igroup’s fortunes were more dismal.IBM (IBM) also experienced strong growth both in revenue andnet income. Its net return rose strongly through the ﬁve years, indicating improving margins as well as continued controls over expense levels. Although IBM’s net return is lower than the two othercompanies in this study, it does not reﬂect a negative. Every industry is different, and this simply indicates that the gross margins forIBM are different than for AT&T and Citigroup. For example, IBMmanufactures and sells hardware so it has inventory costs as well asdirect labor. In comparison, both AT&T and Citigroup focus moreon services and, in the case of Citigroup, interest income. The margin from this kind of activity is invariably higher than for corporations selling products. This makes the point that comparisonsbetween industries are not valid. A valid comparison would be tocontrast IBM to other information technology (IT) hardware manufacturers and Citigroup to other ﬁnancial institutions.
Tracking Earnings Per Share Over TimeThe net income reported by a company is a dollar value but analysisoften takes place in shorthand. Even the dollar values leave off sixzeroes by reporting in millions of dollars. Earnings (net income) arecommonly reported not by dollar value but by earnings per share(EPS).There is a good reason for this. If one company has 10 million
31
The Bottom Line
shares outstanding and another has 20 million, an identical dollarvalue of net income has vastly different signiﬁcance on a per-sharebasis—regardless of the percentage of net return. EPS is also signiﬁcant because corporate shares outstanding may change overtime. In an ideal situation, issuing more shares translates to higherEPS because the infusion of new capital enables the company togrow over time.It is also important to recognize a trend among large listed companies to buy and retire its own shares on the market, and the effectthis has on EPS. When a company buys its own shares it is a positivesign that management believes the stock is a bargain at its currentprice. When it buys those shares, the company retires them permanently. So if earnings are exactly the same from one year to the next,but the company buys a large portion of its outstanding shares andretires them, this will increase EPS.The calculation of EPS involves dividing earnings by the number of outstanding shares. Earnings cover one full year, so the calculation needs to be adjusted if and when the number of shareschanges. For example, if the company bought (and retired) sharesduring the year, the number of average shares outstanding has to beadjusted to make the calculation accurate. And if the company issued new shares during the year, that also has to be taken into account in calculating EPS.A word on modifying the outstanding shares: The calculationhas to include a weighting for the months speciﬁc numbers of shareswere outstanding. For example, if a company started the year with9 million shares and bought and retired 150,000 shares at the beginning of the third month of its ﬁscal year, it would have to calculate the average shares as follows:2 months, 9 million shares outstanding10 months, 8.85 million shares outstandingaverage shares outstanding:2/12  9.00 million  1.5010/12  8.85 million  7.37total  8.87 million shares
32
Winning with Stocks
This is the number of shares outstanding to be used in calculating EPS. The calculation involves dividing earnings by the numberof shares outstanding. This formula is summarized in Figure 2-3.For example, returning to the previous example of AT&T, Citigroup, and IBM, earnings per share is a revealing analytical tool.The real meaning of earnings is more signiﬁcant when analyzed ona per-share basis than on the dollar value of net return, as shown inTable 2-2.The EPS for AT&T has declined over the ﬁve years in question,so on this basis performance has been disappointing. Citigroup, incomparison, experienced a steady rise in EPS, and IBM’s performance was even stronger. From an investor’s point of view, whichattempts to place value on the revenue and earnings trend, an EPSanalysis over at least ﬁve years is the best procedure to follow.You might expect price performance to track EPS, or in otherwords, as EPS improves, the stock’s price range should climb aswell. This is a reasonable assumption, although outside conditionsaffect price range as well. The general condition of the market for aparticular industry will keep prices down even as EPS rises, or viceversa. However, it is interesting to study the price ranges for a period of time compared to EPS. A summary is shown in Table 2-3.The comparison reveals that you cannot rely solely on EPS topredict market share. Over a long period of time, prices will rise forcorporations whose earnings and EPS rise, but in the short term itis more elusive. In the case of AT&T, the low price rose during theﬁve years while the high price in the range fell. This makes sensewhen you also observe the decline in EPS over the same period. The
FIGURE 2.3. EARNINGS PER SHARE (EPS)
net earnings= EPSshares outstanding
33
The Bottom Line
TABLE 2-2. EARNINGS PER SHARE (EPS)
In MillionsCompany
Year
NetProﬁt
SharesOutstanding
EPS
AT&T
20062005200420032002
$ 7,3564,7864,9795,9717,473
3,9023,3793,3223,3293,351
$1.891.421.501.802.23
Citigroup
20062005200420032002
$21,24919,80617,04617,85313,448
5,0005,1855,2295,2205,200
$4.253.823.263.422.59
IBM
20062005200420032002
$ 9,4167,9948,4487,6135,334
1,5541,6281,7101,7541,737
$6.064.914.944.343.07
Source: Standard & Poor’s Stock Reports
Citigroup history makes sense. The low price levels nearly doubled,even though the high price range showed less growth. The case ofIBM is more puzzling: While the low price range went up substantially, the high price actually fell (even though EPS doubled duringthe period). This could indicate that the stock was undervalued atthe end of ﬁscal 2006, with a high price of only $98. In fact, 10months into 2007, IBM stock was selling above $115 per share.This level of growth makes more sense given the change in revenue,earnings, and EPS over the previous ﬁve years.The lesson from this analysis is clear: You can use net returnand EPS to pick stocks. The recent history may conﬁrm what yousee in price trends, or price trends may be lagging behind, pointingto possible bargains in the market. The case of IBM is a good example of this, with a falling high price trend over ﬁve years through
34
Winning with Stocks
TAB L E 2 - 3 . E P S A N D S H A R E P R I C E R A N G E
Company
Year
EPS
Share Price RangeLowHigh
AT&T
20062005200420032002
$1.891.421.501.802.23
$2422231920
$3626283241
Citigroup
20062005200420032002
$4.253.823.263.422.59
$ 4543423024
$5750534952
IBM
20062005200420032002
$6.064.914.944.343.07
$ 7372917354
$ 989910095126
Source: Standard & Poor’s Stock Reports
2006, which improved into 2007. However, conditions in marketwide trends also affect these stock price ranges, so that is only onepiece of the puzzle.
Core EarningsNet income is supposed to accurately reﬂect the operational outcome for a company. Unfortunately, accounting rules are very liberal, and corporations often include in ‘‘net income’’ some forms ofincome that are not recurring and not even related directly to theirprimary business.Standard & Poor’s (S&P), which rates corporate creditworthiness, devised a system for adjusting net income to ﬁx this problem.The corporate core earnings is an adjusted version of net income
The Bottom Line
35
that removes noncore income. It also puts expenses into the picturethat may have been excluded from the conventional accounting reports.Core earnings should track reported net income fairly closelyand, in fact, in well-managed companies core earnings are veryclose to ‘‘net income.’’ But in some other companies, a lot of variation is found between net income and core earnings. It often is accompanied with a lot of volatility in the numbers, with revenue andnet income changing from one year to the next. Volatility in theﬁnancial statements makes it very difﬁcult to predict future growthlevels, so that alone is a troubling sign. When you also see chroniclarge adjustments between reporting earnings and core earnings, itis even worse. A one-time adjustment can be expected if an unusualoccurrence is in play, such as the sale of a large operating unit oran accounting restatement. But when core earnings adjustments aresubstantial every year, it indicates that there is a larger problem inthe way the company is reporting its proﬁts and losses.You will discover a correlation between core earnings adjustments and the stock price over a period of time. The more volatilethe year-to-year ﬁnancial reports and core earnings adjustments,the more volatile the stock price will be. Those companies reportingvery little in the way of core earnings adjustments will also tend toreﬂect long-term price appreciation and low volatility on the technical side (price movement)—not always, but often.A comparison of three corporations’ net income and core earnings demonstrates not only the variety of outcomes, but the signiﬁcance that these adjustments can and do make. Table 2-4 showsthese results for a ﬁve-year period.These results summarize a range of possible core earnings adjustments. McDonald’s (MCD) reported relatively minor adjustments each year, reducing net income from a high of $325 millionin the earliest year to only $25 million in the latest. Because coreearnings track net income fairly closely and the trend is in the samedirection for both, these adjustments are not troubling.In comparison, Du Pont de Nemours (DD) also reported risingnet proﬁts and core earnings but the level of annual adjustments isfar higher, and two of the ﬁve years showed core earnings higher
36
Winning with Stocks
TAB L E 2 - 4 . N E T I N C O M E A N D C O R E E A R N I N G S
Company
Year
In Millions of DollarsNet ProﬁtCore Earnings
Adjustment
McDonald’s
20062005200420032002
$ 2,8732,6022 2791,508992
$ 2,8482,5402,1001,226667
$ 25 64 179 282 325
Du Pont de Nemours
20062005200420032002
$ 3,1482,0531,7801,0021,841
$ 2,7681,9652,0081,132398
$ 380 882281301,443
General Motors
20062005200420032002
$ 1,97810,4582,8052,8621,736
$ 1,972$6,7414,0404,510 838
3,9503,7171,2351,648 2,574
Source: Standard & Poor’s Stock Reports
than net income. The earliest year had a negative adjustment of$1.443 billion. This level of adjustment is very troubling. Net income was reported at $1.841 billion, but core earnings were only$398 million. Even the latest reported year, with a downward adjustment of $380 million, represented 12 percent of total net income.General Motors (GM) was the most troubling of the three.Every year showed adjustments between net income and core earnings of more than $1 billion. The two latest years approached $4billion, which is massive. Even though four of the ﬁve years showedan increase between net and core, this level of adjustment is disturbing. It points out the ﬂaws of the accounting rules, which allowcompanies to report so inaccurately that this level of adjustmentbetween net income and core earnings is needed. The fact that theproblem is chronic in the case of GM raises another question: Why
The Bottom Line
37
does the company continue to report net income in the manner itdoes, and why are so many adjustments required?Each case should be investigated to determine the reasons forcore earnings adjustments, especially when they are so large. InGM’s case, these adjustments were the result of what the companycalled ‘‘special attribution’’ and ‘‘restructuring and impairmentcharges.’’ These references involve accounting decisions due tolosses in primary manufacturing as well as the parts business, andobvious disagreement between GM’s auditors and S&P’s (the company that deﬁnes and calculates core earnings). The fact that thesedifferences have not been resolved indicates that similar very largeadjustments are also likely to recur in the future. From the point ofview of the investor or analyst considering whether to buy a company’s stock, this level of uncertainty is very troubling. The problems GM faces are severe and more will be explained in a laterchapter. The point to remember here is that the huge adjustmentsto arrive at core earnings serve as a warning that more is wrong inthe ﬁnancial results.1
Core Earnings BasicsThe concept of core earnings has only been around since 2002,so long-term comparisons between reports and core earnings arelimited. However, the comparison for the years the data have beenpublished can be very valuable.The primary core earnings adjustments include two broad categories: ﬁrst are items to be included in earnings that are often leftout, and second are items to be excluded that companies often leavein.
Items Included in Core EarningsEmployee stock option grants are beneﬁts given to top executivesand other employees. The options allow the employee to buy sharesof the company’s stock at a ﬁxed price as long as those options areexercised by a speciﬁed date in the future. The problem with this
38
Winning with Stocks
beneﬁt is that in the past, options were given out but never placedanywhere on the books as expenses. They were explained in footnotes only. So when an executive exercised the options, the effectwas to dilute the value of all other shares, but without ever recordingthe expenses. Standard & Poor’s correctly pegged stock options asa current-year expense, one that artiﬁcially bolstered reportedproﬁts. As a form of compensation, these options are properly reported as expenses in the year they are granted, even if they are notexercised until many years in the future.Restructuring charges is a fancy way of describing ‘‘cuttingback’’ on expenses, usually involving closing down plants and layingoff employees. It sounds more esoteric, but it simply is an admissionthat the company is too big or unable to compete on the scale of itsprevious size. Companies have expenses associated with this ‘‘restructuring,’’ such as severance pay to laid-off employees. S&P hasidentiﬁed these as current-year expenses. Companies have preferredto capitalize these expenses and amortize them over a number ofyears, but that is inaccurate.Write-down of assets are reductions in value. This is accomplished normally by way of depreciation and amortization, but someassets simply lose value above and beyond those periodic charges.Companies often capitalized these reduced values as a form of additional amortization, but under the core earnings interpretation, theyshould be included in current-year expenses.Pension costs are among the largest expenditures some companies have each year. Under an oddity of accounting, these costswere simply excluded from the operating reports, as though providing pension beneﬁts did not relate to current year activity. Coreearnings adjusts the proﬁt and loss in those instances to reduceproﬁts by the amount of pension costs. This is especially appropriatebecause many companies prefer to exclude costs while improperlyincluding estimated pension proﬁts (see items excluded below).Research and development (R&D) bought by the company arealso included as current-year expenses and not amortized overmany years. It is a favorite trick under the accounting rules tospread expenses out over several years to keep proﬁts high, but
The Bottom Line
39
when a company buys R&D, core earnings rules state that thoseexpenses are to be included in the year the expenses are incurred.
Items Excluded from Core EarningsGoodwill impairment is somewhat technical, but it is worth abrief explanation. ‘‘Goodwill’’ is an intangible asset, an estimate ofa company’s value above and beyond its buildings, equipment, andother physical assets. When a company buys a competitor, for example, it may overpay to close the deal. The deﬁnition of goodwillis the net difference between the price the acquiring company paidand the tangible value of assets. ‘‘Impairment’’ is an expense bywhich companies reduce the goodwill asset to reﬂect diminishedvalue. Under the core earnings rules, impairment cannot be countedas a current-year expense. The rule is fair: An intangible asset isbooked with no tangible asset to back it up, so reducing its value tocreate a current-year expense is not allowed. (Remember, however,that core earnings are simply an estimate restatement of income andexpenses, and not a change in the tax-based report issued by thecompany. Core earnings simply is an attempt to adjust proﬁt andloss to reﬂect outcome for the primary business of the company.)Gains or losses from the sale of capital assets are forms of income not related to the primary business. Capital assets—buildings,trucks and autos, ofﬁce and manufacturing equipment, and so on—are normally capitalized or set up as assets and depreciated overseveral years. At the point these assets are sold, the difference between sale price and book value (price less depreciation) is a netproﬁt or loss. However, these gains and losses are not part of coreearnings. The same rule applies when companies sell operatingunits, which may change net proﬁt by billions of dollars. It is nonrecurring, however, and cannot be called a part of current-yearproﬁts.Pension gains are an oddity in accounting. A pro forma numberis created to estimate gains based on investment activity, and thesegains are often far from accurate or are difﬁcult to pin down. Because the gains are unrealized and based on estimates, they are ex-
40
Winning with Stocks
cluded. Even realized pension gains are not part of the current-yearincome of the company.Gains and losses from hedging activities that have not been realized are also excluded. An unrealized gain or loss is one existing onpaper, just as ownership of stock with value higher or lower thanoriginal cost is not counted until sold. Companies use available cashto invest in the market through hedging, but any unsold asset gainsor losses cannot be counted under core earnings rules.Merger and acquisition (M&A) expenses are often the subject ofaccounting manipulation. Depending on the timing of when theseexpenses are booked or how the deal is put together, M&A expenseshave been used in the past to artiﬁcially inﬂate net proﬁts or defertax liabilities. Under the core earnings rules, expenses of acquiringother companies are left off of the proﬁt and loss summary.Litigation or insurance settlements or proceeds can be substantial, either as forms of income or as expenses. In either case, they arenonrecurring and are not part of the current-year primary (core)earnings. When companies include these in the income statement,they are removed to arrive at core earnings.
The Price-Earnings RatioThe fact that core earnings adjustments have often been substantialis troubling to anyone depending on fundamental analysis to pickstocks. If, in fact, core earnings adjustments are large (either upward or downward) then all proﬁt-based ratios will be distorted.While company-to-company comparisons are valuable, they become questionable when the core earnings are not similar. For example, if one company has little or no adjustments and another hasvery large adjustments, they cannot be compared accurately.There is self-deception involved in using traditional but inﬂexible models for stocks. Favorite ratios like the price-earnings (P/E)ratio are obviously going to be distorted whenever net proﬁts areadjusted, at times in the billions of dollars. So a P/E ratio has to bevalued with potential core earnings in mind; when core earnings
41
The Bottom Line
adjustments are signiﬁcant, the P/E should be viewed with thatqualiﬁcation. However, because P/E is so widely used and invariably based on net income (and not on core earnings), it is difﬁcultto apply a revised standard universally. It is prudent, however, to beaware of the level of core earnings adjustments and to analyze P/Eon an adjusted basis—core P/E—whenever adjustments are substantial.The P/E is easy to calculate. Price per share is divided by earnings per share (EPS); the formula is summarized in Figure 2-4.For example, a stock sells today at $55.00 per share, and latestreported EPS was $4.55. So P/E is:$55.00 12$4.55
The P/E is always expressed as a single numerical value called themultiple. It is commonly rounded to the closest whole number. Soin this example, the multiple is 12, meaning the stock is selling at12 times earnings.In studying P/E, it is reliable to study the P/E range over aperiod of years and to also review year-end price and earnings. Otherwise, the ratio is distorted. For example, if you look at today’sprice and compare it to the latest-known EPS, you could be distorting the ratio. If EPS is two months old and the price has changedconsiderably since that latest quarterly report, P/E in its currentform is not a reliable indicator.Table 2-5 shows the ﬁve-year range of P/E for three companies.It is valuable to compare these and interpret what the P/E reveals.
FIGURE 2.4. PRICE/EARNINGS RATIO (P/E)
price per share= P/Eearnings per share
42
Winning with Stocks
TAB L E 2 - 5 . P R I C E - E A R N I N G S R AT I O S
Company
Year
HighP/E
LowP/E
Merck (MRK)
20062005200420032002
2317192221
1612101412
JPMorgan Chase (JPM)
20062005200420032002
1217281250
91422619
Starbucks (SBUX)
20062005200420032002
5553685048
3937352934
Source: Standard & Poor’s Stock Reports
These historical P/E levels and trends are quite different fromone another, and they are also very revealing. In picking stocks tobuy or determining whether to hold or sell, it is useful to employseveral ratios; however, just by looking at the P/E you can concludea lot about each of these companies.Merck reported a historically low P/E range as well as consistency. This is desirable because it implies not only low volatility,but very steady growth in earnings and in price. In comparison,JPMorgan Chase (JPM) has been quite volatile, although its P/Erange has come down over ﬁve years, which is positive. The largechanges in the ﬁrst three years were signiﬁcant, but since then therange and level have both calmed down. Starbucks has reportedconsistently high P/E; even its annual low P/E range has been highat over 21 in February 2008 (see table). For anyone looking forstocks with bargain-level multiples, Starbucks is too expensive. One
43
The Bottom Line
of two things would need to occur: Earnings would have to growconsiderably without a corresponding change in price range, or theprice would have to fall.
Year
StarbucksP/E RangesLowHigh
20072006200520042003
2339373529
4255536850
Source: Standard & Poor’s Stock Reports.
P/E is, and should be, a favorite ratio for valuing stocks, and it issimple to comprehend. In determining whether a stock is relativelycheap, the P/E is the most reliable tool. P/E is an important test ofvalue, and the following points should be remembered:1. P/E is a reliable value test. In identifying bargains, P/E helpsas a comparative test. The higher the P/E, the greater the likelihoodthat the stock is too expensive. A very high P/E translates to higherthan average risk. A ‘‘typical’’ P/E is a matter of opinion, but mostwell-priced stocks offer P/E between 10 and 25. So for many investors, comparative P/E analysis is one method for narrowing down alist of potential investments.2. P/E is easy to understand and compare. Unlike some ratheresoteric ratios, P/E is simple. It is useful for tracking one company’sstock over time as well as for making comparisons between differentstocks.3. Your decisions are made easier using P/E. Investors strugglewith the question of when (and if) to buy, as well as whether to holdor sell stocks. A basis has to be used for making decisions to cutlosses or to take proﬁts, or even to continue holding a stock. TheP/E can be used to set a standard. For example, if P/E rises, itindicates that the stock is overpriced compared to its previous price
44
Winning with Stocks
levels. This does not necessarily mean that the stock’s market pricehas risen; it could mean that the earnings have declined. Even whenprice remains at the same level, if earnings per share decline, thenP/E will rise.The problem of core earnings remains. If the difference betweenreported net proﬁt and adjusted core earnings is large, then P/E willbe distorted. This is especially true in those cases where core earnings adjustments are erratic. When adjustments occur in the billionsof dollars, often replacing reported proﬁts with core net losses, theP/E as reported clearly cannot be depended upon for year-to-yearor company-to-company analysis.Adjustments between reported net income and core earningsnot only affect investor decisions concerning portfolio holdings,they also affect market perceptions of a stock’s value as an investment. At the same time, the items adjusted to reﬂect only core earnings remain valid adjustments for companies; they are just not partof the core earnings, meaning they cannot be expected to recur.Ultimately, the real ‘‘value’’ of a company is what it would beworth if it were liquidated today. This enterprise value consists ofthe net value of the company if it were to be liquidated entirely. Thisexcludes intangible assets and recognizes the claims of both equityinvestors (stockholders) and debt investors (bondholders and otherlenders).The valuation of a company is a difﬁcult and elusive matter.Accounting rules are complex enough so that no one has an easytask trying to compare one organization to another, or even to geta reliable picture of what happens in one company from year toyear. Because fundamental transactions and reports affect the stockprice, it is far too difﬁcult for anyone to simply determine whethera company’s current price is a good bargain. This is why the basicP/E continues to serve as a reliable and worthwhile indicator. Coreearnings in many cases make only an insigniﬁcant difference inP/E, so perhaps the smartest way to evaluate stocks is to ﬁrst eliminate those companies with excessively large core earnings adjustments, and then make P/E comparisons over several years andamong several companies.
The Bottom Line
45
The next chapter takes this discussion to another level, the current yield. This comes from dividends the company declares andpays. For many investors, dividend income is going to act as a signiﬁcant portion of total income, but this aspect of total return isoften overlooked or discounted by investors more intrigued by dayto-day market price action.
Note1 As of the end of 2006, General Motors reported negative net worth of $5.441billion, and total long-term debt at 115% of total capitalization. Source: GMannual statement, at www.gm.com.
This page intentionally left blank
C
H
A
P
T
E
R
3
YIELD ANDYIELD HISTORY
W
hat is dividend yield and how can it be used to judge and comparestocks? This chapter explains dividends and historical yield as ameans for judging stability and fundamental strength. It also explains why yield as reported in the ﬁnancial press is deceptive. Thepress reports yield as a percentage of the stock’s current price; investors should track yield based on their purchase price only, because market price is changing constantly.Misconceptions about yield abound. The investor has to remember that rate of return varies depending upon how manymonths or years an investment is owned. This chapter explainshow yield and return work and how yield differs from earnings—in other words, how net earnings as a percentage of sales isvastly different than the combination of dividend yield on investedcapital plus capital gains. Because investors tend to obscure thedifference, it is necessary to mark the distinction in order to clarifyall comparisons.
47
48
Winning with Stocks
Dividends as a Form of IncomeIt is easy to overlook, or even ignore, dividends when picking andcomparing stocks. The yield is quite small in terms of percentagesand dollar value, so does the dividend really mean much at all? Dividend yield is one of the more important criteria for choosing companies as investments for several reasons:1. Dividends are a form of income. Over many years, a persistent stream of current income adds up. As a segment of retirementincome, dividends can play a major role, so having a portfolio ofsafe, high-yielding stocks is a smart long-term plan.2. Reinvested dividends provide compound rates of return. Taking dividends in cash makes no sense until you plan to actually usethe dividend income for monthly expenses. While building wealthover many years, reinvested dividends create a powerful form ofcompound returns. Not only do you earn ‘‘dividends