Carlson: Stock Analysis 101

02/28/2003 12:00 am EST

Focus:

Charles Carlson

Editor, DRIP Investor

Chuck Carlson is the editor The DRIP Investor, which is the leading authority on dividend reinvestment plans. He is also a contributing editor to Dow Theory Forecasts, which has been around since 1946 and is one of the financial world's most respected publications. He believes all individuals have the ability to conduct their own stock analysis, and here he demystifies eight basic financial analysis tools.

"I am going to talk about the best predictors of stock performance. My aim tonight is to simply help educate you. What I want to do is give you living, breathing tools to equip you to be a better investor. Things you can apply to your own investing. These are things that have worked effectively for me, and hopefully will work effectively for you. People would be smarter investors if they approached investing not so much as going out and buying a stock, but buying a company. Most people when they make a stock investment think about buying a piece of paper. And because of that, they don’t really think through what they are really doing, which is buying a piece of a company.

"If like Bill Gates, you could go out and buy entire companies instead of just shares, you would ask different questions. You would make better investment decisions. For example, how many of us when evaluating a company think about things like regulations, unions, barriers to entry, etc. As a business owner, the thing that should matter the most is profit. And what generates profit? How fast I sell the thing I make and how quickly I can get paid for it. You can have a great product, but if you’re customers don’t pay in a timely fashion, you can be up the creek. Conversely, you can have a great product, but if nobody buys it, you’re not getting anywhere.

"One  great tool in evaluating a company is what’s called the inventory turnover ratio. In effect, this looks at the 12-month cost of goods sold, divided by the average inventory. These are items you can find on any company’s income statement and balance sheet. It is very easy to compute on your own. You can also take that ratio and turn it into days to sell inventory simply by taking that number and dividing it into 365. Now why is inventory turnover important? Because you want to constantly be creating products that are being sold in the market. How many times you turn over that inventory is going to have huge impact on the profit that you will be generating at the end of the day. Just using this indicator to look at the telecom companies in 2000-2001 would have shown that their inventories were expanding, and expanding, and expanding. But while they making stuff, nobody was buying it. If you look at nothing else about a company, but want to decide the best stock to buy in a group, the single best metric I would pick is this. At the end of the day, that’s what matters.

"Two is that not only does a company have to make stuff, they have to get paid well for it. Thus, you must couple inventory turnover with profit margins. Obviously, a company can get rid of products if it’s just dumping them on the market at any price. So you want to look at net operating profits to see if it is stable. This will keep you out of a lot of trouble, especially in technology and manufacturing companies. You can measure how quickly customers pay for products by looking at the receivables turnover ratio. This is the 12-month annual sales of the company divided by the average accounts receivable. You can also change this to days receivable or how many days it takes the company to bring in its receivables. Again, going back to the telecom equipment and technology areas, what you would have found if you looked at receivables? That the customers were taking longer and longer to pay. Why? Because they were in bad financial shape. If you’re customers’ health isn’t good, that will eventually translate into problems for your business.

"Three , you must look at payables turnover. If you’re trying to get a look at a company’s financial health, one of the things you have to look at is how well that company manages its payables. On the one hand, if you own a company you don’t want to be paying your payables every few days, because that’s money that’s gone. You want to try and expand your payables as long as possible without affecting your credit position or your relationships with suppliers. So just because a company pays it’s bills in ten days, isn’t necessarily a smart thing. What you don’t want to see happen is a company that has traditionally paid its bills every 45 days, that now goes to 65 days, and then to 75 days, etc. What we’re trying to do is look at concrete tools to let you peer into a company to judge its financial health. This will make you a better investor and that’s what investing is all about. To determine payables, you look at 12-month cost of goods sold divided by the average accounts payable. You take the accounts payable in this period, and the same number from the year earlier period. You take the average of that and that’s your denominator. To turn that into a days-payable number, you divide that number into 365.I know this stuff might be kind of boring, but the fact of the matter is that investing is not as easy as it seemed in the late 1990s. This is not rocket science. You can go to the SEC.gov Web site and basically pull down the 10-Qs for any publicly-traded company. So you can easily get these numbers. What is the optimum way to run a company? Well you want to make things as quickly as possible, you want to sell them quickly, and you to get paid as soon as possible, hopefully before you have to pay for the costs of that product.

"Four is sales per employee. It's very simple. If you were going to buy a company, one of the things you would want to know is how efficient is the current workforce in generating revenue. All things equal, you would rather own a company with five employees generating $50 million than you would a company with 50 or 500 employees that generates the same $50 million. Why? Employees cost companies money. You want to be as efficient as possible to generate the maximum revenue with the minimum number of people. Just divide the annual sales by the total number of employees. You can get these numbers on Yahoo! Finance or generally in the company’s 10-Q or 10-K. This is a good metric to try and evaluate how good a company’s acquisition programs have been. One way to judge if a company is really adding value to its operations through an acquisition is looking at what is happening with sales per employee. What you’re looking for is trends. Be aware that this number may change as a result of an acquisition; the acquired firm may not be as efficient.  But you want to see how an acquisition may impact these numbers a year down the road. And you also want to look at these things relative to other companies in their industry.

"Five is the fixed asset leverage ratio. It’s a mouthful, but it’s simple. It is annual sales at a company divided by the average fixed assets of the company. These assets are basically plants, equipment, and property. Why does this matter? If you’re going to buy a company, you want that company to be able to maximize the amount of sales for the least amount of fixed assets that you would have to go out and buy. You have to buy these assets, and the more money you put into a business, the more risk you have on the line if things don’t work out. So you want to buy companies that generate the most out of their fixed assets. This just makes sense.

"Six is long-term debt as a percentage of total capital. If you are buying a business, you want to understand what kind of debt load you will inherit in the deal, and what kind of debt the company needs to have in order to generate its business. This is a real simple financial ratio. You are looking at the long-term debt of a company divided by the company’s total capital. And total capital is the long-term debt plus shareholder equity. Again, all of this is found on a company’s balance sheet. Like everything else, absolute numbers don’t always mean the same thing. In capital intensive industries, like autos, which require a lot of capital and equipment, the company will likely have a fair amount of debt. Other industries don’t require much capital. What many companies have found over the past three years is that this is a risk measure. It shows you the amount of leverage a company has on its balance sheet. In boom times, people don’t seem to care too much about financial risk, but in the last three years, they have. Picture that you have an adjustable rate mortgage that’s fixed for three years and then balloons. Then, you can pay it off, or take another loan. But you don’t know what the environment will be in three years. Rates can go up or down. Maybe you won’t be able to refinance, because of a change in your credit situation. That’s what’s happening in corporate America these days. You can look at the long-term ratio of two companies and they may have the same debt ratio of say 30%. But if company A has all its debt due in two years and company B has its debt due in ten years, these companies have distinctly different financial profiles. Companies that can’t refinance their debt in the current environment have to either sell assets or go out of business. A lot of firms leveraged up their financial positions when things were good, and they are now paying the price. You can find this amount in a company’s 10-K, or in the footnotes to financial statements, which is must reading. By looking at a company’s long-term debt structure, you can see how much debt is due in 12 months, 24 months, etc.

"Seven is the PEG ratio, which looks at valuation. First, you take a company’s p/e ratio, which is the stock price per share divided by the earnings per share. Take this ratio and divide it by the company’s long-term growth rate. You can look at ratios on a trailing basis or a forward basis. All this information is easily available on Yahoo!; it will show you what the consensus estimate is for a company, as well as the expected long-term growth rate. Now, two companies can have the same ratio, but what you want to know is can you buy that growth at a reasonable price? We’re not really pure value buyers or pure growth investors; we tend to follow GARP - growth at a reasonable price. The S&P 500 index’s PEG ratio is now about 1.3 and many companies are trading at significant discounts to this level. We like the drug stocks, particularly Pfizer (PFE NYSE), which trades at a PEG below one. Pfizer, at $28, is a very, very attractive stock. It may not go anywhere in the next six months, but if you’re looking to buy quality and growth at a reasonable price, Pfizer looks like a good idea. Another interesting stock based on its PEG ratio is Health Management Associates (HMA NYSE), which runs hospitals mostly in rural areas. Despite a difficult industry, this company has produced 57 consecutive quarters of same-hospital growth. In other words, the hospitals they have owned and operated for at least 12 months, have shown growth. You can now buy this stock for less than 16 times earnings and its PEG is less than one. I see very good support at 15-16 and think this is a very good stock. I think you can get to the mid-20s on this stock.

" Scott’s (SMG NYSE) is another company with a PEG below one. It dominates the turf and horticulture markets. These are the Miracle-Gro people. The gardening market is one of the greatest ways to play demographics in this country. They also benefit from increased home ownership, the aging population, and increased leisure time. After TV, the most popular pastime is gardening. They own this market and they are branching out into lawn care service, landscaping, etc. They had a record year in 2002 and they will have another record year in 2003. They’ve beaten estimates in each of the last four quarters. You can buy this stock for just 13-14 times earnings and at a PEG ratio of less than one. Another company I like is SunGuard Data Systems (SDS NYSE). They provide financial infrastructure and computer processing systems for financial services companies. They also provide disaster back-up systems. If you have a disaster recovery system somewhere offsite, you’re company may contract with SunGuard to operate that. They just reported solid earnings, but the company has taken it on the chin, just like a lot of other financial service companies because financial markets and trading volumes are down. Earnings have grown in each of the last ten years. And the PEG right now is less than one.

"Eight is the payout ratio. This probably isn’t the most crucial ratio, when you are trying to assess how well a stock is going to perform. But in this day and age, with everyone focused on dividends, knowing a company’s payout ratio is pretty helpful. The payout ratio is the 12-month dividends paid, divided by the company’s 12-month earnings per share. This ratio shows the cushion the company has in both paying its existing dividend, and growing its dividend. Obviously, if a company has a low payout ratio of say 15%, it will have the ability to raise its dividend if the environment warrants. On the other hand, if a company has a payout ratio of 95%, how much can they raise the dividend? More likely they might have to cut it if business turns down. As an investor, don’t go out and chase yield. A stock yielding 14% is doing so because soon it’s going to be yielding 4%, because they are going to cut or omit their dividend. In addition, you want to look at dividend growth. If you buy stocks for a long period of time, than dividend growth is going to matter more to you over time than the initial dividend yield. Here are some companies I happen to like for dividend growth: Bank of America (BAC NYSE) is now yielding 3%-4%, which is a pretty good yield in this market. They have had 12% dividend growth on average per year for the past 15 years. That compounds pretty fast. One of my favorite companies is  Sysco (SYS NYSE), the food distribution company. It really dominates its market. It has shown dividend growth of 15% a year on average for 15 years. This is a stock that is never cheap. But occasionally it dips into the mid to upper 20s. At 28, you may want to nibble; at 26, buy. It’s a good, good company."

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