Mary Lund-Davis Student Investment Fund (SIF)

Investment Analysis Guidelines

These guidelines provide a good starting point for the analysis of investments. Evaluating the concepts presented here should provide you with a greater understanding of the potential for growth (or decline) a specific investment represents. The first question that probably comes to mind when thinking about analyzing an investment opportunity is, What should I analyze? The initial response to this question is simple. Its the Peter Lynch strategy to investing. Research what you know. If youre a skier and have noticed that a new brand of skies or snowboards has emerged that everyone is buying, then find out who makes them and research that company as a possible investment. If you love to shop for clothes, then keep your mind open to the companies that are hot at the moment. Are they likely to keep their current momentum for a significant amount of time that would result in large profits? If so, consider them as an investment (e.g. Abercrombie and Fitch in 1997). You are doing an internship at a large company and notice they are installing millions of dollars worth of new technology equipment? Find out who makes it You get the picture. Ok, with that said, how do you go about finding good companies that you may have never heard of or will never be exposed to? The best way to find great new companies is to read, read, read. When you are reading information about one company and another is mentioned, follow up on it. This is especially easy online where you are in a world of unending cross-threaded information. That being said, a few good places to start are: Microsoft Moneycentral http://moneycentral.msn.com/investor/home.asp Yahoo! Finance http://finance.yahoo.com/ CNBC http://www.cnbc.com/ If you think a certain sector is going to be especially hot but dont know exactly how to go about finding the best company to buy within the sector, then check out these online stock screeners. They allow you to choose an industry and set some restrictions regarding financial ratios among other things and spit out companies that fit your criteria: Yahoo! Hoovers WR Hambrecht & Co. Morningstar http://screen.yahoo.com/stocks.html http://www.hoovers.com/search/forms/stockscreener/ http://sites.stockpoint.com/wrh/stockfinderpro.asp http://screen.morningstar.com/StockSelector.html

These sites have predefined criteria and are awesome for finding possible investments: CNBC Quicken Microsoft http://www.cnbc.com/tools/stock_quick_search_stocks.asp http://quicken.webcrawler.com/investments/stocks/search/ http://moneycentral.msn.com/investor/finder/predefstocks.asp

The absolutely coolest custom screener is Microsofts found at: http://moneycentral.msn.com/investor/finder/customstocks.asp Check this one out. It is pretty difficult to figure out at first, but once you understand everything it will prove to be extremely helpful.

OK, now that you have discovered some companies that you want to investigate, what do you look for?

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Mary Lund-Davis Student Investment Fund (SIF) MAIN CONSIDERATIONS Analysis of the Industry Growth Domestic and International. Who are the major players? Who are the customers? Where are the markets for the products? Product life cycles. Elasticity of demand. Emerging business methods/technologies. Research and development expenses. Analysis of the Financial Numbers found in SEC Filings (Forms 10-Q and 10-K) Financial statements can be interpreted by calculating financial ratios, which are divided here, into four major categories: liquidity ratios, activity ratios, debt ratios, and profitability ratios. Liquidity ratios tell you how easily a company can pay its short-term liabilities. Activity ratios indicate how fast the company collects its accounts receivable or pays its bills, and the speed with which accounts payable, inventories, and accounts receivable are turned over. In general, the faster it collects and the slower it pays, the better off the company is. Debt ratios reveal the financial leverage of the company and whether debt is becoming too top-heavy. Debt ratios can alert you to liquidity problems. Profitability ratios reveal how effectively a company uses its assets to produce sales, to keep costs in line, and to generate net income. The data for these ratios can generally be found through horizontal and vertical analysis of a companys financial statements: the income statement, balance sheet, and statement of cash flows. The preferred sites for SIF members to collect financial data are http://www.tenkwizard.com/ and http://finance.yahoo.com/. As using an investments printed annual report nowadays seems an ancient idea, the most up to date financial reports can be found at 10K Wizard. Form 10Q's are quarterly and form 10K's are annual. The site will also keep you up to date on any other documents that have been filed with the SEC. Industry comparison ratios can be found at Yahoo! by entering a ticker symbol and clicking: profile ratio comparisons. Annual earnings per share numbers can be found by clicking: profile performance. Earnings growth numbers can be found by clicking on research. Liquidity Ratios Current ratio Acid-test ratio (Quick ratio) Activity Ratios Average collection period Average payment period Inventory turnover ratio Inventory conversion ratio Debt ratio Debt to equity ratio Long-term debt to total assets Times interest earned ratio Overall coverage ratio Profitability Ratios Operating profit margin Net profit margin Return on equity (ROE) Return on investment (ROI) Market Value Ratios EPS Price to earnings ratio (P/E) Price to earnings to growth ratio (PEG) Book value per share Price to book ratio (P/B) Payout ratio Dividend yield

Ratios should not be limited to those on this list. All ratios you feel necessary should be included in your analysis, including those that are industry specific. An example of information that can be used for other ratios would be Research and Development expenses. This is important in many fast-changing industries. One could calculate: R&D to Sales, R&D per employee, or R&D to net Income.

! IMPORTANT !

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Mary Lund-Davis Student Investment Fund (SIF) Financial ratios have much more value when used as a means of comparison. When looking at ratios, you can and should, depending on the ratio and situation, compare them to the market as a whole, to competitors within the industry, and to the historical values given to the investment itself. ADDITIONAL CONSIDERATIONS Management of the Company Whos on the board of directors (and whos come and gone)? Has anyone significant recently left the company (and what was the impact on the company)? Is management a major shareholder? Who does the CEO answer to? How is management compensated? Technical Analysis Technical Analysis is used when looking at historical charts of price as well as financial ratios plotted over time. Use this type of analysis when proposing a buy price. If an investment you feel is a good buy at its current levels but is trending down, it may be of benefit to set a lower buy price and pick up the investment at an even better value. Trends. Support levels. Highs/lows. Volume. Trends in the industry - Seasonal? Other Institutional holdings. Insider Trading. Recent news.

These considerations are to be used as guidelines only. Individual investments may require other issues that are not included here (e.g. - future prices of steel for the automotive industry etc.)

RATIO DEFINITIONS
LIQUIDITY RATIOS
An asset's degree of liquidity depends on how quickly that asset can be converted into cash without incurring a substantial loss. Liquidity management consists of matching debt claims with asset maturities and other cash flows in order to avoid technical insolvency. The measurement of liquidity is important. The main question, therefore, is whether or not a company can generate sufficient cash to pay its suppliers and creditors. In essence, liquidity ratios test a company's degree of solvency. Two well-known ratios used to measure the liquidity of a company include the current and the acid-test (quick) ratios. CURRENT RATIO The current ratio is the relationship between current assets and current liabilities: Current ratio = Current assets Current liabilities 3 of 11

Mary Lund-Davis Student Investment Fund (SIF) The current ratio roughly indicates the margin of safety available to a company to meet short-term liabilities. The ratio can vary, depending on the industry and the type of company. The current ratio does not always measure a company's true liquidity. Obviously, a company with large cash reserves and marketable securities is more liquid than a company with large inventories and high collection period receivables. A more refined ratio to deal with the asset mix problem would be to eliminate the component in current assets that is the least liquid. ACID-TEST RATIO (QUICK RATIO) By eliminating the less liquid inventory category and concentrating on assets more easily converted into cash, the acid-test (or quick) ratio determines whether a company could meet its creditor obligations if sales were to drop catastrophically.

Quick ratio =

Current assets - Inventories Current liabilities

ACTIVITY RATIOS
Activity ratios determine the speed with which a company can generate cash if the need arises. Clearly, the quicker a company can convert inventories and accounts receivable into cash, the better off it is. The following ratios and computations assume that a year has 360 days. AVERAGE COLLECTION PERIOD Finding the average collection period of a company will tell you how long that company must wait before receivables are translated into cash. Note that cash sales are excluded from total sales. Accounts receivable Annual credit sales / 360 days

Average Collection Period =

Accounts receivable is found on the balance sheet and credit sales are found on the income statement. As with other ratios, the average collection period must be examined against other information. If this company's policy is to extend credit to customers for 38 days, then a period of 45.8 days implies that the company has trouble collecting on time and should review its credit policy. Conversely, if the company's usual policy is to set a 55-day collection period for customers, then the 45.8-day average indicates the company's collection policy is effective. AVERAGE PAYMENT PERIOD The counterpart to accounts receivable is accounts payable. To find out the average payment period for accounts payable, you simply do the same thing you did for accounts receivablethat is, divide annual purchases into accounts payable: Accounts payable Annual credit purchases / 360 days To obtain this figure,

Average Payment Period =

However, annual credit purchases are not reported in a financial statement. estimate the percentage of cost of goods sold that are purchased on credit. 4 of 11

Mary Lund-Davis Student Investment Fund (SIF) Example: Calculating the Average Payment Period Problem: Assume an accounts payable figure of $275,000. If cost of goods sold is $3,000,000 and it is estimated that 80% of these goods are purchased on credit, what is the average payment period?
SOLUTION: The figure to use for annual credit purchases is $2,400,000 ($3,000,000 x .80). The average payment period for accounts payable can now be computed:

Average Payment Period =

Accounts payable .80 X $3,000,000 / 360 days

= 41.3 days

The average payment period (for accounts payable) of the company is 41.3 days. Anything lower might mean that sellers give a discount or that they consider the company a poor risk and therefore hold it to stricter terms. Anything higher might indicate that the company can receive good credit terms, or that it is a slow payer"that is, it is using suppliers as a source of financing. CONVERTING INVENTORIES TO CASH Inventory turnover is important to a company because inventories are the most illiquid form of current assets. Because the company must tie up funds to carry inventories, it is advantageous to sell inventories as quickly as possible to free-up cash for other uses. Generally, a high inventory turnover is considered to be an effective use of these assets. The inventory turnover ratio is calculated as follows: Costs of goods sold Average inventory

Inventory turnover =

Example: Inventory Turnover If a company's annual cost of goods is $3,000,000 and an average inventory value is $300,000, then the company's inventory ratio is 10 times.

Inventory turnover =

$3,000,000 $300,000

= 10 times

Another way of analyzing the ability of a company to convert inventories into cash employs the inventory conversion ratio, which tells you how many days it takes to convert inventories into cash. The formula for this ratio is: Inventory conversion to cash period (days) 360 days Average inventory

Be careful when interpreting the inventory turnover and conversion figures. A high turnover ratio does not necessarily imply that a company is effective in moving inventories. A high ratio can occur when a company continually runs out of stock because it does not produce or purchase enough goods. In this case, a high ratio actually implies poor planning or control of inventories. As a result, unless the inventory policy of a company is studied in detail, a ratio alone does not provide enough information about the ability of that company to generate cash from inventories.

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Mary Lund-Davis Student Investment Fund (SIF)

DEBT STATUS OF THE COMPANY

A company may borrow money for short-term purposes, mainly to finance working capital, or for long-term reasons, mainly to buy plant and equipment. When a company borrows for the long run, it commits itself to make periodic payments of interest and to repay the principal at maturity. To do this, it has to generate sufficient income to cover debt payments. One way to find out the debt position of a company is to analyze several debt ratios. DEBT RATIO The debt ratio indicates the percentage of total assets that is financed by debt. The lower the debt ratio, the less financial leverage; the higher the debt ratio, the greater the financial leverage. Total liabilities Total assets

Debt ratio =

Example: Debt Ratio If a company's balance sheet shows liabilities at $1,000,000 and assets of $5,000,000, then

Inventory turnover =

$1,000,000 $5,000,000

= .2, or 20%

A high ratio tends to magnify earnings and a low ratio could mean inefficient use of debt. DEBT/EQUITY (D/E) RATIO The debt/equity ratio involves the relationship between long-term debt and stockholders' equity. This is calculated as:

Debt to equity ratio =

Long-term debt + Value of leases Stockholders Equity

Thus, if long-term debt and leases on the balance sheet is $2,000,000 and stockholders' equity is $5,000,000, the debt/equity ratio is ($2,000,000 -$5,000,000), or 40%. Electric utilities, which have steady inflows of receipts, can safely afford to have high DIE ratios, whereas cyclical companies usually have lower ones. In other words, the customers of electric utilities make periodic payments to these companies. Because these utilities know just about how much they will be paid and are allowed to raise customer charges when their rates of return fall below a certain level, they can estimate profits fairly well. Knowing this, they feel more confident about issuing bonds because the income they will generate in the future will ensure that they can meet interest and principal payments without much danger of default. Cyclical companies, on the other hand, enjoy high operating profits in good economic periods but must endure low operating profits in periods of economic contraction: If they issue substantial debt, they may not be able to cover interest payments when profits deteriorate. As a result, these companies must adopt a more conservative debt policy and issue more equity, which does not require payment of dividends in bad business periods. LONG-TERM DEBT/TOTAL ASSET (LD/TA) RATIO The long-term debt/total asset ratio (LD/TA) relates debt to the total assets of a company, and can provide useful information regarding the degree to which that company finances its assets with long-term debt.

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Mary Lund-Davis Student Investment Fund (SIF) Long-term debt to total Assets ratio Long-term Debt Total Assets

This ratio can serve as an alternative for evaluating financial leverage.

TIMES INTEREST EARNED RATIO It is also important to find out how well a company can pay its interest. This ratio measures how well a company's interest payments are covered by the operating income of the company. The higher the rates, the better situated the company is to pay off its creditors. EBIT = Earnings before interest and taxes = operating profits. EBIT Annual interest expense

Times interest earned ratio =

Example: Times Interest Earned Ratio lf EBIT is $8,000,000 and annual interest charges are $3,000,000, then $8,000,000 $3,000,000

Times interest earned ratio =

= 2.67 times

In other words, income is 2.7 times higher than interest charges. Low interest coverage indicates a dangerous position because a decline in economic activity could reduce EBIT below the interest a company must pay, thus leading to default and ultimate insolvency. This danger, however, is mitigated by the fact that EBIT is not the only source of coverage. Companies also generate cash flows from depreciation, which can be used to pay off interest. What a company should aim for is a big enough cushion so that it is in a position to pay its creditors. The interest earned ratio is deficient because the denominator does not consider other fixed payments such as principal repayments, lease expenses, and preferred dividends. OVERALL COVERAGE RATIO To deal with the problems associated with the times interest earned ratio, an overall coverage ratio can be computed:

Cash Inflows Overall coverage ratio = Lease expenses t = tax rate + Interest charges +

Debt repayment 1-t

Preferred dividend 1-t

All charges in the denominator are fixed and must be taken into account. A company and its investors would like to see the highest coverage possible, but this depends partly on the profitability of the company.

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Mary Lund-Davis Student Investment Fund (SIF) When debt ratios get out of line, the company may find that its cost of capital increases. The value of its stock may also deteriorate in response to the higher degree of risk associated with the company. Therefore, financial managers must be careful to avoid carrying excessive debt in their capital structures.

PROFITABILITY RATIOS
Profit analysis begins with an examination of the way the asset mix of a company is employed. Good managers make efficient use of their assets. Through increased productivity, they are able to reduce or control expenses. If the rates of return for a given company fall below an acceptable level, the P/E and the value of the company's shares will declinewhich is why the measure of profit performance is crucial to any company. GROSS PROFIT MARGINS Gross profit margins show how efficiently a company's management uses material and labor in the production process. Gross profit margin = Sales Cost of goods sold Sales

Example: Gross Profit Margin If a company has $1,000,000 in sales and cost of goods sold amounts to $600,000, its gross profit margin would be $1,000,000 - $600,000 = 40% $1,000,000

Gross profit margin =

When labor and material costs increase rapidly, they are likely to lower gross profit margins unless the company can pass these costs on to customers in the form of higher prices. OPERATING PROFIT MARGINS Operating profit margins show how successful a company's management has been in generating income from the operation of the business. EBIT Sales

Operating profit margin =

Example: Operating Profit Margin If EBIT amounted to $200,000 compared to sales of $1,000,000, the operating profit margin would be $200,000 $1,000,000

Operating profit margin =

= 20%

This ratio is a rough measure of the operating leverage a company can achieve in the conduct of the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean effective control of costs, or they can mean that sales are increasing faster 8 of 11

Mary Lund-Davis Student Investment Fund (SIF) than operating costs. NET PROFIT MARGINS Net profit margins are those generated from all phases of a business. In other words, this ratio compares net income with sales. Net profits after taxes Sales

Net profit margin =

Example: Net Profit Margin If a company's after-tax earnings are $100,000 and its sales are $1,000,000, then $100,000 $1,000,000

Net profit margin =

= 10%

The level of these margins varies from industry to industry. Usually, the better managed companys record higher relative profit margins because they manage their resources more efficiently. From an investor's point of view, it is best for a company to hold profit margins above the industry average and, if possible, to demonstrate an improving trend. RETURN ON EQUITY (ROE) RATIO The return on equity (ROE) ratio measures the rate of return to stockholders. This ratio is one way of assessing the profitability and the rate of returns of the company, which can be compared to those of other stocks. Net profits after taxes Stockholders equity

ROE =

RETURN ON INVESTMENT (ROI) RATIO The return on investment (ROI) ratio measures the combined effects of profit margins and total asset turnover.

ROI =

Net income Sales

Sales Total assets

Net income Total assets

The purpose of this formula is to compare the way a company generates profits, and the way it uses its assets to generate sales. If assets are used effectively, income (and ROI) will be high; otherwise, income (and ROI) will be low.

MARKET RATIOS
Market ratios used to compare the value of a company in relation to the rest of the market, specifically within its industry, or in relation to its own historical value. EARNINGS PER SHARE (EPS) 9 of 11

Mary Lund-Davis Student Investment Fund (SIF) EPS is usually calculated on a quarterly and annual basis. It is used in calculating the P/E ratio and is found as follows: EPS = Total earnings # of shares outstanding

PRICE TO EARNINGS RATIO (P/E) P/Es rank the value of companys relative to their earnings per share. This ratio reflects investors' assessments of the growth of earnings, the risk of the company, its efficiency, and its financial status all in a simple ratio package. The P/E is the price multiple investors are willing to pay for each dollar of earnings per share. A highperformance company that is growing rapidly and has good management and relatively low risk usually has a high P/E, and a poor performing company is given a low P/E. The computation the P/E is:

P/E =

Price per share Earnings per share (EPS)

PRICE TO EARNINGS TO GROWTH RATIO (PEG) The PEG ratio (also known as the Fool ratio) was created by the guys at the Motley Fool (fool.com). The premise it is based upon is rather simple. It's an investment valuation rule of thumb, actually: In a fully and fairly valued situation, a growth stock's price-to-earnings ratio should equal the percentage of the growth rate of its company's earnings per share. Taking that as a given the Fool Ratio neatly and numerically summarizes a companys P/E ratio in relation to its growth rate. PEG ratio = P/E ratio 2-year earnings growth estimate

With PEG ratio .50 or less .50 to .65 .65 to 1.00 1.00 to 1.30 1.30 to 1.70 Over 1.70

Tend to Buy Look to buy Watch (or "hold") Look to sell Consider shorting Short

In plain English, these numbers say, "Tend to buy stocks when their P/E's are half their growth rates; tend to sell stocks when their P/E's equal their growth rates; tend to sell short when their P/E's exceed their growth rates by 30% or more." Also, please note that the Fool Ratio should not be applied to every situation. Ignore the Fool Ratio for the following industries: airlines, banks, brokerage houses, leasing companies, mortgage companies, oil drillers, and real-estate companies.

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Mary Lund-Davis Student Investment Fund (SIF) These industries, for their different reasons, have low P/E's that virtually never reach their growth rates, mainly because their companies are valued off assets they hold (like oil deposits and real estate) rather than operating earnings. Also, the larger the company, the less you should rely on the Fool Ratio. The bigger a company is, the less likely it is to be valued purely off of earnings. BOOK VALUE PER SHARE The book value per share is used when calculating the Price to Book ratio:

Book value per share =

P/E ratio Stockholders equity

PRICE TO BOOK RATIO (P/B) The ratio of a stock's market price to its book value gives another indication of how investors regard the company. Companies with relatively high rates of return on equity generally sell at higher multiples of book value than those with low returns. Price per share Book value per share

Price to book ratio =

If a company earns a low rate of return on its assets, then its P/B ratio will be relatively low versus an average company. Thus, many airlines, which have not fared well in recent years, sell at P/B ratios below 1.0, while very successful firms such as Microsoft that achieve high rates of return on their assets, posses market values well in excess of their book values. In early 1997, Microsoft's book value per share was $7 versus a market price of $82, so its price/book ratio was $82/$7 = 11.7 times. DIVIDEND YIELD Stockholder dividends are paid out of net income. Stockholders are paid, in the form of dividends, for there percentage of ownership. Dividends also are indicative of the company's ability to generate earnings and are a measure of financial stability. To find out how much a company pays out of its earnings you calculate the payout ratio:

Payout ratio =

Dividend per share (DPS) Earnings per share (EPS)

To find the yield an investor receives on his or her shares in the form of a dividend, you calculate the dividend yield: Dividend per share (DPS) Price per share

Dividend yield =

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