By Aaron nematnejat
This section is a continuation of the previous section where we outlined qualitative concepts in determining good quality stocks. We described details in the 10-k as well as qualities of the CEO and board of directors.
In this section we will provide metrics where a calculator can be used to determine the quality of a stock.
Factors affecting the Income Statement
Growth and profitability are the most important factors in determining the value of a stock. It is important therefore to determine the current levels of earnings as well as future prospects. When looking at the income statement one has to look forward in how the various variables can be adjusted and what factors will make them adjust.
Starting with the top of the statement we have revenue, which is price of goods multiplied by quantity sold during the accounting period. So a natural question to ask is can the company raise prices? In terms of microeconomic theory what is the price elasticity of demand of the goods. If the price is inelastic, this means that the company can raise prices without affecting demand (quantity sold) as much and thereby increase revenue. Factors that determine this are competition, product differentiation and consumer tastes. The greater each of these variables, the more power the company has to increase pieces.
We than ask can the company increase output. Gross profit will go up if profit margins don’t change as output increases. For a profit maximizing firm output should increase until the marginal revenue of goods sold =marginal cost of the goods.
What are the companies’ prospects for cutting cost? Cutting costs will eventually increase the bottom line and thereby increase profit margin. Cost cutting can be done by having a more efficient supply chain, a more efficient management structure or simply eliminating inefficient divisions or even subsidiary companies. Cutting costs will lead to higher profit margins which are expressed as
Profit Margin = Net Income (Profits)/ Cost of Goods Sold (Expenses)
Find out if net income is affected by one time expenses. Are the so called one time expenses occurring more often than just once in say ten years or more frequently? Furthermore if the company makes money or has an unusual “one time profit” what do they do with the excess cash? How efficiently do they invest it? Do they engage in buybacks? What are the growth prospects of the company? Find out what measures the company is taking to gain competitive advantage in the industry. What new products are they coming out with? How are they marketing the new product? These all have implications in the growth prospect, and increasing demand for the products.
What are insiders of the company doing? Insiders probably know the company better than anyone else as they are involved in the management of it (however it is important to note that just because an insider is selling a stock doesn’t mean that it is having problems, as insiders very often have to sell their stake to raise cash for personal use etc.). Also find out what the companies clients are doing. This has huge implications on futures earnings, Find out what the client concentration is. This information is available in the 10-K.
Balance Sheet Factors
Assets
I will not go into the details of the balance sheet in this article. A basic knowledge of the area is assumed (if one is looking for a basic knowledge of a companies balance sheet please refer to “The Little Book of Value Investing” by C. Browne (2007) Pages 87-93). However to summarize, a balance sheet is a snapshot within a specific time a list of the assets and liabilities of a company. This list is split into current assert/liabilities and 8long term assets/liabilities.
Net Equity = Assets – Liabilities.
One quantitative indicator which should be measured before investing in a stock is the current ratio. The formula is:-
Current Assets/Current Liabilities
This gives an investor an indication of the cash available to a company to pay of its current debt and obligation. Check out the current ratio over the past couple of years. Has it grown? The higher the number the easier it can pay of its liabilities. Very often investors adjust this formula into what is known as the quick ratio or the acid test ratio which is defined as:-
(Current Assets – Inventory) / Current Liabilities.
This is a more refined metric because inventory is included in the current asset section in the balance sheet and very often inventories are not sold or if they stock pile they are sold at a discount. Investigate if inventories have been rising in the past few years. Investigate if liabilities have been growing in recent years or if liabilities have been growing at a faster rate than assets.
In terms of long term assets, check out if land and stock which has been acquired in recent years has appreciated in value. Very often these entries are placed in the balance sheet at cost price and not mark to market. If these investments have appreciated then the book value of the company will also increase.
Intangible Assets
Intangible assets should be most often taken out of any calculation for the simple reason that companies overpay for them and it is too difficult to place a value on an entry where there is no physical aspect to it. There are two metric tests which we will carry out before investing in a stock. The first one has to do with subtracting goodwill and other intangible assets from the assets section of the balance sheet and calculating the resulting book value from the refined figure namely
Adjusted Book Value =
(Total Assets – Goodwill and Other Intangibles) – Total Liabilities
And the resulting price to book ratio is the price per share / adjusted book value per share.
Furthermore as a quick test one can also quickly calculate the intangibles asset ratio:-
Intangibles Asset Ratio = (Goodwill + Other Intangibles)/Total Assets.
According to Heiserman this figure should be less than 20%.
Shares Outstanding and Dilution
Very often a company does not have the credit line to be able to issue long term debt. To raise capital they would issue shares instead. This is a great method to avoid loading up the interest cover charge but the negative is that it causes dilution. This means that for every dollar that the company earns will spread out to more shareholders. For investors who want to calculate ratios on an historical basis it is very important to adjust the ratios to account for dilution. Very often one would track historical P/E but one has to be aware that many employees are awarded with stock options when exercised will dilute the total shares outstanding. This means that a conservative investor will calculate EPS by dividing the total net income by shares outstanding + securities with the potential to be converted into equity (multiplied by the conversion ratio). This will provide the fully diluted EPS. Compare the growth in the shares outstanding in the past 10 years. If the figure has been growing appropriate adjustments need to be made.
Revenue Growth
One of the most important factors analysts use to determine the expected future stock price is the growth rate of a company. Growth rate calculations are especially important for start up companies which currently have very little net income and expected to have much higher future returns. This is the main reason why startups trade at very high or no P/E. Off course calculating a companies expected future revenue growth has various challenges such as estimating the demand and competitive environment of the company and thereby making an estimation based on conclusions arrived.
As a proxy we can estimate growth by simply calculating the current momentum in growth. A simple method of doing this is by calculating the 5 year revenue growth. We use revenue growth instead of net income growth for the simple reason that net income can increase by cost cutting, which is limiting (one can only cut costs up to the point that it become zero), but revenue can rise in an unlimited amount. For this reason we use the formula
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5 Year Revenue Growth =
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(Revenue in Year 5 – Revenue in Year 1)
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Revenue in Year 1
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According to Hewitt Heiserman (see his book “It’s Earnings that Count”) one should look for revenue growth of at least 30% in the past 5 years.
Having high revenues isn’t always a positive sign however. Look to see if a company has increased their revenues because of multiple acquisitions or through organic internal growth. The notes to the financial statements usually indicate this. The notes also indicate where the company hides some of the bad news as they are written in small print.
Debt to Equity Ratio
One of the leading indicators in financial literature of a company’s health is the debt to equity ratio. This ratio is simply expressed as
Total Liabilities
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Total Assets – Total Liabilities
According to Heiserman debt to equity ratios of greater than 75% should be avoided, because the leverage structure increases the likelihood of the company getting bankrupt. I personally am not too much of a proponent of this ratio because a company with a high level of debt to equity can have enough assets to be able to cover up the debt. For example supposing a company has assets worth 100 million USD and debt worth 50 million USD. This would create a debt to equity ratio of 100%. But the important point is that the assets are still twice as large as the liabilities and if a company is trading at a low enough price it will produce a low price to book stock which in many cases is a value investment (especially if many of the assets are liquid investments).
Stock Based Compensation
Many companies pay their employees in terms of stock rather than actual cash. These can be distributed terms of actual stock or stock options where there is a preset method of exercising it. Financial statements have a section on stock based compensation. In a section like the “accounting Policies and Notes to Consolidated Financial Statements” they will have a section on stock based compensation which compares the “net income as reported” as well as the “pro forma net income”. This difference is the stock base compensation. As a ratio Heiserman created the following formula:-
Stock Based Compensation
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Net Income
He notes that one should avoid companies with a ratio of more than 15%.
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