
If the shares are trading at $100, the company might declare a two-for-one stock split. In other words, once the split takes effect, each share becomes two shares; the stock prices drops in half. If you owned 100 shares of a company worth $100 each, after the split you would own 200 shares each worth $50. The total investment is identical in both cases.
Stock splits can make the shares more liquid, since the number of shares has increased and the price has dropped.
Some other definitions
Fiscal Year versus Calendar Year
Sometimes companies have a New Year’s Day that differs from January 1! For reasons that may be related to their business activity, the company has a financial or fiscal year that does not coincide with a calendar year. For example, if you are retailer, you might want the fiscal year to end on June 30. The period leading up to December 31, can be very hectic. Trying to manage sales and close out all accounts for the year could be a daunting task. Further, if sales are slow in December, you could try discounting in the spring to get revenue numbers up for the fiscal year! The major impact that this issue has is when it comes to the Value Line Investment Survey—see appendix 3 for details. In Value Line, stock prices are reported on a calendar year basis, while financial results are reported on the company fiscal year.
What’s the business cycle?
I’ll start off by talking about another term—the GDP or gross domestic product. The GDP is the sum of all goods and services, that is, a measure of economic activity over a period of time—normally a year. Items that make up something else—production of doors that become part of cars—aren’t counted towards GDP, just the final items. Most of the time, the GDP grows steadily—usually due to increases in productivity. However, on occasion the GDP declines. If the GDP declines for two or three consecutive quarters, the economy is said to have entered a recession. (Some people say two quarters, while others prefer three—imagine: economists disagreeing—well I never!) The business cycle is the cycle of change in economic activity (as measured by the GDP) over time. This cycle—from low-point to low-point—is irregular. Currently (August 2000) we’re in the longest period of expansion (growth after a recession) ever measured.
If a recession is very severe, the GDP declines extremely sharply and many people are put out of work, this recession is referred to as a depression. The last depression occurred in the 1930s. Economies in the western world are now structured such that depressions are very unlikely to occur. In fact, there has been no major depression or serious hint of a depression in western countries since the recovery after World War II.
What’s a growth company
As is often the case, opinions can differ on what constitutes a growth company. This definition is probably the only time that I don’t care about earnings! I define a growth company as a company with revenues that are impervious to the business cycle. A growth company has steadily increasing sales even when there is a down turn in the business cycle. Growth companies can have erratic earnings, but the growth in the top line on their income statement is not affected by the business cycle.
What’s the business life cycle?
Think about the Roman Empire. It had an introductory phase—Romulus and Remus founded the thing. I had an early growth phase. Rome was a small city state surrounded by others. The Etruscans had a much larger nation and could have conquered the Romans. It had a rapid growth phase—growth through “acquisition.” The Romans went around conquering peoples. Actually, it had a few distinct growth spurts. The early empire had competitors—Carthage—but Rome proved more adroit and eventually neutralized competitors. The empire had a long mature phase when nothing much happened. They experimented with different management styles, republic, temporary dictators, eventually settling on monarchy. There were frequent internal struggles for the top job. Although the empire was successful and profitable, it decided to have a spin off. The empire split in two: east and west. The Western Empire went into a decline phase (AT&T J); competitors entered once safe markets, eventually the empire collapsed. The Eastern Empire flourished (Lucent J) and outlasted its parent by a thousand years. You’ve just learned about the business life cycle for the Roman Empire.
Every business goes through such a cycle. There’s the early phase when the company has a new idea. The company is small and vulnerable. However, being small, the company is not on the radar screens of competitors. There’s a growth phase. The market is now becoming established. Dozens of companies form as people sense great opportunity. There are sufficient customers that there is not too much competition among companies. Growth is rapid and sustained by expanding the market. The companies then enter a phase, still a growth phase, where competition among companies starts. Margins start to shrink and consolidation within the industry occurs. As the rate of growth slows down further, the remaining companies enter a mature phase. They generate cash; however, the market is close to saturation, so companies pay this cash out as dividends. Every industry reaches this mature phase where the rate of consolidation slows down, but doesn’t stop. Eventually, 90% of the market is held by three or four companies. Finally, new technology kicks in and the big, well-established behemoths don’t respond fast enough and start an inexorable decline. Sales collapse, margins shrink, the industry folds.
The figure that follows traces out the business life cycle. You can think of any industry and follow its progress along the curve. The rail industry is in the decline phase, while the Internet is in the early growth area. The auto industry is in the mature phase; the biotech sector is probably in the mid growth area.
What’s a mutual fund?
A mutual fund is an investment vehicle that offers shares to the public. The mutual fund uses the cash obtained in selling these shares to invest in financial instruments. Mutual funds have professional managers. The funds usually have a defined investment style: exclusively common stock, specific industries or sectors of the economy. Unlike public companies, there is no secondary market—“stock exchange”—for mutual fund shares. The shares are bought from and sold to the fund.
What’s the deal with professional money mangers?
Professional money managers are all grouped together as if they’re one thing—which they’re not. We most often think of a money manager as someone who is in charge of one of the thousands of mutual funds. That person makes decision as to what stocks should be bought and sold. Peter Lynch is perhaps the most famous of all mutual fund managers—he’s a bench mark!
Money managers often compete with one another for the investing public’s dollars. Since the investing public looks for past performance, companies often put pressure on their managers to perform well on a quarter-by-quarter basis.
Over the long term, the vast majority of actively managed funds (over 90% by some reckoning) under-perform the overall market. Often, fund managers cannot risk buying out-of-favor companies—like the pharmaceutical industry in 1993/4. Such companies might put a short term drag on the overall performance of the fund. Individual investors often do not have this restraint. They can buy companies when they’re selling at a cheap price.
Reading a Stock Table
It’s easy to get basic information the share price of a company; this information is displayed in most national and regional newspapers—most likely in the business section. The three main national papers that NAIC people look at are the Wall Street Journal, Investors Business Daily and USA Today.
The Wall Street Journal
The WSJ is the granddaddy of them all. It’s published by Dow Jones. The stock price information is included in section C and has a standard format. Prices are provided for the New York Stock Exchange, the American Stock Exchange (AMEX), which is now merged with the NASDAQ, and the NASDAQ.
The Journal reports stock quotes in a format that’s easy to follow and is mimicked, to a lessor extent, in most regional papers. An excerpt from a stock page of the Journal is below. There are thirteen columns, each with a different piece of information. From the left they are as follows:
1.
This column contains footnotes, which provide information about the company or the stock. For example, the letter “s” means a recent stock split (discussed later), “n” means the stock was issued in the past 12 months, an up arrow indicates a 52-week high, while a down arrow means a 52-week low. These footnotes are explained in section C of the Journal.
2. This column contains the high closing price of the past 52 weeks.
3. This column contains the low closing price of the past 52 weeks.
4. An abbreviation for the name of the company. In some regional papers, the ticker symbol isn’t provided, but there is some kind of abbreviation for the name of the company.
5. This column contains the ticker symbol: a unique representation for the company. On the NYSE (and AMEX) ticker symbols are between one and three letters; ticker symbols of four letters are found on the NASDAQ; if a NASDAQ ticker has five letters, it means that the company is based overseas—it’s a foreign corporation.
6. This column contains the dividend, if one is paid. This term will be explained in detail later. Suffice it to say that a dividend is a cash payment authorized by the board of directors of a corporation and paid to the shareholders.
7. This column gives the dividend yield—this term will be discussed later in Chapter III.
8. This column gives the PE or Price Earnings ratio. We’ll cover this topic in detail in Chapter III. The PE ratio is the price of a share divided by the earnings per share.
9. Here we see the volume for the preceding trading day. The volume is in round lots: trades of 100 shares. So, if the column says 2,345, it means that 234,500 shares were traded in the preceding day.
10. In a given day, the price fluctuates. This column shows the high price the shares reached in a given day.
11. This column shows the low that the shares hit. If you are interested in following price movements in details, you can log onto bigcharts.com. There you can plot the price movement (and volume) minute-by-minute if you’re so inclined!
12. This column gives the closing price for the shares. This is the number reported on shows like The Nightly Business Report, and Wall $treet Week with Louis Rukeyser.
13. This column shows the price change from the last trading day. For example, if a company closed at $20 per share today and $19¾ yesterday, the change would be +¼ or a 25¢ increase.
That’s it. This is the information that the stock tables in the Journal provide.
Investors Business Daily
IBD changes the information in the stock tables from day to day. I won’t really focus in too much on IBD. It does provide very valuable information. It charts the price behavior for stocks that are in the news. IBD focuses more on technical analysis and so ranks stocks for timeliness. For more information on IBD, I suggest buying a copy. From the perspective of a fundamental investor, IBD provides the information you require—and more!
USA Today
USA Today keeps the same format each day! A copy of the stock table from the NYSE taken from a recent edition is below.
The picture is a little hazy, but USA today reports just a few things. A fifty two week high and low appears first. The price range is followed by the name of the company (an abbreviation not the ticker symbol). The annual dividend is the reported. The dividend is followed by the PE ratio based on trailing earnings per share. The concept of PE and trailing earnings is discussed in Appendix 3. The final trading price from the previous day is reported; this number is followed by the change oat the close on the day immediately preceding this report.
What are the S&P500 and the Dow all about?
When listening to the national news, radio stations or other financial news outlets, one often hears about the Dow, the NASDAQ, the S&P, the Russell the Wilshire and so on. Each of these things is an “index”: a snapshot of the market or part of the stock market.
An Index is reminiscent of an opinion poll: a sample that’s meant to be representative of the whole population. The Dow, or the Dow Jones Industrial Average (DJIA) is a collection of thirty large companies. The Dow contains companies like Intel, McDonald’s, Wal-Mart and Microsoft. The Dow is the oldest index—it’s been around for well over a hundred years. In the early days of the Dow, the index contained railroad companies, later steel companies, today more technology companies.
The S&P500 is the most widely copied index. It contains 500 companies representative of the overall economy. The S&P is a “weighted index”—it’s weighted to the market capitalization of the member companies. So if one company (Company X) has a market capitalization that’s ten times that of another company (Company Y)—and both are members of the S&P—then Company X is weighted ten times as much as Company Y. If you’ve heard of an “index fund,” it’s a mutual fund that mimics the makeup of the S&P500.
The Wilshire 5000 is an index that represents the overall market. It is a weighted index of about 7000—despite what the name suggests.
How do I find a good company?
According to Peter Lynch, it’s staring you right in the face! Peter Lynch has the philosophy that you know from your experience at work or at home, who provides the best service. Chances are when you investigate further, you will fine an excellent company behind that superb service.
The best way to find a good company is to look for one. I know that this statement is trite, but it is also very true. In the next few chapters you will learn about the NAIC methods for analyzing companies. One thing will be clear: good companies jump off the page at you. Let me tell you how these tools work; you’ll get more information as we proceed.
First off, the SSG summarizes key financial information of a single company into a standard format. As you get used to the SSG, you will become familiar with the key indicators of quality.
Once you have an SSG completed for your target company, you then complete SSG’s for competing companies in the same industry. The SCG allows you to compare a number of companies and select the strongest. You can then read up on the industry; get analysts reports from the investor relations department of a company; decide for yourself if this is the industry for you. Time and time again, you will discover than one or maybe two companies stand out in a given industry: they just do things right. Microsoft stands out among software companies; Southwest Airlines jumps off the page when you look at airlines; if you start in on drug stores, Walgreen has an impressive past; Johnson and Johnson looks like some kind of machine! McDonald’s has an impressive track record. I am not recommending any of these companies; I am pointing out that their histories look pretty good.
So, you do the SCG and find a company that you like. Once you have amassed a number of companies, you have a portfolio. You manage this portfolio using the PERT. PERT will tell you when a company is “on sale”: when the share price is lower than it is on average based upon the company earnings. PERT is a great way to stock up on a company when the world turns against it. I personally love it when bad things happen to good companies!
You can get ideas from any number of sources: friends at work, at church, at little-league; publications like the Wall Street Journal, Business Week, Better Investing Magazine, &c.; television shows such as Wall $treet Week with Louis Rukeyser, the Nightly Business Report; Moneyline, CNBC shows can all be invaluable sources of information. All of these sources can be launching pads for further investigation.
I think that investment clubs have a particular advantage in this area. A club usually consists of a diverse group of people with a variety of work experiences. These experiences can give a club an edge in analyzing a host of different industries. Learning the structure of an industry, the relationships and leaders within an industry are important. People who actually work in a given industry often have a head start in understanding it—the structure, terms, competitors, regulatory environment, and so on. As you become more experienced with your companies, you learn more. Being part of a club gives you a bit of an edge right at the get-go!
How do I research a company?
The best way to start off your research on a company is to get ther annual report. The annual report is a publication from the management of the company to shareholders. The report details what the company does and what it plans to do; key news; who the main players are; a list of the board of directors; financial information with some explanations. I’ll touch on the annual report later in this section.
There are a host of on-line resources available and many of these are listed in the first appendix. Keep in mind a few things (1) just because it’s on the web doesn’t mean that it’s true; (2) you often read someone’s opinion; the person’s time horizon could be very short.
Media reports on a company can also be a good starting point. There are now many cable companies dedicated to providing financial information to the masses: CNBC, CNNFn and Fox all have shows that run from early morning until evening providing detail on companies and the markets. Once again, caution should be exercised here as these programs often concentrate on price movements without regard to the long-term fundamentals that can drive value. Keep in mind that the market is a public opinion poll; these shows are like the Weather Channel for all things financial. A farmer would not likely change his opinion on the climate just because a storm is forecast! You’ll find when it comes to things financial, the media focuses on the “weather”; NAIC investors learn the rhythms of the climate!
Sources of Information
When analyzing a company, you will want financial information. To see how well a company has done, you need to examine the numbers. There are a number of sources of information. You can go to the company itself and ask for the annual reports; you can also review the 10-K and 10-Q. There are also companies that gather and publish financial information. The two big sources in this field are Standard and Poors and Value Line. There are others, but these are the big guys! Standard and Poors (S&P) reports faithfully the numbers a company publishes. If you want exact information, S&P is for you. Value Line, on the other hand, normalizes data. There is a discussion on Value Line in appendix 3. Many NAIC people prefer Value Line to S&P, because Value Line focuses directly on the operations of the company.
What’s Fundamental versus Technical Analysis?
Fundamental analysis focuses in on what drives the earnings engine of the company. It gets in under the hood of the company. Technical analysis, in its purest form, concentrates more on what other people think of the company. Technical analysis likes to look at stock price behavior and is not as concerned as to what is driving that behavior. Say you’re at a motor car race. A fundamental analyst is interested in the cars, a technical analyst prefers to study the crowd.
A word or two about accounting
Keep in the following in mind. This section is written to augment your studies. I write it because it supports my perspective on investing and helps support the NAIC tools. You don’t have to read this section if you don’t want to.
Like it or not, as you delve into the world of investing, you’re going to learn a little bit about accounting. When most people think of accounting, an image of bookkeeping probably pops into the head. As you’ll discover—I hope—accounting is much, much more than bookkeeping.
The goal of accounting is to provide financial information so that people can make a decision. Accountants attempt to provide accurate information about the health and operations of a business. This activity is a little trickier than you might think. | An asset is a probable future economic benefit obtained or controlled by a particular entity as a result of a past transaction or event. |
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Let’s say that you an importer of widgets—Garden Widgets Inc. You import the widgets from SinoWid—a leading Chinese manufacturer. You have exclusive rights to sell these products in the hot US widget market. You start of with $1 million in cash, which you use to invest in a warehouse to store the widgets. These things—cash, a warehouse, even the widgets—are assets. An asset is something that is likely to have economic value some time in the future; the asset was purchase or otherwise obtained by the company as a result of something that happened in the past.
Depreciation and amortization
If you invest $500,000 to buy the warehouse, have you incurred a $500,000 expense. Well, you might have exchanged an asset of a half million in cash for a different asset called a warehouse, but accountants would say it’s not really a one time expense.
If you think the useful life of that warehouse is 25 years, the presumably this asset would be used up—depreciated—over that time. In fact, your half million dollar investment would be expensed over 25 years—perhaps at $20,000 per year
Depreciation is the consumption of a tangible asset—a physical asset, such as a car, a machine, a building, etc. An intangible asset, on the other hand, is not physical. Examples of intangible assets include things like trademarks, know-how, patents and so on. Intangible assets are used up over time too—a patent has a life span. Consumption of an intangible asset is called amortization.
Who decides how fast things depreciate, what an asset is and so on? Well, accounting practices should adhere to a thing called generally accepted accounting principles or GAAP (pronounced just like the clothing store!) GAAP is almost a dynamic tradition! Accountants patrol one another to make sure that what they’re doing makes sense (and earns dollars—sorry!) The industry is really self regulated—and that’s the way it should be. The system works! (Stepping off soap box!) When it comes to accounting for financial reporting purposes, another body is responsible for establishing GAAP: it’s the Financial Accounting Standards Board—FASB (pronounced FAZ-bee). The SEC has delegated the authority to FASB to come up with rulings for interpreting GAAP.
Revenues and expenses
Let’s talk about revenues for a second. A revenue item seems pretty self-explanatory. We’ve talked about an asset already—it’s something of value a company owns. A revenue is something that increases the size of an asset. You’ve heard the term “revenue stream”; imagine a stream of revenue—let’s say cash. As it flows into your company it increases your stockpile of cash—your stockpile is an asset. However, there is a wrinkle when it comes to accounting. Imagine the following events in the life of a widget order
1) You receive a purchase order from IBM for 1,000 widgets at $100 each
2) You get the widgets from your warehouse and package them
3) FedEx picks up the package and off the widgets go
4) You send an invoice for $100,000 to IBM in a separate FedEx shipment
5) FedEx confirms the arrival of the widgets
6) IBM sends a document acknowledging receipt and acceptance of the widgets
7) A check for $100,00 is received from IBM
8) You lodge the check into the company checking account
9) The check bounces! (just kidding—sorry IBM)
Here’s the question for you: in which of the nine events above can you recognize (record in the books) a revenue for $100,000. The general rule in accounting is that revenues are recognized when they are earned and expenses are recognized as they are incurred. This rule is called the accrual principle. The accrual principle has a corollary called the “matching concept.” In reporting the financial activities of a business entity, accountants try to associate all relevant expenses with the appropriate revenue. You can almost picture this concept as a cause and effect relationship: effort and results are matched together.
So, in the example above, when does this revenue recognition occur?
Well, you have some latitude here. Most people would agree that the revenue should be recognized at or before step 8—let’s not wait until the check clears. No complaints received from GAAP. Some might recognize the revenue at step 7—again, nothing wrong with that. How about at step 5 or 6—that would work. Step 4 anyone? Well, some companies would recognize the revenue at step 3. Garden Widgets would be well served to recognize the revenue at step 3—Note, cash has not changed hands at this point. Revenue and expense recognition has nothing to do with transfer of cash.
Think of it this way, Garden Widgets is in the business of selling products to a customer. They’re only going to sell to people whom they believe can pay their bills. So once those widgets are shipped out the door, most of the work in the sale has been done. It’s fine to recognize the revenue at that point.
A revenue is recognized then the business activity is essentially completed. Once those widgets are shipped and not available for sale to anyone else, it’s time to recognize the revenue. If a company decides to be super conservative in its revenue recognition, it might wait until some other point. However, the key point is that when the widgets are shipped, revenues could be recognized at that point. The revenues are realized when the cash is received—when the transaction (swapping one thing for another)—is completed. The terms recognition and realization are related one to the other, but they do not mean the same thing.
In fact, mention of a company being super conservative leads me to another point. A principle exists in accounting referred to as conservatism (sounds like the Tories are back!) This conservative principle means that when accountants have two or more choices, they select the one that is less likely to overstate assets or earnings. You often read in Business Week or the Wall Street Journal criticisms of accounting practices that are not conservative. This principle might sometimes conflict with the historical principle. On occasion, accountants will write-down (devalue) an asset, when it is believed that its value is overstated on the balance sheet. Although this violates the historical principle, it preserves its overall intent.
When accountants report financial information, they are doing a balancing act with a series of accounting principles. The information has to be accurate and meaningful yet conservative; it has to be useful for making decisions in the future yet adhere to an historical principle. Accounting for financial reporting purposes is a tough job!
For various reasons, some customers just don’t pay, so Garden Widgets might create a special account called the “allowance for doubtful accounts.” They could split the sale up: 98% as a revenue, 2% to the allowance for doubtful accounts. As you read company financial, you will see that not all customers pay and that judgement is exercised in offsetting some of the revenue stream to cover these occurrences.
Expenses, which decrease assets or increase a liability, are recognized as they are incurred. If you import a lot of product from SinoWid, none of that product would be expensed until it is sold. The widgets in the warehouse would be recorded as an asset called inventory. I’ll talk about inventory in a minute. There’s one big exception to this rule: R&D expense. R&D is expensed immediately. So if a pharmaceutical company spends $500 million over ten years, those funds are expensed as they are incurred. When we get to talk about a thing called ROE, return on equity, the consequences of this matter will be clear. The key thing to keep in mind is that if a company buys some kind of an asset that has a useful life of over a year—that item will be depreciated. Each reporting period (four times each year), you incur depreciation expense for that item.
Depreciation and financial reporting
Let me say a little more about depreciation. You’re getting a belly-full here, but you can come back and read it later, if these topics crop up again. To recap, depreciation is the “using up” of a tangible asset over time. There are two things you have to decide when you depreciate something: over what period of time will you depreciate it and how much will you depreciate each period. But, there’s more! Depreciation for financial reporting and tax reporting purposes are not necessarily the same. For example, let’s say you work for Pfizer and you buy a chemical reactor (a 4,000 gallon reaction vessel) to manufacture a pharmaceutical product. You spend $2 million to buy and install the thing. The IRS might have you depreciate this asset over seven years, even though the manufacturer says that it will last twenty years. Further, they have a depreciation schedule that might have $500,000 in year one, $400,000 in year two, $300,000 in year three—a modified kind of depreciation schedule. When you develop your books for the IRS, you follow their rules for depreciation.
When it comes to reporting for financial purposes (shareholders, Wall Street and so on), the depreciation differs. You might have a nice linear schedule—an equal amount in each period—or some kind of non-linear schedule (of which there are many). So, the chemical reactor that Pfizer bought would likely be depreciated over twenty years—its useful life. The asset would be depreciated at a rate of $100,000 per year, or $25,000 in each quarter.
The bottom line is that when you look at an income statement prepared for the IRS and compare that to one prepared for shareholders, they would differ. There’s nothing sinister or underhanded going on here—it’s all perfectly legal! Again, you’ll have to wait until later for a discussion on the consequences of this difference.
Inventory
Now for something else about inventory. It all sounds pretty simple: you buy the widgets at $100 each and as you sell them, you incur an expense for one hundred bucks per widget. However, what do you do if you buy widgets for different prices due to currency fluctuations? You might think: you charge for the widgets you sell; however, for accounting purposes, you don’t have to do it that way—sometimes, you just can’t! Here's a case for you to think about.
You work for Continental Airlines at the Newark hub. You’re the Director of Fuel Management. You have tanks that store 2,000,000 units of fuel: half the tanks are for overflow and are usually empty. You really only need 1,000,000 units, so that’s all you keep in fuel inventory. Fuel prices plummet to $1 per unit, so you decide to fill the empty overflow tanks. So you buy 100,000 units a week. The price spikes $1.10 by the first week, it’s $1.20 in week two. By the tenth week, the price reaches $2.00! So, then you start to use these extra 1,000,000 units, how much do you expense per gallon? Tricky. They’re all mixed up together in the overflow tanks.
Well, accountants have two methods to use up inventory, abbreviated as LIFO and FIFO. They’re not dogs! LIFO is last in, first out. And, you guessed it, FIFO is first in, first out. So, if you used LIFO and put 100,000 units into various aircraft, you expense this fuel at $2 per unit—the last fuel in cost $2 per unit. With FIFO, you would expense $1.10/unit—the first fuel in storage cost $1.10 for each unit. Once again, the consequences will be discussed later. However, if you wanted to minimize your expenses, in this example, you’d prefer $1.10/unit. When accounting for inventory, companies sometimes change from LIFO to FIFO and vice versa. It can be used to “manage earnings” If a company changes accounting practices for inventory, it will be noted in the financial statements.
I have talked over a lot of issues. So, let’s get cracking on where the financial information originates—financial reports.
Company Financial Information—the Annual Report
As mentioned in the last section, public companies are required to provide information to their shareholders and other interested parties. This information is provided four times per year in quarterly and an annual report. These reports provide a summary of the financial status of the company. In addition, the company files information with the SEC, the Securities and Exchange Commission; there are two basic reports: the 10-Q for quarterly information and the 10-K for annual information. The financial information in annual reports can differ from the 10-K. There’s nothing sinister in the reason for these differences. Shareholders need information useful in making an investment decision. The SEC has strict requirements that detail what a company must report. You can ask a company for their SEC filings (10-K and 10-Q) and use these to augment what you find in the annual report.
In the next few sections, I want to detail exactly what you will find in the annual report of a company. While annual reports differ from company to company, they all have the same basic structure. Keep in mind that when numbers are reported, except for per share data, they are in 1,000’s. For example, when you see depreciation and amortization totaling 17,795, it means 17,795,000—almost $18 million. The three trailing zero’s are discarded to simplify the reporting.
Letter to the Shareholders
The first few pages of the annual report contain some useful information. The inside cover often has a summary of recent financial highlights. These will contain information from the balance sheet and income statement that you will learn about in detail later on. It is an opportunity of management to present recent impressive events.
The letter to shareholders is an excellent place where you can hear directly from management about the strategies and future prospects of the company. Until recently, this letter was about the only place to get such insight; however, nowadays, CEO’s regularly appear on channels like CNBC where they gladly discuss company strategy and recent events. Nevertheless, the letter in the annual report is carefully written and should be read with equal care. If management feels that there might be problems ahead, they could subtly alert shareholders to this possibility in the letter. I have a tendency to amplify any hint of bad news. If you read a phrase like “we are working to aggressively counter some gains by competitors in the southwest,” I read the worst into that. They’re in trouble in some area; their competitors are eating their lunch and the company is forced to react. I get a kick out of translating “spin” into English. Maybe I err too much on the side of caution, but I believe it’s better to be conservative. Pleasant surprises are better than nasty shocks.
The Balance Sheet
The balance sheet is a listing of the company’s assets and liabilities. If you think of your own personal finances, you have things that you own: a house, a car, furniture, food and so on. You also might owe money. There could be a mortgage on the house; a home equity loan, a car loan and some credit card debt. The difference between what you own (your assets) and what you owe (your liabilities) is what you’re worth (your equity).
A balance sheet is a listing of the assets and liabilities of a company together with a listing of the shareholders equity. If you think about it, if you subtract off the liabilities from the value of the assets, you get the shareholders equity. Think through the example of personal finances discussed in the preceding paragraph.
Assets are listed in a specific order: in the order of liquidity. Liquidity is a subjective measure of how quickly and easily something can be converted into cash. Cash is clearly liquid. Stanley Cup Playoff tickets are pretty liquid too—fans will pay to buy them. Property on the other hand can be illiquid. Selling property takes time and involves expenses—if it takes time or there are costs involved in converting an asset to cash, it makes that asset illiquid.
Below is the balance sheet for Clayton Homes, taken from the 1999 annual report.. Note all figures are given in thousands, so $2,680 is really $2.68 million
Let me first run through some of the items on the balance sheet, just to explain what they are. Whenever you see something in parentheses it means it’s a negative number. For example, a loss of a million dollars would be abbreviated as ($1,000). You’re going to have to think back to the example earlier of a company importing widgets from China. Revenues are recognized as a receivable. . You decide (based upon the norms in your industry) when you book the revenue. It might be when you ship the widgets out of your warehouse, or when the FedEx acknowledges receipt. Whenever that event occurs, you create a receivable. When you receive the actual payment, the receivable becomes cash. You can view a receivable as a sale that is not yet cash. Say the receivable is $1,000; upon payment, receivables are decreased by $1,000 and cash is increased by that same amount.
The concept of an inventory as an asset is reasonably self-explanatory. We covered it earlier in this chapter. In the widget example, if you bought 1,000 widgets and stored them in your warehouse, those widgets would be your inventory.
Property, plant and equipment is pretty clear. Deferred income taxes are items marked for payment. Deferred income taxes will be discussed in detail later on.
Accounts payable is the mirror image of a receivable. When the widgets arrive, the invoice might be “net 30”: you have 30 days to pay. Payables are debts you owe. Ideally, a company wants receivables to be paid as quickly as possible and payables to permit extension of payment over a long time. The joke is receivables should be “net now,” while payables should be “net never”! You receive cash immediately but you never have to pay a bill J.
In the equity section of the balance sheet, Clayton Homes is a good example because there are two classes of stock: common and preferred. Common stock, or shares of common stock, is something we’ve already discussed. Preferred stock is something different. Preferred shares are like common shares, but they have a “bond” flavor J. This class of shares is called preferred, because it is higher in the pecking order when it comes to getting a dividend. The company might create a class of preferred shares that have no voting rights (often the case); the company may be able to buy them back at a fixed amount; there is a dividend—it’s normally higher than dividend given to common shareholders. If a dividend is declared by the board, the preferred shareholders get paid first. The preferred shares could have a convertible feature. In other words, there might be a provision that allows conversion to common shares at the discretion of the company. CMH is authorized to issue preferred shares, but has decided not to do so.
Now, when shares are created, they often have a par value! I say often, because sometimes shares are “no par.” There’s really no need to worry about what par value is—it’s an accounting relic.
The only consequence of having a par value is how things get recorded. For example, let’s say a company is authorized to issue shares with a par value of $1. It goes ahead and sells 20 million shares, raising $200 million—in other words, the shares were sold at $10 each. Since the par value is a dollar, one dollar of the sale of each share is accounted for under common stock, the other nine dollars is called “additional paid-in capital.” It’s just an accounting way of divvying things up.
The reason that par value exists was probably to protect investors capital. In some states, the value of the asset based was not allowed to go below the value of the common stock. In other words, corporate officers just couldn’t pull all the invested money out of the company.
Corporate capital that comes from company operations is called retained earnings. The total value of retained earnings—found in the statement of shareholders equity and the shareholders equity section of the balance sheet—is actually the total accumulation of company earnings less any dividends that have been paid out to shareholders. Earnings for a given financial year are added to retained earnings from the previous year to give the new value for retained earnings. Earnings are the raison d’être of the Income Statement. Earnings start of in the income statement and then they make their way to the balance sheet via the statement of shareholders equity—what a great segue to the income statement! In fact, earnings appear on each of the four financial statement that a public company is required to publish.
The Income Statement
The income statement for Clayton Homes is below. The income statement might be given a slightly different name; however, the information it provides doesn’t change. While the balance sheet shows the state of the company at some point in time, the income statement shows the change in revenues and expenses over a period of time. For the case below, this period of time is one financial year (July 1, 1998 to June 30, 1999)
The document is a “consolidated statement of income,” in that the income statement from each business unit is taken and combined into one large income statement.
That’s the income statement! Let’s go through some of the key points.
Revenues are flows into the company resulting from business activity. For example, interest on cash in the bank isn’t considered as a revenue—a revenue comes from operations—what the company does. If the company sold property and generated a lot of cash, that’s not revenue. Sales and activities related to the operations of the company are revenues. Sales are actually “net sales.” Often, companies have a category called “allowance for doubtful accounts,” or something like that. Not everyone pays their bills; there’s always a certain percentage of sales that are never collected, so companies estimate what that percentage might be. Another account is created to manage this estimate—the allowance for doubtful accounts—a certain fraction of revenues would be placed in this account; the rest is a receivable.
You see the word “gain” in financial statements of companies. A gain and revenue are not the same thing. A revenue is a flow of assets into the company. A gain, on the other hand, is an increase in the equity of the company. We’ll talk about this topic when the statement of shareholders equity is reviewed. A gain does not appear on income statement, it appears on the statement of shareholders equity. For example, if Clayton Homes has made an investment in the shares of, say, Wal-Mart; these shares are recorded on the balance sheet as an asset. If they’re sold at a profit, this profit is recorded as a gain in the equity of the company. If they’re sold at a loss (that’s a challenge for a long term investor!), then the loss is recorded in the shareholders equity section. Gains and losses occur in activities other than the core operation, the raison d’être, of the corporation.
We touched on revenue recognition before. Different companies might have different rules. For example, let’s stay you own an air conditioning installation company. You might recognize a revenue when substantially all of the work is done. Another company might wait until the house has been inspected by the city. Different companies might have slightly different rules.
The next broad category is “costs and expenses.” This category is actually operating expenses—expenses incurred in generating revenues. Cost of sales might also be called the cost of goods sold. For the example discussed earlier, the cost of goods is what was paid to buy the widgets. Selling, general and administrative (called SG&A) lop pretty much all the other operational expenses into one neat bundle. You’ll find depreciation in here as well as the electricity bill and the cost of repairing the copy machine! People often complain that their company doesn’t breakdown expenses into intimate detail. But remember, if you can figure out the detailed cost structure, so can a competitor. A company has to provide what is required and not too much more! Clayton Homes has included some provisions for losses here too. Companies might breakout an expense if they are “material.” Material might mean greater than 5% of revenues—it depends upon the company. The one expense that is sometimes broken out is research and development (R&D). Clayton Homes has no material R&D expense.
Operating income is obtained by subtracting operating expenses (cost of sales, SG&A, financial services interest and provision for credit losses for the example of Clayton Homes) from revenues. Revenues were $1.344 billion for the period and operating expenses totaled $1.092 billion. The difference between these two numbers is $251.285 million. Operating income is often referred to as earnings before interest and taxes, or EBIT (pronounced eee-bit!)
We’re not done with income just yet! Clayton Homes also generated interest—this is recorded as interest income after the operating income. If a company incurs a loss, the number would be placed in parentheses. Operating income plus interest income is income before taxes. A provision for taxes is added (estimated taxes) and this number is subtracted from income before taxes to give net income. Net income is the very last line on the income statement (I’ll discuss what follows, but it’s really for information purposes), hence the phrase “what’s the bottom line”.
If there is any extraordinary income, it follows next. Something is extraordinary if it’s not likely to occur again in the future. Extraordinary items are often not generated from operations. If a company found half a billion dollars of gold on land it owned, that would be extraordinary!
Net income is described on a per share basis as this information is useful to shareholders. As we will see later, share price appreciation seems to correlate with earnings (net income), so knowing net income per share—earnings per share—is important. Earnings per share is abbreviated as EPS—you will see EPS a lot! EPS is obtained by dividing net income by the number of shares outstanding. Note, if the company buys its own shares, those shares are not considered as outstanding, they are called treasury stock. If a company buys back its own shares and “cancels” them, these shares are now neither issued nor outstanding. (Suitable adjustments must be made to the statements of equity if shares are canceled.) Only if the corporation owns and keeps these shares on the books are they referred to as treasury stock.
EPS is reported on a basic and diluted basis. Remember EPS is found by dividing the net income by the number of shares outstanding. So, why are there two flavors of EPS? It’s a good question.
I have alluded to this point early, when I talked about preferred shares. Some financial instruments exist that can be converted into shares. Some times preferred shares are convertible. There are convertible debt instruments—convertible bonds. Stock options exist. A stock option is a financial instrument that gives the owner the right (but not the obligation) to buy shares of common stock at a predetermined price within a defined period of time. To incentivize management, the board of directors might give the CEO options worth a half million shares. The shares could be bought by the CEO at $5 per share any time within the next seven years. The CEO gets to buy these shares regardless of the market price—the company will sell the shares (perhaps from the treasury stock) at $5 each. Naturally, the CEO will only exercise the options if the shares are trading at more than $5 each. Stock options have made some people extremely wealthy.
So, aside from the shares issued and outstanding, more shares could enter circulation if any of the financial instruments discussed above are converted or exercised. If more shares come into existence, then the EPS will be diluted—same amount of net income divvied up among more shares. Dilution is important to investors, since there is a relationship between share price and EPS. Generally, if EPS grows, so will the share price. If EPS falters—and if it’s diluted, EPS decreases—then the share price will probably decline too. FASB, discussed earlier, has come up with some criteria for determining how to determine the effect of creating more shares.
FASB requires that EPS be reported on a basic and diluted basis. To determine basic EPS, you take net income and divide it by the number of shares outstanding. To calculate diluted EPS, companies have to follow the ruling promulgated by FASB (number 128). They figure out what financial instruments could be exercised or converted into shares and then add these hypothetical shares to the number of outstanding shares. If you look at the Clayton Homes example, they had, on average, 145,211,000 shares outstanding in fiscal year 1999. Following FASB 128 there would have been, on average, 145,931,000 shares—three quarters of a million more! Diluted EPS helps investors better understand the risks associated with EPS. We will see later when we work with EPS in Parts II and beyond, we will only use diluted EPS.
The Statement of Cash Flows
Here is the statement of cash flows for Clayton Homes. It was found in the annual report for 1999.
As was discussed earlier, accountants have a certain amount of leeway with the components of earnings. Some people have problems with the somewhat subjective nature of the accrual principle in accounting. These people would rather see the sources of cash. The Statement of Cash Flows helps them.
There are two ways to develop a statement of cash flows: direct and indirect. In the direct method, all changes in cash are shown. In the indirect method, the work of the accountants has to be undone and sources of cash determined indirectly. The statement of cash flows is a little trickier in some respects than those discussed already. I’ll talk about this statement in general terms.
Clearly, the long term survivability of a company will be in jeopardy if it cannot generate cash. Many small businesses go under, not because of financing, but because of cash flow. Companies do not have cash on hand to cover their bills. There are many companies that “factor” receivables. They lend money to the company based on the value of the receivables. As you might imagine, the interest rates sometimes charged might make a credit card company blush.
Examining cash flow puts companies on an even footing. If a company decides to lease rather than buy—that is, have leasing expenses rather than a fixed schedule of depreciation—examining cash flow can negate these accounting choices. As mentioned earlier, the statement of cash flow might be regarded as “undoing” an accountant’s work.
Cash flow from operations sounds self-explanatory and it is. Cash flow from operations measures the ability of the company to generate cash from its operations! Generating revenues and paying expenses.
As discussed, accountants have leeway when it comes to recognizing revenues and expenses, so earnings are consequently affected. The goal of a cash flow analysis on operations is to undo the accrual approach—easier said than done!
The analysis starts with net income. Remember net income (earnings) is the “bottom line” of the income statement. We’ve now seen earnings in one form or another appear in each of the three statements so far examined. (What’s the betting you’ll see earnings again when we hit the statement of shareholders equity? Anyone say 100%?) So, we start with net income—earnings—and start adding things back.
Depreciation is not a cash item. Think about it, does depreciation, or for that matter amortization have any affect on cash? None at all. Depreciation is a noncash expense. You pay for an asset, but you don’t pay out anything at all when that asset is depreciated. Adding depreciation back in brings you closer to what the cash from operations might be.
Remember that we are concentrating on operations, so if there are any losses (or gains), things that didn’t derive from operations, these get added (or subtracted) back in. In the Clayton Homes case, there was a gain from a sale—cash generated from something that isn’t at the core of what CMH is all about. This gain is added right back in.
We talked earlier about an allowance for doubtful accounts—a guess at the percentage of your customers that are deadbeats! Certain provisions for bad times reduce earnings. Adding them back in—they’re not cash events—brings you closer to where the money is!
Notice, that we are scouring the balance sheet and income statement for items that affect cash. Deferred income taxes do. We’ll talk about them later.; check the index if you want to bounce to them right now. It’s an expense but a noncash expense, so whoosh, it’s added back in.
There are some changes in accounts on the balance sheet (receivables, payables and inventories) that are non cash. You compare the level year over year and if it changes you add (or subtract) the difference right back in. What you’re doing is adjusting for the major changes in working capital—the money required to keep the business going from day to day. The last three items are changes in working capital.. We’ll look at receivable, payables and inventories later.
The sum of these adjustments gives the cash provided by operations—that’s $66.15 million. This number is lower than net income—but we haven’t finished just yet. Clayton Homes has three other entries found in their industry. These adjustments must be made to get net cash flow provided by operations. This figure is now $91.72 million.
Cash flow from investing activities follows next. A company requires assets to run a business. This part of the cash flow statement reports activities associated with such investments. When you look at “old economy” businesses, you’ll see lots of hard assets—machines etc. Nude economy business—whoops, I mean new economy business won’t have these sorts of assets. You see a company like Clayton Homes which is also in financial services has hints of cash in this area.
The purchase of an asset or an investment uses up cash. If cash is consumed, the change is negative—in parentheses. If a company sells an asset—or in the case of Clayton Homes sells a receivable—this sale is a source of cash—a positive change. Clayton has positive cash flow from investing activities. In some capital intensive industries this number can be negative. It’s negative because the company made some type of long-term investment in its asset base. Clayton has generated cash through the sale of some assets
Cash flow from financing activities is the last section in the statement. Broadly speaking, you can view the cash flow from operations as “what went on in the income statement.” Cash flow from investing certainly has a balance sheet sort of focus! While cash flow from financing will seem to lean towards the statement of shareholders equity. Of course, you know by now that each section of this statement looks at more than one other financial report.
Cash from financing looks at things like dividends (which use cash) and cash use to repurchase (or sell) stock. The statement also examines the financing of other activities. If the company issued some long term debt, the cash position of the company would be increased. Clayton Homes retired debt—it used up cash in the process. The company issued shares of stock, generating $3.6 million in cash. It also repurchased a lot of stock, using up $81.4 million. Later, you’ll see that when a company buys back its own shares, these shares are “put in limbo”! When it comes to calculating EPS, only issued shares are considered. (The issue of diluted EPS is discussed in appendix 3).
Clayton Homes has increased its overall cash position from $1.7 million last year to $2.68 million currently: an increase of $949,000. It’s important for a company to have positive cash flow if it is to survive.
Now, we’ve looked at cash flow, so what? Many people like to see cash flow per share (EBIT per share or EBITDA per share—that’s earnings before interest, taxes, depreciation and amortization). Others like a flavor of cash flow not introduced here—free cash flow. For free cash flow changes in “net working capital” are added back in. For me the take home message is simple. If earnings are bad, I don’t want to hear excuses.
I am reminded of a movie like Grease! Imagine girls getting together after one of them went on a date. They ask “was he . . .?” “did he . . .?” “was he . . .?” to each question the Olivia Newton John squirms even more and more saying “well no.” At the very end, to defend herself, the ultimate zinger: “He has a great personality!” To me cash flow is the personality of a company. If you can’t say something good about earnings—let’s try cash flow.
Now, I am being a little disingenuous here—far too dismissive of cash flow. But GAAP has a certain amount of wiggle room. If accountants can’t make legitimate use of GAAP to present the company—through its earnings—in the best light, then perhaps its just not a great company!
The Statement of Shareholders Equity
Just as for the income statement, the statement of shareholders equity can have a number of different names; however, in all cases in breaks out the equity section in more detail. Below is the statement issued by Clayton Homes in its 1999 annual report.
This statement can also be called the statement of owners equity, the statement of changes in owners equity or the statement of capital. Like many words in finance, the word capital can mean slightly different things in different contexts. When talking about the statement of shareholders equity—capital and equity are the same thing. Shareholders—owners—invest capital in the corporation. They capitalize the corporation. These investors own a share in the capital stock of the corporation.
The statement of changes in shareholders equity addresses any changes that affect the capital of the corporation. Comprehensive income includes not only income, but changes in equity such as distributions to owners (dividends). There are some changes that can affect the makeup of equity but not its value. For example, if a company declares a stock split, or if preferred shares are converted into common shares.
Let me first of all run through the items in the first column of the statement above and expand some more. The top and bottom rows show the state of various accounts at the start of and the end of a given fiscal year. There are six columns in all. Columns two through five show changes made to various accounts during the fiscal year. The first is a description, the second is shareholders equity. (Remember: shareholders equity is the difference between the value of the assets and the value of the liabilities. The total shareholders equity of $947,768 on June 30, 1999—the figure at the end of column 2—is identical the same as in the balance sheet. In fact, this statement shows how that number was determined.) You can picture the next four columns as breaking up shareholders equity into components: common stock, additional paid-in capital, retained earnings, and other comprehensive income. If you add up the numbers in a given line found in the third through the sixth column, you get the number in column two.
Net income has been defined previously. Comprehensive income consists of net income (from operations) together with all other sources of income. One other source is an unrealized loss than occurred on securities that were available for sale. The term “gain” and “loss” were discussed in the section dealing with the income statement. If you scoot up you will find that there are securities available for sale recorded as assets on the balance sheet. These securities have been written down, as their market value declined.
Accounting rules have a thing called the historical principle. This principle means that assets are recorded at their purchase price regardless of what the market says they’re worth. For example, if your company bought an acre of land on Manhattan for $100 in 1801; it would be recorded as worth $100—even though you could sell it for many millions. If an asset loses value, it can be written down—the historical principle allows companies to underestimate the value of an asset but not overestimate that value.
The total comprehensive income, printed in bold face, is net income (taken from the income statement) less the unrealized loss. Total comprehensive income was $154,147 in fiscal year 1999.
Next, the company bought 6,465,000 shares of its common stock. Total shareholders equity dropped by $81.394 million. The average price per share is $12.59 ($81.394 million divided by 6.465 million shares). Remember that weird accounting tradition about par value discussed earlier? The par value is $0.10 per share, so $647,000 of the transaction affects the value of common stock recorded on the balance sheet; the rest is credited to additional paid-in capital. When a company buys back its shares, they are still issued but not outstanding.
The company declared and paid dividends of $0.064 per share during the year—that’s a whopping 6.4¢ per share! The company paid out $9.606 in dividend payments during the year. You might think to yourself, hey, I could calculate the number of shares. If I pay out $9.606 million and it represents $0.064 per share, then $9.606 million divided by $0.064 should give me the number of shares. You’ll find this number differs when compared to the number used to calculate EPS in the income statement. Remember the number of shares is changing as the company buys them back: treasury stock is not outstanding so doesn’t get a dividend.
Distributions to owners , are most commonly dividends. These distributions decrease the equity of the corporation. In essence, when you make a distribution, you’re taking something that would have been recorded in the Shareholders Equity part of the balance sheet and giving it to the shareholders. You are reducing retained earnings.
Finally, the company went ahead and issued 3.602 million shares. These shares were issued as a result of incentive or other benefit plans. They increase the pool of issued and outstanding shares and are recorded on the balance sheet under “common stock” and “additional paid-in capital.”
If you read down the columns, the changes in 1999 are added (or subtracted) to the total at the end of 1998—found at the head of the respective column. For example, at the end of fiscal 98, retained earnings were $703.754; earnings (or net income) of $154.968 million increased retained earnings. Dividend payments of $9.606 million reduced them slightly. Summed together, retained earnings at the end of fiscal year 99 were $849.116. This number is transferred over to the balance sheet in the equity section. Earnings link all four reports together.
Some Other Items
Why do stock prices plummet if earnings dip slightly?
I delayed addressing this topic until we’d been through a bit of a numbers-fest! I talked earlier about money managers. In many cases, money managers have models for the financial performance of companies. Just as we will do in chapters 2 through 5, the models seek to learn the future, often using information learned from behavior in the past. These models are based on earnings or more likely free cash flow. In summary, free cash flow is the amount of cash you could extract from the business each accounting period without affecting its operations.
Now, the models call for a few things, but the most important thing is a growth rate for the free cash flow (which is tied to growth in earnings) and some kind of discount rate. Free cash flows are discounted. In other words, thanks to inflation, if you had a choice between receiving $100 to day and $100 a year from now, most people would want the cash now. A hundred dollars will probably have less buying power a year from now due to inflation. People have investing choices. If government bonds pay 7%, then the company would have to beat that, since there’s no risk with government bonds. Some discount rate is chosen to take all these sorts of things into consideration. A terminal value is also selected—the calculation does not normally extend beyond five years. In this example, the terminal value is added to the figure in year 5; the number is discounted back for five years at 15% each year.
Let me give you a wacky example. It’s 1990 and let’s say a company is growing in earnings at 20% per year. The company has earnings of $1 per share. It has free cash flow of $2 per share. The company is expected to report $1.20 per share in earnings and $2.40 in free cash flow.
| 1989 | 1990 | 1991 | 1992 | 1993 | 1994 | End |
EPS | 1.00 | 1.20 | 1.44 | 1.73 | 2.07 | 2.49 | |
FCF/share | 2.00 | 2.40 | 2.88 | 3.46 | 4.15 | 4.98 | 19.92 |
Discounted FCF | | 2.09 | 2.18 | 2.27 | 2.37 | 2.47 | 9.90 |
The cash flows are discounted at 15% per year. In other words, the middle line is what the cash flow is projected to be; the bottom line is the cash flow expressed in terms of today’s dollars—money in the hand today! A terminal, ending, value is selected. The discounted free cash flows are summed to get a value—$21.28 in this example.
Now, let’s say that the company reports earnings that are just 2¢ shy of expectations. In other words, instead of growing at 20%, earnings grew at 18%. This new growth rate would be used to figure out the growth in cash flows into the future. Here goes
| 1989 | 1990 | 1991 | 1992 | 1993 | 1994 | End |
FCF/share 20% | 2.00 | 2.40 | 2.88 | 3.46 | 4.15 | 4.98 | 19.92 |
FCF/share 18% | 2.00 | 2.36 | 2.78 | 3.29 | 3.88 | 4.58 | 18.30 |
Discounted FCF | | 2.05 | 2.11 | 2.16 | 2.22 | 2.27 | 9.10 |
The cash flows are still discounted at 15%. The new value ascribed to the company is $19.91. In other words, if there is a shortfall in earnings of just 2 pennies, this model would trigger an instantaneous drop in share price from $21.28 to $19.91, that’s $1.37 per share. If the company had one billion shares outstanding, the 2¢ shortfall in earnings would wipe out $1.37 billion in company value. Financial models related to the one illustrated above are used widely on Wall Street. The use of these models accounts, in parts, for sudden drop in share prices when earnings and short fall is announced.
The Federal Reserve also plays a role in share price valuations! If interest rates are increased from say 5% 5.25%, the discount rate used in the free cash flow model would also increase.
Let’s say that the company does announce earnings as expected, but this announcement happens on the day that the Federal Reserve increase rates from 5 to 5¼%. The increase of quarter of one percentage point. However, 5.25 is 1.05 times as large as 5.00. The rate increase causes the discounting factor to increase from 15% to 15.75%. Here’s the effect.
| 1989 | 1990 | 1991 | 1992 | 1993 | 1994 | End |
EPS | 1.00 | 1.20 | 1.44 | 1.73 | 2.07 | 2.49 | |
FCF/share | 2.00 | 2.40 | 2.88 | 3.46 | 4.15 | 4.98 | 19.92 |
Discount (15%) | | 2.09 | 2.18 | 2.27 | 2.37 | 2.47 | 9.90 |
Discount (15.75)% | | 2.07 | 2.15 | 2.23 | 2.31 | 2.40 | 9.58 |
The new share price would be $20.54. The drop is not as dramatic as the last example; however, the point is illustrated. If there are changes in either growth rates or interest rates, share prices are affected. These changes usually don’t seriously affect the business operations of a growth company. They do affect what some people think such companies should be worth!
The Efficient Market Theory (EMT)
The Efficient Market Theory (also referred to as the Efficient Market Hypothesis or The Principle of Capital Market Efficiency) is expressed in many ways, but one of the more common is that “all available information is reflected in the price of a stock.” The idea is that no one has an advantage. The minute something is known about a company, the price of its stock and bonds adjusts instantaneously to reflect this new knowledge. Securities—stocks and bonds—are always fairly priced. Most of us simply don’t believe this theory. For one thing. If it’s true, why did stocks adjust so precipitously in October of 1987? In the US the markets are as efficient as markets can be; however, there does seem to be an element of the irrational every now and again. The stock market seems to be efficient in the long-term and pretty wacky in the short run. I think it was Benjamin Graham—or perhaps Warren Buffet—who said that in the short term, the market is a voting machine; while in the long term, it’s a weighing machine.
The Capital Asset Pricing Model
This model was touched on earlier when we talked about beta; for those interested, I’ll just run through it in a little detail. Someone got a Nobel Prize in economics for this model, so fasten your seatbelts.
You start of by saying that there are some investments for which there is no risk! It’s an audacious claim, but most people believe it. It’s generally accepted that if you hand dollars to the federal government and buy bonds, your investment is “safe”: you’ll get regular interest payments and you’ll get your principal back (the amount of your investment) when the bond matures. If you sit and calculate the annual return you get from this investment, that’s the return you get without risk. Anything that asks you to take on more risk, better give you a higher return than government bonds, otherwise, you’d be dumb to assume that risk.
Lottery tickets have a rate of return of less then –50%: you get 50¢ back for every dollar you “invest.” (I haven’t adjusted that number to an annualized rate); so if you “invest” in the lottery, you’re investing in an asset that gets a much lower return than government bonds. Go back and read the last sentence in the previous paragraph. The pardon me for my bluntness J.
Now this “riskless rate” is obtained if you invest in government bonds. We all know that stocks—on the average—do better than bonds. So, you’d expect the rate of return for the market overall to be higher than the return on government bonds—it is. When you measure the return of the stock market over many years and compare that number with the rate of bonds, the stock market does better.
Let’s ratchet it up one more notch. We’re not interested in just any old stock, we love growth stocks. We already accept there’s more risk with them. They do better than the market overall, but some growth companies falter. We have a rule of five—we accept that one out of five (on average) will stumble. Let’s face it, we want to invest in companies that are a real and ever present threat to competitors. It turns out that even the wisest investor will put his or her money in an also-ran.
So, I’ve described three situations: a riskless investment—government bonds, the market which is riskier than those bonds, and growth stocks—they do better than the market, but they have more risk. There is a way to tie all these things together. Let’s give names to these three rates:
rb = | riskless rate | | rm = | market rate | ro= | some other rate |
The “some other rate” we’re talking about right now is the overall rate of return you expect from growth stocks over a goodly period of time! Actually, as stated, that rate is greater than the riskless rate.
Okay, so the market rate of return is a larger than the riskless rate (or risk-free rate); you could say, it’s equal to the risk free rate plus something; that something is described below.
rm = rb + (rm – rb)
It’s equal to the riskless rate plus the difference between the market rate and the riskless rate. Think about it, if the risk free rate is 5% and the market rate is 12%; the difference is 7%. If you look at this equation, all it says is that rm is equal to rm! You can generalize this relationship as follows:
ro = rb + bo(rm – rb)
I’ve taken quite a leap here from the equation above. But think about it for a moment. All that is being said is that the equation for the market rate can be generalized. Any rate of return can be broken up into the riskless rate and some multiple of the market rate/riskless rate increment. That multiple is bo, and bo is a measure of the volatility of this “other rate” compared to the market. That’s all it’s saying.
If this other rate of return is equal to that of the market, then bc is 1. If it’s riskier, then bo is greater than one, less risky and it’s less than one. bo is a measure of the risk of this of this asset in terms of the risk of the market.
Is gold a good investment?
To many people, the answer is a resounding yes. But hold on! It’s worth investigating this topic a little bit more. Consider the following: when Elizabeth the First of Great Britain and Ireland was on the throne, and ounce of gold would buy a man a fine suit of clothes, a good pair of shoes and a sumptuous meal. Today, with Elizabeth II of Great Britain and Northern Ireland on the throne, an ounce of gold would buy a man a suit of clothes, his pick at Payless Shoe Store and a Happy Meal. Gold doesn’t even keep pace with inflation.
Review
In this chapter, we’ve covered a lot of ground. The focus has been on learning about stocks, the markets on which they are traded, what they represent and who buys and sells them. We’ve examined companies and how they are constructed. We’ve looked at information the company supplies to the public to let investors know how it’s doing. The next step is to analyze that information.
Questions
1. Which of the following is a core principle of the NAIC?
(a) Invest regularly
(b) Reinvest all earnings
(c) Choose from among growing companies
(d) Diversify to reduce risk
(e) All or the above
2. In which of the following is a “legal fiction” created?
(a) Sole proprietorship
(b) Diversified business
(c) Partnership
(d) Corporation
(e) Forwarding office
3. Which of the following is true?
(a) assets = liabilities + equity
(b) assets = liabilities – equity
(c) equity = assets + liabilities
(d) assets are always less than liabilities
(e) debt and equity are the same thing
4. Insiders are people like
(a) stockbrokers
(b) preferred shareholders
(c) corporate officers
(d) all corporate employees
(e) SEC investigation officers
5. Each of the following could describe a bond except
(a) Callable
(b) A form of equity
(c) Convertible
(d) Zero coupon
(e) A form of liability
6. A company goes public through
(a) Private placement
(b) Interest payments
(c) an IPO
(d) debt placement
(e) conservation of capital
7. The “stock market” is
(a) found only in New York City
(b) places to finance debt
(c) Another name for capitalization
(d) where shares of companies are bought and sold
(e) All of the above
8. NASDAQ stands for
(a) North American Securities Dealers Automated Quotation
(b) Notes, assets, securities, debentures all quoted
(c) Non-asset secured debenture automated quotation
(d) National Association Securities Dealers Automated Quotation
(e) National Automated System for Declaring All Quotes
9. A specialist is found
(a) on the floor of the New York Stock Exchange
(b) on the floor of the NASDAQ
(c) on any exchange
(d) at member broker houses
(e) all of the above
10. In a stock trade, GTC stands for
(a) good until canceled
(b) guaranteed to clear
(c) gross total cash
(d) guided to cancel
(e) greatest total conversion
11. A spread is
(a) the fixed commission all brokers are legally required to charge
(b) the difference between a buy and sell price
(c) the number of shares required to make a $100 trade
(d) the difference between the daily high and low
(e) None of the above
12. When a two-for-one stock split occurs
(a) The number of shares halves and the price doubles
(b) The number of shares doubles and the price doubles
(c) The number of shares halves and the price halves
(d) The number of shares doubles and the price halves
(e) None of the above
13. The S&P 500 and the DJIA is each
(a) a foreign security
(b) an index
(c) a stock exchange
(d) a major brokerage house
(e) subsidiaries of the NAIC
14. Depreciation and amortization are used in accounting for
(a) tangible and intangible assets, respectively
(b) intangible and tangible assets, respectively
(c) very liquid and very illiquid assets, respectively
(d) equity and liabilities, respectively
(e) short-term and long-term debt, respectively
15. An annual report has which of the following?
(a) a balance sheet
(b) an income statement
(c) a statement of shareholders equity
(d) a statement of cash flows
(e) all of the above
16. Which of the following does not appear on the balance sheet?
(a) cash
(b) net income
(c) short-term debt
(d) property, plant and equipment
(e) retained earnings
17. Which of the following could appear on the income statement?
(a) Cash flow from operations
(b) Liquid assets
(c) Selling, general and administrative
(d) Accounts payable
(e) Accounts receivable
18. A growth company
(a) follows the business cycle
(b) has declining revenues
(c) does not follow the business cycle
(d) has no expenses
(e) none of the above
19. When a company buys back its own shares, the shares are
(a) issued and outstanding
(b) outstanding and canceled
(c) outstanding but not issued
(d) neither issued nor outstanding
(e) issued but not outstanding
20. The NAIC tools to be covered this class are the following:
(a) SSG, PERT, SCG and PPG
(b) SSG, SCG, PMG and PERT
(c) PERT, SSG, TTN and NASDAQ
(d) NYSE, NASDAQ, NAIC and NTSB
(e) EPS, PERT, SSG, GCS, and END
