analyze investments pta0505

How ToAnalyze

InvestmentLike the Pros

Personal FinancePersonal Finance

The Hard Facts 1

Collecting Data 2

The Ratios 8

Technical Indicators 20

Selected List Of CompanyAnd Industry Information 23

TABLE OF CONTENTS

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By The Editors Of Personal Finance

The Hard FactsWithout financial facts and figures, professional analysts

couldn’t make informed decisions. Financial analysisdemonstrates how past conditions and events came to pass;more important numbers exhibit what could happen in thefuture. 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 duringa 10-year period and if the management team remainsintact, we might logically expect the trend to continue.

What numbers do the pros use? Most analysts use the rawinformation presented by accountants concerning sales,margins, expenses, profits and taxes. Unfortunately, thenumbers themselves tell only part of the story. The trick isto know what the numbers mean and to relate them to eachother and to industry norms.

Financial analysis is designed to determine a company’srelative strengths and weaknesses—whether the firm isfinancially sound and profitable relative to other firms in itsindustry and whether its position is improving or deteriorat-ing over time. Analysts need this information to estimatethe riskiness of the endeavor under consideration and todetermine if the firm is worthy of an investment.

Of course, the numbers aren’t the whole story. There arepsychological factors that affect the stock market. Some ana-lysts say the stock market is 15 percent numbers and 85percent psychology, following the postulate that all invest-ment issues are human related. That’s why savvy analystsuse 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 helpyou become a confident investor.

1www.pfnewsletter.com

Collecting DataThe first concern of the analyst is finding reliable infor-

mation. Where do you look? The most commonly employedinformation, and the most dependable, is historical. Of thevarious reports corporations issue, the annual report is byfar the most important.

The Annual Report Financial Statements Principally, 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 willaffect future operations. The report includes four basicfinancial statements: the income statement, the balancesheet, the funds flow statement and the statement ofchanges 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 processinvolves reviewing a great deal of formal or informal data rele-vant to the specific purpose of the analysis. Almost all of thedata needed is found in the following financial statements.

1. Balance Sheet

The balance sheet describes the categories and amountsof assets utilized by the business and the offsetting liabilities

incurred by lenders and owners.Sometimes called the statement offinancial condition, or statement offinancial position, it must always“balance.” Why? Because the totalassets invested in the business atany point in time, by definition, arematched precisely by the liabilitiesand owners’ equity position.

2 How To Analyze Investments Like the Pros

Balance SheetAssets = Liabilities + Owner Equity

Assets LiabilitiesCurrent assets $50 Current liabilities $26Fixed assets 125 Long-term liabilities 97Other assets 2 Owners’ equity 54Total assets $177 Total liabilities $177

and net worth

The balance sheet is sometimes reduced to a simpleaccounting equation: assets = liabilities + owner equity (seebox on p. 2). Ultimately, all transactions appear within thisbasic equation.

The balance sheet assigns values to equipment andother assets, describes amounts owed on both short- andlong-term horizons, lists funds available for continuedoperation of the business, and determines the value of thestockholders’ equity.

Keep in mind that balance sheets can become obsoletevery quickly. Like your monthly bank statement, they reflectconditions on the compilation date.

The major categories of assets are: current assets (itemsthat turn over in a short period of time, such as cash, mar-ketable securities, accounts receivable and inventories);fixed assets (buildings, land, mineral resources, heavymachinery, vehicles, etc., all of which are used over the longhaul); and other assets (deposits and intangibles like copy-rights and patents).

Major liabilities include: current liabilities (obligations todistributors, tax authorities, employees and lenders due withinone year); long-term liabilities (an assortment of debt instru-ments like mortgages and bonds); and owners’ equity (fundscontributed by various classes of owners ofthe business as well as accumulated earningsretained in the business).

2. Income Statement

The income statement describes thedollar value of goods and services sold,gross profit, funds expended to makeprofits happen, including writeoffs andtaxes, 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 StatementRevenues - Expense = Profits

Sales $4,000Costs and expenses 2,400Writeoffs 100Depreciation 100

Earnings before interestand taxes $1,400Interest expense 25Earnings before taxes 1,375Taxes 475

Net Income $900

Where the balance sheet reflects the financial conditionon a specific date, income statements tell what happenedover a period of time, usually one year. The net profitearned by a business enterprise is found by deductingexpenses 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 infinancial 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 statementsand answers the following questions: Where did the compa-ny get its funds during the year? What did the firm do withthese funds? Is the firm’s financial position stronger orweaker, 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 informationfrom income statements.

As noted, from this greatly simpli-fied example (see box), the compa-ny’s current assets declined duringthe year. You can also see that thefirm used available funds to financelong-term liabilities, because fixedassets were up from $110 to $125,with a corresponding jump in long-term debt. It’s just this sort ofsnooping, combined with a vigilantreading of all text, that puts thespotlight on patterns.

Is the firm’s financial positionstronger or weaker, as measured bychanges in net working capital? It’s

weaker. Working capital declined by $15 (current assetsdown by $5 and current liabilities up by $10).


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

Current assets $50 $55 –5Fixed assets 125 110 +15Other assets 2 0 +2Total assets $177 $165 +12

Current liabilities $26 $16 +10Long-term liabilities 97 59 +38Owners’ equity 54 90 –36Total liabilities $177 $165 +12and 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 financialposition gives more details concerning the change in owner-ship accounts, or net worth, as recorded by the beginningand ending balance sheets. Getting a closer look at thefunds flow statement allows you to make a more detailedanalysis. For example, you can determine whether debt or anew 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 thataffect operating performance. While there are many ways tocompare numbers, ratio analysis is accomplished simply bydividing one number into the other.

Ratios Financial 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 youare, the more success you will have as an investor.

Ratios have a number of advantages:

• They clarify the relationship between numbers that aredifficult to see and comprehend by themselves.

• Ratios focus on trends that may be impossible to spotin a column of numbers.

• Ratios make numerical reporting easier to follow andmore 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 youattempting 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 facevalue. Question everything.


• How precise do the answers need to be? Will additionalresearch 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 manyindustries, which makes it difficult to obtain meaningfulstatistics. For example, General Motors operates numer-ous businesses, from automobiles to finance to insur-ance to locomotive construction.

• Inflation badly misrepresents balance sheets becausefinancial statements are based on historical costs. Profitsare affected because inventory values rise with inflation.

• Some firms employ “smoke and mirrors” to makefinancial statements look better. Cash accounts can beskewed by including money from long-term debt withcash, improving year-end “quick” and “current” ratios.After analysis is endorsed by accountants and resultsprinted, debt can be paid off.

• Different accounting practices can mislead. Firmswithin similar industries may use contrasting deprecia-tion schedules.

• Ratios consider past activity. History is worth recogniz-ing, but the future is always uncertain. Never assumethat obsolete printed material has any application intoday’s world, even if it’s only a few months old.

Regardless of its limitations, ratios allow investors tofocus on problems. More important, they provide the toolsto determine if company managers recognize transforma-tions in their industry, adapt to changes, and if they’re con-trolling finances properly.


The RatiosRatios are the foundation of what analysts call “funda-

mental analysis.” In traditional ratio analysis, very few addi-tional information sources beyond the balance sheet andincome statement are used. However, don’t confine yourdigging 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 Monitor Ratio compilation and analysis is a clerical process. It requires

determination in the collection of data, accuracy in calculationand perseverance in comparison with industry averages. There’sno relationship between the size of a firm and the number ofratios requiring review. It depends entirely on your style andthe 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 customratios may or may not provide significant information.Problems arise when attempting to compare unusual ratiosto 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 inmind that numbers must be consistent from one period toanother. Extraordinary items should be removed from cur-rent and past data. Remember that new information couldmake previous data invalid.

Asset Management Ratios

Sales Growth Ratio

Without grease for the wheels, a company won’t runfor long. Sales provide the grease; nothing happens until


somebody sells something. This ratio measures just howwell 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 marketingor customer preferences) or from without (competitors, tech-nological change or a recession). Whatever the cause, failure togrow sows the seeds for future difficulties.

This ratio is calculated by examining current year saleswith 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 Year

On the income statement on p. 12, we note net sales of$1.29 million. This equation requires you to examine theprevious year’s income statement (not shown) and net salesfrom 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 severalyears 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 sometimesincrease 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 isusually a sign of improving efficiency, while a decrease maymean 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 neededper unit of automobiles produced.



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

AssetsCurrent 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) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,000Tangible 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 LiabilitiesNotes 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, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000,000Additional 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 numberof employees. After reading the annual report, we discoverthat 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 otherfirms within the industry and track the figure over several years.

Total Expense Ratio

This ratio indicates managerial success in controllingexpenses. The lower the number the better.

Total Expense Ratio = Total Operating Expenses/Net Sales

Interest Expense Ratio

Some companies depend on borrowed money to financelong-term growth, even daily operations. Still others rely onequity capital and cash flow from profits. This ratio studies theinterest cost relative to the sales of the company.

You should give this ratio close scrutiny, watching closelywhen borrowing is significant and comparing with similar firms.

Interest Expense Ratio = Interest Expense/Net Sales

Turnover Of Assets

Sometimes called the investment turnover ratio, assetturnover ratios measure how many times the company’s assetsare 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 atrendline chart; downward trends signal declining efficiency.

Inventory Turnover

This ratio assesses how well management controlsinventory. 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 betteryardstick because cost ofgoods sold varies consider-ably between firms.

The average inventory isdetermined by adding openingand closing figures and divid-ing by two. We’ve simplifiedour example so that both fig-ures are $300,000.

Inventory Turnover = Cost Of GoodsSold/Average Inventory

Profitability Ratios Profits are very important.

Unless the company hasunlimited resources, operat-ing unprofitably over a peri-od of time will deplete capitalto the point that nothing isleft to pay employees or buyraw materials.

Continuous break-evenoperations provide no cushion for contingencies. What’sworse, without profits, rational investors will not investnor will lenders supply the funds needed for growth and expansion.

Gross Margin

Low margin means that too much is being paid formerchandise, or selling prices are too low, or both. Avalue of zero means that the goods are sold for the sameprice paid for them. Negative values are possible if sellingprices are below cost overall. Such evidence would indi-cate extreme competition.


XYZ Company Income StatementYear Ended Dec. 31, 2006

RevenuesGross sales . . . . . . . . . . . . . . . . . . . . . . . . . . .$1,300,000Less 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 . . . . . . . . . . . . . . . . . . . . . . . .800,000Gross Profit . . . . . . . . . . . . . . . . . . . . .$490,000

Operating ExpensesWages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$160,000Marketing expenses . . . . . . . . . . . . . . . . . . . . . . . .75,000Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35,000Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .5,000Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . .12,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . .10,500Bad-debts expense . . . . . . . . . . . . . . . . . . . . . . . . .20,000Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . .14,000Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25,000Additional expenses . . . . . . . . . . . . . . . . . . . . . . . .50,000Total Operating Expenses . . . . . . . . . . .$406,000

Income From Operations . . . . . . . . . . . . . . . . . . . .$84,000Net Profit Before Taxes . . . . . . . . . . . . . . . . . . . . . .84,000Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12,000Net Profit After Taxes . . . . . . . . . . . . . .$72,000

Margin is closely related to pricing. Remember that marginis lower where the customer can pick and choose among manysuppliers and higher where choices are limited. A high marginwould 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 netsales, a number that even the most inexperienced investorshould monitor. Management attempts to increase profitsby increasing margins, though price increases may failbecause customers could seek substitutes or forgo the prod-uct entirely. Margins are also affected by purchasing rawmaterials. Increasing raw material order quantities from sup-pliers could lower prices and operating expenses.

Break-Even Margin = Total Operating Expenses/Net Sales

Operating Margin

Operating 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 debtexpense 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 growthto bottom-line profit growth. The ratio is the differencebetween this year’s and last year's after-tax net profit, dividedby last year’s after-taxes net profit.

It’s best to plot this data for several preceding years on atrendline to see if profits fluctuate significantly from year toyear. This ratio requires us to examine the previous year’sincome 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 betweenwhat 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 demonstratehow 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 tosales. It’s useful to investors, lenders and anyone who mayneed to compare the efficiency of two firms in similar or total-ly different businesses. You want to know how successful acompany is at converting gross profits into net profits.

Firms with high returns on gross profit display at leasttwo common characteristics: They’re in good lines ofbusiness and competitors are scarce.

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

Return On Assets

This ratio indicates how successful management is inutilizing assets to make profits. It really measures thefirm’s earning power of its asset investments. Averages forthis ratio vary greatly by line of business. Obviously, steelmanufacturers require more assets than a sales-orientedbusiness.

Some analysts remove intangible assets from the equation andaverage 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 ofthe return-on-investment ratios. Pay particular attention to thisratio because it reports how much the company is earningfrom dollars invested.

The national averages for this ratio vary from 5 to more than20 percent depending on the business. Lower returns may limitinvestment, restrict growth and ultimately the dividend-payingability. Many variations for this ratio exist, with the resultingnumbers differing significantly.

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

Some firms obtain money entirely from equity investors, orfrom profits resulting from business. Money obtained this waydoesn’t have to be repaid, and there’s no interest cost. Otherfirms obtain needed cash by borrowing from banks, or by issu-ing debt instruments such as bonds. Company survival mayhinge on its ability to meet such obligations. Business successresults from maximizing the use of other people’s money.

Liquidity Ratios

Current Ratio

This ratio is computed by dividing current assets by currentliabilities. Sometimes called the liquidity ratio, this ratio is perhapsthe best-known measure of financial strength on a specific date.

When companies get into financial difficulty, they pay debtsslowly. When tough times appear, the current ratio will fall andcould spell trouble for the firm. Industry averages aren’tetched in stone, but a popular rule of thumb for this ratio is 2percent or better. Many consider this number the minimumnecessary for reliable cash flow, though some lines of businessoperate 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? Becauseit considers only those assets that can be converted to cashquickly. 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 aredue 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’sowned. When the ratio exceeds 100 percent, it indicatesthat the investment capital provided by lenders exceeds thatprovided by the stockholders.

Debt To Equity = Total Liabilities/Stockholders’ Equity

Debt To Assets

Also called the debt ratio, this ratio compares what’sowed to the value of assets employed by the business. Thetotal 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 theratio 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 ofsales. There’s no correct value for this ratio, but if it moves outof 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 circumstancessour. This is the most critical of the solvency ratios andassumes that inventory, accounts receivable, prepaid expens-es and other current assets are illiquid. Only cash is availableto meet obligations. Examine this ratio closely to determineif a firm is operating too close to the abyss. Develop atrendline and follow this ratio over time.

Judgment Day Ratio = Cash/Current Liabilities

Cash To Total Liabilities

Cash is the ultimate asset—in fact, it’s the only asset thatothers will pay you to hold. Unfortunately, comparativeinformation on levels of cash held by corporations isn’t easi-ly obtained. Sometimes you can make many permutationsto uncover actual cash amounts.

Cash To Total Liabilities = Cash/Total Liabilities

Market Value Ratios Investment 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, youdon’t want any surprises.

Market value ratios, sometimes called investmentratios, examine a company’s progress from a bottom-lineposition. When market values flounder, investors “bailout” quickly, forcing down the price of the security.

Book Value Per Share

The stockholders’ equity is divided by the number ofshares of stock outstanding. When new stock is sold fromtime 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 limitedinformation for evaluating holdings. They communicateonly one fact—the amount of the payout. These numbersare 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 bedivided by 22 million shares, the number of shares ofstock outstanding.

Dividend Yield

The dividend yield relates dividend payout to thestock price. High yields are characteristic of matureindustries, like utilities. Low-yielding stocks indicategrowth companies.

Dividend Yield = Dividend Dollar Amount/Current Stock Price

In this simplified example, dividend amount is not includ-ed. Suppose the stock price is $45 and the yearly dividendsadd to $3.15. The yield would be 7 percent.

Price-To-Earnings Ratio

Price-to-earnings (P/E) ratios are oft-quoted by analystsand represent per share market price of a company’s stockdivided by after-taxes net profit per share.

When investors are optimistic, as they were for most of thelatter 1990s, they’re willing to pay more for anticipated futureearnings. When a company’s future is viewed pessimistically, orthe industry is boring, the ratio is likely to be low.

P/Es change with stock price movement, so to arrive atthe 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 currentprice by the company’s estimated earnings for the nextfour quarters. One way to foretell growth is to examinehistorical patterns.


Many analysts maintain that low P/E stocks are positive(bullish indicators) while high P/E stocks are signs of animpending correction. It’s a good habit to develop trendlinecharts 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, otherwiseknown as the PEG ratio, is a way to measure a stock’s valuerelative to its growth rate. The PEG ratio is calculated bydividing a company’s P/E ratio by its five-year expectedearnings 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 avacuum. Consequently, you should compare PEG ratiosthat appear especially high or low to other competitors inthe industry as well as the market as a whole to get a senseif the stock is truly under or overvalued relative to its peersand 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 thefuture. The higher the ratio, the more optimistic are buyers.

Note that book value does not accurately report the marketvalue 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 marketprice, this time relating it to sales. The idea is to put a priceon a business that correlates to annual sales.

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


Technical IndicatorsThe preceding chapters were primarily concerned with

fundamental analysis or the firm foundation theory. Thefundamental investor matches value to price.Fundamentalists believe that investment prices reflect allavailable information relevant to determining value. Anynew information is quickly digested by the investing publicand 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 oninvestors’ moods. Technicians pay little attention to what thecompany does, concentrating on how the stock price performs.Technicians employ indicators, charts and computer programsto 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 ofspecific 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 andvolume traded as pictured on daily, weekly and monthlycharts. By looking at a stock’s pricing activity, futureprices can be forecasted.

Other Technical Indicators Dow Theory is the oldest and most widely used of the

technical theories. As with other technical procedures, it’sbased on trends indicated by price movements. Named afterCharles Dow, this theory contends that the stock market ismade up of two types of “waves.” These waves are pri-mary—a bull or bear market cycle of several years’ durationand a secondary wave lasting from weeks to months.

Dow believed his theory applied to the general marketand that individual stock selections would rise or fall withthe averages much of the time.


Speculative influence is reflected in the ratio of activitybetween Nasdaq and American Stock Exchange (AMEX)stocks to New York Stock Exchange (NYSE) volume. Thetheory is that when activity and prices of Nasdaq and AMEXstocks 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 viewthe market. The smaller investor is presumably lessinformed and so tends to follow established and predictablepatterns. 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 ormutual fund prices to averages tracked over a period oftime. As a new price is added to the list, the oldest pricefalls off. All prices are “aver-aged” by dividing the sumtotal by the number of daysor weeks monitored.Investors invest in the mar-ket as long as the movingaverage is above the S&P500 average, the Wilshire5000 average or whateverindex is monitored.

A most-active stock listis published in many dailynewspapers, giving highs,lows, last prices and changesin the volume leaders on theNYSE and Nasdaqexchanges. Many investorswatch these lists closely andeither buy the issues afterthey’ve appeared on the listfor three consecutive days orshort 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 knowwhether 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&P500 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 newhighs or lows. These are the stocks that hit new highs orlows for the year during the previous day’s trading session.Technicians believe that when more stocks are making newhighs than lows, bullish times will result.

Advances vs. declines is a simple measure of the numberof stocks having advanced in price and the number thathave declined. Widely followed and quoted, this is thoughtto illustrate the general direction of the market.

Volume, the number of shares traded daily, is an importantindication of where the market is headed. Buyer enthusiasmto climb aboard rising markets frequently push prices higher.

Momentum measures the velocity of an index, comparingcurrent numbers to an index or a moving average.

How To Evaluate A Mutual Fund Interested 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 duringthat time frame?

• Was growth apparent each year? How did the fundperform in the bear markets of ‘87, ‘90, ‘94 and thefall of ‘98?

• Did the fund outperform other funds with similarobjectives?

• Is the current portfolio manager the person who builtthe fund? If not, how long has the present managerdirected 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 awayfrom loaded funds, especially when there are so manygood no-load funds. Is the expense ratio—the sum of alladministrative and management fees divided by theNAV—below 1.5 percent? Avoid funds with ratiosabove 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 stocksand industries.

Key Industry Overviews• Standard & Poor’s Industry Surveys—New York:Standard & Poor’s Corp. Quarterly updates.

• Value Line Investment Survey—New York: ValueLine. 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 Internetaddress 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.


InternetA great Web site that provides everything from 15-

minute delayed stock quotes to price charts to financialratios is Yahoo Finance. The Web site ishttp://finance.yahoo.com. Investors get analysts’ upgradesand downgrades, earnings estimates and industry compar-isons for financial ratios.

A new financial site that's set to rival Yahoo! Finance isGoogle Finance (finance.google.com).

Market Indexes Tracking the market is a complicated undertaking. For

example, if you asked your broker “How’s the market doingtoday?” chances are you’d receive information on the DowIndustrials. But with only 30 stocks, they’re a very narrowrepresentation of how the broad-based market is doing.Other, more broadly based, widely followed and quotedmarket measures are:

• The S&P 500 includes the best stocks in industry,technology, transportation and utilities listed on theNYSE, AMEX and the Nasdaq.

• The Wilshire 5000 consists of all US equities, realestate investment trusts and limited partnerships—morethan 5,800 securities.

• The NYSE Composite includes about 2,500 commonstocks listed on the NYSE.

• The Value Line Composite is an average of all 1,700stocks followed by Value Line.

• The Nasdaq Composite measures all domestic stockstraded 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 stocksin the Russell 3000.


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