The Five Rules for Successful Stock Investing 7

Analyzing a Company – The Basics

Because [analyzing companies] can be a daunting task, I suggest that you break down the process into five areas:

1. Growth: How fast has the company grown, what are the sources of its growth, and how sustainable is that growth likely to be?
2. Profitability: What kind of returns does the company generate on the capital it invests?
3. Financial health: How solid is the firm's financial footing?
4. Risks/bear case: What are the risks to your investment case? There are excellent reasons not to invest in even the best-looking firms. Make sure you look at the full story and investigate the negatives as well as the positives.
5. Management: Who's running the show? Are they running the company for the benefits of shareholders or themselves?

You can't just look at a series of past growth rates and assume that they'll predict the future [...]. It's critical to investigate the sources of a company's growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that's generated by cost-cutting or accounting tricks.

In the long run, sales growth drives earnings growth. Although profit growth can outpace sales growth for a while if a company is able to do an excellent job cutting costs or fiddling with the financial statements, this kind of situation simply isn't sustainable over the long haul – there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottom line. In general, sales growth stems from one of four areas:

1. Selling more goods or services
2. Raising prices
3. Selling new goods or services
4. Buying another company

If you don't know how fast the company would have grown without acquisitions, don't buy the shares – because you never know when the acquisitions will stop. Remember, the goal of a successful investor is to buy great businesses, not successful merger and acquisition machines.

The first component of ROA (Return on Assets) is simply net margin, or net income divided by sales, and it tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business. The second component is asset turnover, or sales divided by assets, which tells us roughly how efficient a firm is at generating revenue from each dollar of assets. Multiply these two together, and you have return on assets, which is simply the amount of profits that a company is able to generate per dollar of assets. Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating assets into profits.

ROA helps us understand that there are two routes to excellent operational profitability: You can charge high prices for your products (high margins), or you can turn over your assets quickly.

Return on equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity – in other words, it measures how good the company is at earning a decent return on the shareholder's money.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

The Risks of Debt-Driven Returns on Equity

The three levers of ROE are:
- net profit margin  (achieve through operational efficiency)
- asset turnover (achieve through operational efficiency)
- financial leverage (achieve through employing high debt)

But does it matter if a company's high ROE comes from high debt and not operating efficiency?

If a company has a steady or steadily growing business, it might not matter that much.

For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem.  And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk.

If a company's business is cyclical or volatile in some other way, though, watch out.

The problem is that debt comes with fixed costs in the form of interest payments.  The company has to make those interest payments every year, whether business is good or bad.

When a company increases debt, it increases its fixed costs as a percentage of total costs.

In years when business is good, a company with high fixed costs as a percentage of total costs can make for a great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line.

When business is bad, however, the fixed costs of debt push earnings even lower.  

That is why debt is sometimes referred to as leverage:  It levers earnings, making strong earnings stronger and weak earnings weaker.

When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile.  

So the next time you're thinking about profitability, make the distinction between the kind that is internally generated (through operational efficiencies) and the kind that is inflated by debt (through leverage).

You can make a lot of money of stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.

ROA

A visual glossary of corporate finance

http://glossary.income-outcome.com/

ROA And ROE Give Clear Picture Of Corporate Health

by Ben McClure 

With all the ratios that investors toss around, it's easy to get confused. Consider return on equity (ROE) and return on assets (ROA). Because they both measure a kind of return, at first glance, these two metrics seem pretty similar. Both gauge a company's ability to generate earnings from its investments. But they don't exactly represent the same thing. A closer look at these two ratios reveals some key differences. Together, however, they provide a clearer representation of a company's performance. Here we look at each ratio and what separates them.

ROE
Of all the fundamental ratios that investors look at, one of the most important is return on equity. It's a basic test of how effectively a company's management uses investors' money - ROE shows whether management is growing the company's value at an acceptable rate. ROE is calculated as:

Annual Net Income             Average Shareholders' Equity

You can find net income on the income statement, and shareholders' equity appears at the bottom of the company's balance sheet.

Let's calculate ROE for the fictional company Ed's Carpets. Ed's 2009 income statement puts its net income at $3.822 billion. On the balance sheet, you'll find total stockholder equity for 209 was $25.268 billion; in 2008 it was $6.814 billion.

To calculate ROE, average shareholders' equity for 2009 and 2008 ($25.268bn + $6.814bn / 2 = $16.041 bn), and divide net income for 2009 ($3.822 billion) by that average. You will arrive at a return on equity of 0.23, or 23%. This tells us that in 2009 Ed's Carpets generated a 23% profit on every dollar invested by shareholders.

Many professional investors look for a ROE of at least 15%. So, by this standard alone, Ed's Carpets' ability to squeeze profits from shareholders' money appears rather impressive. (For further reading, see Keep Your Eyes On The ROE.)

ROA
Now, let's turn to return on assets, which, offering a different take on management's effectiveness, reveals how much profit a company earns for every dollar of its assets. Assets include things like cash in the bank, accounts receivable, property, equipment, inventory and furniture. ROA is calculated like this:

Annual Net Income             Total Assets

Let's look at Ed's again. You already know that it earned $3.822 billion in 2009, and you can find total assets on the balance sheet. In 2009, Ed's Carpets' total assets amounted to $448.507 billion. Its net income divided by total assets gives a return on assets of 0.0085, or 0.85%. This tells us that in 2009 Ed's Carpets earned less than 1% profit on the resources it owned.

This is an extremely low number. In other words, this company's ROA tells a very different story about its performance than its ROE. Few professional money managers will consider stocks with an ROA of less than 5%. (For further reading, see ROA On The Way.)

Watch: Reture On Assets

The Difference Is All About Liabilities
The big factor that separates ROE and ROA is financial leverage, or debt. The balance sheet's fundamental equation shows how this is true: assets = liabilities + shareholders' equity. This equation tells us that if a company carries no debt, its shareholders' equity and its total assets will be the same. It follows then that their ROE and ROA would also be the same.

But if that company takes on financial leverage, ROE would rise above ROA. The balance sheet equation - if expressed differently - can help us see the reason for this: shareholders' equity = assets - liabilities. By taking on debt, a company increases its assets thanks to the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt. In other words, when debt increases, equity shrinks, and since equity is the ROE's denominator, ROE, in turn, gets a boost. At the same time, when a company takes on debt, the total assets - the denominator of ROA - increase. So, debt amplifies ROE in relation to ROA.

Ed's balance sheet should reveal why the company's return on equity and return on assets were so different. The carpet-maker carried an enormous amount of debt - which kept its assets high while reducing shareholders' equity. In 2009, it had total liabilities that exceeded $422 billion - more than 16 times its total shareholders' equity of $25.268 billion.

Because ROE weighs net income only against owners' equity, it doesn't say much about how well a company uses its financing from borrowing and bonds. Such a company may deliver an impressive ROE without actually being more effective at using the shareholders' equity to grow the company. ROA - because its denominator includes both debt and equity - can help you see how well a company puts both these forms of financing to use.


Conclusion
So, be sure to look at ROA as well as ROE. They are different, but together they provide a clear picture of management's effectiveness. If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that managers are doing a good job of generating returns from shareholders' investments. ROE is certainly a “hint” that management is giving shareholders more for their money. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company's fortunes.

by Ben McClure (Contact Author | Biography)

Ben McClure is a long-time contributor to Investopedia.com.

Ben is the director of Bay of Thermi Limited, an independent research and consulting firm that specializes in preparing early stage ventures for new investment and the marketplace. He works with a wide range of clients in the North America, Europe and Latin America. Ben was a highly-rated European equities analyst at London-based Old Mutual Securities, and led new venture development at a major technology commercialization consulting group in Canada. He started his career as writer/analyst at the Economist Group. Mr. McClure graduated from the University of Alberta's School of Business with an MBA.

Ben's hard and fast investing philosophy is that the herd is always wrong, but heck, if it pays, there's nothing wrong with being a sheep.

He lives in Thessaloniki, Greece. You can learn more about Bay of Thermi Limited atwww.bayofthermi.com.

Filed Under: Accounting, Fundamental Analysis, Investing Basics, Stock Analysis, Stocks

http://www.investopedia.com/articles/basics/05/052005.asp

Evaluating Company Management in Fundamental Analysis

Evaluating Company Management in Fundamental Analysis
BY STOCK RESEARCH PRO • APRIL 21ST, 2009

When evaluating a stock, many investors will look at the strength and effectiveness of company management as part of the due diligence process. The corporate scandals of recent years have reminded all of us of the importance of having a high-quality management team in place. The role of the management team, as far as investors are concerned, is to create value for the shareholders. While most investors see the significance of strong management, assessing the competence of an executive team can be difficult.

The Role of Company Management
A strong management team is critical to the success of any company. These are the people who develop the ongoing vision of the company and make strategic decisions to support that vision. While it can be said that every employee brings value, it is the management team that “steers the ship” through competitive, economic and the other pressures associated with running a company. In measuring the effectiveness of the management team the investor is able to determine how well the company is performing relative to its industry competitors and the market as a whole.

Assessing Management Performance
Some of the metrics a fundamental investor might use in measuring the effectiveness of company management might include:
Return on Assets: The ROA provides an indication of company profitability in relation to its total assets. Part of effective company management is the efficient leverage of company assets to produce earnings.

A Return on Assets Calculator

Return on Equity: The ROE measures net income as a percentage of shareholders equity. For shareholders, the ROE provides a means of measuring company profitability against how much they have invested. The ROE is best used to compare the profitability of the company (and company management, by extension) with other companies in the industry.

A Return on Equity Calculator

Return on Investment: The ROI measures the effective use of debt for the benefit of the company. Skillful use of debt resources by company management can play a significant role in the growth and prosperity of the company.


http://www.stockresearchpro.com/evaluating-company-management-in-fundamental-analysis

Bullbear Stock Investing Notes
http://myinvestingnotes.blogspot.com/

Average Return on Equity and Assets at Commercial Banks

http://www.extension.iastate.edu/agdm/articles/others/HenMay09.html

Looking for the firm with an economic moat (Evaluating Profitability)

The first thing we need to do is look for hard evidence that a firm has an economic moat by examining its financial results. (Figuring out whether a company might have a moat in the FUTURE is much tougher.)

What we are looking for are firms that can earn profits (ROIC) in excess of their cost of capital (WACC) - companies that can generate substantial cash relative to the amount of investments they make.

Use the metrics in the following questions to evaluate profitability:

1. Does the firm generate free cash flow? If so, how much?
Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

FCF Margin:  Divide FCF by sales (or revenues). This tells what proportion of each dollar in revenue the firm is able to convert into excess profits.

If a firm's FCF/Sales is around 5% or better, you've found a cash machine.

Strong FCF is an excellent sign that a firm has an economic moat.

(FCF/Total Capital Employed or FCF/Enterprice Value are some measures.)


2. What are the firm's net margins?
Net margins look at probability from another angle.

Net margin = net income/ Sales

It tells how much profits the firm generates per dollar of sales.

In general, firms that can post net margins above 15% are doing something right.

3. What are the returns on equity?
ROE = net income/shareholders' equity
It measures profits per dollar of the capital shareholders have invested in a company.

Although ROE does have some flaws -it still works well as one tool for assessing overall profitability.

As a rule of thumb, firms that are able to consistently post ROEs above 15% are generating solid returns on shareholders' money, which means they're likely to have economic moats.

4. What are returns on assets?
ROA = (net income + Aftertax Interest Expense )/ firm's average assets
It measures how efficient a firm is at translating its assets into profits.

Use 6% to 7% as a rough benchmark - if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.

The company's aftertax interest expense is added back to net income in the calculation.  Why is that?  ROA measures the profitability a company achieves on all of its assets, regardless if they are financed by equity holders or debtholders; therefore, we add back in what the debtholders are charging the company to borrow money.


Study these metrics over 5 or 10 years

When looking at all four of these metrics, look at more than just one year.

A firm that has consistently cranked out solid ROEs, ROA, good FCF, and decent net margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results.

Five years is the absolute minimum time period for evaluation, 10 years is even better, if you can.


Consistency is Important

Consistency is important when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time - not just for a year or two - that really makes a firm valuable.



These benchmarks are rules of thumb, not hard-and-fast cut-offs.

Comparing firms with industry averages is always a good idea, as is examining the trend in profitability metrics - are they getting higher or lower?

There is a more sophisticated way of measuring a firm's profitability that involves calculating return on invested capital (ROIC), estimating a weighted average cost of capital (WACC), and then looking at the difference between the two.

Using a combination of FCF, ROE, ROE and net margins will steer you in the right direction.


Additional notes:

DuPont Equation

ROA = Net Profits / Average Assets
ROA = Asset Turnover x Net Profit Margin

ROA
= (Sales/Average Assets) x (Net Profits/Sales)
= Net Profits/Average Assets

ROE = Net Profits / Average Shareholder's Equity
ROE = Asset Turnover x Net Profit Margin x Asset/Equity Ratio*

ROE
= (Sales/Average Assets) x (Net Profits/Sales) x (Average Assets/Average Equity)
= Net Profits./ Average Equity

*Asset/Equity Ratio = Leverage

Spotting Cash Cows

Spotting Cash Cows
by Ben McClure (Contact Author | Biography)

Cash cows are just what the name implies - companies that can be milked for further ongoing profits with little expense. Producing plenty of cash, these companies can reinvest in new systems and plants, pay for acquisitions and support themselves when the economy slows. They have the capacity to increase their dividend or reinvest that cash to boost returns further. Either way, shareholders stand to benefit. To help you spot cash cows that are worthy of your investment, we look at what sets these companies apart and offer some guidelines for assessing them.

 

The Cash Cow: An Overview
A cash cow is a company with plenty of free cash flow - that is, the cash left over after the company meets its necessary yearly expenses. Smart investors really like this kind of company because it can fund its own growth and value.

• A cash cow can reinvest free cash to grow its own business - thereby boosting shareholder returns - without sacrificing profitability or turning to shareholders for additional capital.
• Alternatively, it can return the free cash flow to shareholders through bigger dividend payments or share buybacks.

 

Cash cows tend to be slow-growing, mature companies that dominate their industries. Their strong market share and competitive barriers to entry translate into

• recurring revenues,
• high profit margins and
• robust cash flow.

Compared to younger companies - which tend to reinvest their profits more aggressively to fuel future growth - more mature businesses (with less room for growth) often generate more free cash since the initial capital outlay required to establish their businesses has already been made.

 

Finally, a cash cow can often be a tempting takeover target. If a cash cow company seems like it can no longer use its excess cash to boost value for shareholders, it is likely to attract acquirers that can. (For more on what this means, see The Basics of Mergers and Acquisitions.)

 

The Life of the Cash Cow: Free Cash Flow
To see if a company is worthy of cash-cow status, you of course need to calculate its free cash flow. To do so, you take cash from operations and subtract capital expenditures for the same period:

Free Cash Flow = Cash Flow from Operations - Capital Expenditure

 

 

(For more on calculating free cash flow, see Free Cash Flow: Free, But Not Always Easy.)

 

The more free cash the company produces the better. A good rule of thumb is to look for companies with free cash flow that is more than 10% of sales revenue.

 

Consumer products giant Procter & Gamble (PG), for example, fits the cash cow mold. Procter & Gamble's brand name power and its dominant market share have given it its cash-generating power. Take a look at the company's Form 10-K 2004 Annual Report's (filed on Sept 9, 2004) Consolidated Statement of Cash Flows (scroll to sec. 39, p.166). You'll see that the company consistently generated high free cash flows - these even exceeded its reported net income: at end-2004, Procter & Gamble's free cash flow was $7.34 billion (operating cash flow - capital expenditure = $9.36B - $2.02B), or more than 14% of its $51.4 billion sales revenue (net sales on the Consolidated Statements of Earnings). In 2004, PG produced real cash for its shareholders - a lot of it.

 

Cows That Stand Apart from the Herd: Price and Efficiency
A Low Cash Flow Multiple
Once you've spotted a cash cow stock, is it worth buying? For starters, look for companies with a low free cash flow multiple: simply, divide the company's stock price (more precisely, its market capitalization) by its underlying free cash flow. With that calculation, you can compare how much cash power the share price buys - or, conversely, you see how much investors pay for one dollar of free cash flow.

 

To find PG's free cash flow multiple, we'll look at its stock price on the day it filed its 2004 10-K form, which was Sept 9, 2004. On that day, the stock closed at $56.09 (see PG's trading quote that day on Investopedia's stock research resource). With about 2.5 billion shares outstanding, Procter & Gamble's market value was about $140.2 billion.

 

So, at the financial year-end 2004, PG was trading at about 19 times its current free cash flow ($140.2 billion market value divided by 2004 free cash flow of $7.34 billion). By comparison, direct competitor Unilever traded at about 25 times free cash flow, suggesting that Procter & Gamble was reasonably priced.

 

Free cash flow multiples are a good starting point for finding reasonably priced cash cows. But be careful:

• sometimes a company will have a temporarily low free cash flow multiple because its share price has plummeted due to a serious problem.
• Or its cash flow may be erratic and unpredictable.
• So, take care with very small companies and those with wild performance swings.

 

High Efficiency Ratios
Besides looking for low free cash flow multiples, seek out attractive efficiency ratios. An attractive return on equity (ROE) can help you ensure that the company is reinvesting its cash at a high rate of return.

 

Return on Equity = (Annual Net Income / Average Shareholders' Equity)

 

You can find net income (also known as "net earnings") on the income statement (also known as "statement of earnings"), and shareholders' equity appears near the bottom of a company's balance sheet.

 

On this front, PG performed exceedingly well. The company's 2004 net earnings was $6.5 billion - see the Consolidated Statement of Earnings p.35 (p.161 in the PDF) on the 10-K - and its shareholders' equity was $17.28 billion - see the Consolidated Balance Sheets p.37 (p.163 in the PDF). That means ROE amounted to nearly 38%. In other words, Procter & Gamble was able to milk 38 cents worth of profits from each dollar invested by shareholders. (For more on evaluating this metric, see Keep Your Eyes On The ROE.)

 

To double check that the company is not using debt leverage to give ROE an artificial boost, you may also want to examine return on assets (ROA). (For more on this topic, see Understanding The Subtleties Of ROA Vs ROE.)

 

ROA = Return on Assets = (Annual Net Income / Total Assets)

 

Turning again to Procter & Gamble's 2004 Consolidated Statement of Earnings and Balance Sheets, you'll see that the company delivered an impressive 11.4% ROA (net earnings / total assets = $6.5B / $57.05B). An ROA higher than 5% is normally considered a solid performance for most companies. Procter & Gamble's ROA should have reassured investors that it was doing a good job of reinvesting its free cash flow.

 

Conclusion
Cash cows generate a heap of cash. That's certainly exciting, but not enough for investors. If they provide other attractions, such as high return on equity and return on assets, and if they trade at a reasonable price, then cash cows are worth a closer look.

 

by Ben McClure, (Contact Author | Biography)

 

Ben is director of McClure & Co., an independent research and consulting firm that specializes in investment analysis and intelligence. Before founding McClure & Co., Ben was a highly-rated European equities analyst at London-based Old Mutual Securities.

 

 

http://www.investopedia.com/articles/stocks/05/cashcow.asp

Return on Assets

This measures the company's profitability, expressed as a percentage of its total assets.

Why it is important

Return on assets (ROE) measures how effectively a company has used the total assets at its disposal to generate earnings. Because the ROA formula reflects total revenue, total cost, and assets deployed, the ratio itself reflects a management's ability to generate income during the course of a given period, usually a year.

The higher the return the better the profit performance. ROA is a convenient way of comparing a company's performance with that of its competitors, although the items on which the comparison is based may not always be identical.

ROA = net income / total asset

Variation of this formula

A variation of this formula can be used to calculate return on net asset (RONA)

RONA = net income/(fixed assets + working capital)

And, on occasion, the formula will separate after-tax interest expense from net income:

ROA = (net income + interest expense) / total assets

It is therefore important to understand what each components of the formula actually represents.

TRICKS OF THE TRADE

• Some experts recommend using the net income value at the end of the given period, and the assets value from beginning of the period or an average value taken over the complete period, rather than an end-of-the-period value; otherwise, the calculation will include assets that have accumulated during the year, which can be misleading.
  
  
• While a high ratio indicates a greater return, it must still be balanced against such factors as risk, sustainability, and reinvestment in the business through development costs. Some managements will sacrifice the long-term intersts of investors in order to achieve an impressive ROA in the short term.
  
  
• A climbing return on assets usually indicates a climbing stock price, because it tells investors that a management is skilled at generating profits from the resources that a business owns.
  
  
• Acceptable ROAs vary by sector. In banking, for example, a ROA of 1% or better is considered to be the standard benchmark of superior performance.
  
  
• ROA is an effective way of measuring the efficiency of manufacturers, but can be suspect when measuring service companies, or companies whose primary assets are people.
  
  
• Other variations of the ROA formula do exist.

ROTC, ROA, ROE and Buffett's Durable Competitive Advantage

1. Warren Buffett has learned that a consistently high return on total capital is indicative of a durable competitive advantage. He is looking for a consistent ROTC of 12% or better.

2. With banks and finance companies he looks at the return of total assets ROA to determine if the company is benefitting from some kind of durable competitive advantage. Warren Buffett looks for a consistent return on assets ROA in excess of 1% (anything over 1% is good, anything over 1.5% is fantastic) and a consistent ROE in excess of 12%.

3. In situations where the entire net worth of the company is paid out, creating a negative net worth, Warren Buffett has only made investments in those companies that show a consistent ROTC of 20% or more. The high ROTC is indicative of a durable competitive advantage.

Also Read:

1. Return on Total Capital (ROTC)
2. The Right Rate of Return on Total Capital (ROTC)
3. ROA of Banks, Investment Banks and Financial Companies
4. Using ROTC Where the Entire Net Worth of the Company has been taken out
5. ROTC, ROA, ROE and Buffett's Durable Competitive Advantage
   

ROA of Banks, Investment Banks and Financial Companies

Banks, investment banks and financial companies rely on borrowing large amounts of money that they hope to loan out at higher interest rates to businesses and consumers.

A company like Freddie Mac, which deals in residential mortgages, carries $175 billion in short-term debt and $185 billion in long-term debt. If your business is borrowing money at 6% and loaning it out at 7%, there is no way your return on total capital ROTC is going to even approach 12%.

In these instances, Warren Buffett likes to look at what the bank or finance company earned in relation to the total assets under its control. The rule here is, the higher the better. Anything over 1% is good and anything over 1.5% is fantastic.

Learning Point

With banks, investment banks, and financial companies, look for a consistent return on assets ROA in excess of 1% and a consistent return on shareholders' equity ROE in excess of 12%.


Also Read:
Return on Total Capital (ROTC)
The Right Rate of Return on Total Capital (ROTC)
ROA of Banks, Investment Banks and Financial Companies
Using ROTC Where the Entire Net Worth of the Company has been taken out
ROTC, ROA, ROE and Buffett's Durable Competitive Advantage