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How To

AnalyzeInvestment Like the Pros

Personal FinancePersonal Finance



The Hard Facts

Without financial facts and figures, professional analysts

couldn’t make informed decisions. Financial analysis

demonstrates how past conditions and events came to pass;more important numbers exhibit what could happen in the

future. The real purpose of this analysis is to identify proba-

ble outcomes if certain actions are undertaken. For exam-

ple, if past sales growth averaged 10 percent annually during

a 10-year period and if the management team remains

intact, we might logically expect the trend to continue.

What numbers do the pros use? Most analysts use the raw information presented by accountants concerning sales,

margins, expenses, profits and taxes. Unfortunately, the

numbers themselves tell only part of the story. The trick is

to know what the numbers mean and to relate them to each

other and to industry norms.

Financial analysis is designed to determine a company’s

relative strengths and weaknesses—whether the firm isfinancially sound and profitable relative to other firms in its

industry and whether its position is improving or deteriorat-

ing over time. Analysts need this information to estimate

the riskiness of the endeavor under consideration and to

determine if the firm is worthy of an investment.

Of course, the numbers aren’t the whole story. There are

psychological factors that affect the stock market. Some ana-lysts say the stock market is 15 percent numbers and 85

percent psychology, following the postulate that all invest-

ment issues are human related. That’s why savvy analysts

use intuition and psychology to supplement the numbers.

But without a solid grasp of how the pros use numbers,

you’ll never be in the major leagues of investing. The tech-

niques contained herein and in Personal Finance will help you become a confident investor.

1www.pfnewsletter.com



Collecting Data

The first concern of the analyst is finding reliable infor-

mation. Where do you look? The most commonly employed

information, and the most dependable, is historical. Of the various reports corporations issue, the annual report is by

far the most important.

The Annual Report Financial StatementsPrincipally, the annual report provides two types of infor-

mation: a description of the firm’s operating results duringthe past year and a discussion of new developments that will

affect future operations. The report includes four basic

financial statements: the income statement, the balance

sheet, the funds flow statement and the statement of

changes in owners’ equity . Taken together, these state-

ments depict the firm’s operations and financial position.

In order to evaluate the merits of an investment, investorslook for information that tracks the business and try to under-

stand the flow of funds into and out of the firm. This process

involves reviewing a great deal of formal or informal data rele-

vant to the specific purpose of the analysis. Almost all of the

data needed is found in the following financial statements.

1. Balance SheetThe balance sheet describes the categories and amounts

of assets utilized by the business and the offsetting liabilities

incurred by lenders and owners.

Sometimes called the statement of

financial condition, or statement of

financial position, it must always

“balance.” Why? Because the totalassets invested in the business at

any point in time, by definition, are

matched precisely by the liabilities

and owners’ equity position.

2 How To Analyze Investments Like the Pros

Balance Sheet

Assets = Liabilities + Owner Equity

Assets LiabilitiesCurrent assets $50 Current liabilities $26

Fixed assets 125 Long-term liabilities 97

Other assets 2 Owners’ equity 54Total assets $177 Total liabilities $177

and net worth



The balance sheet is sometimes reduced to a simple

accounting equation: assets = liabilities + owner equity (see

box on p. 2). Ultimately, all transactions appear within this

basic equation.

The balance sheet assigns values to equipment andother assets, describes amounts owed on both short- and

long-term horizons, lists funds available for continued

operation of the business, and determines the value of the

stockholders’ equity.

Keep in mind that balance sheets can become obsolete

very quickly. Like your monthly bank statement, they reflect

conditions on the compilation date.The major categories of assets are: current assets (items

that turn over in a short period of time, such as cash, mar-

ketable securities, accounts receivable and inventories);

fixed assets (buildings, land, mineral resources, heavy

machinery, vehicles, etc., all of which are used over the long

haul); and other assets (deposits and intangibles like copy-

rights and patents).Major liabilities include: current liabilities (obligations to

distributors, tax authorities, employees and lenders due within

one year); long-term liabilities (an assortment of debt instru-

ments like mortgages and bonds); and owners’ equity (funds

contributed by various classes of owners of

the business as well as accumulated earnings

retained in the business).

2. Income Statement

The income statement describes the

dollar value of goods and services sold,

gross profit, funds expended to make

profits happen, including writeoffs and

taxes, and how much net profit or lossresulted. The income statement is some-

times referred to as the operating state-

ment, earnings statement or profit-and-

loss statement.


Income Statement

Revenues - Expense = Profits

Sales $4,000

Costs and expenses 2,400

Writeoffs 100

Depreciation 100

Earnings before interest

and taxes $1,400Interest expense 25

Earnings before taxes 1,375

Taxes 475

Net Income $900



Where the balance sheet reflects the financial condition

on a specific date, income statements tell what happened

over a period of time, usually one year. The net profit

earned by a business enterprise is found by deducting

expenses from revenues, or in equation form: revenues -expenses = profits (see box p. 3).

3. Funds Flow Statement

The funds flow statement, or the statement of changes in

financial position, provides the basis for an aggressive analy-

sis that focuses on the changes in financial condition result-

ing from management decisions made during a given timeperiod. It’s derived from data appearing in other statements

and answers the following questions: Where did the compa-

ny get its funds during the year? What did the firm do with

these funds? Is the firm’s financial position stronger or

weaker, as measured by changes in net working capital (cur-

rent assets minus current liabilities)?

This statement is prepared by comparing ending andbeginning balance sheets and is combined with information

from income statements.

As noted, from this greatly simpli-

fied example (see box), the compa-

ny’s current assets declined during

the year. You can also see that the

firm used available funds to financelong-term liabilities, because fixed

assets were up from $110 to $125,

with a corresponding jump in long-

term debt. It’s just this sort of

snooping, combined with a vigilant

reading of all text, that puts the

spotlight on patterns.

Is the firm’s financial position

stronger or weaker, as measured by

changes in net working capital? It’s

weaker. Working capital declined by $15 (current assets

down by $5 and current liabilities up by $10).


Funds Flow StatementChanges inBalance Sheets 12-31-05 12-31-04 + or -

Current assets $50 $55 –5

Fixed assets 125 110 +15Other assets 2 0 +2

Total assets $177 $165 +12

Current liabilities $26 $16 +10

Long-term liabilities 97 59 +38

Owners’ equity 54 90 –36

Total liabilities $177 $165 +12

and net worthSources of funds are designated by a "+" and uses by a “-.”



4. Statement Of Changes In Owners’ Equity

The statement of changes in owners’ equity or financial

position gives more details concerning the change in owner-

ship accounts, or net worth, as recorded by the beginning

and ending balance sheets. Getting a closer look at thefunds flow statement allows you to make a more detailed

analysis. For example, you can determine whether debt or a

new equity issue financed company growth.

From Data Collection To Ratio Analysis

The statements discussed provide much useful informa-tion. However, the collection of data is just a starting point.

Once reliable information is assembled, an investor can con-

duct ratio analysis on the firm and then compare the infor-

mation to data of firms within the industry.

Ratio usefulness lies in the ability to turn a series of num-

bers into a powerful display highlighting the elements that

affect operating performance. While there are many ways tocompare numbers, ratio analysis is accomplished simply by

dividing one number into the other.

RatiosFinancial ratios are designed to exhibit relationships among

financial statement accounts, putting numbers into perspec-

tive. Unfortunately, it’s not always clear whether higher orlower values for any given ratio are desirable. When unsure,

look at the trends for the industry. The more enlightened you

are, the more success you will have as an investor.

Ratios have a number of advantages:

• They clarify the relationship between numbers that are

difficult to see and comprehend by themselves.• Ratios focus on trends that may be impossible to spot

in a column of numbers.

• Ratios make numerical reporting easier to follow and

more interesting, especially when comparing firms with-

in an industry.




Here are some of the ways investment analysts put ratios to work:

• Monitoring growth of a company

• Assessing profitability and understanding trends

• Appraising return on investment• Watching expense-related items

• Determining breakeven levels

• Comparing and contrasting operating periods

• Comparing and contrasting planning with actual results

• Comparing and contrasting current expenses to historical costs

• Observing collections and receivables trends

• Comparing and contrasting a firm with competitors

• Comparing and contrasting entire industries

• Comparing and contrasting executive performance

• Monitoring performance under different interest

rate scenarios• Observing employee productivity

• Monitoring employee turnover

• Measuring management’s efficiency

• Measuring the average size of orders

• Clarifying financial statements

• Evaluating returns to shareholders

Before undertaking an analysis, you need to know:

• What is the exact nature of the analysis? What are you

attempting to accomplish?

• Which specific factors and trends are likely to be helpful in ana-

lyzing the stock? What is the order of importance?• Where will your data come from? How old is the data?

• How reliable is the data? What confirmation do you have?

Never accept data from brokers or company officials at face

value. Question everything.




• How precise do the answers need to be? Will additional

research be worth the effort?

• How important are qualitative judgments in the con-

text of the problem? How much of a role does psychol-

ogy play?

Limitations Of Ratio Analysis

As with any investigation, there are drawbacks to ratios:

• Today, conglomerates operate businesses in many

industries, which makes it difficult to obtain meaningful

statistics. For example, General Motors operates numer-

ous businesses, from automobiles to finance to insur-

ance to locomotive construction.

• Inflation badly misrepresents balance sheets because

financial statements are based on historical costs. Profits

are affected because inventory values rise with inflation.• Some firms employ “smoke and mirrors” to make

financial statements look better. Cash accounts can be

skewed by including money from long-term debt with

cash, improving year-end “quick” and “current” ratios.

After analysis is endorsed by accountants and results

printed, debt can be paid off.

• Different accounting practices can mislead. Firms within similar industries may use contrasting deprecia-

tion schedules.

• Ratios consider past activity. History is worth recogniz-

ing, but the future is always uncertain. Never assume

that obsolete printed material has any application in

today’s world, even if it’s only a few months old.

Regardless of its limitations, ratios allow investors to

focus on problems. More important, they provide the tools

to determine if company managers recognize transforma-

tions in their industry, adapt to changes, and if they’re con-

trolling finances properly.




The Ratios

Ratios are the foundation of what analysts call “funda-

mental analysis.” In traditional ratio analysis, very few addi-

tional information sources beyond the balance sheet and

income statement are used. However, don’t confine your

digging to these two statements. There are many advan-

tages to looking beyond the two traditional financial state-

ments for useful input numbers.

Which Ratios to MonitorRatio compilation and analysis is a clerical process. It requires

determination in the collection of data, accuracy in calculation

and perseverance in comparison with industry averages. There’s

no relationship between the size of a firm and the number of

ratios requiring review. It depends entirely on your style and

the comfort level you need to feel safe with your investment.

Beware of pseudo ratios that can’t logically be compared.For example, the ratio of stockholders’ equity to sales prob-

ably expresses no useful relationship. Unique or custom

ratios may or may not provide significant information.

Problems arise when attempting to compare unusual ratios

to industry norms that don’t exist.

Ratios may be categorized into these groups: asset man-

agement ratios, profitability ratios, liquidity ratios andmarket value ratios. When making comparisons, keep in

mind that numbers must be consistent from one period to

another. Extraordinary items should be removed from cur-

rent and past data. Remember that new information could

make previous data invalid.

Asset Management Ratios

Sales Growth Ratio

Without grease for the wheels, a company won’t run

for long. Sales provide the grease; nothing happens until




somebody sells something. This ratio measures just how

well the company is doing with its sales.

Over time you can determine if insufficient growth origi-

nates from within the company (lack of attention to marketing

or customer preferences) or from without (competitors, tech-nological change or a recession). Whatever the cause, failure to

grow sows the seeds for future difficulties.

This ratio is calculated by examining current year sales

with revenues from the previous year. The ratio equation is:

Sales Growth = (Net Sales This Year - Net Sales Last Year)/Net Sales Last Year

Net Sales Last YearOn the income statement on p. 12, we note net sales of

$1.29 million. This equation requires you to examine the

previous year’s income statement (not shown) and net sales

from the period monitored.

Net sales were up 29 percent during the previous year,

indicating rapid growth. The analyst must compare this fig-

ure with industry averages and chart the growth over several

years to look for erratic patterns.

Sales Per Employee

When companies originate, employees wear many hats.

As firms grow, they hire specialists to fill positions, suppos-

edly to improve efficiency. In reality, labor costs sometimes

increase faster than revenues as companies transfer formerpart-time jobs to full-time specialists earning salary and ben-

efits. The risk of expanding too fast is real for all companies,

not just small and medium-sized firms.

You should watch this ratio closely, especially in fast-

growing high-tech industries. An increase in this ratio is

usually a sign of improving efficiency, while a decrease may

mean that the firm is experiencing diminishing returns oranticipated sales have not materialized. Another compari-

son is between employees and production. For example,

contrasting General Motors and Ford employees needed

per unit of automobiles produced.





Sample Balance Sheet XYZ CompanyStatement of Financial Position, Dec. 31, 2006

Assets

Current AssetsCash and marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500Other current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $428,000

Fixed AssetsLand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000Buildings, less depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000Machinery/equipment, minus depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000Total Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000

Other AssetsIntangibles (goodwill, patents, trademarks) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,000

Tangible other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000Total Other Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,000

Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $510,000

Liabilities and Stockholders' EquityCurrent LiabilitiesAccounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000Current portion long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500Other current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —Total Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $147,500

Long-Term Liabilities

Notes and mortgages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000Lease obligations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500Total Long-Term Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000

Stockholders' EquityCapital stock, par value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .0.01Authorized shares, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000,000Issued and outstanding, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000,000

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000Total Stockholders' Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000Total Liabilities and Stockholders' Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $510,000



For this equation, we must dig to determine the number

of employees. After reading the annual report, we discover

that the firm has only 30 employees (not displayed).

Sales Per Employee: 1,290,000/30 = $43,000

The $43,000 means nothing until we compare it with other

firms within the industry and track the figure over several years.

Total Expense Ratio

This ratio indicates managerial success in controlling

expenses. The lower the number the better.

Total Expense Ratio = Total Operating Expenses/Net Sales

Interest Expense Ratio

Some companies depend on borrowed money to finance

long-term growth, even daily operations. Still others rely on

equity capital and cash flow from profits. This ratio studies the

interest cost relative to the sales of the company.

You should give this ratio close scrutiny, watching closely

when borrowing is significant and comparing with similar firms.

Interest Expense Ratio = Interest Expense/Net Sales

Turnover Of Assets

Sometimes called the investment turnover ratio, asset

turnover ratios measure how many times the company’s assets

are employed in the year to create sales. This is a compellingindicator of management efficiency and performance.

Turnover Of Assets = Net Sales/Total Assets

Lower ratios indicate insufficient sales or the need to elimi-

nate unproductive assets. High ratios point to an ability to cre-

ate and process sales at low cost. Follow this ratio with a

trendline chart; downward trends signal declining efficiency.

Inventory Turnover

This ratio assesses how well management controls

inventory. An increasing inventory may show manage-

ment commitment to increase sales, or accumulation of




goods languishing on shelves.

When comparing businesses,

net sales may be the better

yardstick because cost of

goods sold varies consider-ably between firms.

The average inventory is

determined by adding opening

and closing figures and divid-

ing by two. We’ve simplified

our example so that both fig-

ures are $300,000.Inventory Turnover = Cost Of Goods

Sold/Average Inventory

Profitability RatiosProfits are very important.

Unless the company has

unlimited resources, operat-

ing unprofitably over a peri-

od of time will deplete capital

to the point that nothing is

left to pay employees or buy

raw materials.

Continuous break-even

operations provide no cushion for contingencies. What’s

worse, without profits, rational investors will not invest

nor will lenders supply the funds needed for growth

and expansion.

Gross Margin

Low margin means that too much is being paid for

merchandise, or selling prices are too low, or both. A value of zero means that the goods are sold for the same

price paid for them. Negative values are possible if selling

prices are below cost overall. Such evidence would indi-

cate extreme competition.


XYZ Company Income StatementYear Ended Dec. 31, 2006

RevenuesGross sales . . . . . . . . . . . . . . . . . . . . . . . . . . .$1,300,000

Less returns and allowances . . . . . . . . . . . . . . . . . .10,000Net Sales . . . . . . . . . . . . . . . . . . . . .$1,290,000

Cost of Goods SoldBeginning inventory . . . . . . . . . . . . . . . . . . . . . .$300,000Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .800,000

Cost of goods available for sale . . . . . . . . . . . .$1,100,000Less ending inventory . . . . . . . . . . . . . . . . . . . . . .300,000Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . .800,000

Gross Profit . . . . . . . . . . . . . . . . . . . . .$490,000

Operating ExpensesWages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$160,000Marketing expenses . . . . . . . . . . . . . . . . . . . . . . . .75,000Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35,000Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .5,000Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . .12,000Depreciation expense . . . . . . . . . . . . . . . . . . . . . .10,500Bad-debts expense . . . . . . . . . . . . . . . . . . . . . . . . .20,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . .14,000Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25,000Additional expenses . . . . . . . . . . . . . . . . . . . . . . . .50,000Total Operating Expenses . . . . . . . . . . .$406,000

Income From Operations . . . . . . . . . . . . . . . . . . . .$84,000Net Profit Before Taxes . . . . . . . . . . . . . . . . . . . . . .84,000

Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12,000Net Profit After Taxes . . . . . . . . . . . . . .$72,000



Margin is closely related to pricing. Remember that margin

is lower where the customer can pick and choose among many

suppliers and higher where choices are limited. A high margin

would probably indicate this firm has few competitors.

Determine this ratio by dividing gross profit by net sales.Gross Margin = Gross Profit/Net Sales

Break-Even Margin

This is simply the total operating expenses divided by net

sales, a number that even the most inexperienced investor

should monitor. Management attempts to increase profits

by increasing margins, though price increases may failbecause customers could seek substitutes or forgo the prod-

uct entirely. Margins are also affected by purchasing raw

materials. Increasing raw material order quantities from sup-

pliers could lower prices and operating expenses.

Break-Even Margin = Total Operating Expenses/Net Sales

Operating MarginOperating margin is considered a better indicator of man-

agement skill and operating efficiency than net profit margin.

This ratio is important to investors interested in the underly-

ing profitability of the business. Even firms with excessive debt

expense can be proven competitive using this ratio.

Operating Margin = (Net Profit Before Taxes + Interest + Depreciation)/Net Sales

Profit Growth

This ratio measures success in transferring revenue growth

to bottom-line profit growth. The ratio is the difference

between this year’s and last year's after-tax net profit, divided

by last year’s after-taxes net profit.

It’s best to plot this data for several preceding years on a

trendline to see if profits fluctuate significantly from year to year. This ratio requires us to examine the previous year’s

income statement (not displayed).

Profit Growth = (This Year’s After-Taxes Net Profit - Last Year’s After-Taxes Net Profit) /Last Year’s After-Taxes Net Profit




Return On Sales

This is a key profitability ratio, also known as net prof-

it margin. This ratio measures the difference between

what a company takes in and what it spends in conduct-

ing its business.Lower returns are predictable when many rival

companies flirt with the same customers. Conversely,

high returns are common for firms offering propri-

etary products.

Yearly trends are significant because they demonstrate

how well a company’s overall business strategy is working.

It’s best that you diagram returns for several years on atrendline chart to evaluate patterns.

Return On Sales = Net Profit After Taxes/Net Sales

Return On Gross Profit

This ratio compares net profit to gross profit instead of to

sales. It’s useful to investors, lenders and anyone who may

need to compare the efficiency of two firms in similar or total-ly different businesses. You want to know how successful a

company is at converting gross profits into net profits.

Firms with high returns on gross profit display at least

two common characteristics: They’re in good lines of

business and competitors are scarce.

Return On Gross Profit = Net Profit After Taxes/Gross Profit

Return On Assets

This ratio indicates how successful management is in

utilizing assets to make profits. It really measures the

firm’s earning power of its asset investments. Averages for

this ratio vary greatly by line of business. Obviously, steel

manufacturers require more assets than a sales-oriented

business.

Some analysts remove intangible assets from the equation and

average beginning and ending asset totals. To simplify our analy-

sis we’ll use ending total assets taken from the balance sheet.

Return on Assets = Net Profit After Taxes/Total Assets




Return On Net Worth

Sometimes called return on equity, this is the best known of

the return-on-investment ratios. Pay particular attention to this

ratio because it reports how much the company is earning

from dollars invested.The national averages for this ratio vary from 5 to more than

20 percent depending on the business. Lower returns may limit

investment, restrict growth and ultimately the dividend-paying

ability. Many variations for this ratio exist, with the resulting

numbers differing significantly.

Return On Net Worth = Net Profit After Taxes/Stockholders’ Equity

Some firms obtain money entirely from equity investors, or

from profits resulting from business. Money obtained this way

doesn’t have to be repaid, and there’s no interest cost. Other

firms obtain needed cash by borrowing from banks, or by issu-

ing debt instruments such as bonds. Company survival may

hinge on its ability to meet such obligations. Business success

results from maximizing the use of other people’s money.

Liquidity Ratios

Current Ratio

This ratio is computed by dividing current assets by current

liabilities. Sometimes called the liquidity ratio, this ratio is perhaps

the best-known measure of financial strength on a specific date. When companies get into financial difficulty, they pay debts

slowly. When tough times appear, the current ratio will fall and

could spell trouble for the firm. Industry averages aren’t

etched in stone, but a popular rule of thumb for this ratio is 2

percent or better. Many consider this number the minimum

necessary for reliable cash flow, though some lines of business

operate at lower figures.Current Ratio = Current Assets/Current Liabilities

Quick Ratio

Quick assets are current assets less inventory, divided by cur-

rent liabilities. Sometimes called the acid test, this ratio is perhaps




the best measure of liquidity on a specific date. Why? Because

it considers only those assets that can be converted to cash

quickly. Typically, inventories are the least liquid asset.

Quick Ratio = (Current Assets - Inventory)/Current Liabilities

Current Debt To Stockholders’ Equity

This measure of financial strength compares what’s cur-

rently owed to what’s owned. Since current liabilities are

due now, this ratio is another important indicator of com-

pany solvency.

Current Debt To Equity = Current Liabilities/Stockholders’ Equity

Debt To Stockholders’ Equity

This ratio is total liabilities divided by the stockholders’

equity. It compares the total of what’s owed to what’s

owned. When the ratio exceeds 100 percent, it indicates

that the investment capital provided by lenders exceeds that

provided by the stockholders.

Debt To Equity = Total Liabilities/Stockholders’ Equity

Debt To Assets

Also called the debt ratio, this ratio compares what’s

owed to the value of assets employed by the business. The

total liabilities are divided by total assets.

While debt varies greatly from firm to firm, this ratiomonitors success in using debt to build the business. If the

ratio climbs over time, a likely interpretation is that borrow-

ing is financing losses.

Debt To Assets = Total Liabilities/Total Assets

Inventory To Current Assets

Ratios involving inventory are measures of managerial effi-ciency. This ratio is a good indicator of asset allocation and liq-

uidity because it makes the comparison to other assets instead of

sales. There’s no correct value for this ratio, but if it moves out

of its known range it should be viewed as a red flag.

Inventory To Current Assets = Inventory/Current Assets




Judgment Day Ratio

The judgment day is when all possible circumstances

sour. This is the most critical of the solvency ratios and

assumes that inventory, accounts receivable, prepaid expens-

es and other current assets are illiquid. Only cash is available

to meet obligations. Examine this ratio closely to determine

if a firm is operating too close to the abyss. Develop a

trendline and follow this ratio over time.

Judgment Day Ratio = Cash/Current Liabilities

Cash To Total LiabilitiesCash is the ultimate asset—in fact, it’s the only asset that

others will pay you to hold. Unfortunately, comparative

information on levels of cash held by corporations isn’t easi-

ly obtained. Sometimes you can make many permutations

to uncover actual cash amounts.

Cash To Total Liabilities = Cash/Total Liabilities

Market Value RatiosInvestment analysis means looking at anything about a

firm that could impact its ability to meet financial obliga-

tions and provide a growing stream of earnings and divi-

dends. After all, if you’re nearing retirement and countingon dividend income to supplement Social Security, you

don’t want any surprises.

Market value ratios, sometimes called investment

ratios, examine a company’s progress from a bottom-line

position. When market values flounder, investors “bail

out” quickly, forcing down the price of the security.

Book Value Per Share

The stockholders’ equity is divided by the number of

shares of stock outstanding. When new stock is sold from

time to time, this ratio tracks the dilative effects of such sales.

Book Value Per Share = Stockholders’ Equity/Shares Outstanding




Dividend Rate

Dividend rates are important but only provide limited

information for evaluating holdings. They communicate

only one fact—the amount of the payout. These numbers

are frequently located on the balance sheet, in the stock-

holders’ equity section.

Dividend Rate = Dividend Dollar Totals Disbursed/Shares Outstanding

For this simplified example, no dividends are included.

If they were, the total amount of the dividend would be

divided by 22 million shares, the number of shares of

stock outstanding.

Dividend Yield

The dividend yield relates dividend payout to the

stock price. High yields are characteristic of mature

industries, like utilities. Low-yielding stocks indicate

growth companies.

Dividend Yield = Dividend Dollar Amount/Current Stock PriceIn this simplified example, dividend amount is not includ-

ed. Suppose the stock price is $45 and the yearly dividends

add to $3.15. The yield would be 7 percent.

Price-To-Earnings Ratio

Price-to-earnings (P/E) ratios are oft-quoted by analysts

and represent per share market price of a company’s stock divided by after-taxes net profit per share.

When investors are optimistic, as they were for most of the

latter 1990s, they’re willing to pay more for anticipated future

earnings. When a company’s future is viewed pessimistically, or

the industry is boring, the ratio is likely to be low.

P/Es change with stock price movement, so to arrive at

the current P/E, divide the stock’s current price by earn-ings for the most recent four quarters for a trailing P/E.

Or, if you’re forecasting the future, divide the current

price by the company’s estimated earnings for the next

four quarters. One way to foretell growth is to examine

historical patterns.




Many analysts maintain that low P/E stocks are positive

(bullish indicators) while high P/E stocks are signs of an

impending correction. It’s a good habit to develop trendline

charts of the P/Es for stocks that interest you.

P/E = Stock Price/Net Profit After Taxes Per Share

Price-To-Earnings-To-Growth

The price-to-earnings-to-growth (PEG) ratio, otherwise

known as the PEG ratio, is a way to measure a stock’s value

relative to its growth rate. The PEG ratio is calculated by

dividing a company’s P/E ratio by its five-year expected

earnings growth rate. A PEG ratio under 1 suggests a com-

pany is undervalued relative to its growth rate, while a num-

ber above 1 suggests it’s overvalued.

Like other ratios the PEG ratio shouldn’t be used in a

vacuum. Consequently, you should compare PEG ratios

that appear especially high or low to other competitors in

the industry as well as the market as a whole to get a senseif the stock is truly under or overvalued relative to its peers

and the entire stock market.

PEG = P/E ratio/5-Year Earnings Growth Estimates

Price-To-Book

Price-to-book is the per share market price of a compa-

ny’s stock divided by stockholders’ equity per share. Thisratio is a fairly good indicator of how investors view the

future. The higher the ratio, the more optimistic are buyers.

Note that book value does not accurately report the market

value of assets because values are derived from historical costs.

Price-To-Book = Stock Price/Stockholders’ Equity Per Share

Price-To-Sales

Here’s another way to evaluate the company’s market

price, this time relating it to sales. The idea is to put a price

on a business that correlates to annual sales.

Price-To-Sales = Stock Price/Net Sales Per Share




Technical Indicators

The preceding chapters were primarily concerned with

fundamental analysis or the firm foundation theory. The

fundamental investor matches value to price.

Fundamentalists believe that investment prices reflect all

available information relevant to determining value. Any

new information is quickly digested by the investing public

and accurately reflected by posted prices.

Technical analysis is the castle-in-the-air theory. That is,

technicians don’t concentrate on a stock’s value, but on

investors’ moods. Technicians pay little attention to what the

company does, concentrating on how the stock price performs.

Technicians employ indicators, charts and computer programs

to track trends in stocks and bonds and the general market.

They use these indicators to predict price movements.

Fundamental analysis focuses on the intrinsic value of

specific firms. Analysts crunch numbers, conduct ratio analy-

sis and probe factors like sales trends, profits, product analy-

sis, potential markets and managers. By examining the foun-

dation of the firm, future prices can be forecasted.

Technicians focus on the company’s stock price and

volume traded as pictured on daily, weekly and monthly

charts. By looking at a stock’s pricing activity, future

prices can be forecasted.

Other Technical IndicatorsDow Theory is the oldest and most widely used of the

technical theories. As with other technical procedures, it’s

based on trends indicated by price movements. Named after

Charles Dow, this theory contends that the stock market is

made up of two types of “waves.” These waves are pri-mary—a bull or bear market cycle of several years’ duration

and a secondary wave lasting from weeks to months.

Dow believed his theory applied to the general market

and that individual stock selections would rise or fall with

the averages much of the time.




Speculative influence is reflected in the ratio of activity

between Nasdaq and American Stock Exchange (AMEX)

stocks to New York Stock Exchange (NYSE) volume. The

theory is that when activity and prices of Nasdaq and AMEX

stocks begin to move more rapidly than the blue chip issues,speculation is multiplying. That’s the time for conservative,

rational investors to move to the sidelines.

The Odd-Lot Index reveals how smaller investors view

the market. The smaller investor is presumably less

informed and so tends to follow established and predictable

patterns. Concentrating on trades of fewer than 100 shares,

the index alerts its followers when fry investors deviatefrom regular actions.

Moving averages (see box) compare current stock or

mutual fund prices to averages tracked over a period of

time. As a new price is added to the list, the oldest price

falls off. All prices are “aver-

aged” by dividing the sum

total by the number of daysor weeks monitored.

Investors invest in the mar-

ket as long as the moving

average is above the S&P

500 average, the Wilshire

5000 average or whatever

index is monitored. A most-active stock list

is published in many daily

newspapers, giving highs,

lows, last prices and changes

in the volume leaders on the

NYSE and Nasdaq

exchanges. Many investors watch these lists closely and

either buy the issues after

they’ve appeared on the list

for three consecutive days or

short them.


The Moving AverageA solitary number is meaningless unless it’s com-pared to something else. Analysis depends on compar-ison. For example, unless you know the average ofstock prices for the past six months, you won't know whether trends are increasing or decreasing. Andthat's usually what you need to know.

The best way to focus on trends over time is withthe moving average. Moving averages allow you toexamine the direction of a stock or mutual fund bycomparing its price to movements over time. A movingaverage is updated periodically by dropping the firstnumber and adding the most recent number.

For example, a 52-week moving average is deter-mined by adding the stock or mutual fund's closing pricefor the current week to the closing prices of the previous51 weeks and then dividing by 52. Over time, this mov-ing average indicates the trend of prices.

In most cases, analysts compare individual invest-

ment moving averages with a regular market averagelike the S&P 500. For example, as long as the S&P 500 is above its moving average, the outlook is bull-ish. Conversely, when the S&P 500 falls below itsmoving average for three or four weeks, the outlookis bearish.



Similar to the most active list is the daily list of new

highs or lows. These are the stocks that hit new highs or

lows for the year during the previous day’s trading session.

Technicians believe that when more stocks are making new

highs than lows, bullish times will result. Advances vs. declines is a simple measure of the number

of stocks having advanced in price and the number that

have declined. Widely followed and quoted, this is thought

to illustrate the general direction of the market.

Volume, the number of shares traded daily, is an important

indication of where the market is headed. Buyer enthusiasm

to climb aboard rising markets frequently push prices higher.Momentum measures the velocity of an index, comparing

current numbers to an index or a moving average.

How To Evaluate A Mutual FundInterested in mutual fund investing? Before you invest in

a mutual fund, obtain answers to these questions:

• What was the annual return of the fund for the past 10

years? Did the fund outperform the S&P 500 during

that time frame?

• Was growth apparent each year? How did the fund

perform in the bear markets of ‘87, ‘90, ‘94 and the

fall of ‘98?

• Did the fund outperform other funds with similarobjectives?

• Is the current portfolio manager the person who built

the fund? If not, how long has the present manager

directed the fund? There’s no substitute for experience

(especially when your money is in jeopardy).

• Does the fund have a load? Do your best to stay away from loaded funds, especially when there are so many

good no-load funds. Is the expense ratio—the sum of all

administrative and management fees divided by the

NAV—below 1.5 percent? Avoid funds with ratios

above that.




Selected List Of Company

And Industry Information

Your local library should have some or all of the follow-ing publications investment experts use to evaluate stocks

and industries.

Key Industry Overviews• Standard & Poor’s Industry Surveys —New York:

Standard & Poor’s Corp. Quarterly updates.• Value Line Investment Survey —New York: Value

Line. Looseleaf with weekly updates.

• Morningstar Mutual Funds —Monthly updates. A run-

down and rating of mutual funds.

Corporate Profiles And Summary Information10-Ks and Annual Reports to shareholders. All of these

public filings can be found on the “Edgar” database provid-

ed by the Securities & Exchange Commission. The Internet

address is www.sec.gov.

• Hoover’s Handbook —Profiles of more than 500 majorcorporations.

• Moody’s Manuals —Bank & Finance. Industrial.

International. OTC Industrial. Public Utility.

Transportation. New York: Moody’s Investors Service.

• Standard & Poor’s Bond Guide —New York: Standard

& Poor’s Corp. Monthly.• Standard & Poor’s Stock Guide —New York: Standard

& Poor’s Corp. Monthly.

• Standard & Poor’s Stock Reports —New York: Standard

& Poor’s Corp. Weekly updates.




Internet A great Web site that provides everything from 15-

minute delayed stock quotes to price charts to financial

ratios is Yahoo Finance . The Web site ishttp://finance.yahoo.com. Investors get analysts’ upgrades

and downgrades, earnings estimates and industry compar-

isons for financial ratios.

A new financial site that's set to rival Yahoo! Finance is

Google Finance (finance.google.com).

Market IndexesTracking the market is a complicated undertaking. For

example, if you asked your broker “How’s the market doing

today?” chances are you’d receive information on the Dow

Industrials. But with only 30 stocks, they’re a very narrow

representation of how the broad-based market is doing.

Other, more broadly based, widely followed and quoted

market measures are:

• The S&P 500 includes the best stocks in industry,

technology, transportation and utilities listed on the

NYSE, AMEX and the Nasdaq.

• The Wilshire 5000 consists of all US equities, real

estate investment trusts and limited partnerships—more

than 5,800 securities.

• The NYSE Composite includes about 2,500 common

stocks listed on the NYSE.

• The Value Line Composite is an average of all 1,700

stocks followed by Value Line.

• The Nasdaq Composite measures all domestic stocks

traded on the Nasdaq, about 4,600 issues.

• The Russell 3000 contains 3,000 large US companies,

or more than 90 percent of the US equity market.

• The Russell 2000 features the 2,000 smallest stocks

in the Russell 3000.


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