Getting Started in Security Analysis E-Book

Peter J. Klein

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: The Getting Started In Series
• Sprache: Englisch

Seitenzahl: 472

Veröffentlichungsjahr: 2009

Beschreibung

An updated look at security analysis and how to use it during tough financial times Due to the current economic climate, individual investors are starting to take much more time and effort to really understand their investments. They've been investing on their own in record numbers, but many have no idea how to handle the current financial crisis. This accessible guide shows you how to take control of your investment decisions by mastering security analysis. This fully updated Second Edition of Getting Started in Security Analysis covers everything you need to fully grasp the fundamentals of security analysis. It focuses on the practical mechanics of such vital topics as fundamental analysis, security valuation, portfolio management, real estate analysis, and fixed income analysis. * Easy-to-follow instructions and case studies put the tools of this trade in perspective and show you how to incorporate them into your portfolio * Along with dozens of examples, you'll find special quiz sections that test your skills * Focuses on key security analysis topics such as deciphering financial statements, fixed-income analysis, fundamental analysis, and security valuation If you want to make better investment decisions, then look no further than the Second Edition of Getting Started in Security Analysis.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Acknowledgements

Introduction

Investment Report Checklist

People

Assets

Technology

International Strategy

Return

Operations

Cost-Effective Management

Part 1 - Tools of the Trade

Chapter 1 - Accounting

The Big Three

The Balance Sheet

The Cash Flow Statement

Chapter 2 - Economics

Determining the Health of the Economy

Government Releases and Indicators

International Investing

Appendix—International Parity Conditions

Purchasing Power Parity

Interest Rate Parity

Chapter 3 - Investment Mathematics

Future Value of Money

Present Value of Money

Net Present Value and Internal Rate of Return

Annuities

Present Value and Future Value

Annuities

Net Present Value and Internal Rates of Return

Chapter 4 - Quantitative Analysis

Basic Statistics

Part 2 - Fundamental Financial Security Analysis

Chapter 5 - Equity Analysis and Valuation

Sources of Information

Return on Equity (ROE)

Using Financial Statement Footnotes

Management Analysis

Industry Analysis

Evaluating Growth

Evaluating Risk

Equity Valuation

Case Study: Equity Valuation

Chapter 6 - Credit Analysis

Basics of Bonds

Credit Analysis Tools

Credit Ratings

Chapter 7 - Real Estate

Types of Real Estate

Real Estate Financial Statements

Investing in Real Estate: Hard Assets

Investing in Real Estate: Real Estate Loans

Investing in Real Estate: Mortgage-Backed Securities

Investing in Real Estate: Real Estate Investment Trusts

Part 3 - Portfolio Management

Chapter 8 - The Investment Management Process

Modern Portfolio Theory

Investment Management

Step 1. Investor Diagnosis—Ascertaining One’s Needs and Constraints

Case Study: Investment Policy Statement for Susan Fairfax

Step 2. The Capital Markets—Managing Expectations

Step 3. Portfolio Construction and Implementation

Step 4. Monitoring the Portfolio

Epilogue

Appendix - Selected Tables

Bibliography

Index

Copyright © 1998, 2010 by Peter J. Klein. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Klein, Peter J.

p. cm.—(The getting started in series)

Includes bibliographical references and index.

eISBN : 978-0-470-56464-6

1. Investment analysis. 2. Securities. 3. Portfolio management. I. Iammartino, Brian R., 1978- II. Title. III. Title: Security analysis.

HG4529.K565 2009

332.63’2—dc22

2009025141

For my son,Jack Patrick Walsh KleinCui multum datum est multum quaeretur ab eo

—PJK

For my parents, Nick and Eileen Iammartino,who helped make this possible,and for my wife, Meredith Hamilton,who helped make it happen

—BRI

Acknowledgments

There have been many colleagues that I would like to thank—those who served as a sounding board, de facto editors, and cheer-leaders—who kept me going through this project. Primary among these is Brian Iammartino, without whose insights, indefatigable work ethic, and financial acumen this work would have suffered greatly. Watching Brian “grow up” over the last 15 years has been a thrill and I expect great things coming from his mind (and pen) over the next several years. Additionally, one could never ask for a better “partner” than Jane Voorhees—truly the best in the business. Also, the following have been instrumental in this work, as well as in my practice’s day-to-day “financial thinking”: Stacey Tucker and Robert Limmer of UBS Wealth Management, Adam J. Gottlieb of Ruskin Moscou Faltischek, PC, and John Curran of Tigris Financial.

Clients and business associates are also a valuable resource in an undertaking such as this; they often provide insights that others, especially those “in the business,” may overlook. I would especially like to thank Dr. Robert Ross—the quintessential entrepreneur, and founder of the Ross University Medical School, Veterinary School and School of Nursing. Additionally, Don Hill of Sherman, Connecticut has been an invaluable resource over many years, as has been the Rosen family—Robert, Florence, and David—thank you for your efforts and enlightening debates. Jerry Sloane of Berdon LLP was instrumental in guiding me in many different areas, especially accounting, which is his profession. The late Claire Friedlander deserves special thanks for her never-ending trust and appreciation for my work. Though she is missed each day, her memory and legacy will live on for decades to come—thank you Claire—I miss you. The following have also “served bravely in the field of duty”—putting up with my verbose e-mails and constant debates about the economy and markets: Barbara Weisen, Susan Monosson, Wendy Wiesel, Sam Reiner, Dr. & Mrs. Paul Brandoff, Bob Singer, Ronald J. Morey, Jed Morey, Howard Maier, John Catsimatidis, Danny Frank, Paul Watson, Jules Weiss, Peter and Susan Furth, Dr. Harvey Stern, Dr. and Mrs. Jack Giannola, Dr. & Mrs. Greg Fiasconaro, Stuart Henry, Stan Henry, Dara Schlesinger, Robert Larocca, Peter and Barbara Serenita, Roy and Kim Collins, Toby Caldwell, Danielle Fehling, Ron & Kathie Eckert, Michael McManus, Dr. and Mrs. Wechterman, and Terry Plavnick.

I would also like to thank my extended family and friends for their continued support and encouragement. Finally, I would like to thank my family—my wife of nearly two decades, and my three children, without whom I am not complete and with whom, by my side, together, we can scale any mountain, overcome any setback, and celebrate every milestone.

—Peter J. Klein

I must start my acknowledgments with the most important of all. Peter J. Klein is not only my co-author of this work; he was my first supervisor at my first job in the finance industry. I couldn’t have asked for a more inspirational and wise mentor as I was getting started in security analysis myself. I thank him for giving me the opportunity to come along for the ride on this book adventure.

At the Wharton School, I have professors such as Nick Gonedes to thank for giving me the finest business education available in the world today. At Harvard, my eyes were opened to a world of new possibilities. Most notably, Professor Linda Bilmes was and continues to be an amazing source of support, advice, and motivation.

I have been blessed with wonderful colleagues throughout my professional life, but none more so than the Managing Partners of Westport Point Capital, Mary Lou Boutwell and Erin O’Boyle. I thank them not only for enthusiastically supporting this book, but also for patiently supporting me in my growth from real estate novice to published author. Tom Welch and Seth Rosen of Colliers Meredith & Grew also provided me invaluable insight into the complex world of mortgage-backed securities.

Last but certainly not least, my friends and family provide the backbone of all that I do. My parents Nick and Eileen, sister Susan, brother-in-law Ross, Aunt Ethel and Uncle Frank, and Grandma Rachel have supported me throughout my life, and my nephews Timothy and Peter have provided ample diversion from the world of finance. My in-laws Pat and Andrea Hamilton, along with their entire families, have made me feel like one of their own. Finally, I thank my wife, Meredith Hamilton, without whose encouragement my name would not appear on the cover of this book. A theme of this book is that finance is by necessity an imperfect science, but my life is perfectly imperfect with her by my side.

—Brian R. Iammartino

Introduction

You are about to begin a journey into the science of investment analysis. Many of you may think that using the word science to describe the activities of Wall Street is a misnomer. Luck, chance, or voodoo are probably closer to your explanation of investment activity. We hope to convince you otherwise. As you make this journey, it should become obvious that investment analysis and its related extensions are rigorous enough to be taken as an actual science.

Like other scientific disciplines, investment analysis requires a working knowledge of its basic concepts. Part 1, “Tools of the Trade,” explores these concepts, with considerable emphasis on exercises that hone awareness, expertise, and understanding of this once arcane subject. A century ago, the task of investment counseling belonged to men of prudence who, for fear of being wrong, usually invested funds with guaranteed returns and did not rely on scientific discipline. The fear of not being beyond reproach—otherwise known as “reputation fear”—provided enough guidance for these men. Typically the wealthy and elite, they did not see the utility of investment analysis for the simple reason that they did not have to—they were already rich.

Today, investment analysis plays a meaningful role in planning for a comfortable financial future. This book provides the reader with a firm foothold on this important subject (although the basic concepts may prove helpful in many of life’s other exercises). Mastery of investment analysis takes much more than a cursory read through this text; it requires years of study and perhaps decades of practical experience. Our hope is to provide today’s investor—novice or seasoned—with enough understanding to simulate the workings of Wall Street analysts. An investor, after reading this manual, will have a fundamental store of financial information; will understand the terms, pricing, and research of a financial services provider; and will find the daily financial papers more interesting.

Many investors are well aware of the basics of financial planning through exposure to myriad seminars, books, magazines, and web sites. They need the next level of information. Just think about how many of your friends understand the risk-return trade-off (more risk, more return), asset allocation (spreading assets around into many classes), and the need for long-term investing habits. But how many wish they understood how a company’s shares are valued, or how the workings of regression analysis and the typical economic releases in a given month directly affect the value of their investments? Part 1 is designed to provide this essential background.

Part 2, “Fundamental Financial Security Analysis,” sets forth the notion that the tools described in Part 1 can be of practical use only if the investor understands how a given company is valued. Thus in this part, we explain the methodology behind the valuation techniques of a company’s equity and debt securities: Consequently, these valuation techniques build on the lessons of Part 1. Without a firm understanding of the tools analysts use, it is impossible to firmly grasp the true valuation process.

With tomes of data available, how should we quantify the value of this company? Which calculations must be executed to ascertain the true value of this company?

Part 3, “Portfolio Management,” is a discussion of the investment management process—the symbiosis of the tools and valuation techniques with the financial planning process. It includes an examination of the laws and regulations that govern this highly regulated industry. To fully grasp these legal constraints, today’s serious investor must understand and be able to use the investment management process.

Lastly, as a housekeeping item, the reader should be aware of some literary licenses taken in this text. The pronouns “he” and “she” are used interchangeably throughout; this is done for stylistic simplicity and does not reflect the current percentage breakdown in the investment analysis field. The terms VFII (Very Financially Interested Individual—pronounced “vif-fee”) and NFII (Not Financially Interested Individual— pronounced “nif-fee”) are introduced early on in this text and refer to the current investment-user market. People who have started to read this book should consider themselves either a VFII or a reformed NFII. The terms analyst, practitioner, and investor (seasoned or novice) are also interchangeable throughout this work, and in each case the word refers to the user of investment analysis. From professional to novice, all analysts should be in the continual learning phase. The professional analyst specializing in real estate may require a briefing on the workings of the equity market, just as a seasoned investor could be brought up to date on the changing dynamics of macroeconomics releases.

While the ultimate purpose of this book is to educate today’s proactive investor in the science of investing, by no means can it serve as a proxy for a complete education in this expansive field. It can, however, provide the investor with a solid foundation of knowledge. Any interested investor (VFII) can request an incessant flow of research reports from either his representative at the issuing firm or the company itself (most companies will release the research reports; however, they require the prior permission of the analyst’s firm to do so); but understanding jargon-laden reports usually takes more than a cursory background in the subject.

Investment Report Checklist

As a first step toward a better comprehension of the research reports issued by firms, it is a good idea to study what the professional groups look for in a quality report. See Table I.1.

Industry considerations. Investigate the industry (or, if a diversified company, the principal industries) of the issuer of the security. Considerations should include historical growth and future potential, the nature of worldwide competition, regulatory environments, capital requirements, methods of distribution, and external and internal factors that might change the structure of the industry.

• Company’s (or issuer’s) position in the industry. Analyze the company’s strengths and weaknesses within the industry environment. This analysis should not only be based on discussion with the company’s management, but should also include information from competitors and such trade sources as distributors.

TABLE I.1Security Analysis Checklist

• Income statement and statement of cash flows. Review statements for a period covering two business cycles and investigate reasons for annual and seasonal changes in volume growth, price changes, operating margins, effective tax rates (including the availability of tax loss carryforwards), capital requirements, and working capital.

• Balance sheet. Investigate the reasons for historical and prospective changes in the company’s financial condition and capital structure, plus the conformance of accounting practices to changes either proposed or implemented by accounting rule-making bodies.

• Dividend record and policy.

• Accounting policies. Determine policies and examine the auditor’s opinion.

• Management. Evaluate reputation, experience, and stability. Also evaluate the record and policies toward corporate governance, acquisitions and divestitures, personnel (including labor relations), and governmental relations.

• Facilities/programs. Review plant networks, competitive effectiveness, capacity, future plans, and capital spending.

• Research/new products.

• Nature of security.

• Security price record.

• Future outlook. Examine principal determinants of company operating and financial performance, key points of leverage in the future (e.g., new markets and geographical expansion, market-share improvement, new products/services, prospects for profit margin improvement, acquisitions), competitive outlook, major risks (e.g., competition, erosion of customer base, abbreviated product life cycles, technological obsolescence, environmental hazards), and financial goals (for the short and long term) and the analyst’s level of confidence in achieving them.

The checklist should not be viewed as a complete methodology from which to judge the competency of a research report, but it certainly lends itself to further investigation.

A proactive investor never stops honing his skills, permitting his intuition a better shot at being right. Perhaps he will search for the characteristics common to the best companies. Identifying this set of traits could allow the investor to find the next great company and, hopefully, a great (read: inexpensive) stock. Remember to make this differentiation between company and stock. A great company may be so outstanding that the market will bid up its share price to a level that makes the stock an imprudent candidate for any true fundamentalist. Value investors seek to purchase equities whose fundamental value has not yet been discounted by the market. While the value investor’s analysis will be sensitive to the equations in this text (Dividend Discount Model, DuPont Method of the Return on Equity Equation, sustainable growth), it will also call on a considerable understanding of qualitative and management analysis.

Borrowing from the tenets of value investors, we have developed a methodology that gives the investor a starting point for fundamental equity analysis. The acronym PATIROC summarizes the characteristics critical to the equity investor:

• People

• Assets

• Technology

• International Strategy

• Return

• Operations

• Cost-Effective Management

People

People make a company. A company that inspires its employees and creates a strong, cooperative morale will benefit in the long run. When deciding whether to purchase the equity of a company (stock), an investor should make it part of due diligence to try to learn something about the employees (and the culture of the firm). We don’t mean just about top management (CEO, CFO, or investor relations director), for they are often well trained to represent the facts in a somewhat optimistic, overly biased tone. Try to find out about the employees of the company—the middle management and the factory or “line” workers. They represent the true test of the morale of a company:

How do the frontline employees feel about their company? Do they participate in the company’s retirement plans? Go to company functions? Understand the business and, furthermore, are interested in the success of the company?

Several years ago during an equity search, we came across a company that had this positive “People” characteristic. The company was a fast-growing enterprise that rewarded its employees for achievements above stated goals with stock options. Some employees on the factory floor had over $1 million in stock options. These employees were happy, to say the least, and it showed in the way they spoke about their company and its market share, competition, and new ventures. To an investment professional this was like stepping into nirvana, except that when we asked the human resources director about the prospect of doing investment seminars, he responded, “Our employees would be happy to teach your clients about investments, but wouldn’t that be kind of strange, since they’re your clients?” After catching our breath, we realized that he was dead serious and that we should seek other potential educational seminar opportunities.

Another element of this characteristic is the function of ownership; that is, who are the shareholders, the equity partners, of the company? We want to enjoy the company of smart investors (those professionals with an outstanding record of performance) and most importantly, of management. Insider ownership is compiled and published on a periodic basis and could give the investor valuable insights about the intentions of senior management.

Is this management long-term in their expectations or are they seeking the quick buck? How much of total compensation is made up of stock options? What is the value of management’s share position? Have they purchased more shares during the recent price decline?

While answers to such questions can be informative to the investor, there is a caveat—because of the increasing use of stock options, many of today’s senior management may choose to sell (or “exercise” in the parlance of options) their shares merely as a means of diversification rather than as a portent of an imminent price decline.

Assets

A strong balance sheet is a wonderful characteristic for a company in search of fame and fortune in the annals of great stocks. Assets take many different forms, the most obvious and arguably the easiest to spend being cash or cash equivalents (short-term money market instruments). But when utilized properly, certain noncurrent assets (typically assets that cannot be translated into cash within one operating cycle) can be top performers for a given company. Take, for example, the new factory with the very best in high-tech machinery, or the 30,000 acres of land in the Pacific Northwest that happens to be within one hour’s drive from the Microsoft World Headquarters. While these assets are not easily converted into cash, they are certainly assets. Furthermore, the land can be carried at cost (not current market value) on the company’s balance sheet. The well-trained “asset hound” seeks to break down a company’s balance sheet in search of either the underutilized asset or the undiscovered or unrecognized (by accounting tenets) asset. In many situations, as value investors come to realize, the sum of the parts equals more than the whole.

Technology

Effective application of the newest technical advances makes a business more efficient. Inefficient use of or lack of technology can consequently doom an enterprise to underperformance. A business in the twenty-first century cannot operate in the same fashion as it did 15 years ago—when, for example, was the last time you purchased a good that was not scanned in some way? This often-pervasive act of electronic accounting has a significant dividend to the merchant—inventory control. These cash registers (a term that probably will soon be as antiquated as buggy whip is today) are often plugged into a database that can analyze each store’s sales, margins, discounts, returns and, most importantly, need for reordering. Some economists postulate that this information-driven inventory control mechanism (technology dividend) contributes to the current period of continued low inflation.

Dedication to research and development, within a company’s given area of focus, belongs in this category. Often the savviest investors seek those companies that have consistently posted high R&D expense ratios (as a percentage of revenues). This type of research support differentiates the serious player from those companies (or managements) that are in just for the quick buck. While it may be a non-income-producing expense today, this dedication often pays off. For example, a biotechnology company may have committed millions of dollars over the past four years to a particular new drug discovery technique. This technique, based on genetic research, then yields a major breakthrough that provides the company a significant joint-venture relationship with a major pharmaceutical company.

International Strategy

Only the company that can successfully implement an international strategy can fully compete in the new global community. The expanded marketplace (read: global community) for a company’s goods and services, subjects a company to different currency flows as well as increased competition. Economists have also pointed to this increased market as a contributing factor to the low inflation recently enjoyed by the restructured U.S. corporation. How can a large U.S.-based producer of paper raise its prices aggressively when several internationally based companies stand ready to gobble up market share? The proactive treasurer (and entire financial management team) in a globally sensitive company needs to be aware of the new playing field to maintain effectiveness.

Return

This is the lifeblood of a well-run company; without it, sooner or later, the company will die. Equity investors invest their capital in shares of companies that they expect to post a worthwhile return. This return, or its expectation, provides the groundwork for the share value. In some cases, investors will use a price-to-earnings ratio or perhaps, as described in Chapter 5, a dividend discount method to arrive at a fair value for the company’s shares. As discussed in Chapter 1, the investor needs to pay careful attention to the manipulations of net income that affect the ultimate value of the shares.

Operations

This characteristic reveals the inner workings of the company. How does this business operate? What is the industry like? Competitors? In this category, the investor seeks to identify the company as a business, pure and simple. The investor attempts to divorce himself from the emotions of stock investing and focus on the value of the business, per se. Investors should seek companies with a franchise value, that is, a product or service that is duplicated in a multitude of markets. Companies that come to mind in this category are McDonald’s, PepsiCo, Coca-Cola, and Wells Fargo Bank. In addition to having a franchise value, the company should also be an adept acquirer:

What happens if the company’s market share peaks? What will drive forward the company’s top line and market share expansion?

Acquisitions can be an important part in this equation. The investor should seek companies that have a strong competitive advantage in the acquisition exercise:

Does management endorse expansion through acquisitions? Are they patient enough to wait for the right price? Do they have the assets (high cash levels, low debt levels) to support such a campaign?

Cost-Effective Management

Perhaps a more euphemistically sensitive title would be “lean” (but then the acronym wouldn’t be as catchy). In any sense, the more frugal a company is with its expenses, the more likely that it is a tightly run ship. And companies run this way typically have greater staying power in a bad economy or market (for their products). All too often, small companies raise capital through the equity market only to spend millions on a “world headquarters”—a 30,000-square-foot architecturally imposing structure, landscaped on a 10-acre campus sporting flags from every nation, expensively appointed in imported carpets and mahogany furniture. In no way are we suggesting that a growing company should avoid spending money to improve its working environment or competitiveness within its market. But there is a limit to what can be classified as an expense—or simply expensive. An expense is an expending of capital with a probability of a return to justify that expense; conducting business in an expensive way is often proof that a company is out of control. If you were the owner of a small hardware store in town and a candidate for a clerk position walked in and demanded $15 per hour, hiring this applicant would be expensive (unless the person possessed some extrasensory abilities to attract a strong increase in hardware buyers in the town). On the other hand, if you decided to hire three clerks at $5 per hour each, to work the floor simultaneously in order to achieve a “full-service” hardware store strategy (to differentiate from the warehouse strategy of the large chains), then this expense can be justified (as an attempt to increase market share through a differentiation strategy).

While these “PATIROC” characteristics are not the only traits that define a good company, they certainly give the investor the right direction. With these screens in place, the investor has the further responsibility to be skeptical of price. Don’t overpay for a great company. Should the music ever stop, even for a quarter or two, the price action in the stock would be unforgiving. Look for great companies with specific characteristics, and then apply a good dose of skepticism to the price of the shares. Investing in a great company with an inflated price tag does not make much fundamental sense. We, as prudent equity investors, must have a well-defined exit strategy that focuses on changes that can affect the company’s ongoing operations or stated value. Such changes include the departure of senior or founding management, industry fragmentation, new product or company entrants, and—most pervasive—the increased valuation of the company’s share price. While all investors hope for an increase in the share price of the underlying equity, one needs to be acutely aware of the implications toward value: To achieve success, equity investors must often ask themselves these questions, always second-guessing their research to uncover any flaws. Maybe that is why it can be such a gut-wrenching but rewarding exercise.

Is this increased valuation warranted or is it due to external market forces (too much capital chasing too few good investments)? Has the company’s management endorsed, by increasing their own positions, this increased share price? Is this price appreciation industry-wide? Does it speak to euphoria or is it firmly footed in sensible valuation?

Finally, throughout this journey, please remember that investment analysis is not a game but rather a venerable discipline firmly entrenched in many scientific disciplines. As a means of support and proper manners, however, we still offer all readers good luck.

Part 1

Tools of the Trade

Part 1 requires the working knowledge of certain important disciplines that are firmly footed in the mathematical and economic sciences. Any financial analyst needs to study these disciplines—work with them time and time again—before being ready to progress farther into the financial analysis maze. As with many other professional pursuits, most of the early work (grunt work, “paying your dues,” “coming up the ladder”) builds a foundation on which the higher skills depend. They are the building blocks that the investor will use countless times in the construction of a portfolio.

The tools of financial analysis are as critical to investment success as surgical instruments are to a brain surgeon. With a working knowledge of these tools, the financial analyst, whether a beginner or a seasoned investor, will have the skills to recognize a timely investment opportunity.

The four tools of financial analysis are:

1. Accounting

2. Economics

3. The mathematics of finance

4. Quantitative analysis using basic statistics and regression analysis

In Chapter 1 we discuss the all-important science of accounting, or as we call it—“the scriptures of business.” Accounting is the written language of business—the figures that bring it all together and the universal language an analyst uses to understand the business. A working knowledge of accounting enables the investor to dissect the company’s financial statements to better understand the specifics within a business as well as searching for any inconsistencies or red flags. In this case, the investor acts as a detective, searching through data from sources initiated by several types of media, to identify information that permits an analysis and subsequent valuation.

Additionally, careful examination of financial statements can lead to a better understanding of management’s policies and style: Answering such questions can lead to a more comprehensive valuation of any company.

Does management have a conservative or liberal bias with regard to accounting policies? By which method are non-current assets depreciated? What is the “quality” of the earnings? How are the revenues determined? What methods are employed?

Chapter 2, “Economics,” focuses on the items, such as government indicators and the important parity conditions that exist in international economics. Studying these areas is essential for attaining a more complete picture of how economic events affect the valuation of financial instruments:

When are the major economic indicators released and what do they tell us about the economy? Does the economic business cycle permit an advantage in timing of the stock market? What role does the Federal Reserve play in the conditioning of our financial markets? How have the theories of economic science differed in the past 100 years?

Chapter 3, “Investment Mathematics,” deals with the underpinnings of the entire study of investment finance—the mathematics behind the future value of money. After a discussion of the different formulas used to calculate this all-important mathematical concept, several problems are presented that permit the practitioner a repetitive learning format. This “problem set” format lends itself to much of this chapter, for investment mathematics, simple enough in theory, requires the practical understanding that comes with repetitive problem solving (e.g., What is the future value of $1,000 in 6 years at a compounded rate of 6 percent per year? What is the internal rate of return, or valuation, of a specific investment project?).

Chapter 4, “Quantitative Analysis,” is the final chapter in Part 1. The quantitative approach to investment analysis is critical when the investor is making a hypothesis about the relationship between independent variables and a particular firm’s earnings. This chapter also discusses the differences between simple and compounded annual returns so to better evaluate the returns quoted in the financial press and within the industry. Again, the problem set format is used to further reinforce the practical applications of this theory (in addition, the appendix in Chapter 4 covers regression analysis).

Okay, so let’s buckle up our tool belt and begin this journey into the world of Security Analysis.

Chapter 1

Accounting

In this chapter, you will learn the following aspects of accounting:

• The big three: the balance sheet, the income statement, and the cash flow statement.

• The basics of managerial accounting.

The practice of accounting is the tabulating and bookkeeping of the capital resources (in currency terms) of a particular firm. The actual entries listed on the accounting statements do not tell us anything concrete about the firm’s business activities, but reflect how accountants record these activities. That is not to say that accounting statements are without value; they are among the most important pieces in the valuation puzzle, but without careful study, they do not reveal any information of consequence. This inadequacy of accounting data lies within the procedures themselves; in most cases, an investor needs to be proficient in this art to gain any insight into the future prospects of the concern in question.

The Big Three

The financial statements of a business enterprise are essentially their scribes—the books, as we affectionately call them. These “books” document—in the universal language of numbers—the ins and outs of the flow of capital within a business enterprise. The books come in three chapters, if you will: the balance sheet of assets and liabilities, the income statement of revenues and costs, and the cash flow statement which reconciles the inflows and outflows of cash. These three statements are interlinked, as we will soon see, and their interaction—and the understanding of the implications between each statement—is a critical part of the analyst’s core competency. In the sections that follow we discuss each statement in detail.

The Balance Sheet

The balance sheet serves as a snapshot of the current net worth of a particular firm at a given moment in time. It illustrates, in some detail, the asset holdings (fixed and current) as well as the liabilities, in such fashion that the offsetting amounts equal the net worth of the company (equity). In its simplest form, the Balance Sheet offsets the enterprise’s assets (the value of things they own) with the liabilities (the value of things they owe), which results in the equity (the net worth) of the enterprise. As we will see, the key in this statement is how these assets and liabilities are valued—this will give the analyst and investor keys to unlocking value opportunities or red flags of caution. When examining the balance sheet be mindful of the inputs—in other words, how these values came to be—for, as in many business pursuits, the devil is in the details. These details are compiled in the often forgotten “fine print” of the footnote section of the accounting documents. It is here, in these footnotes, that the perceptive analyst (“detective”) can uncover opportunities and important issues. The following definitions provide an understanding of this financial statement’s individual components. (See Table 1.1 for a sample of this statement.)

Assets

The first major section of the balance sheet lists assets, including the following:

Current Assets This consolidation entry includes assets that can be converted into cash within one year or normal operating cycle. The following entries are components of current assets:

TABLE 1.1ABC Products—Balance Sheet 12/31/08

• Cash. Bank deposit balances, any petty cash funds, and cash equivalents (money markets, U.S. Treasury Bills).

• Accounts receivable. The amount due from customers that has not yet been collected. Customers are typically given 30, 60, or 90 days in which to pay. Some customers fail to pay completely (companies will set up an account known as “reserve for doubtful accounts”), and for this reason the accounts receivable entry represents the amount expected to be received (“accounts receivable less allowance for doubtful accounts”).

• Inventory. Composed of three parts: (1) raw materials used in products, (2) partially finished goods, and (3) finished goods. The generally accepted method of valuation of inventory is the lower of cost or market (LCM). This provides a conservative estimate for this occasionally volatile item (see Aside on page 30: LIFO versus FIFO).

• Prepaid expenses. Payments made by the company, in advance of the benefits that will be received, by year’s end, such as prepaid fire insurance premiums, advertising charges for the upcoming year, or advanced rent payments.

Fixed Assets (Noncurrent Assets) Assets that cannot be converted into cash within a normal operating cycle. The following are fixed assets:

• Land, property, plant, and equipment. Those assets not intended for sale, and used time and time again to operate the enterprise. The typical valuation method for fixed assets is cost minus the accumulated depreciation—the amount of depreciation that has been accumulated to this point. This is an important consideration—the fact that certain long-term assets are not marked-to-market (a term that has clearly entered our lexicon in the last year or so)—for it lends itself to some potential uncovering of value. A value investor seeking equities that the market is not correctly valuing, for a host of reasons from misunderstanding the company’s business to not correctly valuing its assets, can often find opportunities to be marking-to-market these long-term assets.

Liabilities

The next major portion of the balance sheet lists liabilities, including the following:

Current Liabilities This entry includes all debts that fall due within 12 months (or one operating cycle). By matching the current assets with the current liabilities, the investor can get a good idea of how payments will be made on current liabilities:

• Accounts payable. Represents the amount the company owes to business creditors from whom it has purchased goods or services on account. This is often referred to as “Trade-Related Debt.”

• Accrued expenses. The amounts owed and not yet recorded on the books that are unpaid at the date of the balance sheet.

• Income tax payable. The debt due to the Internal Revenue Service (IRS) or other taxing authorities but not yet paid. These are, by definition, accrued expenses, but because they are tax related, they carry with them a certain importance to the analysis of the firm.

Long-Term Debt These are debts due beyond one year (or one operating cycle).

Stockholders’ Equity

The last major section of the balance sheet is the stockholders’ equity section, which includes the following:

Stockholders’ Equity The total equity interest that all shareholders have in the company. Stockholders’ equity, like any other equity, is the net worth remaining after subtracting all liabilities from all assets. The true measure of the firm’s reputation as an outstanding company resides in its ability to grow this equity amount. The book value of a firm is calculated as the stockholders’ equity—the assets minus the liabilities.

Retained Earnings The amount of earnings, above the dividend payout, accumulated by the firm. Although retaining earnings may be an appropriate strategy at a given point in a firm’s life cycle, it can also be an invitation to an activist investor seeking a cash cow investment opportunity. Furthermore, a company retaining too much of its earnings can open questions about why these cash flows haven’t been reinvested in high net present value (NPV) projects so the company can continue to grow. (Is this firm running out of good opportunities?)

The Income Statement

Whereas the balance sheet is the record of net worth for the firm, the income statement illustrates the firm’s operating record. In this statement, the firm’s income and expenses are reconciled to arrive at a value of net income for the period in question. Very often, the analysis of equities focuses on this net income value (known as earnings). The information gleaned from one particular year is not as critical to the analysis of a particular firm as the data for several years or, better yet, the projected (future) earnings information. It is this forecasting exercise that can make or break an investment decision, regardless of the security in the capital structure. An analyst used a myriad of inputs (macroeconomic data as well as company-specific expectations) to ascertain a spectrum of likely earnings in future years. The analyst who can consistently forecast a firm’s earnings most accurately will earn heavy kudos (not to mention an increase in institutional trading revenues for his firm’s trading desks).

To put the corporate accounting statements in perspective: The income statement is similar to your personal tax filing for a given year, reconciling income (W-2, capital gain and dividend earnings, etc.) versus expenses (mortgage expense, business expenses, etc.). The balance sheet, on the other hand, is similar to your personal net worth statement that you might organize for an estate planning document or mortgage application.

The following definitions should aid in understanding this financial statement (see Table 1.2):

• Revenue. The amount received by the company for rendering its services or selling its goods. The total revenue is calculated by simply multiplying the number of goods sold by the price per unit (quantity sold × price per unit). Revenue always initiates the income statement because, by definition, it is the starting point of operating activities. Net total revenue takes into account any returned goods and allowances for reduction of prices.

• Cost of goods sold (COGS). The primary cost expense in most manufacturing companies—all the costs incurred in the factory to convert raw materials into finished product. The cost-of-goods expense also includes direct labor and manufacturing overhead associated with the production of finished goods. The fixed cost is the amount that will not typically increase with increases in output of the finished product; it includes expenses in operating an enterprise (e.g., rent, electricity, supplies, maintenance, repairs), often called “burden,” or “overhead.” A variable cost can be directly traced to the production process and therefore will typically increase as the number of units produced increases (e.g., raw material costs, sales commissions).

• Gross profit. The amount of excess of sales over the cost of sales. Gross profit is often represented as a ratio (in percentage form):

The following example illustrates the gross profit margin (see Table 1.2):

TABLE 1.2ABC Products—Income Statement 12/31/08

Therefore the gross profit margin is $2,106,664 divided by $6,019,040 or 35 percent.

• Operating expenses. This line item serves as a heading for the consolidation of the non-direct costs incurred in the operations of a business. Selling, general, and administrative expense is the most typical operating expense for a company. As businesses differ operationally and economically, so will their allocations toward operating expenses. For example, the computer software development company will have a higher commitment toward operating expenses (salaries, bonuses, educational seminars, marketing, etc.) versus a wholesale manufacturing company whose largest costs are typically the raw materials used in the production process. Sales, general, and administrative expenses (SG&A) are important items in the analysis of a company for they illustrate the management’s fiscal restraint or resistance to temptation. When a VFII notices the sales of a company increasing but the SG&A growing at a faster rate, a yellow flag of caution is raised. Components of SG&A include salaries, commissions, advertising, promotion, office expenses, travel, and entertainment expenses.

• Operating earnings before depreciation (earnings before interest, taxes, depreciation, and amortization—EBITDA). Known as a measure of cash flow, for it factors out the non-cash charges included in depreciation and amortization expense. Many analysts, especially those specializing in relatively new, very capital-intense industries rely on this measure as the true earnings of the company.

• Depreciation and amortization expense. The estimated amount that management expects to use in the future to replace its operating facilities. It can be thought of as an escrow account where the company sets aside a specific (defined by tax policies, equipment’s salvage value, and estimated useful life) amount each year to be used in the future to repurchase the operational necessities (plant and equipment) of the enterprise. Amortization is depreciation, but instead of referring to a tangible asset, it refers to an intangible asset (e.g., goodwill, patents).

• Operating earnings. Earnings attributed to the activities of the company without any impact from the financing of its balance sheet. This earnings figure is used in the calculation of an “enterprise value” or value of the business as if it were a private concern.

• Interest expense. Amount that equals the company’s outstanding debt multiplied by its debt expense (i.e., interest owed to bondholders). Under current corporate tax law, the debt payments made to bond holders are tax deductible: This amount is subtracted from the operating earnings before calculating the taxes.

• Income tax expense. Tax rate (approximately 36 percent on the corporate level) multiplied by the pretax earnings.

• Net income. Earnings, plain and simple—the last entry on the income statement, the bottom line. Ironically, it is the opening entry for much of what is known as fundamental analysis—the analysis of a business utilizing quantitative models to determine the earnings and subsequent valuation.

The Cash Flow Statement

The cash flow statement is the third statement in our accounting statements and is considered by many to be one of the most important. Unlike the Income Statement and Balance Sheet, the Cash Flow Statement illustrates the movement of cash rather than incorporating accounting rules and treatments to arrive at values. In the cash flow statement what we are getting is the “best” view of the activities of the company without the vagaries of accounting rules. The bottom line is that the Cash Flow Statement can tell us “Where did the money come from?” and “What was it used for?”—two very important questions for investors to grasp. It is important to understand that in the cash flow statement we are only interested in cash and cash equivalents (highly liquid fixed income securities with maturities less than three months).

There are two methods used to formulate the cash flow statement—the Direct Method and the Indirect Method (shown in Table 1.3). In the Direct Method we start with Net Cash Received from customers (the actual amount of cash—not sales—that came into the company over the period) and add or subtract from this figure other “sources” or “uses” of cash over the period, to arrive at the value for Operating Cash Flow. The Indirect Method starts with Net Income and makes a series of adjustments to that number to arrive at the value for Operating Cash Flow.

There are three pieces to the Cash Flow Statement—Cash Flow from Operations, Cash Flow from Investing Activities, and Cash Flow from Financing Activities. While the resulting net number from all of the three is used as the figure for the “Net Change in Cash” for the period—it is the Cash Flow from Operations that many analysts focus on as a clue to evaluating the management’s abilities and the overall strength of the company.

TABLE 1.3Cash Flow Statement—ABC Company for the Year Ended 20XX: Indirect Method

Cash Flow from Operations

Cash Flow from Operations is any cash transaction related to the company’s ongoing business—that is, the business activities that are responsible for most of the profits. Operating activities usually involve producing and delivering goods and providing services. Cash flow from operations is the healthiest means of generating cash. Over time, Cash Flow from Operations will show the extent to which day-to-day operating activities have generated more cash than has been used.

Direct Method

While not the most widely used method to calculate cash flow, the Direct Method must be also done if the Indirect Method is chosen. What we are doing in this method is seeking a guideline to the flow of cash in and out of the company. So we need to study each piece of the company in order to ascertain this flow of cash. The basic equation here is:

Cash received in the operation of the business (that is, from sales of goods and services) MINUS the cash used to operate the business (that is, the costs of the goods and services) EQUALS Operating Cash Flow (direct methodology). The following is a good template:

Cash Flow From Operations:

(+) Cash received from customers

(+) Other operating cash receipts (if any; i.e. dividends)

(-) Cash paid to suppliers (including suppliers of inventory, insurance, advertising, etc.)

(-) Cash paid to employees

(-) Interest paid

(-) Income taxes paid

(-) Other operating payments, if any

(=) Total net cash provided (used) by operating activities

In Table Format:

Sources of cash (additions):

Cash received from customers Dividends received Cash provided by operations

Uses of cash (subtractions):

Cash paid for inventory Cash paid for insurance Cash paid for selling expenses Interest paid Taxes paid Net Cash from operations

So what we are doing in this Direct Method of Cash Flow from Operations is to seek the actual flow of cash in each piece of the business that either generates or uses cash. One option that might make the calculation of cash received from customers easier is to estimate it based on changes in some balance sheet accounts: Take accounts receivable at the beginning of the year, add to it sales for the period, and then subtract accounts receivable at the end of the year to compute how much in cash was collected. This interaction between accounting statements is a definitive advantage to the VFII who is seeking data that others may not have the time or expertise to uncover.

Indirect Method

Here we start with the Net Income figure (from the Income Statement) and we go through pieces of the enterprise to ascertain if the change (from period to period) led to an addition to cash (Source) or a decrease of cash (Use). Part of this exercise is counter-intuitive—for example, an increase in deferred taxes is a Source (or addition) of cash because we are deferring the payment of cash, while an increase in inventories is a Use (or subtraction) of cash because we are buying more goods with cash.

The following list is the basis to these entries:

In the Indirect Method we sort of jump a bunch of smaller steps (in the Direct Method) by starting with Net Income and then making the necessary adjustments to arrive at Cash Flow.

Once the Operating Cash Flow is computed we need to do a similar procedure to the Investing and Financing parts of the Cash Flow Statement.

Net Cash Flow from Investing Activities

In this part of the cash flow statement we focus on those changes to the cash position of the company having to do with investing activities. Examples of investing activities are:

• Purchase or sale of an asset (assets can be land, building, equipment, or marketable securities)

• Loans made to suppliers or customers

The purchase of an asset is a use of cash, whereas a sale of an asset is a source of cash. Similarly, loans made to others is a source of cash. So what we do in this section is look at the balance sheet changes for items like land, building, equipment, and securities. By looking at these data points we can determine the changes in Cash Flow from Investing Activities.

Cash Flow from Financing Activities

In this section we are focused on the changes in cash from activities related to the financing of business. So changes in debt, loans, or dividends are accounted for in cash from financing. Changes in cash from financing are a source of cash when capital is raised, and they’re a use of cash when dividends are paid. Thus, if a company issues a bond to the public, the company receives cash financing (source); however, when interest is paid to bondholders, the company is reducing its cash (a use of cash). Here again we look at the balance sheet and income statement data to determine the changes in these specific areas.

A company can use a cash flow statement to predict future cash flow, which helps with matters in budgeting. For investors, the cash flow reflects a company’s financial health: basically, the more cash available for business operations, the better. However, this is not a hard and fast rule. Sometimes a negative cash flow results from a company’s growth strategy in the form of expanding its operations.

By adjusting earnings, revenues, assets, and liabilities, the investor can get a very clear picture of what some people consider the most important aspect of a company: how much cash it generates and, particularly, how much of that cash stems from core operations.

Having defined the basic components of the accounting statements, we can begin to analyze these components. Managerial accounting simply refers to using and analyzing accounting data to maximize the resources of the company. Decisions about the method chosen to depreciate an asset (straight-line or accelerated) could be crucial to the profitability of a company. The decisions surrounding the evaluation of a company’s fixed cost structure (the allocation of costs that do not change with the level of output, e.g., rental cost) versus its variable cost structure (expenses that vary with the amount of output generated, e.g., raw materials, selling expenses) could also be crucial to future planning.

PROBLEM SET: UNDERSTANDING ACCOUNTING AND THE STATEMENTS

Question 1

The Brittany Company, which manufactures robes, has enough idle capacity available to accept a special order of 10,000 robes at $8 per robe. An expected income statement for the year without this special order is as follows:

Assuming no additional selling expenses, what would be the effect on operating income if the company accepted the special order?

Answer

The three important facts in this problem are:

1. The idle capacity situation that currently exists within the company; this relates to a fixed cost structure that is able to take on more capacity without increasing its (fixed) costs.

2. The rather large size of the order that is being considered.

3. The assumption that no further selling (variable) costs would be incurred in this order.

The following computation breaks down the accounting data to better illustrate the problem:

The Brittany Company

The preceding calculations indicate that it would be advantageous (to the tune of $17,500 in additional profits) to accept this special order.

The other (quick and intuitive) method is to examine the per unit costs:

• Revenues from special order are $8 per unit.

• Variable costs per unit are $6.25; assume that due to idle capacity there are no additional fixed costs.

• Net profit is therefore $1.75 per unit, or $17,500 for 10,000 units.

Question 2

From a particular joint process, The UTA Company produces three products—X, Y, and Z. Each product may be sold at the point of split-off or processed further. Additional processing requires no special facilities, and production costs of further processing are entirely variable and traceable to the products involved. In 2007, all three products were processed beyond split-off. Joint production costs for the year were $60,000. Sales and costs needed to evaluate UTA’s 2007 production policy follow:

Joint costs are allocated to the products in proportion to the relative physical volume of output.

To maximize profits, UTA should subject which products to additional processing?

Answer