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In this section, we will look at some of the tools you can use in making an investment decision from balance sheet information. If you are not familiar with balance sheets, you are advised to first read the section entitled, "Understanding the Balance Sheet". It provides a good overview of the functions of a balance sheet and its components. We will cover the following topics here: • • • • • Why You Should Analyze a Balance Sheet Liquidity Ratios Leverage Bankruptcy Tying It All Together
A thorough analysis of a company's balance sheet is extremely important for both stock and bond investors.
Why You Should Analyze a Balance Sheet
The analysis of a balance sheet can identify potential liquidity problems. These may signify the company's inability to meet financial obligations. An investor could also spot the degree to which a company is leveraged, or indebted. An overly leveraged company may have difficulties raising future capital. Even more severe, they may be headed towards bankruptcy. These are just a few of the danger signs that can be detected with careful analysis of a balance sheet. Beyond liquidity and leverage, the following section will discuss other analysis such as working capital and bankruptcy. As an investor, you will want to know if a company you are considering is in danger of not being able to make its payments. After all, some of the company's obligations will be to you if you choose to invest in it. We will start with Liquidity Ratios, an important topic for all investors.
The following liquidity ratios are all designed to measure a company's ability to cover its shortterm obligations. Companies will generally pay their interest payments and other short-term debts with current assets. Therefore, it is essential that a firm have an adequate surplus of current assets in order to meet their current liabilities. If a company has only illiquid assets, it may not be able to make payments on their debts. To measure a firm's ability to meet such short-term obligations, various ratios have been developed. You will study the following balance sheet ratios: • • • • Current Ratio Acid Test (or Quick Ratio) Working Capital Leverage
These tools will be invaluable in making wise investment decisions. Current Ratio The Current Ratio measures a firm's ability to pay their current obligations. The greater extent to which current assets exceed current liabilities, the easier a company can meet its short-term obligations. Current Assets --------------------------Current Liabilities
Current Ratio =
After calculating the Current Ratio for a company, you should compare it with other companies in the same industry. A ratio lower than that of the industry average suggests that the company may have liquidity problems. However, a significantly higher ratio may suggest that the company is not efficiently using its funds. A satisfactory Current Ratio for a company will be within close range of the industry average. Acid Test or Quick Ratio The Acid Test Ratio or Quick Ratio is very similar to the Current Ratio except for the fact that it excludes inventory. For this reason, it's also a more conservative ratio. Current Assets – Inventory --------------------------Current Liabilities
Acid test =
Inventory is excluded in this ratio because, in many industries, inventory cannot be quickly converted to cash. If this is the case, inventory should not be included as an asset that can be used to pay off short-term obligations. Like the Current Ratio, to have an Acid Test Ratio within close range to the industry average is desirable. Working Capital Working Capital is simply the amount that current assets exceed current liabilities. Here it is in the form of the equation: Working Capital = Current Assets - Current Liabilities This formula is very similar to the current ratio. The only difference is that it gives you a dollar amount rather than a ratio. It too is calculated to determine a firm's ability to pay its short-term obligations. Working Capital can be viewed as somewhat of a security blanket. The greater the amount of Working Capital, the more security an investor can have that they will be able to meet their financial obligations. You have just learned about liquidity and the ratios used to measure this. Many times a company does not have enough liquidity. This is often the cause of being over leveraged.
Leverage\Debt to equity
Leverage is a ratio that measures a company's capital structure. In other words, it measures how a company finances their assets. Do they rely strictly on equity? Or, do they use a combination of equity and debt? The answers to these questions are of great importance to investors. Long-term Debt ---------------------Total Equity
A firm that finances its assets with a high percentage of debt is risking bankruptcy should it be unable to make its debt payments. This may happen if the economy of the business does not perform as well as expected. A firm with a lower percentage of debt has a bigger safety cushion should times turn bad. A related side effect of being highly leveraged is the unwillingness of lenders to provide more debt financing. In this case, a firm that finds itself in a jam may have to issue stock on unfavorable terms. All in all, being highly leveraged is generally viewed as being disadvantageous due to the increased risk of bankruptcy, higher borrowing costs, and decreased financial flexibility. On the other hand, using debt financing has advantages. Stockholder's potential return on their investment is greater when a firm borrows more. Borrowing also has some tax advantages. The optimal capital structure for a company you invest in depends on which type of investor you are. A bondholder would prefer a company with very little debt financing because of the lower risk inherent in this type of capital structure. A stockholder would probably opt for a higher percentage of debt than the bondholder in a firm's capital structure. Yet, a company that is highly leveraged is also very risky for a stockholder. When a firm becomes over leveraged, bankruptcy can result.
Bankruptcy is a legal mechanism that allows creditors to assume control of a firm when it can no longer meet its financial obligations. Bankruptcy is a result feared by both stock and bond investors. Generally, the firm's assets are liquidated (sold) in order to pay off creditors to the extent that is possible. When bankruptcy occurs, stockholders of a corporation can only lose the amount they have invested in the bankrupt company. This is called Limited Liability. The stockholders' liability to creditors is limited to the amount invested. Therefore, if a firm's liabilities exceed the liquidation value of their assets, creditors also stand to lose money on their investments. When bankruptcy occurs, a federal court official steps in and handles the payments of assets to creditors. The remaining funds are always distributed to creditors in a certain pecking order: 1. Unpaid taxes to the IRS and bankruptcy court fees 2. Unpaid wages 3. Secured bondholders
4. 5. 6. 7.
General creditors and unsecured bonds Subordinated debentures Preferred Stockholders Common Stockholders
Obviously, to hold secured bonds rather than unsecured bonds is more advantageous in the event of a bankruptcy. This is where you must examine your risk/reward requirements. As you move down this hierarchy, your risk of losing your investment increases. However, you are "rewarded" for taking more risk with potentially higher investment returns. How do you predict bankruptcy? Well, no one can do it perfectly. However, one popular method called a Z-score (developed by Edward Altman) has a good track record. To learn more about "Zscores" go to your local library. We will recap a few of the most important points about learning to analyze a company's balance sheet.
Tying It All Together
Analyzing a balance sheet is fundamental knowledge for anyone who wishes to carefully select solid and profitable investments. The balance sheet is the basic report of a firm's possessions, debts and capital. The composition of these three items will vary dramatically from firm to firm. As an investor, you need to know how to examine and compare balance sheets of different companies in order to select the investment that meets your needs. After reading this section, you should have an understanding of liquidity, leverage and bankruptcy and know how to apply basic ratios to measure each. These ratios should be compared to other firms in the same industry in order for them to have relevance. Be careful, however, that the firms are not fundamentally different even if they are in the same industry. ---------------X---------------
ABOUT INCOME STATMENTS
A company's income statement is a record of its earnings or losses for a given period. It shows all of the money a company earned (revenues) and all of the money a company spent (expenses) during this period. It also accounts for the effects of some basic accounting principles such as depreciation. The income statement is important for investors because it's the basic measuring stick of profitability. A company with little or no income has little or no money to pass on to its investors in the form of dividends. If a company continues to record losses for a sustained period, it could go bankrupt. In such a case, both bond and stock investors could lose some or all of their investment. On the other hand, a company that realizes large profits will have more money to pass on to its investors. In this section, we will cover the following: • • • • • • • • Example of an Income Statement Gross Profit on Sales Operating Income Earnings Before Interest and Taxes Net Earnings (or Loss) Retained Earnings Income Statement Mnemonics The Importance of the Income Statement to Investors
Example of an Income Statement
The income statement shows revenues and expenditures for a specific period, usually the fiscal year. Income statements differ by how much information they provide and the style in which they provide the information. Here is an example of a hypothetical income statement, with revenues in black and expenditures in red (and parentheses): Wilma's Widgets Income Statements for the Years Ending 1998 and 1999 1998 1999 Sales $900,000 $990,000 Less Cost of Goods Sold (250,000) (262,500) Gross Profit on Sales 650,000 727,500 Less General Operating Expenses (120,000) (127,500) Less Depreciation Expense (30,000) (30,000) Operating Income 500,000 570,000 Other Income 50,000 30,000 Earnings Before Interest and Tax 550,000 600,000 Less Interest Expense (30,000) (30,000) Less Taxes (50,000) (54,500)
Net Earnings (Available Earnings for 470,000 Dividends) Less Preferred and/or Common Dividends (70,000) Paid Retained Earnings 400,000
515,500 (80,000) 435,500
Now, as perplexing as those numbers might seem at first, you will become comfortable with them very quickly once we explain what all this financial jargon really means. Let us start by looking at the first term that was calculated - gross profit on sales.
Gross Profit on Sales
Gross profit on sales (also called gross margin) is the difference between all the revenue the company earns and the sales of its products minus the cost of what it took to produce them. Let us move on to clarify how to calculate this important number. Gross Profit on Sales = Net Sales - Cost of Goods Sold Simple, yes, but let's be sure we know what the terms sales and costs of goods sold means to the accountants. Net sales are the total revenue generated from the sale of all the company's products or services minus an allowance for returns, rebates, etc. Sometimes on an income statement, you might see the terms "gross sales" and "returns," "rebates" or "allowances." Gross sales are the total revenue generated from the company's products or services before returns or rebates are deducted. Net sales on the other hand have all these expenses deducted. Cost of goods sold is what the company spent to make the things it sold. Cost of goods sold includes the money the company spent to buy the raw materials needed to produce its products, the money it spent on manufacturing its products and labor costs. When you subtract all the money a company spent in the production of its goods and services (cost of goods sold) from the money made from selling them (net sales), you have calculated their gross profit on sales. Gross profit on sales is important because it reveals the profitability of a company's core business. A company with a high gross profit has more money left over to pump into research and development of new products, a big marketing campaign, or better yet - to pass on to its investors. Investors should also monitor changes in gross profit percentages. These changes often indicate the causes of decreases or increases in a company's profitability. For instance, a decrease in gross profit could be caused by an industry price war that has forced the company to sell its products at a lower price. Poor management of costs could also lead to a decreased gross profit.
Operating income is a company's earnings from its core operations after it has deducted its cost of goods sold and its general operating expenses. Operating income does not include interest expenses or other financing costs. Nor does it include income generated outside the normal activities of the company, such as income on investments or foreign currency gains. Operating income is particularly important because it is a measure of profitability based on a company's operations. In other words, it assesses whether or not the foundation of a company is profitable. It ignores income or losses outside of a company's normal domain. It also excludes extraordinary events, such as lawsuits or natural disasters, which in a typical year would not affect the company's bottom line. An easy way to calculate operating income is as follows: Operating Income = Gross profit - General Operating Expenses - Depreciation Expense General operating expenses are normal expenses incurred in the day-to-day operation of running a business. Typical items in this category include sales or marketing expenses, salaries, rent, and research and development costs. Depreciation is the gradual loss in value of equipment and other tangible assets over the course of its useful life. Accountants use depreciation to allocate the initial purchase price of a long-term asset to all of the periods for which the asset will be used.
Earnings before Interest and Taxes
Earnings before interest and taxes (EBIT) is the sum of operating and non-operating income. This is typically referred to as "other income" and "extraordinary income" (or loss). As its name indicates, it is a firm's income excluding interest expenses and income tax expenses. EBIT is calculated as follows: EBIT = Operating Income + (-) Other Income (Loss) + (-) Extraordinary Income (Loss) Since we already know what operating income is, let's take a closer look at what other income and extraordinary income mean. Other income generally refers to income generated outside the normal scope of a company's typical operations. It includes ancillary activities such as renting an idle facility or foreign currency gains. This income may happen on an annual basis, but it is considered unrelated to the company's typical operations. Extraordinary income (or loss) occurs when money is gained (or lost) resulting from an event that is deemed both unusual and infrequent in nature. Examples of such extraordinary happenings could include damages from a natural disaster or the early repayment of debt. Many companies may not have either other income or extraordinary income in a given year. If this is the case, then earnings before income and taxes is the same as operating income. Regardless of how it is calculated, EBIT is especially relevant to bondholders and other debtors who use this figure to calculate a firm's ability to "cover" or pay its interest payments with its income for the year.
Net Earnings (or Loss)
Net earnings or net income is the proverbial bottom line. It measures the amount of profit a company makes after all of its income and all of its expenses. It also represents the total dollar figure that may be distributed to its shareholders. Net earnings are also the typical benchmark of success. Just a reminder, however, many companies report net losses rather than net earnings. How do we calculate net earnings? Net Earnings = Earnings before Interest and Taxes - Interest Expense - Income Taxes Interest expense refers to the amount of interest a company has paid to its debtors in the current year. Meanwhile, income taxes are federal and state taxes based upon the amount of income a company generates. Often a company will defer its taxes and pay them in later years. Net earnings are particularly important to equity investors because it is the money that is left over after all other expenses and obligations have been paid. It is the key determinant of what funds are available to be distributed to shareholders or invested back in the company to promote growth.
Retained earnings are the amount of money that a company keeps for future use or investment. Another way to look at it is as the earnings left over after dividends are paid out. Generally, a company has a set policy regarding the amount of dividends it will pay out every year. In this case, 70% of net earnings become retained earnings. Calculation of retained earnings: Retained Earnings = Net Earnings - Dividends To better understand retained earnings, we need to explain the nature of dividends. Dividends are cash payments made to the owners or stockholders of the company. A profitable year allows them to make such payments, although there generally are no obligations to make dividend payments. When a company has both common and preferred stockholders, the company has two different types of dividends to pay. Every publicly traded company has common stockholders. Dividend payments to common stockholders are optional and up to each company to decide how (or if) it will make such payments. A firm may decide to plow all of its earnings into new investments to promote future growth. Preferred stockholders are in line before common stockholders if a dividend is declared. However, not all companies have preferred stockholders. As an investor, it is important to know what a company does with its net earnings. An investor needs to know the company's dividend and retained earnings policies to decide whether the company's objectives are in line with the investor's. If the company pays dividends it is incomeoriented. If it retains earnings for future expansion, it is growth-oriented. Knowing the sources of income and expenses is necessary when reading an income statement. Two helpful mnemonic devices have been created out of the major components of the income statement.
Income Statement Mnemonics
Although these mnemonics may not account for every line on an income statement, these two will help you remember the major parts, and the order in which they appear. The word "SONAR" identifies the major sales and earnings. The word "EDIT" summarizes major expenditures. As you look vertically down the first row of letters, you should discover the spelling of "SONAR." The vertical set of letters in the second column spells out "EDIT." S = Sales (gross) E = Less expenses D = Less depreciation (general operating expenses and cost of goods sold)
O = Operating income (before interest and taxes) I T = Less taxes = Less interest
N = A = Available R = Retained earnings
Let's conclude with a review of the importance of the income statement for investors.
The Importance of the Income Statement to Investors
The income statement provides the investor with much insight to the company's revenues and expenses. You can identify where the company spends much of its income and compare that to similar companies. You can also compare a company's performance with previous years. Most importantly, the income statement tells an investor if the business is profitable. If the company continually makes substantial profits, it indicates to bondholders that it is a stable company. The savvy investor will compare income statements of similar companies.
Income Statement Analysis
The income statement is a basic record for reporting a company's earnings. Since earnings are a fundamental component in a firm's worth, it is essential for investors to know how to analyze different elements of this important document. This section is designed to teach you some basic methods for analyzing the income statement. Analyzing income statements is an important tool to help investors appraise their investment options. By analyzing an income statement properly, investors can begin to evaluate the effectiveness of the management of operations in the companies in which they are interested in investing. Proper income sheet analysis can help identify good investment opportunities. It can also reduce the risk involved with choosing a poor investment choice. In this section, we introduce you to the following ratios, tools and concepts to help you analyze income statements: • • • • • • • • Interest Coverage Profitability Ratios Where Did All Those Expenses Come From? Depreciation Expense Basic Points about Calculating Depreciation Straight-Line Depreciation Accelerated Depreciation Selecting a Depreciation Method
Interest Coverage (a.k.a. Times Interest Earned)
Interest Coverage is the measurement of how many times interest payments could be made with a firm's earnings before interest expenses and taxes are paid. From a bondholder's perspective, interest coverage is a test to see whether a firm could have problems making their interest payments. From an equity holder's perspective, this ratio helps to give some indication of the short-term financial health of the company. The following formula is used to determine the coverage of interest: Earnings Before Interest and Taxes (EBIT) ---------------------------Interest Expense
Interest Coverage Ratio =
A higher ratio is typically better for bondholders and equity investors. For bondholders a high ratio indicates a low probability that the firm will go bankrupt in the near term. A company with a high interest coverage ratio can meet their interest obligations several times over. Stock investors typically like companies with high interest coverage ratios too. A high ratio indicates a company that is probably relatively solvent. Thus, all other things equal, an investor should be very careful with firms that have a low Interest Coverage Ratio with respect to other companies in their industry. Since the fundamental purpose of the income statement is to report profits or losses, understanding the various profitability ratios that follow is extremely helpful to your analysis of a firm.
Profitability is often measured in percentage terms in order to facilitate making comparisons of a company's financial performance against past year's performance and against the performance of other companies. When profitability is expressed as a percentage (or ratio), the new figures are called profit margins. The most common profit margins are all expressed as percentages of Net Sales. Let's look at a few of the most commonly used profit margins that you can easily learn to use to help you measure and compare firms: Gross Margin is the resulting percentage when Gross Profit is divided by Net Sales. Remember that Gross Profit is equal to Net Sales - Cost of Goods Sold. Therefore, Gross Margin represents the percentage of revenue remaining after Cost of Goods Sold is deducted. Let us take a look at a simple example. Net Sales = Cost of Goods Sold = Gross Profit = Gross Margin = $1,000 - $400 $600 Gross Profit -------------------------Net Sales
In this example the Gross Margin = 600/1000 = .60 or 60% Since this ratio only takes into account sales and variable costs (costs of goods sold), this ratio is a good indicator of a firm's efficiency in producing and distributing its products. A firm with a ratio superior to the industry average demonstrates superior efficiency in its production processes. The higher the ratio, the higher the efficiency of the production process. Investors tend to favor companies that are more efficient. Operating Margin. As the name implies, operating margin is the resulting ratio when Operating Income is divided by Net Sales. Operating Income -------------------------Net Sales
Operating Margin =
This ratio measures the quality of a firm's operations. A firm with a high operating margin in relation to the industry average has operations that are more efficient. Typically, to achieve this result, the company must have lower fixed costs, a better gross margin, or a combination of the two. At any rate, companies that are more efficient than their competitors in their core operations have a distinct advantage. Efficiency is good. Advantages are even better. Most investors will tend to prefer a more efficient company. Let's move on to the last profitability measure we will cover in this section. Net Margin: As the name implies, Net Margin is a measure of profitability for the sum of a firm's operations. It is equal to Net Profit divided by Net Sales:
Net Margin =
Net Profit --------------Net Sales
As with the other ratios you will want to compare Net margin with other companies in the industry. You can also track year-to-year changes in net margin to see if a company's competitive position is improving, or getting worse. The higher the net margin relative to the industry (or relative to past years), the better. Often a high net margin indicates that the company you are looking at is an efficient producer in a dominant position within its industry. However, as with all the previous profit margin measurements, you need to always check past years of performance. You want to make sure that good results are not a "fluke." Strong profit margins that are sustainable indicate that a company has been able to consistently outperform their competitors. The savvy investor uses profitability margins to help analyze income statements of prospective investments. Companies with high interest coverage ratios, gross margins, operating margins and net margins will always be very attractive to investors.
Where Did All Those Expenses Come From?
You have just finished learning about interest coverage and profitability ratios. Both of these measures are simple and easy to understand. Interest coverage measures a company's ability to make its loan payments. Profitability ratios measure the bottom line of the income statement earnings. However, to calculate either ratio, you must be able to classify a company's expenses. The interest coverage ratio concerns itself with a specific type of expense (interest expense). Meanwhile, profitability ratios such as net profit margin consider the net effect of all the expenses a company incurs. Most of the expenses a company incur (raw materials, labor, rent, etc.) are straightforward items. In general, companies want to minimize these sorts of expenditures to ensure improved performance and profitability. For example, the less a company has to pay for the raw materials of the products it produces, the more competitive that company can become. Yet, there is one type of expense companies cannot eliminate. In fact, incurring this expense actually helps save the company money. What is this mysterious expense?
Depreciation is the process by which a company gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred. Like all other expenses, depreciation expense reduces the taxable income of the company. Yet, a business reporting a depreciation expense incurs no additional cash expenditure. Simply put,
depreciation allows businesses to reduce their taxable income without making the additional cash expenditure typical of most other expenses. While depreciation is an attractive way to reduce taxable income, specific regulations govern how it is to be calculated and allocated. Let's take a moment to review a few important points about how companies calculate depreciation.
Basic Points about Calculating Depreciation
When analyzing income statements, it is very important to understand how different accounting methods for calculating depreciation affect the income statement. Sometimes the accounting methods selected can materially alter the net result of this important statement. Most businesses have the right to choose amongst a number of different depreciation schedules. Typically, businesses elect a depreciation schedule to suit their specific needs or preferences. In order to make comparisons of different companies, you will need to know the role that accounting plays in the final composition of their respective income statements. A company can choose from several methods (or depreciation schedules) to calculate its depreciation expense. Read below to look at two of the most common methods.
Straight-line Depreciation is the simplest and most commonly used accounting method for depreciation. Basically, the straight-line depreciation method calculates the amount of annual depreciation expense that is to be recorded by dividing the value of the asset (as determined by its purchased price) by its useful life. Often some adjustment is made for the anticipated "residual value" that the asset may have at the end of its "useful life." The IRS provides taxpayers with a depreciation schedule that defines what the useful life of different types of assets (cars, computers, etc.) are to be. Thus, an item that has a relatively short-lived useful life (such as a computer) may be able to be depreciated more quickly than an asset (such as a building) that has a long and useful life expectancy ahead of it. Using a straight-line depreciation schedule, businesses deduct the same amount of depreciation each year until the assets has been fully depreciated. However, straight-line depreciation is not the only method available. Let's look at another popular option.
Accelerated Depreciation Methods
Accelerated Depreciation Methods are also a very common way for companies to allocate their depreciation expenses. These methods are those methods that are utilized to write off depreciation costs more rapidly than the straight-line method. Various accelerated methods exist. Two popular methods of accelerated depreciation are Sumof-the-Years'-Digits and Double Declining Balance. These methods are more complex in nature and we will not delve into their calculations at present.
However, the important thing to know is that each of these methods record depreciation expense more heavily in the current years in comparison to the straight-line method. By recording more expense in the early stages of an assets useful life, accelerated depreciation methods reduce the taxable income for those years and thus reduce income taxes for those years. However, in later years, accelerated depreciation methods will record less depreciation, leaving more income. The company will therefore have to pay greater taxes.
Selecting a Depreciation Method
For the company, the choice of depreciation method will depend on a company's current financial situation and/or its own preferences. Companies that wish to defer current taxable income may elect accelerated depreciation methods to accomplish this goal. However, companies that need to show large earnings in the current year may elect to forgo accelerated depreciation methods and opt for a straight-line method. Both methods have their advantages and disadvantages. Typically, a company is free to choose the method that best suits its preferences. However, as an investor, you will likely not have the power to tell the company what method to use. Instead you will need to know how each of these different methods can alter an income statement. If you can do this, you will be able to evaluate how a company's depreciation schedule impacts the value of the investment opportunity. When making comparisons of different companies, you should always check to see if they use the same accounting methods. If not, you will want to make an adjustment in order to effectively compare these companies. At first, comparing depreciation methods and accounting rules may seem daunting. However, with a little practice you will be armed and ready to really understand the companies you are interested in investing in.
Now that you have completed this section, you should be familiar with some basic methods to help you evaluate different investment options. Using the analysis techniques that we have introduced, you have a good basis of knowledge from which to make informed investment decisions. Remember that the main purpose of the income statement is to report profitability. Because profitability is crucial in any investment decision, knowing some basic techniques of how to analyze the income statement should be a very important part in your development as an informed investor. ---------------X---------------
Calculating Profitability Ratios
Corporate earnings are important to you as an investor. If you compare corporate earnings of prospective investments, you will make wiser investment decisions. Profitability ratios provide you with tools you can use to make these comparisons. In this section you will learn: • • • • • • How Do I Use Fundamentals to Make an Investment Decision? What Is Ratio Analysis? What Can I Learn from Profitability Ratios? When Is an Increase in Earnings a Loss? How to Use Profitability Ratios to Make Investment Decisions Other Ratios to Consider
How Do I Use Fundamentals to Make an Investment Decision?
Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. Performing fundamental analysis will teach you a lot about a company, but virtually nothing about how it will perform in the stock market. Apply this analysis on two competing companies and it becomes clearer which is the better investment choice. In this section, you will learn to use some of the tools of the fundamental analyst. As an investor, you are interested in a corporation's earnings because earnings provide you with potential dividends and growth. Companies with greater earnings pay higher dividends and have greater growth potential. You can use profitability ratios to compare earnings for prospective investments. Profitability ratios are measures of performance showing how much the firm is earning compared to its sales, assets or equity. You can quickly see the difference in profitability between two companies by comparing the profitability ratios of each. Let us see how ratio analysis works.
What Is Ratio Analysis?
While a detailed explanation of ratio analysis is beyond the scope of this section, we will focus on a technique, which is easy to use. It can provide you with a valuable investment analysis tool. This technique is called cross-sectional analysis. Cross-sectional analysis compares financial ratios of several companies from the same industry. Ratio analysis can provide valuable information about a company's financial health. A financial ratio measures a company's performance in a specific area. For example, you could use a ratio of a company's debt to its equity to measure a company's leverage. By comparing the leverage ratios of two companies, you can determine which company uses greater debt in the conduct of its business. A company whose leverage ratio is higher than a competitor's has more debt per equity. You can use this information to make a judgment as to which company is a better investment risk.
However, you must be careful not to place too much importance on one ratio. You obtain a better indication of the direction in which a company is moving when several ratios are taken as a group.
What Can I Learn from Profitability Ratios?
The profitability ratios include: operating profit margin, net profit margin, return on assets and return on equity. Profit margin measures how much a company earns relative to its sales. A company with a higher profit margin than its competitor is more efficient. There are two profit margin ratios: operating profit margin and net profit margin. Operating profit margin measures the earnings before interest and taxes, and is calculated as follows:
Operating Profit Margin = Earnings Before Interest and Taxes Sales Net profit margin measures earnings after taxes and is calculated as follows:
Net Profit Margin =
Earnings After Taxes Sales
While it seems as if these both measure the same attribute, their results can be dramatically different due to the impact of interest and tax expenses. Similarly, the next two ratios appear to be similar but they tell different stories. As an investor, you are interested in getting a return on your investment. So is a corporation. Return on assets (ROA) tells how well management is performing on all the firm's resources. However, it does not tell how well they are performing for the stockholders. It is calculated as follows:
Return on Assets =
Earnings After Taxes Total Assets
Return on equity (ROE) measures how well management is doing for you, the investor, because it tells how much earnings they are getting for each of your invested dollars. It is calculated as follows:
Return on Equity =
Earnings After Taxes Equity
These ratios are easy to calculate and the information is readily available in a company's annual report. All you need do is review the income statement and balance sheet to come up with the data to plug into the formulas. But, do not neglect other income statement information that can save you from making a costly mistake.
When Is an Increase in Earnings a Loss?
Sometimes an increase in company earnings can disguise an operating loss. If a company's operating expenses exceed its operating income, it has an operating loss. If it also has income from investments and tax benefits, this income can offset the loss and show an increase in earnings per share. However, if these other sources of non-operating income are not recurring, the unsuspecting investor may come to an erroneous conclusion about the company's overall financial health. The lesson to be learned here is to carefully scrutinize the financials especially when operating income is negative.
How to Use Profitability Ratios to Make Investment Decisions?
When considering a company as a prospective investment you should review its financial statements. Pay particular attention to the profitability ratios. If you can, calculate the ratios for the same company over several successive years to see if the company earnings are consistent, growing, or declining. Compare your candidate's ratios to other companies in the same industry. This will help you determine where your candidate stands in the industry. Do not ignore other financial information on the income statement and balance sheet. Pay particular attention to losses in income items. For more information on financials, see the sections on Understanding Balance Sheets and Understanding Income Statements.
Other Ratios to Consider:
Price to Earnings Ratio (P/E) The price to earnings ratio, or P/E, is figured by dividing the stock price by the company's earnings per share (EPS). The P/E is a performance benchmark that can be used as a comparison against other companies or within the stock's own historical performance. For instance, if a stock has historically run at a P/E of 35 and the current P/E is 12, you will want to explore the reasons for the drastic change. If you believe that the ratio is too low, you may want to buy the stock. You will generally find a P/E ratio based on either the prior reporting year's earnings, or the earnings of the prior four quarters added together. This latter number is referred to as LTM or Latest Twelve Months. While this is useful for understanding the history of a company, most analysts prefer to view a forward-looking P/E ratio. This ratio is calculated by dividing the stock price by the analysts' earnings estimate for the next year or two. One other note on P/E Ratios. Sometimes, when a company is not doing well, it will buy back shares so that the EPS and P/E Ratio will appear better. This can be seen in the example below.
Example 1 Net Income Shares Outstanding Earnings Per Share (EPS) Stock Price P/E Ratio $1,000,000 10,000,000 $0.10 $3.00 30
Example 2 $1,000,000 8,000,000 $0.125 $3.00 24
In the table above, the only change from Example 1 to Example 2 is in the number of shares outstanding. The net income and stock price remain the same. However, by changing the shares outstanding, the EPS has changed quite a bit. This means that the P/E ratio has also changed. At first glance, if a stock's EPS has increased 25% and its P/E ratio has gone from 30 to 24 it might look like a better buy. However, the truth is that nothing has changed but the number of shares. The stock is not a better buy in Example 2 than it was in Example 1. Where P/E Does Not Apply When looking at newer companies such as Internet start-ups or bio-techs, there is often no net income, so there are no earnings per share. In these cases the P/E ratio does not apply, forcing analysts to turn to other measures. The most common alternative ratios include: revenues per share, gross income per share or cash flow per share. All these ratios take the relevant number from an income statement, divide them by the number of shares and then divide the stock price by this number. For example if XYZ Corp. has sales of $1 billion and 100 million shares outstanding, then the revenue per share is $10. If the stock is trading at $90 per share, the price to revenue ratio is 9x. There are flaws in taking these ratios, but in the absence of a meaningful P/E Ratio, they are a good place to start. Current Ratio The current ratio provides an indication of how liquid a company may be in the coming year. To calculate it, take the current assets and divide that number by the current liabilities. You will find all of these figures on the balance sheet. An answer of 1.0 or better is generally considered good. However this, like other ratios, can depend on a company's current stage of growth. A start-up company should have a lower ratio than an established company. If it does not, then you will want to ask yourself why and do further research. A current ratio can also be affected by how much long-term debt a company has in relation to its short-term debt. Some companies prefer to use short-term debt and reissue it more often. Other companies minimize their use of short-term debt. Most companies use a mix depending on what is available to them, what is cheaper at the moment and how their economists project interest rates for the future. Hence, this ratio also needs to be used to build a bigger picture rather than in isolation.
Long-Term Debt to Equity The long term debt to equity ratio can tell you how much debt a company is using to finance its operations. If this number is too high it may signify future liquidity problems. If this number is too low it can signify inefficient use of the financing alternatives available to a company. This ratio is calculated by taking the long-term debt of a company and dividing it by the shareholders' equity. Be sure to include the company's lease obligations (which can be found in detail in the footnotes of an annual report) when calculating long-term debt. Start up companies which have access to the debt markets, often have higher ratios than more established companies. In addition, the amount of debt a company can safely issue varies by industry. For example, companies with large manufacturing facilities often have more long-term debt than companies that provide services or software. Therefore, it is useful to look at the ratios of numerous companies in the same industry before drawing any conclusions. Total Debt to Equity Since companies can affect either the current ratio or the long-term debt to equity ratio by altering their mix of short-term and long-term debt, this ratio can often be more useful than the other two. This ratio is calculated by dividing all long-term debt, short-term debt and lease obligations by the shareholders' equity. ---------------X---------------
How Analysts Present Their Findings
The study of all this data is known on Wall Street as fundamental analysis. Most analysts would view themselves as fundamental analysts, meaning they make investment decisions based on the available information about a company. After going through the history of the ratios above, other ratios not explained here and the nonfinancial information available on a company (product, strategy, marketing, management, etc.), the analysts build models that project what will happen to a company in the future. Based on these models they issue two pieces of information. The first piece of information you will likely see is an analyst's projected earnings per share (EPS) for a company. Projections for many companies are available online, where you can see the mean or average projection as well as the extreme projections and the recent movement in the projections. Since investors rely on analysts to filter the information provided, when analysts change these projections, it will often affect the price of the stock. In other words, the analysts' projections act as an information source in their own right. When an analyst lowers an earnings projection for a company, people assume they have learned something negative about a company's future performance. As a result, they believe a company is less valuable and sell their stock. Conversely, when an analyst raises their earnings projection, people believe they have learned something positive about the future of a company. In this case investors will view the company as more valuable and proceed to buy the stock. An analyst also makes their own buy or sell recommendation, often including a target stock price. While many firms use synonyms for the following terms, these are the basic recommendation levels: Strong buy - Investors are strongly encouraged to buy a stock with this recommendation. Buy - Buying a stock with this recommendation is suggested, but with a little less emphasis. Accumulate - Investors are advised to buy a stock with this recommendation steadily over time. Hold - Investors are advised neither to buy nor sell, but if you are a pessimist reading between the lines, this might be construed as a signal to sell. Sell - The analyst recommends that investors unload this stock.
When Is The Right Time To Buy?
Once you have found an investment idea, researched it thoroughly and have done a detailed analysis, it will be time to make a decision. If an individual stock seems to have good prospects, if it fits your portfolio and if the risk is acceptable, the time may be right to buy the stock. The decision on when to buy is yours alone.
Dollar Cost Averaging
Dollar cost averaging can give you an investment strategy that evens-out the fluctuations in the price of an investment made over time. It works by purchasing the same dollar amount of shares at regular intervals. It is most commonly used to purchase mutual fund shares on a regular basis. We will cover the following in this section: • • • What Is Dollar Cost Averaging? An Example of Dollar Cost Averaging A Helpful Formula for Calculating Average Price Per Share
What Is Dollar Cost Averaging?
Dollar cost averaging is the practice of purchasing the same dollar amount of shares of an investment each period. When the price is up, you buy fewer shares. When the price is down, you buy more shares. It is usually advised to make the payments on the same day each period. This differs from buying the same number of shares each time. Let us explain this with some examples. Imagine instead of dollar cost averaging that you choose to buy 100 shares on the 15th day of every month for four consecutive months. Assume the share prices were the following on the 15ths of these months: Date Jan 15 Feb 15 Mar 15 Apr 15 Price/Share $30 $50 $100 $40 Total Avg. Price Per Share Shares 100 100 100 100 400 Cost $3000 $5000 $10,000 $4000 $22,000.00 $55
By dividing the total amount you paid ($22,000) by the number of shares you purchased (400) you find that the average price is $55 per share. Now let's examine what happens when you invest a set amount of dollars each month.
An Example of Dollar Cost Averaging
If you invest the same amount of money as the previous example over four months, you would invest $5500 on the 15th of each month. You get the following: Date Jan 15 Feb 15 Mar 15 Apr 15 Price/Share $30 $50 $100 $40 Total Shares 183.333 110 55 137.5 Cost $5500 $5500 $5500 $5500
Avg. Price Per Share
You purchased 485.833 shares with your total investment of $22,000. By dividing $22,000 by 485.833, you arrive at an average price of $45.28 per share. This is a savings of $9.72 per share from the $55 per share in the previous example. You purchased more shares for the same investment. You can see that when prices are low, you can buy more shares. Conversely, when prices are high you will buy fewer shares. Thus, when it comes time to receive dividends, you will have more shares on which you can earn dividends. By using a little more math, you can see your savings in another way. Read below to find out how.
Formula for Figuring Price per Share and Cost per Share
With the following handy formula, you can compare what you would have paid per share using different investment strategies. In fact, this is the same simple formula we used in the previous two examples to compare the results of buying a fixed number of shares per month compared with purchasing a fixed dollar amount of shares per month. You can determine your average price per share (what you paid) with this formula: Average Price = Total Amount You Paid Numbers of Shares Bought
As you should recall, using dollar cost averaging the average price per share was $45.28 compared with purchasing the same number of shares each month which resulted in an average price per share of $55. Dollar cost averaging gives you an advantage because it helps reduce the average price you pay. This is true because the Dollar Cost Averaging method takes advantage of the fluctuation in price.
Dollar cost averaging is a simple and straightforward method of investing. It is often an attractive option for the investor who wants to systematically contribute to their investment portfolio over time. By electing to dollar cost average, you can help reduce some of the risk that poor timing and potentially adverse price fluctuations will have on your investment decisions. Using the dollar cost average method, it is not as likely that you will purchase too much of a particular security at a time when it is priced relatively high in the market.
Introduction to Margin Accounts
In this section, you will learn the mechanics of margin accounts. You will learn about their limitations and how to engage in margin transactions. You will also learn when to use a margin account and the potential rewards and risks of using margin.
This section contains the following lessons: • • • • • • Why Use a Margin Account? How Do You Set Up a Margin Account? What Are the Limitations in Margin Accounts? What Is a Margin Call? How Do Margin Transactions Work? Is a Margin Account for You?
Why Use a Margin Account?
Let's begin with the terms. Margin account. An account you establish at a brokerage firm that lets you borrow from your broker to buy securities or for any other purpose. Margin. The amount you must deposit when you use your broker's credit to buy securities. A margin account lets you make a secured loan against your own portfolio. The advantage is that you do not have to sell any of your portfolio to obtain the cash. Furthermore, you have no repayment schedule. You are free to repay the loan at anytime, unless your collateral falls below the required amount. While most investors use the borrowed cash to buy additional securities, you can use it for any purpose. However, the wholly owned securities in your portfolio are collateral for the loan. You will also need a margin account if you are engaging in short sales. See the section on Selling Short for more information. Interested? Let's see how to establish a margin account.
How Do You Set Up a Margin Account?
You have a choice of two types of brokerage accounts. You can open a cash account or a margin account. A brokerage cash account is a simple account you may use to buy and sell securities. You pay for transactions with cash. A margin account is a credit account. You pay a certain percentage of the purchase price of your marginable securities and borrow the remainder from the brokerage firm. When opening a margin account you must sign a margin agreement form, which outlines the rules for using your margin account. Once you have placed securities in your margin account, you can borrow on margin anytime thereafter, without having to complete any other applications or forms.
What Are the Limitations in Margin Accounts?
The Board of Governors of the Federal Reserve System regulations, as well as other regulatory bodies, apply restrictions on margin lending practices. You may not borrow the full amount of your portfolio. The Federal Reserve Board (FRB) regulates the amount of credit brokers can extend to its customers. Currently, you can borrow up to 50% of the value of your marginable stocks to make a new purchase. In the past, it has varied between 40 and 100 percent. The "New York Stock Exchange minimum initial equity requirement" holds that your equity be at least $2,000 whenever you enter into a new margin account transaction.
The "NYSE Minimum Maintenance Rule" requires that the equity in your account must be at least 25% of the current market value of margined securities. All of these requirements are minimums and can be increased at any time by your brokerage firm and/or by the regulatory agencies of the securities industry. Not all securities are fully marginable. Your brokerage firm may have its own requirements and your broker can tell you which ones would not apply. Your broker will charge interest on the margin loan as long as it is not repaid. The rates vary but generally will go down as the amount you borrow increases. You cannot have shares registered in your name and sent out to you when you have purchased these shares on margin. They must remain in the margin account in "the street name." You will receive credit into your account for any dividends they pay. You may remove the shares from the margin account only after you have repaid the amount you borrowed on margin to purchase these shares. If the value of your collateral rises, you can withdraw the amount over your minimum requirement or use it for additional investments.
What Is a Margin Call?
A margin call is a demand by your broker for you to deposit cash or fully marginable securities with your broker. If the value of your collateral falls below the broker's minimum requirement (usually about 30% of the loan), you will receive a margin call by letter, telephone, telegram, or other means, to request additional collateral in the form of cash or fully marginable securities to meet the requirement. However, only a percentage of a security's market value can be used to meet your margin call. If you fail to meet the margin call, your broker is authorized (remember the margin agreement form) to sell the margined securities and any other collateral needed to repay the loan plus interest and commissions. You are responsible for any deficit that may remain after your assets are sold. Let's see how a margin transaction works.
How Do Margin Transactions Work?
Margin accounts let you magnify your gains when you choose wisely. But, choose unwisely, they also magnify your losses. You benefit from using margin only if the stocks you purchase rise in price. If they stay the same, or worse, drop in price, you lose. You must pay interest on the margin whether your stock rises or not. Here is an example: Suppose you have an opportunity to purchase an Internet stock. It is selling for $11 a share. You have about $ 5,500 to invest. So, you purchase 500 shares. A year later, you sell the stock at $33 per share. You receive about $16,300 before commissions on a $5,500 investment. Not bad. However, instead you could use margin. Suppose you bought on margin 1,000 shares of an Internet stock for $11 a share. You put up 50% of the stock's purchase price ($5,500) and borrowed the other 50% from the brokerage firm. Next year, the stock is valued at $33 per share. If you sell the stock and repay the broker, you are left with close to $27,000 after commissions and interest charges. That is even better for a $5,500 investment.
However, what if your stock had dropped in price to $8 dollars? In the cash transaction, you would receive about $4,000 back excluding commissions, from your original $5,000. In the margin transaction, you would receive $8,000, repay the $5,500 you borrowed from your broker, and you would be left with $2,500 of your original $5,500, excluding commissions and interest.
Is a Margin Account for You?
Before you decide to open a margin account, let us review the main points and the risks involved in making margin transactions. • • • • A margin account is essentially a collateralized line of credit. You may use proceeds from a margin account for other investments and other purposes. You will pay interest on money borrowed from a margin account. If you use the margin to buy securities, you must meet certain minimum margin requirements and maintain the appropriate amount of collateral. If the collateral level falls, you can expect a margin call. Using margin to buy securities can magnify your gains. It can magnify your losses as well. You can lose more funds than you deposit in the margin account. A decline in value of securities that are purchased on margin may require you to provide additional funds to your brokerage firm to avoid the forced sale of those securities or other securities in your account. Your brokerage firm can force the sale of securities in your account. If the equity in your account falls below the margin maintenance level required by the law, or below higher "house" requirements, your brokerage firm can sell the securities in your account to cover the margin deficiency. You will also be responsible for any shortfall in the account after such a sale. Securities can be sold without contacting you prior to the sale. Some investors mistakenly believe they must be contacted before a margin call becomes valid, and that the securities in their accounts cannot be liquidated to meet the call, unless they have been contacted first. This is not the case. Most firms will attempt to notify you of margin calls, but are not required to do so. However, even if your firm has contacted you and provided a specific date by which you can meet a margin call, they can still take the necessary steps to protect their financial interests, including immediately selling the securities without notice to you. You are not entitled to choose which securities in your margin account are liquidated or sold to meet your margin call. Because the securities are collateral for the margin loan, your brokerage firm has the right to decide which security to sell in order to protect its interests. "House" maintenance requirements can be increased at any time and without advance written notice. These changes in policy can take effect immediately and may result in the issuance of a margin maintenance call. Your failure to satisfy this call may cause a forced liquidation in your account.
You are not entitled to an extension of time on a margin call. While an extension of time to meet margin requirements may be available to clients under certain conditions, a client does not have a right to the extension.
Buying on Margin
In this section, we will cover the basics of using margins. We will discuss the following: • • • • Why Buy on Margin? Rules for Buying on Margin Which Securities Can Be Margined? Selling Short
Why Buy on Margin?
Let's begin with an example. Suppose you believe that a particular stock will rise in price. It is currently trading at $10 per share and you believe it will soon hit $20. Currently you only have $3,000 in cash to buy 300 shares. You can borrow $3,000 on margin and invest the total $6,000 for 600 shares. If the stock hits $20, your holdings will be worth $12,000 and you can then sell them for that price. You pay back the $3,000 you borrowed, leaving you with your original investment of $3,000 and a tidy gain of $6,000 (before commissions and interest). The chance to magnify your earnings is what buying on margin is all about. However, if the stock declined to $7 a share and you sell, you receive only $4,200. From this amount, you must repay the $3,000 you borrowed. Thus, leaving you with $1,200 of your original $3,000, before commissions and interest. Buying on margin is a strategy for the short term, since holding on to borrowed money too long could result in a loss. You are responsible to meet all margin calls promptly and you are responsible to repay all funds borrowed on margin, even if this amount exceeds the value of your account. As with all investing, there is risk in buying on margin. One of the biggest reasons many people lost lots of money in the stock market crash of 1929 was that they borrowed too much and could not pay back their loans. The government stepped in soon after to create limits.
Rules for Buying on Margin
After the market crash of 1929, the government enacted laws to help prevent the practices that led to the crash. Federal Reserve Board Regulation T sets margin requirements. Regulation T requires that the customer put up a percentage of the total investment amount. The Federal Reserve Board sets this percentage but changes it periodically to keep speculation under control. Currently the margin requirement is 50%. However, some brokerages may require more than 50 percent. You may use fully marginable or partially marginable securities you already own as collateral for the margin. Conversely, you may borrow up to 50 percent of the value of your marginable portfolio. The broker-dealer holds the marginable shares as collateral. You pay the broker interest and commissions on the transactions. To buy on margin, you must have a margin account. You can put up your collateral in cash or securities. You are allowed to add money or securities to your account.
The initial margin is the smallest amount that the investor must pledge at purchase. The bare minimum that must stay in the account is the maintenance margin. When the balance falls below this amount, if the margined securities drop in value, the investor will get a margin call, which is a demand that the account be brought back up to the maintenance margin. If the customer cannot meet the margin call, the broker may sell any and all of the customer's margined securities and other assets to meet the call. The NASD requires maintenance margin on equities of 25%. However, your broker may impose higher margin maintenance requirements. The customer is responsible for any remaining deficit.
Which Securities Can Be Margined?
The Board of Governors of the Federal Reserve System publishes a list of marginable securities. Most brokerages will extend margin on the following types of securities: • • • • • • Listed common and preferred stocks Municipal bonds Federal government bonds, notes and bills Nasdaq Securities Convertible bonds Corporate bonds
Always check with your brokerage firm to determine whether a security is, 1)marginable, and 2) if a higher maintenance requirement is imposed on the security. Some securities are marginable only up to a certain value of the security while still other securities are non-marginable all together. With an IPO, you must wait at least 30 days after a security has been traded in the secondary market before the security may become marginable. Mutual funds and certain options may not be bought on margin or used as collateral in a margin account. Buying on margin is usually simple, but it is risky. If you buy a security with it, and it nose-dives in value, you cannot rescue it with more margin buying. Margining magnifies earnings, and it can magnify losses as well.
Margin accounts are not just used for buying -- you can also use them to sell securities. This is called selling short, or shorting. You can read more about selling short in the next section.
Selling short involves borrowing securities you believe will decline in value and then selling them. You are selling securities you do not own. Looked at another way, short selling is about selling high and then buying low, just the opposite of regular trading. Once you have sold your securities, you hope that the price falls, in which case you buy them back at a lower price. If the price rises, you may be forced to buy the shares back at the higher price, losing money on the transaction. Remember -- you have to buy them back because you must return them to the brokerage firm. In this section about the short sale we will discuss the following: • • • • What Is a Short Sale? What Are the Potential Rewards of Selling Short? What Are the Potential Risks of Selling Short? What Kind of Brokerage Account Do I Need to Make a Short Sale?
What Is a Short Sale?
A short sale occurs when you "borrow" a security from your broker and sell it with the intent of repurchasing it in the future to repay the loan of the security. You might sell short if you believed the price of a security was going to drop and you could re-purchase it at a price significantly below the price for which you sold it. You may have a "long" or "short" position in a security. When you have a "long" position in a stock or bond, you actually own the security in your account. On the other hand, sometimes you may want to take advantage of a price movement in a security you do not own. When you do this, you may take a "short" position by borrowing the security. Here is how selling short works: 1. You borrow a security from your broker. 2. You sell it at its current price. 3. You buy the security back when you believe the price has fallen sufficiently or the broker calls for it (which ever comes first). 4. You return the security back to the broker. As an example, let's say that you really believe that Chocolate Beer, Inc. (XYZ), which is currently $10 per share, is going to fall very far and very fast. You borrow 100 shares of XYZ from your broker and sell them for $1,000. Soon afterward, the stock drops to $4 a share, at which price you buy the 100 shares back for $400. You come out $600 ahead (before commission and interest). If Chocolate Beer, Inc. becomes a hit and its price rises, you will take a loss. Let's say it rises to $15 by the time you must repay the shares. It will cost you $1,500 to buy those 100 shares back. Thus, you must pay $1,500 to replace the shares you sold for $1,000. You must also pay commission and interest costs as well. Dividends or interest earned on the shorted security belong to the person from whom you borrowed it. The broker can also demand that you return the shares at any time regardless of whether the price is up or down.
What Are the Potential Rewards of Selling Short?
Investors use short sales to make gains in a declining market or to hedge against losses in an investment. If you sell short, and buy back at a lower price, you stand to make larger gains than if you had a long position in a security that declines in value. For example: you borrow 100 shares from a corporation, which has a market price of $35. You sell the 100 shares for $3500. The price later falls to $25. You buy back 100 shares for $2500. You have made a profit of $1000 ($3500$2500). Top
What Are the Risks of Selling Short?
As with any investment strategy, there is a downside. If you are incorrect, you may have to repurchase the borrowed security at a price higher than you sold it. In our previous example, if the price of the corporation increases from $35 to $40 and you have to buy the shares back, you have to pay $4,000 and you lose $500. While you have a "short position" in a security, you are responsible for paying any dividends or interest it distributed to the investor you borrowed it from even though you did not receive it either. The security can be called at anytime by your broker and you must return it immediately regardless of the market price. A very important thing to remember when selling short is that you have only a limited amount of money you can earn if you are correct. However, your potential to lose money has no limits. This is true because the money you can make is restricted to the difference between the stock's current market price and the floor price for all securities - $0.00. Whereas, a security can hypothetically appreciate indefinitely. This means that when you sell short, your losses could accrue indefinitely if you do not close out the position. To take advantage of selling short you will need a special brokerage account. Read below to learn more.
What Kind of Brokerage Account Do I Need to Make a Short Sale?
All orders to sell a security short must be placed in a short account. You must have margin privileges with your brokerage firm in order to have a short account. Since selling short requires that you borrow from your broker, you will need to establish credit with your broker and abide by the rules for borrowing against your account. See the section Introduction to Margin Accounts for more information about margin accounts.
Dividend Reinvestment Plans (DRIPs)
Investing in stocks is not hard. While most investors elect to purchase shares directly from a stockbroker, an interesting alternative exists - Dividend Reinvestment Plans. In this introductory section we will explain: • • • What Are Dividend Reinvestment Plans (DRIPs)? Two Types of Dividend Reinvestment Plans Benefits of Dividend Reinvestment Plans
What Is a Dividend Reinvestment Plan?
Some corporations offer their shareholders the option of reinvesting their dividends in additional shares of stock. This allows shareholders to purchase additional shares of stock directly from the company without having to use a brokerage service. This is known as a dividend reinvestment plan (DRIP). However, to be eligible for a dividend reinvestment plan, most corporations require that you purchase your original shares from a brokerage house. Once you own some of the company's stock, you then may be eligible to participate in a dividend reinvestment plan. Nonetheless, many brokerage services can be very helpful in pointing out to investors (who ask) what companies offer dividend reinvestment plans. The obvious advantage to dividend reinvestment plans is the potential to save on brokerage commissions through direct purchases. Nonetheless, there are other attractive features of these plans that we will explore. But before we look at all the potential benefits, let's begin by looking at the two dividendreinvestment plans available to investors. Top
Types of Dividend Reinvestment Plans
There are two types of dividend reinvestment plans: 1. Plans that offers a shareholder stock that already exists, "old stock" 2. Plans that offers a shareholder "new stock" The first type of DRIP has an outside trustee repurchase shares on the secondary market. These shares are purchased to re-issue them to shareholders in the dividend reinvestment plan. The shareholder will get the shares at market price. However, the corporation will often offer to cover the commission and fees to encourage shareholders to participate in the plan. In the second type of DRIP the shareholders receive newly issued shares directly from the company. This implies that the company has the control on whether to provide an additional discount or not. Some corporations will go as far as offering their stock at three to five percent below the market price. Companies offer these discounts because they save the costs of going through an investment banker to issue the new shares. The goal is usually to have shareholders continuing to invest. Read below to see how everyone benefits from these DRIPs.
Benefits of Dividend Reinvestment Plans
Dividend reinvestment plans benefit both the investors and the corporations. For investors: An investor will usually save brokerage fees or will be offered other discounts that a corporation will provide in order to keep the investor. Furthermore, some investors may also enjoy the benefits of the option to purchase more shares in a company they already know and trust, rather than searching through the thousands of options available to them in the free market. For the corporation: By offering the DRIP a corporation raises capital inexpensively. DRIPs can also help provide stability for a company's stock price by offering perpetual demand for the company's shares as new dividends are declared. Furthermore, the corporation may decrease or increase the availability and the benefits of their dividend reinvestment plans based on how much capital they need to raise. Top
Today, about a thousand corporations (mainly the large ones) offer DRIPs. Only about 25% of the shareholders actually choose to take advantage of them. Yet, corporations will continue to offer discounts because DRIPs have proven themselves to be a good way to raise capital. Furthermore, as more investors learn about the benefits of DRIPs, one might expect that more investors will be drawn to the advantages offered by these programs.
Investing in IPOs
The 1990s have witnessed many small start-up companies successfully placing large amounts of stock in the primary market through well-publicized initial public offerings (IPOs). The possibility of buying stock in a promising start-up company and finding the next success story has intrigued many investors. Yet, is investing in an IPO right for you? In this section, you will learn about some of the challenges, basic risks and potential rewards associated with investing in an IPO. You will be able to answer the following questions: • • • • • What Is an IPO? What Should I Look for When Choosing an IPO? What Are the Risks of Investing in an IPO? What Information Should I Get Before Investing? Where Can I Find Information about the Company?
Even if you never invest in an IPO, the lessons you learn here will prepare you to make a decision about whether or not investing in an IPO is suitable for you.
What Is an IPO?
An initial public offering (IPO) is the first sale of a corporation's stock to outside investors. This does not necessarily mean that a company is a new business. It simply means that the company is offering shares of ownership to investors outside the corporate "family" for the first time. Most businesses are privately owned. They do not have "outside" investors. A few people, who may be management or employees and members of their respective families, own all the outstanding stock. Such corporations are referred to as "closely held corporations." These companies are usually small, but some are nationally recognized names such as AVIS Rent-aCar. When a privately held corporation needs additional capital, it can borrow cash or sell stock to raise needed funds. Often "going public" is the best choice for a growing business. Compared to the costs of borrowing large sums of money for ten years or more, the costs of an initial public offering are small. The capital raised never has to be repaid. When a company sells its stock publicly, there is also the possibility for appreciation of the share price due to market factors not directly related to the company. If you are looking for a "diamond in the rough," an initial public offering may be for you.
What Should I Look for When Choosing an IPO?
As with any investment, you must do your homework carefully. Keep in mind that an initial public offering is a cheap way to raise capital. Investing in an IPO is not always best for the investor. Before signing that check, you must be clear about the benefits you hope to obtain from the investment. Are you investing for income, long-term growth or short-term capital gains? The offering's financials will tell the story. • • • As an income investor, you need to examine the company's potential for profits and its dividend policy. You are looking for steadily rising profits that will be distributed to shareholders regularly. A growth investor evaluates the company's growth plan, earnings and potential for retained earnings. You are looking for potential steady increase in profits that are reinvested for further expansion. A speculator looks for short-term capital gains. As a speculator, you look for potential of an early market breakthrough or discovery that will send the price up quickly with little care about a rapid decline. You are not going to be in it that long. Companies that have "fad" products often fit the bill.
This sounds simple, but what are the risks involved?
What Are the Risks of Investing in an IPO?
Slow down. It may sound easy, but it is risky. Before investing in an initial public offering, you need to ask yourself some questions. How much do you really know about this company? A Wall Street sage once said, "Never invest money in anything you don't understand." You may understand all about how an IPO works, but what do you really know about the business of the company in which you plan to invest? Before it went public, the only shareholders in a privately held company were the management, employees and their families. They all know about the
business; they are in it. Before investing, you need to learn the fundamentals of the business. What is their product or service? Who are their competitors? What is their share of the market for their product? What is the likelihood they will succeed with their newfound capital? Ignorance is your worst enemy. You should concern yourself with three kinds of risk related to the company. • • • Business Risk: Does this company have a sound business plan and management with education, training, experience sufficient to execute the plan? Financial Risk: Is this company solvent with sufficient capital to weather short-term business setbacks? Market Risk: Are other investors likely to buy this stock on the secondary market? Does this company possess sufficient appeal to investors in the current market environment (income, growth, or short-term capital gains)? How long is the attraction likely to last?
What Information Should I Get Before Investing?
The more information you have the better decision you will be able to make. Keep in mind that the original stockholders are insiders. Among the information you will want to know is: • • • Business Operations: What is management like? Do the employees like to work there? Is there a large turnover in the labor force? How do customers perceive the company? How do Dunn and Bradstreet and the Better Business Bureau rate the company? Financial Operations: What is the company's credit history? Are they in default on any debts? Have the owners invested sufficient capital to give them a financial stake in the company's success? How does this company's expenses compare to their competition's? Marketability: Would you buy and use their product? Who would? Is their product a longterm commodity or just a fad? Can you buy the IPO shares directly from the issuer?
A substantial advantage can be gained if you can purchase IPO shares directly from an issuer. This could save you "mark-up" and commissions used to pay for marketing the offering. By taking the time to answer each of the questions above, you gain valuable information that will help you decide whether this IPO is a suitable investment for you.
Where Can I Find Information about the Company?
Unless you actively seek out IPOs, the first you hear about an IPO is likely to be that dreaded dinnertime sales solicitation. Fortunately, all the information you need is readily available to you, but you must take the time to read it. Forget about the sales pitch. If the "…deal is too good to pass-up" and "… you must buy it tonight…" chances are you want to gain further information before investing. Federal law states that: ALL INITIAL PUBLIC OFFERINGS ARE REQUIRED TO BE ACCOMPANIED OR PRECEDED BY A PROSPECTUS. The prospectus is the official offering document that contains all material information about the company and its offering. If you are looking for an IPO as an investment, you should be familiar with the following:
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IPOs are often introduced in the financial press with a tombstone advertisement. This contains the "bare bones" information, including the name of the stock, the issuer and how to obtain a red herring. You may obtain a preliminary informational prospectus, red herring, to ascertain whether or not you have any interest in the prospectus and offering when available. Information about the offering is available on the Securities and Exchange Commission's Edgar database at www.sec.gov/edgarhp.htm. Today, many companies have their own web sites that provide information to their customers and prospective investors. Barron's, the Wall Street Journal, Investor's Business Daily and other financial periodicals report on companies going public.
IPOs are not for every investor. They may provide an opportunity for substantial gain for the knowledgeable investor, but the unwary investor is just as likely to get burned.
What Are Stocks?
Stocks are ownership in a company, with each share of stock representing a tiny piece of ownership. The more shares you own, the more of the company you own. The more shares you own, the more dividends you earn when the company makes a profit. In the financial world, ownership is called equity. There are two primary classes of stock. The one you choose depends on what you want from a stock. Preferred stock typically pays regular dividends and is favored by investors who want income foremost from their stocks. Common stock represents ownership of a company and may offer more rights and privileges than preferred stock. Investors may purchase stock on the primary or secondary market. A company sells its stock to the public on the primary market through its initial public offering. Investors may sell their shares through brokers to other investors on the secondary market. The secondary market can be structured as an auction market, like the New York Stock Exchange, or a dealer market, like the NASDAQ. Stock prices (quotes) can be found in newspapers, on television and the Internet.
Types of Stocks
In this section, we will explore what is meant by the many names given to stocks and the corporations that issue them. Each of the following types refers to any of several different qualities of stocks or companies. For example, a stock's classification may come from the size of the company that issued it, or from the perceived investment objective it fulfills. You will be introduced to the following stock types in this section:
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Blue-Chip Stocks Penny Stocks Income Stocks Value Stocks Other Types of Stocks
The term "blue-chip" comes from poker, where the blue chips carry the highest value. Large, established firms with a long record of profit growth, dividend payout and a reputation for quality management, products and services are referred to as blue-chip companies. These firms are generally leaders in their industries and are considered likely candidates for long-term growth. Because blue-chip companies are held in such high esteem, they often set the standards by which other companies in their fields are measured. Well-known blue-chips include IBM, CocaCola, General Electric and McDonald's. Blue-chip stocks are included in the Dow Jones Industrial Average, an index comprised of 30 companies that are all major players in their respective industries. Popular among individual and institutional investors alike, the 30 stocks listed on the Dow account for about one fifth of the total market value (over $8 trillion) of all U.S. stocks. Investors who seek investments that pay moderate dividend yields and that also grow are attracted to blue-chip stocks. These stocks are usually priced high because of their demand, have relatively low volatility and deliver a steady stream of dividends. The main downside is that, since they are so large, they have little room to appreciate, compared to smaller, up-and-coming stocks. Top
Penny stocks, over-the-counter bulletin board (OTCBB) or pink sheet securities are low-priced, speculative stocks that are very risky and are not suitable for every investor. They are issued by companies with a short or erratic history of revenues and earnings. Penny stocks sell for less than $5 per share and their companies have under $2 million in net tangible assets. Therefore, the companies do not qualify to trade on the New York Stock Exchange or on the NASDAQ. Instead, the securities are traded by specially registered Dealers. Quotes for the securities are frequently outdated or delayed and may not be firm. Trades for these securities are always executed on a manual basis. The appeal of penny stocks comes from their low price. Though the odds are against it, if the company that issued them suddenly finds itself on a growth track, their share price can rise rapidly. Investors who trade these securities are speculating as to the company's growth and are willing to assume the entire loss of their investment. Top
Income stocks are those stocks that pay higher-than-average dividends over a sustained period. These above average dividends tend to be paid by large, established companies with stable earnings. Utilities and telephone company stocks are often classified as income stocks.
Income stocks are popular with investors who want steady income for a long time and who do not need much growth in their stock's value (though some growth does occur). In this sense, investors who choose them have something in common with bondholders. To maximize income, some investors will even seek out companies that frequently raise their dividends and are not saddled with debt.
A value stock is a stock that is currently selling at a low price. Companies that have good earnings and growth potential but whose stock prices do not reflect this are considered value companies. Both the market and investors are largely ignoring their stocks. Investors who buy value stocks believe that these stocks are only temporarily out of favor and will soon experience great growth. Factors such as new management, a new product or operations that are more efficient may make a value stock grow quickly. Many companies alternate between value and growth as part of the business cycle. Value stocks are attractive to investors who watch markets carefully for undervalued stocks they feel will move upward.
Other Types of Stocks
Defensive stocks are those whose prices stay stable when the market declines and are issued by industries that naturally do well during recessions. Food and utilities companies are defensive stocks. Debt collection companies also tend to perform well when the market turns sour. Cyclical stocks are stocks that move up or down in sync with the business cycle. Examples include the housing industry and industrial equipment companies, because these companies serve the needs of growing economies. Investors who do not mind buying and selling as the market fluctuates tend to like cyclical stocks. Individuals who prefer to hold a stock for a long time may not like them unless they can weather ups and downs in the stock's value. Gold stocks are the stocks of gold-mining companies. Their value moves up or down with the price of gold. Treasury stocks are stocks that have been bought back by the company that issued them. Companies may buy their stock back from investors when they believe it is underpriced on the market. The company can then set aside the stock for future uses such as debt payment or the awarding of stock options.
Small-, Mid- & Large-Cap Stocks
You may have heard the terms "small-cap," "mid-cap" or "large-cap" in your reading about stocks and the companies that issue them. This short section will discuss segments of the stock market. It will cover the following topics: • Market Capitalization
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Small-Cap Stocks Mid-Cap Stocks Large-Cap Stocks
We will first read about market capitalization and what it means.
"Cap" is short for capitalization, which is the market value of a company's stock. Capitalization gives a picture of a company's size. You can calculate a company's stock capitalization by multiplying market price of its shares by the number of shares outstanding ("outstanding" means in the hands of the public). For example, if ABC Corporation has one million shares outstanding, and the price per share is $10, then ABC Corporation has a market capitalization of $10 million. Corporate stock is often grouped by the company's capitalization. For example, one model would group companies as follows: Small-cap -Mid-cap -between Large-cap -- over $3 billion less $500 than million $500 and million billion
These lower and upper limits will vary depending upon the model. However, the general classification scheme remains true. You can see that stocks are grouped based on their issuer's capitalization. That is where the terms small-cap, mid-cap and large-cap come in.
The stock of small companies that have the potential to grow rapidly is classified as small-cap stock. Many of these companies are relatively new. How they will behave in the market is often difficult to predict. Because of their small size, growth spurts can affect their prices and earnings dramatically. On the other hand, they tend to be volatile and may decline dramatically. Most initial public offerings are for small-cap companies. Most small-cap stocks are oriented toward growth. Growth and aggressive-growth mutual funds often look for small-cap companies for their portfolios. Because they look to grow rapidly, small-cap stocks are likely to forego paying dividends to investors so that profits can be reinvested for future growth of the company. Small-cap stocks are popular among investors who are looking for growth, who do not need current dividends, and who can tolerate price volatility. If successful, these investments can generate significant gains.
Mid-cap stocks are typically stocks of medium-sized companies. Like small-cap stocks they offer growth potential, but they also offer some of the stability of a larger company. Stocks of many well-known companies that have been in business for decades are mid-cap stocks.
Baby blue-chips are mid-cap stocks that have steady growth and a good track record. They are like blue-chip stocks (which are large-cap stocks) but lack the size of blue-chips. These stocks tend to grow well over the long term. Mid-cap stocks, like small-caps, emphasize growth but pay a relatively larger share of their earnings as dividends.
Stocks of the largest companies such as IBM or GE are classified as large-cap stocks. These are large, established companies (many are blue-chips). They often keep large reserves of cash to take advantage of new business opportunities. Together they make up over half of the value of American stock. Because of their large size, large-cap stocks are not expected to grow as rapidly as a smaller capitalized company. Successful mid-caps and small-caps tend to outperform them over time. Investors looking for dividends and preservation of capital with some growth potential choose them. Large-cap stocks pay relatively more in dividends than small- and mid-cap stocks. Investors who want their money to remain relatively safe over the long term are often attracted to large-cap stocks.
Preferred Vs Common Stock
Some corporations issue both common and preferred stock. Each provides unique benefits to investors. Both common and preferred shareholders own a portion of the company, but they have very different rights. Common stock confers voting and pre-emptive rights. Preferred stock may trade voting and pre-emptive rights for dividends and a higher claim to liquidated company assets than common stock. Regardless of whether you choose common or preferred stock you should always read the prospectus before investing. In this section, we will first explain shareholder rights and privileges, followed by common and preferred stocks and their respective properties. For common stock, we will cover these topics: • • • Shareholders' Rights and Privileges An Overview of Common Stock Types of Stock Dividends
For preferred stock will cover these areas: • • • An Overview of Preferred Stock Types of Preferred Stock Features of Preferred Stock
Shareholders' Rights and Privileges
Shareholders may acquire the following rights and privileges when they purchase shares of a company's common or preferred stock (although preferred shareholders may have theirs restricted or applied only in certain situations). Voting Rights Owners of common stock have the right to vote on company matters. For example, they can vote on whether to allow a stock split, or whether the objective of the company should be changed. They cannot, however, vote on whether dividends should be distributed. A shareholder has one vote for each share owned. To cast their votes, most shareholders use a form of absentee ballot called a proxy. Shareholders also elect the management of the corporation. There are two methods of voting. The statutory method provides one vote per share for each vacant seat; this method benefits those who hold many shares. The cumulative method allows those who do not own many shares to have as many votes as there are seats to be filled. Shareholders can cast all their votes for one candidate or distribute their votes among several. For example, if five directors were to be elected, an owner of 30 shares of stock with the cumulative voting right would have 150 votes that they could cast for one director or spread among the five directors. Preemptive Rights Preemptive rights may give shareholders the right to keep their proportionate ownership of the company. If the company offers a new issue of stock to the public, shareholders are accorded the right to buy new shares to keep their percentage of ownership the same. With preemptive rights, they can maintain voting control, share of earnings and share of assets. Preemptive rights let common shareholders buy new shares of stock before non-stockholders. Thus, these rights assure the keeping of previous percentages of ownership. They must be exercised within 45 days. If they are not, the company may sell the stock to non-shareholders. Other Rights of Common Stockholders Shareholders have the right to inspect the books and records of the company. They also have the right to sue the management for any unauthorized activities. They have the privilege of receiving dividends as cash, stock or property. The board of directors, however, is allowed to forego paying dividends if it feels that doing so is against the best interests of the corporation. Stockholders also have the right to receive distributions of any remaining assets should the company go out of business. However, as stated before, they are last in line for the assetclaiming privilege. Preferred shareholders are paid before common shareholders.
An Overview of Common Stock
Common stock represents ownership in a corporation.
Common stock dividends may be paid in cash, stock or property. The most common payment method is a cash dividend. The board of directors determines whether or not to pay dividends to common shareholders. Increases or reductions in dividend payments most frequently depend on how well the company is performing. In a weak economy the company may even suspend dividends until its balance sheet improves. Should the corporation issuing the stock go bankrupt, it may have to liquidate its assets in order to pay its creditors. Common stockholders will receive payment for their ownership interest only after all other creditors, the bondholders, and preferred shareholders have been paid.
Types of Stock Dividends
Stock pays dividends in three forms: cash, stock and property. Let's take a look at each one. Cash dividends are those that are paid out in cash form. They are treated as investment income and are taxable in the year they are paid. Stock dividends are dividends paid out in the form of additional stock shares in the corporation, or shares of a subsidiary corporation. They are usually issued in proportion to shares owned. For example, for every 100 shares of stock owned, a four percent stock dividend will yield four extra shares. When the company distributes these new shares to investors, the price of each share decreases to account for the new shares. This is a recalculation of cost basis. It means that the stock dividends will not be taxed when distributed. Stock dividends benefit the company by conserving its cash and they benefit the shareholder by increasing his/her number of shares of the company. Property dividends are paid with assets owned by the issuing company. Property dividends are usually paid in the form of products or services that the corporation produces. Often the corporation, when paying property dividends, will use securities of other companies owned by the issuer. This concludes our look at common stock. Read below to learn about preferred stock ownership.
An Overview of Preferred Stock
Preferred stock also represents ownership in a corporation. Preferred stock promises guaranteed dividends and a claim on a company's assets that is above that of common shareholders. The trade-off may be that preferred shareholders cannot vote or share other specified rights. Preferred stock pays a fixed dividend that is specified and set down in advance. Unless the stock is retired or called back, it will continue paying dividends forever. Preferred stock is usually issued with a $100 par (face) value. The dividend payments are a fixed percentage of the par. For example, if the par value of a stock share were $100 with a six percent annual dividend rate, the annual dividend would be $6 on that share. In recent years, some companies have also begun issuing preferred shares with variable rates tied to interest rates. The par value is the most that the shareholder will receive if the company declares bankruptcy. Preferred stock is generally issued at its par value.
Types of Preferred Stock
Preferred stock further divides into four types: cumulative, non-cumulative, participating and convertible. Cumulative preferred stock accords its owner a continuous claim to his or her dividends. Any unpaid dividends accumulate until the corporation resumes paying them. Since the cumulative preferred owner is entitled to all past and present dividends, he or she is paid before common shareholders once payment is resumed. If the board of directors suspends dividends, the shareholder still has a claim on them. Non-cumulative (straight) preferred is the opposite of cumulative preferred: it doesn't confer a steady claim on dividends in the event of a dividend suspension. Shareholders of this type may not be paid any missed dividends prior to payments being made to the common shareholders. Participating preferred shareholders receive extra dividends over their normal ones when the company makes an extra profit and the board of directors declares dividends. Convertible preferred stock may be converted to a certain number of shares of common stock. Preferred investors who want the opportunity to share in the appreciation of the company's common stock may find this option attractive. Preferred stock has features other than fixed, steady dividends. The next section will explain these features.
Features of Preferred Stock
Limited Voting Rights Preferred stockholders may be limited to voting only in these situations: • • • When the company wants to merge with another When the company wants to liquidate a large portion of its assets When the company wants to issue new bonds or preferred stock
Call Provisions Preferred stock may carry a call provision. This means that the issuing company can repurchase the stock from the shareholders. Though preferred stock is usually called at par value, some call provisions actually tack on a premium. Because of the steady dividends accorded to preferred shareholders, call provisions are not usually advantageous to them, despite any premiums. However, a corporation may use calls as a way to eliminate dividends, thus increasing earnings for common shareholders.