’s shares. These people are usually the most knowledgeable, and willsometimes buy and sell their stock based on what they believe will happen next. If thepresident, chairman, and directors are selling significant portions of their positions thatcould be cause for concern. But if a couple of insiders are selling small percentages oftheir holdings, then the selling is probably not significant. There are many reasons aninsider might decide to sell stock. Perhaps he or she wants to buy a new house or car, orit’s time to send the kids to college. Neither of these reasons has any bearings on thefirm or its expected fortune—it’s just part of human realities. But if insiders start investing additional money into the company by purchasing shares of stock, this is a verygood indication that they believe the firm has a bright and prosperous future.Insider: (1) A person, due to his or her position at a company, who has access toproprietary information not yet available to the general public; and (2) An officer, ordirector of a firm with a 10% or greater ownership stake in the company’s securities.
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According to Dow Theory, the accumulation phase of a stock exists when a stockbegins to move higher or is in the first leg of an uptrend. During this initial rise, informed and astute investors are buying the stock and pushing it higher. Additionally, if major shareholders are buying large amounts of the stock, then that could bea sign that positive news is going to be released in the near future.However, it is important not to make an investment decision solely based on thisone source of information. This is just one piece of the puzzle that provides additional insight on the company you are investigating. Besides, sometimes investorssour on a stock simply because there has been significant insider activity. This canprove to be a mistake. After all, insiders have bills to pay just like anyone else.Sometimes their living expenses are greater than their salaries and they need to sellstock in order to cover them. In general, there will be much more insider sellingthan buying in any particular stock.Insider selling and buying information is easy to access on the Internet.Yahoo! Finance lists all of the insider buy/sell transactions that have beenfiled with the Securities and Exchange Commission. You can find thisinformation at:••••
finance.yahoo.com/?uwww.zacks.comwww.insidertrading.comwww.insiderscores.com/nindex.asp
When considering insider buying and selling, it is generally better to invest in companies with more insiders holding shares (i.e., the more insiders of the company whoown stock, the better). Why? Who is likely to manage the company more efficiently—an insider with a large stake in the company or someone with no vested interest? Inother words, if you are a large owner of a company (because you own many shares)you will be more likely to work diligently to increase shareholder value and increasethe stock price. Insider ownership of 15% or more is a healthy sign.
4. Management InterviewsAnother means of assessing the performance of your potential investment is to listen to interviews with top management. This will not only give you a feel for management’s opinion of the future, but also key you in to what drives the opinions ofthe professionals. Although you can’t sit down with Jeff Bezos of Amazon.com, orTim Koogle at Yahoo!, the Internet is tearing down some of these barriers and opening up access to company conference calls. The number of companies broadcastingtheir conference calls in real-time and archiving these calls to be reviewed later isincreasing rapidly—so much so that the investment community is beginning to expect it as standard procedure. A great deal can be learned from listening in to thesecalls and interviews, even if you are not able to ask specific questions yourself.The management of a public company also has a financial incentive to communicate
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with the Wall Street analysts. It keeps the doors open to raise capital in the future. Theyalso have incentive to communicate with the media and investors to keep them informed of both positive and negative developments. In this way, they can manage expectations and avoid negative surprises that might be damaging to the stock price.Most individual investors can satisfy their need for information by monitoringthe newswires, the Internet, company conference calls, management communiqués,and annual reports. In a detailed analysis of a company, though, an analyst will raisedifficult questions about management, including:• Who is leaving?• Who are the key men or women?• What would the loss of these individuals mean to the company?• Is the compensation reasonable?• Are there any capital expenditures that could or should have been avoided?• What are the future plans for expansion and capital expenditure?• What is the company’s outlook for its industry?• Who are its chief competitors?• Are there going to be any significant write-offs or adverse charges that willreduce earnings?• What kind of guidance can management give about revenue and earnings forthe quarter?• Are there any big contingent liabilities such as unresolved court cases, orproblems with unfunded pensions?• What is the nature of the company’s contractual relationships with customersand suppliers? Is it heavily dependent on a single customer?From the perspective of valuation, the main goal of these interviews is to determine the internal risks to the company and whether those risks have been reflectedin the financial analysis you perform.Another way to stay abreast of company-specific information is to visit theweb site of the company you are investigating. You will be able to request an investor information packet online, and additional information regarding the company is available.Radio@WallStreet (www.radiowallstreet.com) broadcasts manydifferent conference calls with a variety of companies. Top-levelmanagement discuss the future prospects of their companies in a timelyfashion. This is a great way to confirm or reject ideas that you havedeveloped about a company, and to stay abreast of upcoming events.
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5. Analyst CoverageAn analyst in street parlance is someone who works for an investment bank, brokerage firm, or some other type of financial services company. Analysts study companies, write research reports, and make specific recommendations based on theirconclusions. For instance, there are a large number of analysts that issue reports onIntel Corporation. A company with a large number of Wall Street analysts researching it is said to have a large following, or analyst coverage.Analyst coverage: The number of analysts issuing specific recommendations ona specific company; also known as a following.
After studying the company (mainly using fundamental analysis techniques), theanalyst will issue a specific recommendation on the company. For instance, if theanalyst expects the stock price of the company to increase, he or she may say it is astrong buy or a buy. Simply put, if an analyst believes that a company is undervalued, a buy recommendation might be made. If that company is overvalued, thecompany might be downgraded to a lower recommendation.Often there may be discrepancies or differing opinions among analysts, and thisis what makes a market. For example, Merrill Lynch may believe Cisco Systems(CSCO) is overvalued because of low earnings per share, but at the same timeGoldman Sachs may believe Cisco is undervalued due to the great growth prospectsthat the company has in the future. It is your job as an investor to gather the information, analyze it, and make your own decision about the prospects of the company. Furthermore, as new information about a company, its industry, or theeconomy becomes available, you and the analysts will be forced to wrestle withthese facts and make new determinations of value.Fundamental analysis is an ongoing process in which the value of thecompany is continually being assessed in light of new information.The more analysts that cover the stock, the greater the speedthe new information will be incorporated into the stock price.
Whether it is better to invest in stocks with a large following is subject to debate.Specifically, a stock with many analysts covering it will have a good institutionalfollowing because large investors (mutual funds, insurance companies, financial advisers, etc.) rely heavily on analyst recommendations. After all, if a large investorbuys a stock and it turns out to be a loser, he or she doesn’t have to accept full responsibility if every brokerage firm on the Street had it as a strong buy. Therefore, acompany with many buys and strong buys will often have many large institutionsbuying the stock and that, of course, is a positive for the stock. Conversely, a company with no analyst coverage whatsoever may turn out to be an uncut gem. Since ithasn’t been studied by dozens of Wall Street analysts, it has a greater chance of
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having strong fundamentals that have so far been overlooked. In short, there appears to be no magic number with respect to analyst coverage.
Here are some of the common terms used when analysts make recommendations concerning a stock.• Strong buy: If an analyst issues a strong buy on a stock, it means that he orshe believes that it will be among the best-performing stocks over the courseof the next year or two.• Buy: The analyst is confident in the company and expects the stock price toincrease. When an analyst issues a buy, he or she is advising the firm’s clientsto own shares of the company.• Attractive: When an analyst says a stock is attractive, his or her analysis suggests that the stock is a good value and shares can be purchased.• Accumulate: The analyst recommends that investors make periodic purchases over coming months—buy on the dips.• Market outperform: The analyst expects the stock to perform better than themarket (S&P 500).• Market perform: The analyst expects the stock to perform similarly to themarket.• Market underperform: The stock is expected to perform less well than themarket.• Hold: The analyst has no strong feelings toward the stock either way. He orshe would not buy new shares, but if they are already in the investor’s portfolio, the analyst would not sell them, either. The analyst recommends that theinvestor hold the stock.• Avoid: When a stock is rated avoid, the analyst is recommending that investors not add any shares to their portfolios.• Sell: The analyst is very negative on the company and expects the share priceto fall.• Strong sell: The analyst feels very strongly that there is a fundamental problem with the company and the share price is going to fall in the near future.Avoid any stock with a strong sell rating.
Nevertheless, when dealing with analysts, there are a few guidelines to follow.First, avoid stocks with a majority of sell or hold ratings. It is a sign that there is aserious fundamental problem. Only in rare cases will a Wall Street analyst issue asell rating. Why? Since most brokerage firms also have investment banks that workto help companies raise capital and go public, issuing a sell might hurt future business and is therefore not a good public relations move by an analyst. A sell or strongsell is often a sign of a serious fundamental problem.Second, the changes in analyst recommendations can often cause drastic swingsin a stock price. For instance, stocks can sometimes get a boost when there is a
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change in rating from hold to buy. When an analyst downgrades the outlook for a company, it can cause the share price to fall. That was the case in the example in Figure 7.4.
ACCESSING COMPANY INFORMATIONIn order to really understand a company’s operations, it becomes necessary to openup its books and look at its financial statements. In the next chapter, we will look at10 more tools of fundamental analysis. But before that, the reader needs to find access to company reports or financial statements. There are three principal reports:the income statement, the balance sheet, and the statement of cash flows. The important elements of all three are covered in the next chapter. First, let’s see if youcan get your hands on some.Publicly traded companies are required to file periodic financial statements with theSEC. Specifically, the Securities Exchange Act of 1934 requires all public companiesto report quarterly and annual reports—called the 10-Q and 10-K respectively. Thesereports include the income statement, balance sheet, and statement of cash flows.There are a number of ways to obtain the 10-K and 10-Q. If you have online access, you can go to the company’s web site or surf over to www.10kwizard.com orsecedgar.com. The Securities and Exchange Commission also has a web site
Figure 7.4 Analyst Downgrade—Netsolve (NTSL) (Courtesy of QCharts(www.qcharts.com))
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(www.sec.gov) with a database of company financial statements—known asEDGAR—available to the investing public. From www.sec.gov/edgarhp.htm, it ispossible to search for 10-Ks and 10-Qs of almost any company. The 10kWizardweb site (www.10kwizard.com) also offers access to company financial statementsfree of charge.A number of other services provide more polished versions of the financial statements. Investors have used S&P Stock Reports for years. Today, the reports areavailable in print and online. The online reports are available at the S&P PersonalWealthsite (www.personalwealth.com) for a fee and include all of the important elements from the financial statements. For instance, the online reports offer a synopsis of the income statement (see Figure 7.5).There are several information services that allow investors to search and screenstocks based on fundamental information pulled from the financial statements including Value Line Investment Survey, Market Guide, and Zacks. Unlike the 10-Ksand 10-Qs available from EDGAR and 10kWizard, they are not the actual statements, but contain elements taken from the financial statements.Financial statements can also be found in a company’s annual report. Finding theannual report on the company’s Internet site is often a matter of going to the homepage. For instance, Wal-Mart (WMT) has a site at www.wal-mart.com. Once youplug the URL into your browser and pull up the start page, click on About WalMart. Then, click on Wal-Mart Stores Corporate Information, and voilà—a selection of the financial information can be accessed.Individual company web sites will vary in the information that they make available. Obviously, not all companies offer financial statements online. Nonetheless,
Income Statement Analysis (Million $)1999
1998
1997
1996
1995
1994 1993 1992 1991 1990
Revs.
6,716
3,974 2,938 2,274 1,878 1,377
783
349
232 171
Oper. Inc.
3,138
1,185
798
583
489
383
202
63.9
30.1 16.7
Depr.
447
203
136
86.9
53.6
32.7
21.7
17.4
9.3
7.5
Int. Exp.
33.5
20.2
15.5
12.0
12.9
15.3
6.0
4.8
1.9
1.9
Pretax Inc.
1,357
1,058
718
519
451
355
180
42.3
20.1 12.5
Eff. Tax Rate
26%
25%
25%
26%
28%
30% 29% 32% 35% 29%
Net Inc.
1,011
793
539
386
327
251
Figure 7.5
Sample of Income Statement Analysis from S&P Online Report for EMC
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28.7
13.0
8.9
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many do, and that’s why a company’s web site is a good place to start looking forfinancial statements.If you are really interested in a company and want to see its financial statementsbut do not have the desire to do an online search, the best course of action is to call acompany’s headquarters. If you do not have the telephone number, contact the location nearest you and ask for the number for corporate headquarters. Value Line Investment Survey (again, available in most local libraries) also has company telephonenumbers within their stock reports. If you can get online, go to Excite stock quotesand check a stock’s profile. The phone number and address is listed there.Once you have the telephone number, call the company and ask the receptionistfor investor relations. In most cases, an automated system or voice mail will tell youto leave your name and address after the beep if you want financial information orreports. Then the ball’s in your court. You have to decide what you want: an annualreport (10-K), a quarterly report (10-Q), recent press releases, or some analyst reports. If, by chance, you actually have the chance to speak to a living person, makethe same request or simply ask for an investor relations package. In a few days, youshould receive the package.Investor relations: The department within a company that is responsible forhandling investor questions, issuing press releases, creating financial documents, and sending out financial information.
CONCLUSIONThere are a number of factors to consider when analyzing a company. In this chapter, you have been introduced to the first part of fundamental analysis—the study ofthe company. Unlike technical analysis, which is really a look at the performance ofthe stock price (and the subject of Chapter 9), fundamental analysis is concernedwith the operations of the company. Is the company efficient? How profitable is it?Are sales and revenues growing?At this point, you should be busy trying to get your hands on the annual report ofyour favorite company. Maybe you already have one. If not, annual reports are easily found online. Therefore, try a company’s home page. If this fails, try a search using Yahoo! or Lycos (or your favorite search engine) and type in the company’sname. This often leads to the home page and then the annual report. Other sites offer financial statements online, and several were noted in this chapter. EDGAR atthe SEC site is the most widely used (www.sec.gov).However you choose to do it, actually having the documents before beginning thenext chapter may help you to understand the remaining 10 key elements of fundamental analysis (although it is not essential). The first five were covered in this chapter.They don’t require calculators or complex calculations. In fact, the process of fundamental analysis starts at a very basic level—simply finding out what a company does.
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Other factors to consider are the number of shares insiders hold, management interviews in the media, the company’s position in the industry and market share, and whatWall Street analysts are saying about the stock. The remaining 10 tools are equallyimportant, but require information pulled from the financial statements. So, open thatinvestor relations package, and get ready to start crunching numbers.
ROADMAP TO SUCCESSObjective
Course of Action
FundamentalAnalysis
Definition: A form of securities analysis that attempts to gauge astock’s true value based on the business prospects of thecompany. The focus often centers on the company’s futureearnings and dividends prospects.Fundamental: The study of the company—earnings, sales, profitmargins, return on equity, debt, assets, and so on.Technical: The study of the stock price—price, last trade, high,low, open, close, volume, and so on.What is the purpose of fundamental analysis?• Identify companies with desirable or undesirable attributes:growing profits, increasing sales, positive cash flow, and soon.• Consider the stock price in light of the company’sfundamentals.• Identify a misvalued stock. If fundamental analysis suggeststhat the company is worth more than the stock price, theinvestor will buy the stock in anticipation that it will increasein value.
Chapter 7 Contents
1. The Basics2. Identifying Industry Leaders3. Insider Holdings4. Management Interviews5. Analyst Coverage
The Remaining 10Tools ofFundamentalAnalysis
6. Revenues or Sales7. Earnings or EPS8. Price-to-Earnings (P/E)9. Price-to-Sales10. Research and Development11. Current Ratio12. Debt/Equity13. Management Effectiveness Ratios14. Cash Flow from Operations15. PEG Ratio
Understanding theBasics
The basics reveal a lot:• Understand what the company does. Is it a technology,retailer, or financial services company?
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EXPLORING FUNDAMENTAL ANALYSIS• How does the company make money?• Is the company’s business seasonal, cyclical, or dependenton the weather?• Do you understand the company?• Where is your particular area of expertise?• Fundamental analysis is easier to understand when youinvestigate a company in which you developed a workingunderstanding of its business sector.
Industry Leaders
Successful companies are often industry leaders.• Industry leadership does not necessarily mean the largest insize or revenues.• Successful companies are often trendsetters. For example,Microsoft set the standard for computer operating systemsand became one of the largest companies in the world.• In your area of expertise, are there any companies setting thestandard for a way of doing business or a product?• Look around—what are your friends and neighbors buying?• Are there any companies that are capitalizing on changes inthe industry and increasing market share?• Is competition a threat to future profitability?• Market share is like a piece of pie—the bigger a company’spiece of the pie, the better.
What to Look For
• Examine market share—if you can’t find the exact percentageor have questions, contact the company’s investor relationsdepartment.• How does the company rank within the industry?• Check Zacks ranking.• Check Value Line ranking.• Check S&P ranking.• Check the Investor’s Business Daily industry rankings.• Learn more about the major players in specific industries atwww.stockworm.com or www.zacks.com.
Insider Holdings
Insiders: Officers, directors, and shareholders who own morethan 10% of a company’s shares.• Insiders often have access to information that the generalpublic does not.• Watching what insiders are doing is often insightful. Are theybuying or selling shares?• Well-informed investors often buy shares before a big movein the stock.• Insiders often sell shares for legitimate reasons such as to payfor a child’s college education. In general, there is muchmore insider selling than buying.• Insider activity is just one source of information and, takenalone, not sufficient for making investment decisions.• A company with a large percentage of insider ownership is apositive.
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• 15% or more is a healthy sign.• Access insider buying and selling on the Internet:–www.insidertrading.com–www.insiderscores.com/nindex.asp–finance.yahoo.com–www.zacks.com• Check the percentage of insider ownership in the Value LineInvestment Survey stock reports.ManagementInterviews
Interviews with top management can be insightful.• What is management’s opinion of the future?• Can you access a conference call?• Questions to ask about management:–Who is leaving?–Who are the key members?–Is the compensation reasonable?–What is the company’s outlook for the industry?• Visit www.bloomberg.com.• Listen to radio@Wallstreet (www.radiowallstreet.com).• Watch for television interviews—CNBC, CNN, Wall StreetWeek (public television—Friday evenings), Moneyline(CNN—nightly), and Nightly Business Report (publictelevision—nightly).
Analyst Coverage
• Wall Street Analysts: Study individual companies, assess theirfundamentals, and issue recommendations.• If an analyst rates a company a strong buy or buy, it suggeststhat he or she anticipates the share price to move higher inthe future.• Companies with a large number of buy recommendationswill have a large institutional following. Meaning, many largeinvestors will have an ownership stake and represent animportant source of buying power to keep the stock movinghigher.• A stock with no analyst coverage may prove to be a hiddenvalue not yet discovered by the Street.• Avoid stocks with sell and strong sell recommendations.They are a sign of fundamental problems companies areexperiencing.• Know what analysts are saying about the stocks you areinterested in—visit www.zacks.com to find out.• Monitor the day-to-day changes in analyst recommendations.–finance.yahoo.com–www.bloomberg.com–www.etrade.com
Accessing Company A large amount of financial information can be found in aInformationcompany’s financial reports.• 10-Q—A company’s quarterly financial statements filed withthe SEC.
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EXPLORING FUNDAMENTAL ANALYSIS• 10-K—The annual report to the SEC.• Annual report—A report issued once a year to a company’sshareholders. It contains information from the 10-K andmanagement discussions of the company’s operations.• There are three key financial statements investors need forthe next chapter:–Income statement–Balance sheet–Statement of cash flows• Search the EDGAR database at www.sec.gov to obtainfinancial statements for the companies that interest you; or:• Visit www.10kwizard.com to obtain the financial statements;or:• Go to the company’s web site and pull up the annual report;or:• Call the company and ask for an investor relation’s package;or:• Visit your local library’s business section and look up acompany’s annual reports.
8Analyzing Company Reports
If you were bold enough to call for an investor packet, it is possible that you havealready learned something about the company as a potential investment just by going through this process. A primary avenue for learning about a firm is to have personal contact with an employee. During this process you should have observed howwell you were treated and how responsive the investor relations department was toyour request. Many large companies are inundated with calls for information andsimply do not have the time to give attention to each individual request. Smallercompanies, however, will often spend considerable time with interested investorsand even try to sell them on the company. What was your experience with the investor relations department? Did the company seem efficient? Is it portraying itselfwell to the investment community? These are all important questions that can be answered simply by being observant while doing your homework on the company.If you really want to see how the company operates, and it is in yourarea, ask if you can pick up the investor relations package in person.Sometimes, as a potential investor, you can even get a tour of the facility.
The primary goal at this point, though, is to obtain an investor relations packageand, specifically, the annual report. Why the fuss about an annual report? Actually,it is a very important document containing vital information about the company, aswell as the sector you’re researching. At the same time, beyond the detailed financial information, it is a marketing piece and another vehicle for the company tocommunicate with potential investors. Keep these questions in mind when perusingthe annual report:• What is the main message conveyed by the company?• Are objectives addressed squarely, or is the report too vague?221
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• Does it appear the company is spending its money wisely? How would yougrade it in the following categories?Research and development: Is R&D increasing or decreasing (or nonexistent)?Debt service and reduction: Look at the debt level from past years movingto the present; is debt increasing or decreasing? Have earnings suffered asa result?Salaries and bonuses: This is an area that sometimes causes shareholder angstto rise. Is management being overcompensated for mediocre performance?All these qualitative elements of the company are part of fundamental analysis. Inorder to be confident in your investment, it is important to be confident that management is efficient and looking to add shareholder value. The investor relations department is responsible for conveying these attributes of their company and if they havedone their job properly, then you should feel quite impressed with the organization.Now that you have the investor relations package in hand—or you’ve found thecompany’s financial statements on the Internet—you’re ready to dig deeper and really take a closer look at the company’s finances. In Chapter 7, we covered the firstfive tools of fundamental analysis:1. The basics2. Industry leaders3. Insider holdings4. Management interviews5. Analyst coverageThe remaining 10 steps call for you to inspect the company’s books (i.e., its financial statements). At first, the thought of analyzing financial statements might haveyou moving toward the kitchen to brew up a pot of coffee. Fortunately, I am not going to teach you how to analyze every line on each financial statement. Rather, thefocus will center on the most meaningful aspects. A student of the market can spendyears trying to figure out how to interpret financial statements. Our goal is to focuson the most relevant aspects and the financial ratios that really matter.If you want more details on studying financial statements, a good source isThe Analysis and Use of Financial Statements (second edition, June 1997) byGerald I. White, Ashwlnpaul C. Sondhi, Dov Fried—it’s only 900 pages long!
As we have already determined, the annual report is an important piece of information. It will include management’s discussion of the company, the operationsover the past year, and the outlook going forward. It can sometimes be very persuasive, but given that company management writes it, the report is not always objective. In addition, management may try to bend and shape the actual numbers to putthe company in a better light than perhaps it deserves. This is why you hear of
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so-called accounting irregularities from time to time—some accountant got overlycreative with the numbers and got caught! Be watchful for accounting irregularities,for they often send the guilty stock into a tailspin.To study the numbers, there are three key financial statements included in the annual report: the income statement, the balance sheet, and the statement of cashflows. All three of these financial statements reveal unique pieces of information inregard to the success of a company’s operations.Income statement: A financial report of all revenues and expenses pertaining toa specific time period. This report provides the information necessary to calculate the earnings per share, profit margin, P/E (price-to-earnings) ratio, and P/S(price-to-sales) ratio.Balance sheet: A report that shows the financial status of a business entity at aparticular instant in time. It is like a snapshot of a business, and it also containsthe financial information to calculate the current ratio, debt/equity ratio, returnon equity, and return on assets.Statement of cash flows: A report that shows the cash receipts and cash payments of an entity during a particular period. The important part of this statement is to see positive cash flow from operations. This implies that the companyis actually making money at what it is doing.
THE INCOME STATEMENTThe income statement is a report of all revenues and expenses pertaining to a specific time period. It is a relatively simple, but extremely useful table. When referring to a company’s financial results, analysts and reporters often talk of the “topline” and “bottom line.” The reason is that on the income statement the top line liststhe company’s sales or revenues. Therefore, if someone says that a company hashad significant top-line growth over the past year, it means that the sales have increased significantly over the past year. The bottom line is the profit, or earnings, ofthe company. It appears on—you guessed it—the bottom line of the financial statement and is the most widely followed measure of a company’s performance. Figure8.1 shows the quarterly income statement dated June 30, 2000, from EMC Corporation (EMC). Let’s break each section down into bite-sized pieces.
Revenues or SalesThe primary objective of all companies is to generate sales and revenues. This iswhat generates the cash flow in order for the company to meet obligations and togrow. Again, the sales or revenue figure is also referred to as the top line, becausethese numbers are reported at the top of the income statement. Figure 8.2 takes thefirst items from the income statement in Figure 8.1.
224
ANALYZING COMPANY REPORTSStatement of Income(In Mill