Important Updates for Investors
Carla Pasternak's Premiere Issue of High-Yield International Just
Released
Income expert Carla Pasternak's debut issue of High-Yield
International covers a Taiwanese manufacturer yielding 9.5%... a
rare Mexican monopoly yielding 13.4%... and other top-performing
investments yielding up to 19.0%.
Government's Biofuel Timetable Could Spell +15,900% Growth
+15,900% growth might seem far-fetched... but it's not. In fact, it
is mandated by law. And I've identified the ONLY stock positioned to
capture this growth.
The
Silver Lining to a Falling Dollar
Despite the U.S. national debt, there is a silver lining for income
investors. This massive spending, combined with movement out of U.S.
Treasuries, is going to take its toll on the dollar, and
international income investors could reap the rewards in the form of
higher dividends. |
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| Building
Your Own Value Investing System (Part III) |
Published: October 11, 2005
In Part II of this educational series on value
investing, which I published back on October 4th,
I introduced you to some of the specific methodologies that I use to
uncover quality value candidates. These include the use of advanced
screening tools, as well as an analysis of each firm's income statement.
In today's article I'll bring you Part III of this educational series. In
it, I'll take a closer look at how to analyze a firm's cash flow
statement and balance sheet. I'll also summarize many of my
methodologies and will show you how you can use them to uncover highly
undervalued stocks...
Cash Flow Statement
The Cash Flow statement is undoubtedly one of the most
overlooked -- yet at the same time also revealing -- of all the
financial statements. While earnings can be manipulated by aggressive
accounting techniques and distorted by non-cash adjustments, the cash
that flows into and out of a business is more transparent. To many, free
cash flows (cash from operations less capital expenditures) are the best
indication of a company's profitability. After all, free cash flows
represent the amount left over that is "free and clear" for
management to use to repurchase shares, pay dividends, or reinvest back
in the business.
While the income statement yields such measures as Price/Sales (or
Enterprise Value/Sales), Price/Gross Profits, and Price/Earnings, the
cash flow statement gives us Price/Cash Flow and Price/Free Cash Flow.
If these ratios are not keeping pace with Price/Earnings, then the
company's earnings quality may be called into question. Finally, this
statement gives investors a window to peer into a company's share
issuance and repurchase activities.
As the name implies, the line item labeled "sale/purchase of
stock" provides investors with a summary of a firm's stock
purchases or sales. A negative number on this line typically means that
management has reduced its number of outstanding shares through the use
of stock buybacks. Meanwhile, a positive number is a sure sign that
shareholder dilution is taking place -- most likely from the issuance of
stock options. Even if the number remains level, it may not necessarily
be a positive for stockholders, as sometimes cash is used to repurchase
the same number of shares that have been handed out to executives.
Fortunately, in the near future most firms will be required to list
stock option expenses on their income statements.
Balance Sheet
As we get to the balance sheet, it is time to ascertain the company's
financial health. Here we will be examining the firm's cash and liquid
investments, its long-term debt, its receivables, and its liabilities.
One of the first things I do with the data found on the balance sheet is
adjust the company's price per share to determine its enterprise
value per share. Here is a relatively simple example:
Company XYZ
Current Price = $5.00
Cash = $3.00
Long-term debt = $1.00
Accounts Receivable = $0.75
Liabilities = $0.25
To calculate Company XYZ's enterprise value per share, first begin with
the current stock price of $5.00 per share. From there, subtract the
cash on hand of $3.00, and then add back debt of $1.00. These first
steps leave us with $4.00. Next, subtract receivables of $0.75 and add
liabilities of $0.25. After doing so we arrive at a final adjusted price
of $3.50 per share.
Nearly all of the companies I profile in my biweekly newsletter, Margin-of-Safety
Investing, have an
enterprise value well below their market capitalization -- meaning their
cash and accounts receivable far exceed their debt loads. In fact, many
of the firms I've selected for my model portfolio have stockpiled large
amounts of cash and have zero long-term debt on the books.
Another trait I look for on the balance sheet is a relatively high PPE/Market
Cap ratio. In many cases, companies with large PPE (property, plant, and
equipment) balances own valuable real estate that is recorded at
historical cost. Often, the true value of these assets is substantially
higher -- and somewhat hidden. Of course, before investing I also always
take a closer look at the firm's latest 10k filing to glean additional
information about each property's purchase date and location. These
items can sometimes provide clues as to their true market value.
Next, I dig a little deeper to ensure that the equity section of the
company's balance sheet is clean. This is a crucial step, as even
impressive earnings and sales growth can be watered down by excessive
warrants, preferred stocks, convertible debt, debentures, and other
potentially dilutive securities. I also tend to be leery of firms with
dual-class share structures.
Next, I like to take a closer look at the intangible asset balance. In
particular, I recommend reading each firm's 10Q filing to gain a better
understanding of goodwill. Growing goodwill can be troublesome, as the
amount could eventually lead to a major expense on the income statement
and cut into future earnings. Intangible asset balances are an ideal
place for clever accountants to hide expenses on the balance sheet in an
effort to overstate earnings. Therefore, keep a close eye on rising
intangible asset balances, as they could be an early warning sign that
management is attempting to mask expenses.
When analyzing accounts receivable, one of the most important tasks is
to ensure that an increasing receivables balance is matched by a
corresponding rise in sales. If accounts receivable are growing faster
than sales, then it could be an indication of aggressive accrual
accounting. Inventory balances should also generally not be rising at a
faster rate than sales for a prolonged period of time. Soft assets like
prepaid expenses should remain stable, as this account can hide
transactions that belong as an expense on the income statement.
Finally, I calculate every stock's Price/Book and EV/Book ratios. These
all-important metrics should be stacked alongside market averages and
similar industry peers.
Putting It
All Together:
Whenever I uncover a stock that compares favorably to its competitors in
all of these diverse categories, it becomes a serious contender for my
portfolio. However, more work must still be done. The financial
statements are a great place to begin searching for undervalued stocks,
but there are other factors that should also be weighed carefully.
To begin, there are a number of small, but important, clues that can
either reinforce my opinion or persuade me to look elsewhere. For
example, I have found that little or no institutional ownership can
often be the hallmark of an undervalued company. Furthermore, a stock's
recent movements can also be telling, particularly when compared to
those of close competitors. Stocks have been statistically shown to
demonstrate "mean regression." As a result, companies that
have been lagging for an extended period of time may be due for a
rebound.
Also, the importance of a firm's management team cannot be overstated.
One way to gauge its performance is through ROE (return on equity),
which is a major driver of shareholder value. Examining ROE requires
investors to dig deeper at the variables that underpin the calculation,
such as profitability, capital structure, productivity, and the value of
intangibles.
Finally, an
investor must have a firm grasp not only on the numbers themselves
(which are in a state of constant change), but also the factors that
drive those numbers -- market share, public image, brand loyalty,
patents, pricing power, etc.
Ultimately, everyone should let their individual personality dictate
their investing strategy. Some investors like to roll the dice on a
handful of carefully chosen stocks, while others prefer to hold a
broadly diversified portfolio. Some will have no trouble maintaining a
long-term outlook, while others will lack the right temperament to sit
on a slow-moving, deeply-discounted stock while the rest of the market
surges forward.
There is no single correct way to search for value stocks. With this in
mind, rather than blindly following someone else's system, I suggest you
choose a method that is aligned with your goals and beliefs. Regardless
of the strategy, you should make sure not to let fear, greed, and
emotional reactions influence your investing decisions. Whatever method
you select, if you can manage to avoid shortcuts, do your homework, and
also be patient, then good results will come.
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Important Note: The above article
was merely a small excerpt from a recent issue we sent to subscribers of
our premium value investing service -- Margin-of-Safety
Investing. In each issue of that newsletter, editors Nathan
Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted
stocks that should provide investors with a solid margin of safety at
current prices. To receive your copy of our most recent issue of Margin-of-Safety
Investing, as well as other guidance similar to this twice per
month, you'll need to subscribe to this publication. To learn more,
please visit:
https://www.streetauthority.com/subscribe-msi.asp
Thanks for reading!
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Nathan Slaughter
Editor
Half-Priced Stocks, The ETF Authority
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in-depth guidance on today's leading value opportunities, plus educational guidance, please subscribe to
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Stocks |
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