How Much Research and Analysis Are Sufficient?

Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer.

This diligence is admirable, but it has two shortcomings. 

• First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. 
• Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit. 

This is not to say that fundamental analysis is not useful. It certainly is.

• But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. 
• The value of in-depth fundamental analysis is subject to diminishing marginal returns. 
• Information is not always easy to obtain. Some companies actually impede its flow. Understandably, proprietary information must be kept confidential. 
• The requirement that all investors be kept on an equal footing is another reason for the limited dissemination of information; information limited to a privileged few might be construed as inside information. Restrictions on the dissemination of information can complicate investors' quest for knowledge nevertheless. 

Moreover, business information is highly perishable. 

• Economic conditions change, industries are transformed, and business results are volatile. 
• The effort to acquire current, let alone complete information is never-ending. 
• Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor's informational advantage. 

David Dreman recounts the story of an analyst so knowledgeable about Clorox that he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox's line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the signs....' The stock fell from a high of 53 to 11." 

Although many Wall Street analysts have excellent insight into industries and individual companies, the results of investors who follow their recommendations may be less than stellar. 

• In part this is due to the pressure placed on these analysts to recommend frequently rather than wisely, but it also exemplifies the difficulty of translating information into profits. 
• Industry analysts are not well positioned to evaluate the stocks they follow in the context of competing investment alternatives. 
• Merrill Lynch's pharmaceutical analyst may know everything there is to know about Merck and Pfizer, but he or she knows virtually nothing about General Motors, Treasury bond yields, and Jones & Laughlin Steel first-mortgage bonds. 

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain.

• Yet high uncertainty is frequently accompanied by low prices. 
• By the time the uncertainty is resolved, prices are likely to have risen. 
• Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. 
• The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

Accounting, the language of business.

Whether you are a disciple of Ben Graham, a value investor, or a growth or momentum investor, you can agree that a stock;s price must relate to its financials.

From time to time investors ignore basic numbers like book value, cash flow, interest, and various ratios that fundamentally value common stock.  It is especially common during periods of exuberance or fear that investors depart from the fundamental methods of successful investing.

A sound understanding of how to read the basic financials should keep investors focused and thereby avoid costly mistakes, and also helps to uncover hidden values of the stock market.

Ben Graham's principle of always returning to the financial statements will keep an investor from making huge mistakes, and without huge mistakes the power of compounding can take over.

Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions

Look at Fundamentals

Value investors who paid attention to fundamentals (e.g. strong businesses masked by unprofitable divisions, or companies trading at discounts to cash etc.) reaped enormous profits.

Look for potential catalysts

Investors should look for potential catalysts when making investment decisions.   Catalysts are events that cause a stock's value to be recognised, thus resulting in immediate returns to investors who purchased at a discount. 

• A liquidation is an example of a catalyst, and there are some companies where such events have returned generous - and quick - positive results for investors (e.g. during bankruptcy events, where securities generally trade at a discount to their recoverable values).
• Share buybacks and asset sales also represent partial catalysts, as they can cause a stock to inch closer to its underlying value.  More importantly, such events signal that management is interested in returning value to shareholders, which bodes well for the future.

Some areas where value investors can indeed find value include: 

• liquidations, 
• complex securities (i.e. securities institutions can't purchase because they don't fit set categories), 
• rights offerings (often offering prices lower than current market value), 
• spinoffs (as they are usually sold by holders of the parents, thus depressing prices immediately) and 
• risk arbitrage (depending on the market's mood, as sometimes the market's exuberance can erode returns).

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

Fundamental Analysis Advocates versus Efficient Market Advocates

Fundamental Analysis Advocates

The concept of security analysis in general, and fundamental analysis in particular, is based on the assumption that at least some investors are capable of identifying stocks whose intrinsic values differ from their market values.

Fundamental analysis operates on the broad premise that some securities may be mispriced in the marketplace at least some of the time.

Fundamental analysis may be a worthwhile and profitable pursuit:

• if securities are occasionally mispriced, and 
• if investors can identify mispriced securities.

To many, those two premises seem reasonable.



Efficient Market Advocates

However, there are others who do not accept the assumptions of fundamental analysis.

These so-called efficient market advocates believe

• that the market is so efficient in processing new information that securities trade very close to or at their correct values at all times. and 
• that even when securities are mispriced, it is nearly impossible for investors to determine which stocks are overvalued and which are undervalued.

Thus, they argue, it is virtually impossible to consistently outperform the market.

In its strongest form, the efficient market hypothesis asserts the following:

1.  Securities are rarely, if ever, substantially mispriced in the marketplace.
2.  No security analysis, however detailed, is capable of identifying mispriced securities with a frequency greater than that which might be expected by random chance alone.

Why understanding fundamental analysis is important for investing in stocks?

Fundamental analysis:

Why understanding FA is important? 

FA cannot offer you the magic keys to sudden or instant wealth. If that were true, the Professors of Finance will all be fabulously rich! What FA can do is to provide sound principles for formulating a successful long-range investment program. FA are proven methods that have been used by millions of successful investors.

The motivation for investing in stocks is obvious. It is to watch your money grow.

Why then, for every story of great success in the market, there are dozens more that don't end so well!!!!

More often than not, most of those investment flops can be traced to:

1. Bad timing
2. Poor planning
3. Failure to use common sense in making investment decisions.



Intrinsic Value

The entire concept of stock valuation is based on the idea that all securities possess an intrinsic value that their market value will approach over time.

Security analysis consists of gathering information, organizing it into a logical framework, and then using the information to determine the intrinsic value of common stock.

Given a rate of return that's compatible with the amount of risk involved in a proposed transaction, intrinsic value provides a measure of the underlying worth of a share of stock. It provides a standard for helping you judge whether a particular stock is undervalued, fairly priced or overvalued.



Main message

The aims of fundamental analysis are to determine the asset's intrinsic value and its future growth potential.

Financial Statement Analysis of an Established Business

The stock selection process involves a large component of expectations.

The investor is usually a student of the intrinsic value and relative value, and he incorporates projections routinely into stock evaluations.

In order to form a reasonable basis for predicting corporate performance, however, the investor must understand historical financial results.

The business review enables the practitioner to attach product innovations, competitive struggles, and other qualitative items to changes in sales and earnings.

As the numerical complement to the business review, the financial analysis provides a statistical summary of the company's past by boiling it down to the common denominator of all profit-seeking enterprises - dollars and cents.

Model Research Report

1. Introduction
2. Macroeconomic Review
3. Relevant Stock Market Prospects
4. Review of the Company and Its Business
5. Financial Analysis
6. Financial Projections
7. Application of Valuation Methodologies
8. Recommendation.

Notes:

To a large extent, financial statement analysis is a lost art.  Few business schools stress the topic, and MBA students who major in finance, graduate with only a rudimentary knowledge of accounting, the nuts and bolts of financial statement analysis.

Wall Street and the institutional community deemphasize a careful study of prior financial results.  Research departments are so preoccupied with predicting future earnings that they don't take time to scrutinize past accounting data.  Furthermore extensive analysis is an expensive proposition.

With most institutions owning hundred of stocks and turning over their portfolios two to three times annually, placing a lot of effort in studying the financial statements of a single holding is not worthwhile.

Step-by-step approach to financial statement analysis

1. Begins with organizing the raw information
2. Calculating ratios and interpreting them.
3. Integrate this with the industry-specific performance ratios to make conclusions about a firm's earnings power moving forward.
4. The historical analysis sets the stage for projections, an important component of business valuation.

The Value Investor's Handbook

March 20 2011 

Value investing, and any type of investing for that matter, varies in execution with each person. There are, however, some general principles that are shared by all value investors. These principles have been spelled out by famed investors like Peter Lynch, Kenneth Fisher, Warren Buffet, John Templeton and many others. In this article, we will look at these principles in the form of a value investor's handbook.

Tutorial: The World's Greatest Investors

Buy BusinessesIf there is one thing that all value investors can agree on, it's that investors should buy businesses, not stocks. This means ignoring trends in stock prices and other market noise. Instead, investors should look at the fundamentals of the company that the stock represents. Investors can make money following trending stocks, but it involves a lot more activity than value investing. Searching for good businesses selling at a good price based on probable future performance requires a larger time commitment for research, but the payoffs include less time spent buying and selling and fewer commission payments. (False signals can drown out underlying trends. Find out how to tone them down and tune them out in Trading Without Noise.)

Love the Business You BuyYou wouldn't pick a spouse based solely on his or her shoes, and you shouldn't pick a stock based on cursory research. You have to love the business you are buying, and that means being passionate about knowing everything about that company. You need to strip the attractive covering from a company's financials and get down to the naked truth. Many companies look far better when you judge them on basic price to earnings (P/E), price to book (P/B) and earnings per share (EPS) ratios than they do when you look into the quality of the numbers that make up those figures.

If you keep your standards high and make sure the company's financials look as good naked as they do dressed up, you're much more likely to keep it in your portfolio for a long time. If things change, you'll notice it early. If you like the business you buy, paying attention to its ongoing trials and successes becomes more of a hobby than a chore.

Simple Is BestIf you don't understand what a company does or how, then you probably shouldn't be buying shares. Critics of value investing like to focus on this main limitation. You are stuck looking for businesses that you can easily understand because you have to be able to make an educated guess about the future earnings of the business. The more complex a business is, the more uncertain your projections will necessarily be. This moves the emphasis from "educated" to "guess."

You can buy businesses you like but don't completely understand, but you have to factor in uncertainty as added risk. Any time a value investor has to factor in more risk, he has to look for a larger margin of safety - that is, more of a discount from the calculated true value of the company. There can be no margin of safety if the company is already trading at many multiples of its earnings, which is a strong sign that, however exciting and new the idea is, the business is not a value play. Simple businesses also have an advantage, as it's harder for incompetent management to hurt the company. (For a complete guide to reading the financial reports, check out our Financial Statements Tutorial.)

Look for Owners, Not Managers

Management can make a huge difference in a company. Good management adds value beyond a company's hard assets. Bad management can destroy even the most solid financials. There have been investors who have based their entire investing strategies on finding managers that are honest and able. To quote Buffett, "look for three qualities: integrity, intelligence, and energy. And if they don't have the first, the other two will kill you." You can get a sense of management's honesty through reading several years' worth of financials. How well did they deliver on past promises? If they failed, did they take responsibility, or gloss it over? (Find out more about Buffett's investing in Warren Buffett: How He Does It.)

Value investors want managers who act like owners. The best managers ignore the market value of the company and focus on growing the business, thus creating long-term shareholder value. Managers who act like employees often focus on short-term earnings in order to secure a bonus or other performance perk, sometimes to the long-term detriment of the company. Again, there are many ways to judge this, but the size and reporting of compensation is often a dead give away. If you're thinking like an owner, you pay yourself a reasonable wage and depend on gains in your stock holdings for a bonus. At the very least, you want a company that expenses its stock options. (Still wondering how to investigate the top brass? Check out Evaluating A Company's Management.)

When You Find a Good Thing, Buy a LotOne of the areas where value investing runs contrary to commonly accepted investing principles is on the issue of diversification. There are long stretches where a value investor will be idle. This is because of the exacting standards of value investing as well as overall market forces. Toward the end of a bull market, everything gets expensive, even the dogs, so a value investor may have to sit on the sidelines waiting for the inevitable correction. Time, an important factor in compounding, is lost while waiting, so when you do find undervalued stocks, you should buy as much as you can. Be warned, this will lead to a portfolio that is high-risk according to traditional measures like beta. Investors are encouraged to avoid concentrating on only a few stocks, but value investors generally feel that they can only keep proper track of a few stocks at a time.

One obvious exception is Peter Lynch, who kept almost all of his funds in stocks at all times. Lynch broke stocks into categories and then cycled his funds through companies in each category. He also spent upwards of 12 hours every day checking and rechecking the many stocks held by his fund. As an individual value investor with a different day job, however, it's better to go with a few stocks for which you've done the homework and feel good about holding long term. (Learn the basic tenets that helped this famous investor earn his fortune in Pick Stocks Like Peter Lynch.)

Measure Against Your Best InvestmentAnytime you have more investment capital, your aim for investing should not be diversity, but finding an investment that is better than the ones you already own. If the opportunities don't beat what you already have in your portfolio, you may as well buy more of the companies you know and love, or simply wait for better times. During idle times, a value investor can identify the stocks he or she wants and the price at which they'll be worth buying. By keeping a wish list like this, you'll be able to make decisions quickly in a correction.

Ignore the Market 99% of the TimeThe market only matters when you enter or exit a position; the rest of the time, it should be ignored. If you approach buying stocks like buying a business, you'll want to hold onto them as long as the fundamentals are strong. During the time you hold an investment, there will be spots where you could sell for a large profit and others were you're holding an unrealized loss. This is the nature of marketvolatility.

The reasons for selling a stock are numerous, but a value investor should be as slow to sell as he or she is to buy. When you sell an investment, you expose your portfolio to capital gains and usually have to sell a loser to balance it out. Both of these sales come with transaction costs that make the loss deeper and the gain smaller. By holding investments with unrealized gains for a long time, you forestall capital gains on your portfolio. The longer you avoid capital gains and transaction costs, the more you benefit from compounding. (Find out how your profits are taxed and what to consider when making investment decisions in Tax Effects On Capital Gains.)

The Bottom LineValue investing is a strange mix of common sense and contrarian thinking. While most investors can agree that a detailed examination of a company is important, the idea of sitting out on a bull market goes against the grain. It's undeniable that funds held constantly in the market have outperformed cash held outside the market, waiting for a down market. This is a fact, but a deceiving one. The data is derived from following the performance of indexes like the S&P 500 over a number of years. This is where passive investing and value investing get confused.

In both types of investing, the investor avoids unnecessary trading and has a long-term holding period. The difference is that passive investing relies on average returns from an index fund or other diversified instrument. A value investor seeks out above-average companies and invests in them. Therefore, the probable range of return for value investing is much higher. In other words, if you want the average performance of the market, you're better off buying an index fund right now and piling money into it over time. If you want to outperform the market, however, you need a concentrated portfolio of outstanding companies. When you find them, the superior compounding will make up for the time you spent waiting in a cash position. Value investing demands a lot of discipline on the part of the investor, but in return offers a large potential payoff. (Looking for a little more information on index investing, see the Index Investing Tutorial.) 

http://www.investopedia.com/articles/fundamental-analysis/09/value-investing.asp

The Six Important Financial Parameters

The Technique of Fundamental Analysis

Fundamental analysts believe that the market is 90% logical and only 10% psychological.  Value is related to a company's assets, its expected growth rate of earnings and dividends, interest rates, and risk.  By studying these factors, the fundamentalist arrives at an estimate of a security's intrinsic value or firm foundation of value.

Fundamentalists believe that eventually the market will reflect the security's real worth.

The fundamentalist strives to be relatively immune to the optimism and pessimism of the crowd and makes a sharp distinction between a stock's current price and its true value.

In estimating the firm-foundation value of a stock, the fundamentalist's most important job is to estimate the firm's future stream of earnings and dividends.  The worth of a share is taken to be the present or discounted value of all the cash flows the investor is expected to receive.  The analyst must estimate the firm's sales level, operating costs, tax rates, depreciation, and the sources and costs of its capital requirements.

The fundamentalist uses four basic determinants to help estimate the proper value for any stock.

1.  The expected growth rate.
Rule:  A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings.
Rule:  A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.

2.  The expected dividend payout.
Rule:  A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company;s earnings that is paid out in cash dividends.

3.  The degree of risk.
Rule:  A rational (and risk averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company's stock.

4.  The level of market interest rates.
Rule:  A rational investor should be willing to pay a higher price for a share, other things being equal, the lower the interest rates.


The above valuation rules imply that a security's firm-foundation value (and its price-earnings multiple) will be higher 

• the larger the company's growth rate and the longer its duration;
• the larger the dividend payout for the firm; 
• the less risky the company's stocks; and 
• the lower the general level of interest rates.

In principle, such rules are very useful in suggesting a rational basis for stock prices and in giving investors some standard of value.  But before using these rules, bear in mind the following caveats.

1.  Expectations about the future cannot be proven in the present.

Predicting future earnings and dividends is a most hazardous occupation.  It is extremely difficult to be objective; wild optimism and extreme pessimism constantly battle for top place. "Forecasts are difficult to make - particularly those about the future."

2.  Precise figures cannot be calculated from undetermined data.

There is always some combination of growth rate and growth period that will produce any specific price.  In this sense, it is intrinsically impossible, given human nature, to calculate the intrinsic value of a share.  

The point to remember is that the mathematical precision of fundamental value formulas is based on treacherous ground: forecasting the future.  "God Almighty does not know the proper price-earnings multiple for a common stock."

3.  What's growth for the goose is not always growth for the gander.

It is always true that the market values growth, and that higher growth rates and larger multiples go hand in hand.  But the crucial question is:  How much more should you pay for higher growth?  

There is no consistent answer.  In some periods, the market was willing to pay an enormous price for stocks exhibiting high growth rates.  At other times, high growth stocks commanded only a modest premium over the multiples of common stocks in general.   Growth can be as fashionable as tulip bulbs, as investors in growth stocks painfully learned. 

From a practical standpoint, the rapid changes in market valuations that have occurred suggest that it would be very dangerous to use any one year's valuation relationships as an indication of market norms.  However, by comparing how growth stocks are currently valued with historical precedent, the investor should at least be able to isolate those periods when a touch of the tulip bug has smitten investors.

Why might fundamental analysis fail to work?

There are three potential flaws in this type of analysis.
1.  The information and analysis may be incorrect.
2.  The security analyst's estimate of "value" maybe faulty.
3.  The market may not correct its "mistakes", and the stock price may not converge to its value estimate.

Evaluating a Business Idea

About Judgment in Successful Stock Evaluation and Selection

About Judgment

An indispensable ingredient in successful stock evaluation and selection is the application of ―judgment. While not nearly so complicated as some would have you believe, this is nonetheless more of an art than a science. It‘s a personal skill that you will develop and fine tune as you gain experience.

However, don‘t be intimidated by your lack of experience if you‘re new at it. In fact, because you‘re apt to be more conservative than the investor who has been doing it for a while, you could very well have better results.

The essence of judgment, in this context, is the application of the wisdom that you gain about industries, the natures and ―personalities of companies within certain industries—or just in and of themselves—and the significance of the factors that contributed to the history that you are studying. Such items as the extent to which acquisitions—rather than increases in sales— contributed to growth, the extent of past and potential competition, the changes in management, and so on, all contribute to your judgment. Nor are these at all mysterious. They are all common sense issues that you will simply be more mindful of as you progress.

The approach described below is a very basic approach to help those of you who may be still learning fundamental investing to make the crucial judgment decisions. Each of these suggestions is directed toward the most conservative action to take on the basis of the numbers and the pictures that you see, alone. You may very well change these steps as you grow in experience and gain confidence.

The Three Levels of Judgment
There are three distinct levels of ―judgment:

1. Discounting irrelevant data or ―Cleaning up data to be sure that only applicable data is used in assessing historical trends or performance.
2. Estimating future trends or performance based upon the historical assessment.
3. Estimating future price performance based upon those future trends.


1.  Discounting Irrelevant Data
With respect to the relevancy of data, we know that history cannot be denied. What has happened has happened, and the only decision that you can make about an historical event is whether or not it is applicable in your study to influence your vision of the future.

Eliminating ―outliers is your way of discarding irrelevant data to make historical information more useful and to guide you toward the next step.

2.  Estimating Future Trends
Using your conservative historical trends as starting points, you seek to predict what the future trends in the company‘s performance might be. Here again, you will want to be reasonably modest in your view of the future.
Analysts are paid to be accurate. You are rewarded for being right.

The more modest your estimates, the more likely you are to be right!

3.  Estimating Future Price Performance
By making careful and conservative estimates of the company’s performance, you can then forecast, within limits, how the stock‘s price will perform—and therefore what kind of return you might expect your investment to give you. 


Generally, it pays to accept the conservative alternative in all cases when decisions must be made. Lower estimates in projected growth rates will result in less optimistic price predictions. Since you are focused upon investing rather than speculating—and since there are many stocks available that can meet your requirements—it would seem foolish indeed to ―fudge the figures just to justify the purchase of a particular stock.

The PE: On its way out? For the Intelligent Investor, the PE emerges as the perfect tool to evaluate the degree of disconnect between the herd and reality.

August 31st, 2010

The Wall Street Journal strikes again! This time it’s an article entitled “The Decline of the PE Ratio.” And once again, it was too hard to pass up as a topic for this blog.

The first sentence alleges that the PE ratio “is shrinking in size and importance.” And it points out that, in spite of the fact that U.S. companies announced record profits during the second quarter—beating forecasts by more than 10%—the market dropped 5% this month.

It goes on to connect the dots, making the point that “the market’s average price/earnings ratio…is in free fall, having plunged about 36% during the past year,” and claiming that, because PEs have declined while earnings have risen, that the PE ratio may no longer be a reasonable metric by which to value the market. They’re absolutely right…if the market is what you invest in!

I submit that this article simply puts the cart before the horse and lets the tail wag the dog! (How’s that for mixing a barnyard full of metaphors!)

If the exercise is to analyze the market for the purpose of forecasting where it’s going next—a waste of time for my money, but a preoccupation of the herd—then they’re right in saying the PE has little importance. It never really did! Technical analysis, the tool of the market analyst, never could be  bothered with earnings, or the other fundamentals.  The market is driven by anything but company performance, as the article correctly point out.

However, for the intelligent investor who has only a passing interest in the meanderings of the market, the PE emerges as the perfect tool to evaluate the degree of disconnect between the herd and reality. The lower the PE, especially in the face of growing corporate earnings, the more obvious it becomes that the herd doesn’t understand the nature of investing, and the wider the abyss between the herd and those who understand what investing really is.

And the easier it is to find bargains out there.

To understand the real value of the Price/Earnings ratio, read What’s a PE, and What’s it to Me?

http://www.financialiteracy.us/wordpress/2010/08/31/the-pe-on-its-way-out/#more-2331





Wall Street Journal

The Decline of the P/E Ratio

BY BEN LEVISOHN

As investors fixate on the global forces whipsawing the markets, one fundamental measure of stock-market value, the price/earnings ratio, is shrinking in size and importance.

And the diminution might not stop for a while.

The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company's earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don't.

But while U.S. companies announced record profits during the second quarter, and beat forecasts by a comfortable 10% ....

Better Investing Philosophy

Fundamentals of Investing

 

Explaining the BetterInvesting Philosophy

 

Our February issue traditionally includes an invitation for you to bring a visitor to your investment club meeting so that they can discover how clubs can help them build wealth and can learn about BetterInvesting’s philosophy. Two years ago we published an article explaining our approach to investing that proved popular with readers. This month we’ll tackle the subject again. If you’re bringing a guest to a meeting or want to introduce someone to the BetterInvesting approach, you might consider giving them this issue.

Brad Perry, in his classic book Winning the Investment Marathon, wrote that investing “is pursued most successfully in a simple, straightforward way.” This is the Golden Rule for most investors who employ fundamental analysis and have a long-term perspective. Buy stocks of high-quality companies at good prices and continue holding them as long as the companies’ performance merits doing so.

Sales drives earnings; earnings drives the stock price. That’s what it comes down to for fundamental investors. You might hear of different ways to buy and sell stocks, and countless books have touted systems that promise great returns. But over the long term fundamental analysis is what works in building wealth.
   
Fundamental analysis comes down to studying a company’s financial performance. Broadly, there are those who look for growth stocks and those who look for value equities, but the line between value and growth investing is gray: As Warren Buffett says, value and growth “are joined at the hip.”
   
Value investing, as practiced by Buffett and his mentor Benjamin Graham, is a time-tested method involving fundamental analysis that has served many investors well. But for the typical person who has a job and family and who is managing his own portfolio while following Perry’s admonition to keep it simple, fundamental analysis focused on growth stocks might be more appropriate.
   
This is because individual investors can spot a good growth company quickly. BetterInvesting’s Stock Selection Guide arranges the fundamental data in a way that allows users to see a company’s growth and management performance as well as the stock’s investment possibilities in just a few minutes; see the Stock to Study SSG on pages 29 and 30 for an example. Meanwhile, the work required to spot a good value stock is a little more complex. But as we’ll discuss later, value should be a vital consideration as well.

The Three Most Important Ideas:
Management, Management, Management
The individual investors who belong to BetterInvesting ask two questions when studying a stock:

•  Is this a well-managed company?
•  Is its stock reasonably priced?
   
We seek great management because talented, capable executives know how to ensure their company thrives over the long term amid competitive battles and periodic downturns. These are the people, in other words, who are responsible for driving the sales and growth increases that fuel stock prices.
   
In assessing management, we don’t know everything about a company’s day-to-day operations and boardroom discussions. But as laid out in a methodology promoted by association co-founder George Nicholson, we do have a lot of the information we need. A first step in finding a well-managed company is to look at the history of sales and earnings growth. An important indicator of strong management is its ability to grow the business in good times and bad.
   
We also seek companies that are growing sales and earnings over the long term at a rate that’s high relative to their size. Smaller companies generally should be growing earnings by at least 15 percent a year; mid-size companies, by 10 percent to 15 percent a year; and large companies, by at least 7 percent annually.
   
We want smaller companies to have higher growth rates partly because they generally are riskier investments than large companies. The higher growth rate compensates us for this additional risk, and if we do a good job of assessing these companies, we’ll see handsome returns. As you’ll see in this issue in “Repair Shop” and “Watch List,” finding small companies can be challenging but also quite rewarding.
   
Finally, we favor consistent growth over the long term. In the graph on this page, for example, note the railroad-track-like growth of the company’s sales and earnings. Consistent performance reassures us about the capability of management. And although the past is no guarantee of future performance (as they say in the mutual fund world), history informs our decisions regarding future growth.
   
Two other tests help us assess the company’s management. First, we check the company’s profitability before taxes and other charges outside of management’s control. We like to see stable or growing profit margins. The other ratio is return on equity — how well management is using the equity invested in the company. Again, stable or growing ROE is preferred. Comparing the company’s growth rates, profitability and ROE with those of its peers helps determine whether this is a company built for a long voyage or is simply benefiting from the rising tide for its industry.



Evaluating the Investment Potential

Once we’ve determined the company in question is likely a high-quality one worth studying further, we next project sales and earnings growth. As fundamental investors, we know that in the short term, the market may not reward the company for its excellence. But over the long term, we trust that it will. So it’s the long-term projections — five years, very roughly enough for the company to go through a business cycle — we care about.
   
We start by forecasting sales growth because we need this for building our earnings projection. With the caveat that making long-term predictions can be a humbling experience, we have a number of data points at our disposal, including:

•  The company’s historical growth rate.
•  Company statements regarding growth goals.
•  Wall Street estimates of both short- and long-term growth. Long-term sales growth estimates can be difficult to find but are sometimes buried in analyst reports.
•  The industry’s historical growth rate and estimates of future expansion.
   
More experienced investors might consider such factors as the percentage of recurring revenues, the value of projects under contract but not yet completed and historical organic growth and growth by acquisition. For retailers, they might look at projections for store and square footage expansion as well as same-store sales growth. But history is a powerful teacher for beginning and experienced investors alike.
   
We then estimate earnings growth in light of the sales projection. We’ll consider the company’s history of earnings growth and any goals it has stated. We can also access analyst reports and analysts’ consensus estimates, but these forecasts are usually overly optimistic.
   
Studying past and potential future profit margins and tax rates can help us understand the path revenues will take to earnings. We also want to think about what will happen to the firm’s number of common shares outstanding. For example, if a company regularly buys back shares to reduce the number of shares outstanding and is expected to continue this practice, we would expect future earnings to be spread among fewer shares.
   
When we’re finished, we use the earnings growth rate to arrive at an estimate of earnings per share five years from now. If we have forecast growth of 15 percent a year, and the EPS at our starting point is $1, five years from now EPS will be $2. Two things to keep in mind regarding projections:

•  It’s prudent to be conservative.
A firm might have increased earnings 25 percent annually over the past 10 years, but such performance is extremely difficult to maintain. Gravity will eventually take hold as a company moves from small to mid-size to large.
•  Earnings advances can outpace sales growth for only so long. Over the long term, they usually settle in at the rate of revenue growth. If you’re going to project EPS increases that are higher than sales growth, understand where the additional percentage points are coming from: Increased margins? Lower taxes? Fewer shares outstanding?

Checking Valuation

Once we’ve predicted the EPS five years from now, we’re ready to answer our second question: whether the stock is reasonably priced. Investors are good at discovering high-quality stocks but experience more challenges in determining the proper price to pay for the stock. Our first step is to study the stock’s price-earnings ratios over the past several years and forecast the likely high and low P/Es over the next five years. The P/E, the stock’s current price divided by a company’s EPS, is how much the market is willing to pay for $1 of a firm’s earnings; it’s the most common way to measure how expensive a company’s stock is.
   
Historical valuations can help us in this process, but P/Es often go through unpredictable periods of expansion and contraction as industries go in and out of favor on Wall Street. Another idea to keep in mind is that a stock can trade at extremely high P/Es for a while but eventually will drop — severely so when a high-growth company stumbles. P/Es also tend to contract in times of inflation.
   
After we have predicted what the high P/E for a stock will be, we’re ready to estimate a potential high price for our stock. It’s a matter of simple math: The high point of EPS — what we forecast the EPS to be five years from now — is multiplied by the high P/E to come up with a potential high price. For example, if we predict EPS will be $2 in five years and the high P/E will be 30, our predicted high price will be $60.
   
After projecting the low P/E, we can multiply it by the expected low EPS to come up with a potential low price. Since we’ve determined this is a growth company, we usually can use the most recent 12 months’ EPS as the low point for earnings. I can use other criteria for projecting a low, but this is a common method for determining this figure.

Return Expectations

Now that we have the stock’s potential range from low to high, we’re ready to see whether this stock will provide a suitable return. Our SSG divides the range into three zones: Buy, Maybe (or Hold) and Sell. The lowest 25 percent of the range is the Buy zone, and the upper-most 25 percent is the Sell zone.
   
We include the stock’s dividends — the cash payments of earnings to shareholders — in our return calculations. This gives us three ways to achieve a return on a stock: 

• through dividends,
• through the market increasing the stock’s price in concert with the earnings growth and 
• through the stock’s price rising because the market believes the P/E should be higher.

   
We aim for our stock holdings to return 15 percent annually on average over the next five years, or a doubling of return. That’s an aggressive target, but the idea isn’t to be disappointed if we fail to meet it. It’s to maintain our focus on seeking high-quality growth stocks. Achieving returns of, say, 10 percent yearly is pretty commendable.
Managing Risk

Investors can manage their risk in picking individual stocks by following some simple rules:

•  Require that the company have at least five years of financial history. Younger firms haven’t developed enough of a track record for assessing management performance.
•  Study only companies that have proven they can make money. Someone who invests in a company that has never reported earnings is speculating, not investing.
•  Understand the possible risk and reward of owning a stock.
•  Diversify your portfolio. Even if you’ve done your homework on every holding using all the information you need to make an informed decision, you’ll still make mistakes. If you have a good-size basket of stocks, however, you’ll also have some stocks that perform much better than expected.
   
Besides investing in high-quality growth stocks and diversifying your portfolio, two other simple principles can help you build wealth over the long term. 

• First, reinvest all your dividends and earnings. 
• Second, invest regularly in both good markets and bad; this is often called dollar-cost averaging.

   
The type of analysis I’ve outlined provides a lot of the information fundamental investors need to determine whether a stock is a suitable investment. But not everything. Reading annual reports, listening to conference calls and viewing company presentations will help you form a fuller picture of the company.
   
In today’s unpredictable, volatile market, fundamental analysis is even more important than usual. But for an investor using a simple, straightforward methodology that focuses on the long term, these are also times of great opportunity.

http://www.betterinvesting.org/Public/SingleTabs/BI+Mag/Articles+Archives/0210publiccs.htm

Equity Valuation In Good Times And Bad

May 25 2009 

One very frustrating aspect of the global financial crisis of 2008-2009 was the awareness that the volatility was, in part, exacerbated by an accounting rule. During the late fall of 2008, the Financial Accounting Standards Board (FASB) finally took up discussion of FAS 157, Fair Value Measurements, and issued a recommendation to adopt certain modifications in the form of FAS 157-d, Determining the Fair Value of Financial Assets in a Market that is Not Active.

Determining Fair Value

The central issue that was reviewed: companies holding certain mortgage-backed securities had been required to "mark to market" the value of these investments. In a well-functioning securities market, marking to market is a reasonable way to determine fair value, in the same way that a comparable sales analysis - in a well-functioning real estate market - can offer clarity into the appropriate listing price for residential properties.

When capital markets become dislocated, forcing companies to mark their then-illiquid securities to an indeterminable market value creates a downward spiral of asset impairments, charges to earnings, and degraded capital positions. FAS 157-d recommended several remedies. One important and appropriate remedy is a greater reliance on discounting future cash flows to determine fair value in a distressed market. (For more, see Mark-To-Market Mayhem.)

The Price is Right

During periods of systemic stress, valuation in the public equity markets offers a similar challenge to investors. While one can find a readily available market quote for shares of most common stocks, how confident can investors be that they are paying the correct price? One of the most common valuation methods relies on the P/E ratio of companies. In well-functioning markets, P/E ratios provide a quick and easy assessment of comparable value.

But what happens when the "E" becomes entirely uncertain? And, considering the seismic risk-repricing feature common to distressed markets, how confident can we be that earnings multiples represent fair values? Those market environments demand that we shelve, at least temporarily, our reliance on certain relative value measures, like P/E. Yet, it's clear that during a market melt-down, accurate valuation is as critical as it ever is. (For more, read Is The P/E Ratio A Good Market-Timing Indicator?)

One way to compare value measurements is by assigning various alternatives to the quadrant below.

                    Economic   Accounting

Absolute             -             -

Relative              -             -

Economic measures describe an actual tangible value, while accounting measures approximate actual value and are impacted by GAAP accounting conventions. Absolute value measures describe value on a stand-alone basis. Relative measures are useful when comparing the same measure between two companies. To flesh this concept out a bit, we'll fill in the quadrants with example measures:

                    Economic   Accounting

Absolute           DCF          ROE

Relative             ER            P/E

The discounted cash flow (DCF) method is economic in the sense that it relies on cash flow, an actual tangible benefit to equity holders. It is also absolute, as it relies on the company's own cost of capital, rather than a sense of where the rest of the industry or market is currently valued.

The Enterprise Ratio

A company's enterprise ratio (ER) is found by the following formula:

(market value of debt + market value of stock – cash / cash flow from operations)

Here, too, the components are all economic measures, but the resulting ratio is useful only in comparison to another company's Enterprise Ratio and thus, it is relative.

Return on Equity

Return on equity (ROE) can be estimated several ways, one of which is simply to divide the firm's net income by its shareholder equity. Net income and shareholder equity are GAAP measurements, thus ROE is an accounting function. But like DCF, ROE expresses a measure of return which holds meaning in absolute terms: a company which earns a return on equity in excess of its cost of equity capital has added value. (For more on ROE, read Keep Your Eyes On The ROE.)

P/E Ratio

Finally, the P/E ratio relies on earnings, which is a GAAP concept and it is useful only when compared to the P/E ratio of industry peers or a market index.

In his book, "Active Value Investing" (2007), Vitaliy Katsenelson argues that one prominent feature of secular range-bound markets is P/E multiple contraction. A long period in which stock prices fluctuate but do not progress can tend to diminish investor confidence, which is reflected in the multiple investors are willing to pay for a claim on a company's earnings. A growing number of strategists now believe that 2008-2009 was a secular range-bound market.

Answering the Tough Question

The implication is this: what is a fair multiple to pay in a range-bound market, where multiples aren't likely to be stable? If you think it is a difficult question to answer, you are in good company. Many investment analysts ask the same question. Ultimately, a P/E ratio is never objectively high or low; it always must be compared to something else to have meaning. In a market where value is difficult to discern, relative measures, like P/E, render less meaning than they do in more stable, secular bull markets.

The P/E ratio's usefulness during periods of market stress is further limited by its denominator, which is an accounting measure. Earnings, while important, are subject to many aspects of management discretion such as changes to amortization and depreciation schedules.

Alternatively, DCF analysis offers an approach to valuation which stands alone and at the same time projects a truer estimate of economic benefit.

DCF takes projected future cash flows and discounts them back to the present. The theoretical justification for this method is the sense that the intrinsic value of a financial asset is the value of the future cash flows which that asset generates. Alfred Rappaport argues in "Creating Shareholder Value" (1997) that cash flows from operations are the relevant numerator, because they represent the cash available to equity holders, which results from the core operations of the business. Many industrial companies require that operating cash flows be adjusted for depreciation and high levels of maintenance capital expenditures. In these cases, free cash flow may be a better figure to discount. (For a background on DCF, see our DCF Analysis Tutorial.)

Click Here to join Traders Laboratory - The Professional Traders Community

Discount Rate

Deriving the appropriate discount rate - the weighted average cost of capital - is a bit more complex. The weighted average cost of capital is comprised of a proportional cost of debt, which is approximated by the yield on the firm's long-term bonds, and the cost of equity. The cost of equity is expressed formulaically below:

Ke = r_f + (r_m – r_f) * β

Where:

• Ke = the required rate of return on equity
• r_f = the risk free rate
• r_m – r_f = the market risk premium
• β = beta coefficient = unsystematic risk

The result of discounting future operating cash flows back to the present by the weighted average cost of capital is a clear, objective estimate of the real economic benefit of owning the company today. (To learn more, see The Capital Asset Pricing Model: An Overview.)

Limitations of DCF

Estimating future cash flows from operations requires a sales forecast, which may or may not be accurate; this possibility for error is compounded when forecasting over multiple periods. Moreover, since DCF relies on the above required return for equity formula, we note that the beta of a stock may overstate or understate the actual volatility of the security. Finally, the equity risk premium is not constant.

Likewise, we should point out that not all relative measures are inferior in distressed markets. As with P/E, the price / book ratio utilizes an accounting figure in its denominator. And though the appropriate multiple of price over book may be a relative measure, stocks which are trading below their book value (or, as is common during stressed markets, below tangible book value) offer a type of absolute value opportunity.

The Bottom Line

Intrinsic value and the degree it differs from market price are, ultimately, subjective matters. Severe market dislocations demand that we not only adjust valuations, but that we reassess the metrics by which we derive those valuations. Economic and absolute measures allow the analyst to filter out much of the noise in the market place and provide a theoretically sound means of determining intrinsic value. (For more on DCF, see our related article DCF Valuation: The Stock Market Sanity Check.)

by

Stephen Carr

---

Stephen Carr is principal and porfolio manager for Winthrop Capital Management in Carmel, Ind. Steve's particular areas of interest are equity valuation, dividend policy and behavioral finance.

Read more: http://www.investopedia.com/articles/fundamental-analysis/09/equity-valuation-good-bad.asp?partner=basics051112#ixzz1ubcQMER4