2 Key Concepts for All Investors

07/22/2011 11:30 am EST


Patrick McKeough

Editor, Successful Investor

Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment advice, including how to use financial ratios and other fundamental financial information note Pat McKeough of TSI Network.

Tip No. 1: Use the Right Financial Ratios to Assess Debt Risk
Many successful investors start researching a company by looking at its financial ratios, including its debt-to-equity ratio. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity.

A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump. However, this ratio can mislead, because it compares a hard number with a soft one.

Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment, and so on. Equity numbers are fuzzier. They mostly reflect asset values as they appear on the balance sheet (minus debt, of course).

But the balance-sheet figures may be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance-sheet figures by cutting them or “taking a writedown.”

Or, the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate and other investments.

Instead of focusing on debt-to-equity financial ratios exclusively, we recommend that you also look at the ratio between a company’s debt and its market cap.

Like shareholders’ equity, market cap may differ widely from the net value of a company’s assets. However, a moderate debt-to-market-cap ratio will tend to provide a conservative starting point for analyzing a company’s chances of survival.

A great example is Coca-Cola (KO). The company has long-term debt of $12.7 billion, which represents a moderately high 39% of its $32.6-billion shareholders’ equity. But that debt is just 8.1% of its market cap.

The difference reflects the fact that the company’s balance sheet doesn’t show the true value of its most valuable asset—its so-called intellectual property.

In Coke’s case, one key asset is the secret formula for Coca-Cola, which is reputedly carried on the company’s books at one dollar. More important, the Coke brand name carries no value on the company’s balance sheet.

However, these items are reflected in its huge market cap of $157.2 billion. So put into perspective, the company’s debt is very low.

In contrast, penny mines often have low debt-to-equity ratios. But their shareholders’ equity reflects a lot of investments in mineral properties that will almost certainly never result in any significant revenue. (And their debt is low since no one wants to lend them money.)

NEXT: Tip No. 2: Learn How Share Splits Affect Your Stock Investments”


Tip No. 2: Learn How Share Splits Affect Your Stock Investments”
When a company splits its shares, it is simply cutting itself up into a different number of pieces, without changing its fundamental value. It simply wants its stock to trade in a price-per-share range that seems reasonable to investors.

For example, Computer Modeling Group Ltd. (CMG) recently split its shares on a 2-for-1 basis. Computer Modeling makes software and supplies services that help its clients get as much oil as possible from their existing wells.

Prior to its share split, Computer Modeling Group was trading at around $25 a share; it now trades at a more reasonable $13.25 a share.

If a stock's share price rises too high, some investors may shun it, since it seems expensive. The company’s management may then declare a stock split of, say, 2-for-1 (as was the case with Computer Modeling).

This turns one “old” share into two “new” shares. That’s why Computer Modeling’s share split increased its shares outstanding to 36.48 million from 18.24 million. However, the stock market investment’s market capitalization (the shares outstanding times the share price) is unchanged at $480.3 million.

If you are a Computer Modeling shareholder, your percentage ownership of the company is unchanged—you hold twice as many shares, but you still own the same percentage of the total.

In short, a share split does not dilute your interest. Dilution usually occurs when a company issues shares for less than the current trading price.

For example, if employees exercise options to buy shares at a discount or below the market price, dilution occurs. Each of your shares is now worth slightly less than it was before. This also happens when holders of convertible securities exercise their conversion privileges and exchange their securities for shares at less-than-market prices.

Share splits are often a good way for stock-market investments to attract attention

After a conventional stock split, good news often follows. Companies mainly split their shares when they want to draw attention to themselves—because they expect earnings to rise faster than normal, say. At such times, they may also raise their dividends.

That was the case in March 2011, when Potash Corp. (POT) split its shares on a 3-for-1 basis. Immediately following the split, the company raised its quarterly dividend by 110%, to 7 US cents (post-split) from 3.3 cents.

Our investing advice: Stock splits are a minor detail. Don’t let them distract you from more important matters, such as a company’s fundamental value and how well it suits your investment objectives.

Read more from TSI Network here…

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