Archive for the ‘Stock Market Insights’ Category
Stock Market Insights: The Cash Flow Statement
January 30th, 2010 | 
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Cash is king! Liquidity in the form of cash tells us that the company can meet its’ obligations. The Cash Flow Statement is the third and last statement that we will touch upon. The statement is filed quarterly and year over year in concert with the Profit and Loss and Balance Sheet. The Cash Flow Statement is a measure of incoming and outgoing cash from its’ business operations for a specific point in time. The statement further defines the cash flow of the company that is indicated on the Balance Sheet. There are two methods of accounting that are used 1) accrual and 2) cash. Most companies use the accrual method which accounts for goods delivered as sales regardless of whether they have been paid for or not. The outstanding balance is shown on the Profit and Loss Statement under accounts receivable.
The Cash Flow statement typically divides the accounting for cash into three areas 1) Operating Activities 2) Investing Activities and 3) Financing Activities. It is most favorable if the company is creating their cash flow from Operating Activities as opposed to the other two. The reason is that if the company can sustain its’ operations from daily operations as opposed to investment returns and financing, it shows company strength. Be careful to take note of how large of an impact that depreciation has on the Operating Activities bottom line. Depreciation does not actually contribute cash to the company; it is more of an accounting item.
So, what are we looking for as investors in the Cash Flow Statement? A company with a smaller percentage of capital expenditures, (which is found under Investing Activities) is spending less of the company’s net earnings to remain competitive. It is also prudent to look for a company that uses its’ cash to buy back stock. Stock buyback activity tells the investor that the company believes its’ stock is a bargain and if they feel that way, that is a good sign. The other outcome to stock buyback is that it reduces the outstanding shares and will therefore increases the earnings per share which should at some point increase the value of the stock assuming that the multiple remains constant. You can find this information under the Financing Activity section of the Cash Flow Statement.
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Stock Market Insights: The Balance Sheet
The Balance Sheet is a financial statement indicating the strength of the company at a specific point in time. Most companies will report their Balance Sheet numbers quarterly with a year over year summary at the end of their fiscal year. Put quite simply, the Balance Sheet seeks to “balance” two factors. 1) That which is owned by the company and reflected by its’ assets and 2) that which is not owned comprising both borrowed money (debt and liabilities) and money generated through the equity of shareholders. The Balance Sheet equation is: Assets = Liabilities + Shareholders’ Equity.
Line items that appear under assets on the Balance Sheet can include the following: Current Assets including cash and cash equivalents, Accounts Receivable, Short Term Investments and Inventory. Current Assets fund the day to day operations of the company. If the company is deficient in this area, it will force them to acquire more debt or initiate a capital raise with additional equity. Long Term Assets include Fixed Assets such as buildings and equipment. It also includes Intangible Assets such as intellectual property and blue sky value like good will.
Liabilities include Current Liabilities, Long Term Liabilities. Current Liabilities include such items as Short Term Debt, Accounts Payable, Accrued Expenses and that portion of Long Term Debt that is currently due. Long Term Liabilities comprise items such as mortgages and business loans.
The final part of the equation is Shareholder’s Equity and that is the part of the company that is attributed to claims that the stockholders have on the value of the company. This value is typically arrived at by subtracting Total Liabilities from Total Assets resulting in the Shareholder’s Equity.
So, as investors, what are we looking for on the Balance Sheet to tell us that the company is worth investing in? An appealing investment would be a company with a large cash position that has been created from business operations, not from the sale of bonds or equity shares and little to no debt. We look for a steady rise in inventory to satisfy the demand for the company’s products. Net receivables should be low because that represents the company’s ability to bring cash in the door quickly and efficiently. Next week we will talk about the Cash Flow Statement.
Stock Market Insights: The Profit and Loss Statement
There are three financial statements pertaining to measuring a company’s financial health. They are the Profit and Loss, the Balance Sheet and the Cash Flow statements. Today we will talk about the Profit and Loss statement. The P&L measures and details a company’s revenues and expenses over a set time period such as quarter over quarter or year over year.
The statement comprises four basic parts 1) Sales or revenues 2) Cost of goods or cost of sales 3) Gross Profits and 4) Expenses. The Net Income or earnings is calculated by subtracting the total expenses from the total revenue. The company creates top line revenue or sales and then subtracts returns and damaged merchandise to arrive at Net Sales. Cost of goods is then subtracted from Net Sales resulting in Gross profits. Operating Expenses are then subtracted to reveal the Operating Profit of the company. Other income is added back in and then Interest, Taxes, Depreciation and Amortization is debited to finally arrive at the bottom line Net Profit.
From an investor’s perspective, the question may be asked, “What are we looking for in the Profit and Loss Statement”? The answer is that the statement can reveal how healthy the margins are and whether or not the company is growing its earnings. At some point in the future earnings will translate to stock price. Each sector and industry will have a multiple of earnings that is generally attributed to those companies in that sector and industry. When doing a comparative analysis of a particular company, an investor can compare the company to its peers and sometimes be able to pinpoint when a company appears to be undervalued. The P&L statement can help uncover such opportunities. Next week we will touch on the Balance Sheet.
Stock Market Insights: Measuring Profitability
The purpose of entering into business is to make a profit, so it only makes sense to keep a close eye on profitability measures. This week we are going to touch on two such measures and they are Profit Margin and Operating Margin.
Profit Margin is defined as Net Profits divided by Sales. Another way to look at this measure is that it tells us how much of each dollar of sales is actually kept. A high Profit Margin is an indication that the company is doing a good job of converting sales to bottom line earnings. It is a measure of efficiency. If a company can generate a higher Net Profit on the same amount of sales, then they are more efficiently producing earnings. For example, if “Company A” has a Net Profit of $20 million from $200 million of sales, then the Profit Margin would be 10%. Let’s compare that with “Company B” that generated $30 million in Net Profit on $400 million of sales. Even though “Company B” is generating a larger Net Profit, it is taking greater sales to do it. “Company B” is less efficient than “Company A” and that is reflected in the Profit Margin. “Company A” has a Profit Margin of 10% and “Company B” has a Profit Margin of 7.5%.
Operating Margin is defined as Operating Income divided by Net Sales. Operating Income (Gross Income minus Depreciation) needs to be defined in order to arrive at Operating Margin. Net Sales is defined as sales after returns, missing and damaged goods. Net Sales is a metric that allows a more accurate picture of sales. Operating Margin tells us the amount of resulting revenue after variable costs such as cost of materials and employees. If the number is high, it is considered to be favorable. It is best to measure the company over time against itself in quarter over quarter or year over year comparisons. One time, nonrecurring expenses are not normally included in the Operating Margin calculation.
Stock Market Insights: Measuring Management Performance
One of the key factors in the success of any company is the effectiveness of management. Decisions made on the management level can dramatically enhance or hurt the performance of a company. There are two measures that we will touch on today that can give us insight into how well management is performing 1) Return on Assets and 2) Return on Equity.
Return on Assets is an indication of how effectively a company can achieve a return relative to the amount of total capital invested. The formula for ROA is Net Income divided by Total Assets. The higher the number generated by the formula the better. If management through the myriad of decisions and resources available to them can achieve a high return, then that management team is performing well. It is best to compare performance against the company itself quarter over quarter or year over year. It is also prudent to compare performance to other companies in the same or similar industries.
Return on Equity is similar to ROA in that it is a measure of management performance and their ability to generate a return. ROE measures how well the company can yield a return in relation to the shareholders equity or stock holdings. The formula for ROE is Net Income divided by Shareholder’s Equity. The higher the number generated by the formula the better. As with ROA the measure is most meaningful by comparing the company over time against its’ own performance as well as a comparison against other companies in similar industries.
When considering whether or not to invest in a company, management effectiveness should be a crucial part of your due diligence and these measures will help you in that decision. Robin
Stock Market Insights: Valuation Metrics continued
Continuing our discussion from last time, the next metric of significance is the PEG (Price Earnings Growth) Ratio. While one can measure the value of a stock based upon its’ PE as discussed last week, it is valuable to know if the company is growing and that is what the PEG Ratio tells us. The PEG equals the PE divided by the annual Earnings Per Share growth. The resulting number will project an undervalued company if that number is low. The PEG can be represented in various time periods such as annually or for a longer period such as 5 years. The measure is comparative so one can derive perspective in terms of valuation when comparing the company against its’ own past performance as well as comparing against other companies in a similar industry or sector.
Another metric used for valuing a stock against the market as well as itself is Price/Sales. The formula is the stock’s price per share divided by its’ revenue and is usually represented by the TTM (trailing twelve months). This measure is more accurate when comparing companies in similar industries and sectors. The measure does not account for how efficiently the company is operating because expenses are not included in the calculation.
Finally, this week we will touch upon one additional valuation metric, Price/Book. This measure compares the Market Value of the company as reflected by the share price of the stock divided by its’ Book Value which is defined as its’ Total Assets less liabilities and Good Will or blue sky value. If the company exhibits a lower number, it can be indicative of an undervalued company although, further investigation may reveal that the company may have internal problems.
We hope that your Holidays have been joyful. Best, Robin
Stock Market Insights: Introduction to Financial Statements and Valuation Metrics
I am beginning a series on key stock market information to help you become a more effective retail trader. We will begin by investigating Financial Statements. We will look at the Balance Sheet, the Income Statement and the Cash Flow Statement as well as other key metrics and financial ratios. We will also look at valuation measures that help give insight into the perceived value of a company.
It may make sense to first talk about the measures that are used to typically try and determine the value of a company. Market Cap is a term used to describe the size of a company. Market Capitalization is defined as the OUTSTANDING SHARES x THE PRICE PER SHARE. OUTSTANDING SHARES are defined as shares held by not just the public, but also insiders. The FLOAT is the total shares available for public trading.
So, if the number of shares OUTSTANDING is 1 million and the price per share is $50, then the MARKET CAP for the stock is 50 million. Stocks are usually categorized into Large Cap, Mid Cap and Small Cap. Large Cap is over $10 Billion, Mid Cap is from $2 to $10 Billion and Small Caps are between $300 Million and $2 Billion.
Another metric that is used by many investors to reflect a more accurate value of a company is its ENTERPRISE VALUE. EV more closely depicts the value of a company because it takes into account not only its cash and equity but also the debt of the company.
The final measure that we will explore today is the P/E Ratio. This is a valuation measure that is based upon comparing a stock’s price divided by its earnings per share. PE is many times expressed in relation to its last four quarters or sometimes as its (TTM) trailing twelve months as well as forward projections into the upcoming twelve months.
This is a good start and we will continue our discussion next week. Best, Robin
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