ions, Except Per Share Figures)December 31,1999
December 31,1998
December 31,1997
$5,983733
$4,861575
$4,023465
6,716
5,436
4,488
2,7515075731,436208
2,6003964351,08882
2,317295332826—
Operating Income(See Figure 8.3)Investment IncomeInterest IncomeOther Income/Expense
1,241
834
717
132(33)18
114(35).4
83(31)1
Income before TaxesIncome Taxes(See Figure 8.4)Net IncomeEarnings per ShareShares Outstanding(See Figure 8.5)
1,357347
914260
769182
1,011.981,031
654.641,015
588.591,011
Revenues:Net salesServicesTotal:(See Figure 8.2)Operating Expenses:Cost of SalesCost of ServiceResearch & DevelopmentSelling, General, & Admin.Other Charges
Figure 8.1
EMC Income Statement (Courtesy of EMC Corporation—www.emc.com)
What to look for: Increasing year-to-year revenue growth. EMC showed ahealthy increase in year over year sales from 1997 through 1999. In 1998, totalrevenues increased at a 21% clip and the number increased to 23% in 1999.
The absolute level of sales growth isn’t as important as the percentage increaseof revenue growth. Is the company’s revenue increasing at an adequate rate? Ideally, a company will be increasing revenues at least 20% annually. Remember, however, that corporate financial statements (10-Qs) are filed quarterly. As an investor,you should monitor them at least that often.Growth rates are dependent on many things including the size of the firm, the industry, and so on. For example, a 20% to 50% growth in a large cap stock is spectacular; but the same growth in a micro-cap would be very disappointing. Likewise, thegrowth rate of a dot-com is usually much higher than a retailer. It all comes down toknowing an industry and the firms in that industry. As a basic rule of thumb, you’relooking for firms that are significantly outperforming their fellow competitors.
THE INCOME STATEMENT
2251999
1998
1997
Revenues:Net SalesServices
$5,983733
$4,861575
$4,023465
Total:
6,716
5,436
4,488
Revenues: The company’s total income from sales before expenses.Figure 8.2
The Top Line of the Income Statement
10-Q: The quarterly financial report filed by firms that have securities listed withthe SEC. It is less detailed, but filed more frequently than the 10-K found in theannual report. This report will contain the quarterly balance sheet, incomestatement, and statement of cash flows.With the right strategy, you can make as much money in aslow-growth industry as a high-growth one with much less risk.
In the process of generating revenues, all companies incur costs and expenses. Ifyou own a restaurant, for instance, you have to pay the lease on the building, thecosts of the raw ingredients, and the salaries of the staff. On the income statement,the business’s expenses or costs of doing business, are subtracted from revenues toarrive at the operating income (see Figure 8.3).
Research and DevelopmentOne of the key tools of fundamental analysis can be found in the “Operating Expenses” section of the income statement—research and development costs. Manybusinesses spend significant amounts of money on research and development toTotal RevenuesOperating Expenses:Cost of SalesCost of ServiceResearch & DevelopmentSelling, General, & Admin.Other Charges
6,716
5,436
4,488
2,7515075731,436208
2,6003964351,08882
2,317295332826—
Operating Income
1,241
834
717
Operating Expenses: The costs associated with doing business anddeveloping sales.Operating Income: The company’s income after expenses have beensubtracted from total revenues.Figure 8.3
Operating Expenses and Operating Income
226
ANALYZING COMPANY REPORTS
create new products or processes, to improve present products, and to discover newknowledge that may be valuable at some future date. This is especially important inthe drug and biotechnology industries because their revenue streams are dependentupon the new drugs that they have in their pipelines for future sales.It can be helpful to compare the percentage of sales that R&D comprises in acompany’s expenses to other companies in the same industry. It is an indicator ofhow dedicated a firm is to remaining or becoming the leader in its respective marketsector. As we can see, the dollar figure for R&D is found on the income statementunder the category “Operating Expenses.”What to Look For: Make sure research and development is a companypriority. Many companies will reduce the amount of money theyallocate toward research and development in order to cut costs andappear more profitable in the present. By doing so, they could bejeopardizing their future. EMC is, again, demonstrating a desirableattribute in this case: It is steadily increasing R&D expenditures.
After operating expenses like research and development are subtracted from revenues, nonbusiness income and expenses are added or subtracted from operating income. For example, if you own an auto repair shop and took out a loan to buy thetools, you will make periodic payments on that loan. That is known as interest expense. If you have a lot of cash in the bank for your business needs and earn intereston that money, you will report interest income. As you can see from Figure 8.4,EMC is generating more money from its investments than it is paying out in interestincome—a favorable sign.After investment income and expenses are either added or subtracted from operating income, we now have the income for the company. Is that what the companygets to keep? Of course not! It’s time to pay Uncle Sam.
Earnings and Earnings per ShareAfter taxes are considered, the result is net income and represents the company’sbottom line. Net income or earnings are perhaps the most widely followed piece offundamental information monitored by investors. They represent the real profitsgenerated by the company.Investment IncomeInterest IncomeOther Income/Expense
132(33)18
114(35).4
83(31)1
Income before TaxesIncome TaxesNet Income
1,3583471,011
914260654
771182588
Income before Taxes: This number tells you how much a companyhas made before paying its tax obligations.Figure 8.4
Income before Taxes
THE INCOME STATEMENT
227
Earnings per share are calculated by dividing a company’s total after tax profits by the company’s number of common shares outstanding (see Figure 8.5).The annual and quarterly earnings figures are most meaningful when comparedto the previous year or the same quarter of the prior year. In this way, you end upcomparing apples to apples by taking into account seasonal fluctuations in demand for the product. A large percentage increase in quarterly earnings compared to the same quarter in the prior year would indicate the company is makingmore money than it was in the past (i.e., it is growing at a profitable pace). It’simportant to see earnings acceleration in the stocks you are considering owning.Earnings should be growing percentage-wise on a quarter-to-quarter basis, aswell as simple earnings per share numbers. Quarterly earnings should be increasing by, say, 15% to 30%. Make sure you compare the most recent quarter to thesame quarter of the prior year.Earnings acceleration: The rate at which quarterly earnings per share are increasing. It is important to see your company’s earnings increasing 15% to 30%per quarter.
It is also important to study the annual earnings performance of the company.This is a simple process that compares the total earnings of the most recent fiscalyear to the total earnings of the prior year. Generally, investors will want to seemeaningful growth in a company’s annual earnings compared to the prior year. Annual earnings should also be increasing at a 15% to 30% rate. For more aggressiveinvestors, it should be larger.Earnings data can be found in financial publications, such as the Wall StreetJournal and Investor’s Business Daily, or by going online to visit one of themany websites that feature this kind of data. Visit Yahoo! Finance, Zacks, orQuicken.com for earnings information on your potential investments.
Earnings SurprisesOne final note regarding earnings: A number of analysts will cover a company andestablish a range of earnings estimates. Often the range is fairly narrow. That is, if
Net IncomeEarnings per ShareShares Outstanding
1,011.981,031
654.641,015
589.581,011
Net Income: The company’s total profits.Earnings per Share: The net income or earnings of the companydivided by the number of shares outstanding. This is the primary toolthat analysts look at to determine a company’s profitability.Figure 8.5
Earnings per Share (EPS)
228
ANALYZING COMPANY REPORTS
an analyst at Merrill Lynch expects EMC to report 25 cents in quarterly earningsper share, estimates at competing brokerage firms will probably be similar—at leastwithin a penny. However, there is another, unofficial estimate that Wall Streetspeaks of called the “whisper number.” So, for instance, if the average estimate ofanalysts is for EMC Corporation to earn 25 cents in the quarter, talk and rumorsamong investors may be for the company to report 28 cents. The whisper numberwill almost always be higher by 2 or 3 cents.A company that beats analysts’ estimates and the whisper number is said to posta positive earnings surprise. This is a solid sign that management is doing a goodjob. The opposite is also true, and is called a negative earnings surprise. This kindEarnings estimates: This is the anticipated earnings per share figure that analystsexpect a company to report on the release date. It is very important that companies beat their earnings estimates; otherwise their stocks run the risk of gettingclobbered.Whisper number: A company’s unofficial earnings estimate anticipated by stockmarket investors. If a company does not meet or beat the whisper number, thenthere is a possibility that the stock will get thrashed. This number is derived fromperceptions, and if the perceptions are not met, then short-term traders do notwant to be in the stock.
of surprise can cause the price of the stock to get hammered. When viewing earnings histories, it is important to make sure that the potential investment does nothave a habit of delivering these negative surprises to the street. Unfortunately, thistype of news has a way of repeating itself with companies.Stocks can also see short-term price moves when analysts change their earningsforecasts for the companies. In the example from Chapter 7, we saw how Netsolvelost considerable ground on the day it was downgraded from buy to attractive and, atthe same time, the analyst cut earnings estimates for the stock. The opposite can happen when earnings estimates are upgraded; a stock can gain in price very quickly.The earnings per share number found on the financial statementsis not the only important factor to consider when lookingat a company. Fundamental analysis calls for lookingat what stock market investors expect the companyto report in the future—the whisper number.
Earnings per Share RankThe earnings per share rank is a rating spearheaded by Investor’s Business Daily. Itmeasures a company’s growth over the last two quarters in comparison to the samequarters in the past year and then factors in the past three- to five-year annualgrowth rate. The resulting number is then compared to other companies and given a
THE INCOME STATEMENT
229
rank of 1 (lowest) to 99 (highest). The EPS rank basically tells a trader how profitable a stock is in comparison to the more than 10,000 stocks available to be traded.I prefer to work with stocks with a ranking of 95 or better when buying, and stockswith an EPS rank of 20 or less when selling. It is a good idea to track the EPS rankof your stocks on at least a weekly basis. This will give you the chance to makechanges to your portfolio if there is a dramatic change in the character of your investments. Also, pay attention to a stock’s ability to consistently grow by researching the EPS rank at least five years back. If you find a consistent growth pattern,you can bet that investors are willing to pay more for that stock.
Profit MarginAnother profitability ratio is called profit margin. This number is calculated by dividing net income of the company by sales and gives the profit per dollar of sales.This ratio is not very helpful if looked at by itself. However, when compared toother companies in the same industry, it can help determine the more efficient organization. Many times, you will hear analysts or guests on CNBC talking about howthey expect margins to be improving for a particular company in the next quarter.This profit margin figure is exactly what they are referring to, and it is readily available on several of the Internet-based stock market research services such as Yahoo!Finance, Zacks, and Hoover’s.Profit margin: This number, calculated by dividing net income of the companyby sales, gives the profit per dollar of sales. The higher the profit margins, themore money the company is making on each sale that it completes. Analystspay close attention to this figure, and any signals of profit margins decreasingshould be considered a red flag by the investor.
Price-to-Earnings RatioThe most popular valuation ratios are the price/earnings ratio (P/E) and the price/salesratio (P/S). P/E ratios are used to easily compare the value that is being paid for acompany’s earnings. To calculate a stock’s P/E ratio, you have to divide the company’s market price by its earnings per share (see Figure 8.6). Typically, this is quotedfor the most recent 12 months, but can also be quoted using an analyst’s estimates forforward periods. For example, if XYZ stock is trading at $20 per share and had earnings last year of $1 per share, its trailing P/E would be 20. If XYZ was expected toearn $1.33 next year, it would have a leading, or forward P/E of 15 (20 / 1.33 = 15).This is especially instructive for a fast-growing company. For instance, let’s say XYZearned only 20 cents per share last year, but was expected to earn $1 per share in theupcoming 12 months. If XYZ was presently selling for $20 per share, it would have atrailing P/E of 100 (20 / .20 = 100) and a leading P/E of 20 (20 / 1 = 20). Since the P/E
230
ANALYZING COMPANY REPORTS
Current Market Price of StockPrice/EarningsRatio (P/E)Earnings per Share
Figure 8.6
Typically shown as “LastTrade.” It is the last price atwhich a share was purchasedor sold.Also referred to as “PrimaryEarnings per Share.” Netincome for the past 12 monthsdivided by the number ofcommon shares outstanding,
P/E Ratio Basics
for the Dow Jones Industrial Average ranged from a low of 16 to a high of 28 from1995 to 2000, the P/E of 100 for XYZ based on trailing earnings is quite high. However, if the firm can meet its estimated earnings, it would be attractively priced. Thus,as an investor, you have to be concerned with not only the quality of the estimates, butthe probability of the firm to grow at its estimated rate.The P/E ratio is also used by money managers to make a quick determination ofwhether a stock is cheap or expensive relative to its peers in the industry or compared to the broader market, such as the S&P 500. You may have heard an analystor investor make a statement that they expect a company’s P/E multiple to expand.This means typically that this particular stock has a much lower multiple than itspeers; and because the analyst feels that the company’s fundamental situation isgood or improving, the stock should trade at a level that compares favorably withthe rest in its industry. If the average for XYZ’s industry is a P/E of 40, then thisstock may be undervalued. If XYZ is trading at a P/E of 100 ($100 per share) withan industry average of 40, then the stock is probably overvalued. On any sign ofweakness, the stock will likely come tumbling down.How are industry averages established? Brokerage firm analysts establish guidelines for each industry. For example, a slow-growth industry, such as the steel industry, may have a P/E of only 10, while a high-growth industry, such as theInternet businesses, may have a P/E of 40 or higher.The P/E ratio is used to describe the current state of a stock’s price. Because it isrelated to the market price of the stock, the P/E ratio changes with every trade. It isnot generally used to forecast future prices. It simply lets traders know how well thestock is doing right now. In general terms, faster-growing companies have higherP/Es than more mature entities, as investors are willing to “pay up” for the higherearnings growth rate. However, valuing a company by its future earnings is a dangerous game since earnings range significantly.
Price-to-Sales RatioThe price/sales ratio is very similar to the price/earnings ratio. This single number isarrived at by dividing the market price of the company by the sales of the company,typically for the recent fiscal year. Price/sales is more typically used for companies
THE BALANCE SHEET
231
Price/earnings ratio: Divides the company’s market price by their earnings pershare. This ratio is most helpful when compared to industry averages and theoverall market. Some will use this ratio as a means to gauge whether a securityis overvalued or undervalued. Companies with high P/Es are considered overvalued, and companies with low P/Es are considered undervalued.
or industries without net income, or earnings, particularly when profitability is relatively far out into the future. This means of valuing a company has been very popular recently, especially with young high-technology companies that have theprospects of great success in the future, but lack current earnings. Again, both theP/E ratio and P/S ratios are calculated for you at Yahoo! Finance or Zacks.
THE BALANCE SHEETThe balance sheet shows the financial status of a business entity at a particular instant in time. A good way to think about the balance sheet is that it is a snapshot ofthe financial health of a company on a specified date. A summary of EMC Corporation’s balance sheet is displayed in Figure 8.7. It shows a listing of what the company owns (assets) and what it owes (debt to lenders and equity to shareholders).There are really two sections to the balance sheet separated by the dark solid line.On the top half, you have assets, and on the bottom, liabilities. This financial statement gets its name from the fact that the two sections balance themselves out. That is,for every asset there is a liability. Furthermore, both assets and liabilities are subdivided into two categories: current and noncurrent. If an item is current, it means that,in the ordinary course of business, it will be turned into cash over the next 12 months(in the case of a current asset) or will be paid in the next 12 months (in the case ofcurrent liabilities). For example, inventory should be sold and accounts receivable
Current assets: That portion of a company’s assets that, in the normal course ofbusiness, are or will be turned into cash in the next 12 months. Current assetsinclude cash and cash equivalents (short-term investments), accounts receivable(moneys owed the firm by its customers), inventory, and prepaid expenses (likeannual insurance premiums). In most companies, automobiles would be classedas long-term assets because they will last more than one year. However, automobiles held for resale by an automobile manufacturer (Ford, GM, etc.) wouldbe classed as inventory, or a current asset.Current liabilities: Short-term obligations that a company has to its creditors,employees, and so on. This figure tells you how much the company owes in thenear future.Total assets: The sum of current and long-term assets.Total liabilities: The sum of current and long-term liabilities.
232
ANALYZING COMPANY REPORTSBalance Sheet (Millions)December 31, 1999
December 31, 1998
$1,1097151,625619147104
$ 8359821,2936205086
Total Current Assets:(See Figure 8.8)Long-term InvestmentsNotes, ReceivablesProperty, Plant, and EquipmentDeferred Income TaxesIntangible and Other Assets
4,319
3,866
1,350771,023109295
5623582327314
Total Assets:(See Figure 8.10)Current Liabilities:Current Portion of Long-term DebtAccounts PayableAccrued ExpensesIncome TaxesDeferred Revenue
7,173
5,627
9370611249158
2929945716194
Total Current Liabilities:Deferred Income TaxesLong-term ObligationsOther Liabilities
1,39712568612
1,0407575230
Total Liabilities:Stockholders’ Equity:Common Stock, par value $.01Additional Paid-in CapitalRetained Earnings
2,220
1,897
101,7063,300
101,4802,289
4,9527,173
3,7295,627
Current Assets:Cash and Cash EquivalentsShort-term InvestmentsAccounts ReceivableInventoriesDeferred Income TaxesOther Assets
Total Stockholders’ EquityTotal Liabilities and Stockholders’ Equity:(See Figure 8.11)Figure 8.7
EMC Balance Sheet
should be collected in the upcoming year. Similarly, accounts payable (bills from suppliers) and the current portion of long-term debt will be paid in the next 12 months.The most obvious example of a current asset is cash. Figure 8.8 shows the topsection of EMC’s balance sheet. Notice that the first line is cash or cash equivalents.Cash equivalents are simply short-term investments that can be readily sold or liquidated, but at the same time earn a small amount of interest. At the end of 1999,
THE BALANCE SHEET
2331999
1998
Current Assets:Cash and Cash EquivalentsShort-term InvestmentsAccounts ReceivableInventoriesDeferred Income TaxesOther Assets
$1,1097151,625619147104
$ 8359821,2936205086
Total Current Assets:
4,319
3,866
Current Assets: A company’s assets that will, in the normal course ofbusiness, be turned into cash in the next 12 months.Figure 8.8
Current Assets from EMC’s Balance Sheet
EMC had over a billion dollars in cash, and that is up considerably from 1998. Cashis good. That is, successful operations generate cash. As the cash is stockpiled, itgenerates interest. Recall from the income statement: EMC is generating significantinterest income. However, fundamental analysis is not that simple. Many piecesmust be synthesized to come up with an accurate picture of a company. For example, the accumulation of cash may also be an indication of poor financial management unless there is a specific need for it, such as acquisitions or impending majorasset purchases.What to Do: Develop an affinity for a company thatincreases cash on the balance sheet from one yearto the next, and you may find your own profits growing.
Current RatioThe balance sheet has the information needed to compute important ratios. Specifically, financial strength or solvency ratios help to assess the ability of a firm to meetthe financial obligations they will have over the coming year. The ratio that is mostwidely used in this category is the current ratio. The current ratio is calculated bydividing current assets by current liabilities (see Figure 8.9). It measures the company’s abilities to pay its current obligations from its current assets. This number isused primarily to make relative comparisons among firms in a given industry, and isa quick look at the operating strength of the company.The current ratio helps to determine if a company can pay its obligations on timewith the cash that it has available. A general rule of thumb states that the current ratio should be 2 or greater. That does not mean a current ratio of 1 or 1.5 is terrible,but it may raise a red flag. Also, this number is very industry-specific. It is importantthat companies have the cash available to meet their short-term obligations, and thatis why this number is used. For EMC (see Figure 8.10), the current ratio calculationis as follows:
234
ANALYZING COMPANY REPORTS
Current RatioIndicator of short-termdebt paying ability.Determined by dividingcurrent assets by currentliabilities. The higherthe ratio, the moreliquid the company.
Current Assets
Current LiabilitiesFigure 8.9
Value of cash, accounts receivable,inventories, marketable securities,and other assets that will, in thenormal course of business, beconverted to cash in less than oneyear.Amount owed for salaries, interest,accounts payable, and other debtsdue within one year.
Current Ratio = Current Assets / Current Liabilities
Current AssetsLong-term InvestmentsNotes, ReceivablesProperty, Plant, and EquipmentDeferred Income TaxesIntangible and Other Assets
4,3191,350771,023109295
3,8665623582327314
Total Assets:
7,173
5,627
Total Assets: The sum of current and long-term assets.Figure 8.10
EMC Long-Term and Total Assets
Current ratio =
Current assetsCurrent liabilities
=
4,3191,397
= 3.1
EMC’s current ratio at 3.1 is quite high, and hence they should have little difficulty meeting its near-term obligations.In addition to the current items, the balance sheet also lists longer-term assetsand liabilities. This includes long-term investments, receivables, property, plant,equipment, patents, and other assets that are not easily liquidated. Together, thelong-term and current assets equal the company’s total assets. The same is true onthe liability side. Longer-term debt (that which is due in 13 months or more) isfound below the current liability section of the balance sheet.
Debt/Equity RatioIs debt good or bad? Are there certain levels that raise a red flag? I’m glad youasked. The debt-to-equity ratio is used similarly to the current ratio and can help answer those questions. The ratio is total liabilities divided by stockholders’ equity(see Figure 8.11).The debt-to-equity ratio reflects to what extent the owners’ equity will be able to
THE BALANCE SHEET
235
Stockholders’ Equity:Common Stock, par value $.01Additional Paid-in CapitalRetained Earnings
101,7063,300
101,4802,289
Total Stockholders’ Equity:Total Liabilities and Stockholders’ Equity:
4,9527,173
3,7295,627
Stockholder’s Equity: The owners’ interest in the assets of the business. Itequals the amount invested by the owners in the company plus anyprofits (or minus losses). This has no relationship to either the stock priceor the cash in the business.Figure 8.11 EMC Stockholders’ Equity
Debt-to-Equity RatioDetermined by dividinglong-term debt by commonstockholders’ equity.Debt to equity =
Figure 8.12
Total Liabilities
Assets provided by creditors.
Shareholders’Equity
Assets provided byshareholders.
Total liabilitiesShareholders’ equity
Debt-to-Equity Ratio Basics
cushion or cover the claims of creditors if the company should go to liquidation. Acompany with more debt, relative to its peers, is regarded as one with more inherentrisk as an investment. Again, this number is very industry-specific (the calculation isshown in Figure 8.12), and these are also calculated for you on Yahoo! Finance andZacks. In the case of EMC, the debt/equity ratio would be calculated as follows:Debt/equity ratio =
Total long-term debtTotal equity
=
2,8544,952
= 0.58
Debt/equity helps the analyst determine if a company is overleveraged, and if thecompany is using the appropriate amount of debt. Generally, there is not just onelevel of debt that is appropriate. This is a company- and industry-specific issue. Butit is helpful to compare the company’s debt/equity to its industry and the overallmarket. If a company’s debt/equity ratio continues to increase every year, and theoverall trend in the industry is going lower, then that would be a red flag.However, and this is an important point, the amount of debt, and the debt/equity ratio of a company is a financing decision, not an operating decision. If a company hasgood operations but a heavy debt load (and the stock’s performance is being harmedbecause of it), this can change literally overnight with the sale of a firm, a new stockissue (equity infusion), or a judicious acquisition. Remember that the business of
236
ANALYZING COMPANY REPORTS
business ultimately comes down to producing, selling, and delivering goods and services. While financing choices may constrain or enhance such endeavors in the shortrun, in the long haul it is operations that triumph. For instance, if XYZ had a billiondollars in debt and was acquired by EMC, which used its billion dollars in loose cashto pay off the debt, XYZ would be left with its operations—good or bad.
MANAGEMENT EFFECTIVENESS RATIOSManagement effectiveness ratios help investors determine how efficiently the management of the company has used its assets and how successful the company hasbeen at executing its business strategy. These ratios include return on equity (ROE)and return on assets (ROA). In general terms, if you want to compare the skill ofthe management team of one company to another, these ratios are a good place tostart. Return on equity is computed by dividing net income by net worth (net worthis also known