Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
March 14, 2004
http://www.dynamicinvestors.net
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Mr. Market took investors for a wild ride this week, with news that the current account defecit is at an all time high, and an awful terror attack in Spain, pushing the markets lower. The Dow plummeted 355.47 points (3.4%) to finish at 10,240.08. The S&P 500 dropped 36.29 points (3.1%), ending the week at 1120.57. And to my shock and amazement, my buddies over at the Nasdaq held up the best this week, falling 62.92 points (3.1%) to 1984.71. Both the Dow and Nasdaq are in the red for the year, down 2% and 1%, respectively, while the S&P holds onto a less than 1% gain.
Common wisdom is blaming this week's market drop on the devastating train bombing in Spain. Fears of terrorism spooked investors after a group linked to al-Qaeda took credit for the bombing. While I believe the terror attacks had an effect on the markets, there's definitely more at work. I think we're seeing the beginning of a major correction in the stock markets. The bombings gave investors an excuse to run for the exits, and dump their overpriced stocks. Things settled down Friday, and the markets came roaring back, but I don't think it's going to last.
Except for a small gain last week, the Nasdaq has been down 8 straight weeks, off almost 8% from its high. Up to now, the selling has been disciplined and orderly, but I expect that to change as the relentless downtrend starts to take its toll on jittery investors. Last time, the buy-and-hold believers stayed put as the markets fell around them, convinced things would eventually right themselves. The last year and a half has been like vindication for them, and if Mr. Market decides to show investors who's boss by erasing those gains, the ranks of believers might just start shrinking. And when investors lose faith in the market, they panic, selling anything and everything just to avoid further losses. It's not until the panic sets in, and the majority of investors have given up on stocks, that we'll reach the bottom. We're a long way from that.
After peaking in early 2000, stocks took almost three years to hit their most recent lows in late 2002. In that time, the S&P had four major rallies: 19%, 21%, 21%, and another 21%. And what characteristic do you think was common to three out of the four rallies? Each of the first three rallies ended with the market falling back lower than where it started, and the fourth rally came within just a few points. That, dear reader, is how a bear market works. It's a bull market in reverse. In bull markets, there are occasional large pullbacks, but the main trend is always up. In a bear market, we get big positive moves, but the overriding trend is always down. The S&P is up 45% from the most recent lows. Are you prepared if the market decides to erase all those gains?
I'm going to make a recommendation, which I rarely do, one that's only for experienced investors. If you don't want to sell stocks in your portfolio, buy some protective put options. I recommend buying put options on the Nasdaq 100, commonly known as the Cubes, after the ticker symbol QQQ. The triple Qs track the 100 largest stocks in the Nasdaq, and will move with the composite as it declines. The options are fairly cheap right now, as there is little volatility priced into them. If you'd like to learn more about options, check out www.Optionetics.com. Read up on options before you get involved with them, because it's easy to lose money if you don't know what you're doing.
In other financial news, the dollar was up on the week against the Euro, finishing at 1.2227. Gold ended the week at $395, while silver finished at $7.03. The gold market is offering investors a great opportunity to buy in right now, while the dollar is offering a good chance to sell.
I guess that'll do it for this week. I'll leave you to poneder this trivia question. What characteristic is common to over 50% of the world's billionaires (besides the fact that they're billionaires)? You may be surprised at the answer, which I'll give you next week. Until then, happy investing.
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Analyzing The Income Statement
As I mentioned last week, the Income Statement is the most popular of the financial statements, and in my opinion, also the most overused. Many investors view the Income Statement as gospel, unaware that it really tells the investor little more than the accounting profit a company generated over a period of time. It doesn't represent cash profit, which comes from the Cash Flow Statement, nor does it accurately detail the value a company creates. Still, it's an important financial statement that's useful when analyzed properly.
Criticism of the Income Statement aside, it really is a valuable document for investors. You will find that most of the analysis of the Income Statement is in relation to the Balance Sheet, because assets are what generate sales and profit. Sales and profit by themselves don't tell us a whole lot, but when you look at them in relative to the assets and capital needed to produce them, they're very valuable numbers. As we get into some of the analytical tools, you'll understand what I mean.
As with the Balance Sheet, it's important to compare the Income Statement from year to year, preferably going back at least five years. The following sites provide financial data, which can be accessed via the stock's ticker symbol.
Dynamic Investors
Yahoo! Finance
The Motley Fool
http://quote.fool.com/Index.aspx
http://moneycentral.msn.com/home.asp
Remember, almost all companies
are required to post financial reports on their websites, so if you want the raw
data direct from the
Once again, the first order of business is to build year-over-year and common size Income Statements. The common size statement lists all income and expenses as a percentage of sales, allowing you to identify what the company's cost drivers are, and what the margins are at different levels of cost.
Using Anheuser-Busch's 2002 annual data, I've created a common size and year-to-year statement. You can click here to access it. I recommend setting up similar spreadsheets for all your investments.
Margins
Margins were explained in last week's newsletter (which you can access here), but suffice it to say that if margins are getting bigger each year, it's generally a good thing. The common size statement will give you all your margin data. You should look at the following margins, noting changes from year to year:
Gross Margin = Gross Profit / Sales
Operating Margin = Operating Profit / Sales
EBIT Margin = Earnings before interest and taxes / Sales
Net Margin = Net Income / Sales
Asset Turnover
Asset Turnover = Sales / Assets
The asset turnover ratio calculates the dollar of sales generated by each dollar of assets, and measures management's efficiency at using assets. The higher asset turnover is, the better. Generally, companies with low profit margins, like Wal-Mart, have high asset turnover, while company's with high profit margins have low asset turnover.
Cash Conversion Cycle
(
The Cash Conversion Cycle
measures the company's cash management abilities. It approximates the average time between
when the company actually pays for materials, and when it collects cash on its
sales. A cycle time less than 30
days is considered good, while a cycle less than zero is great. It's
the metric I think is most important because, as you'll see,
it
Of course, it helps to know what each component of the CCC represents, and how they're calculated. Balance Sheet numbers we use in these calculations should be the average value for the year, so you should look at the prior year's Balance Sheet, compared to the current year's, and take the average values. We use average values because the Income Statement shows results over a period of time, while a Balance Sheet is simply a snapshot at the end of the year. Year-end Balance Sheet values don't always represent the activity that occurred during the period, therefore we take the average value, under the assumption that it's more representative.
I'll use Anheuser Busch's 2001 and 2002 results in the following examples.
Days Sales Outstanding (DSO)
DSO = Average Accounts Recievable / (Sales/365)
DSO represents the amount of time it takes the company to collect cash on its credit sales. Because most sales in today's world are made on credit, a company can take days, weeks, or months to collect the cash behind a the credit sale. The faster the company can collect the cash, the more efficient it is. Note that we divide the annual sales by 365 to give us the average daily sales.
Anheuser-Busch had receivables of $630.4 million and $620.9 million at the end of 2002 and 2001 respectively. The average receivables for the year were $625.7 million. Sales for 2002 were $13,566 million.
DSO = 625.7 / (13,566 / 365) = 16.8 days
It took an average of 16.8 days for Anheuser Busch to collect cash on its 2002 sales.
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Days Inventories Outstanding (DIO)
DIO = Average Inventories / (Cost
of Goods Sold/365)
DIO represents the amount of time it takes for the company to run through, or "turn", its inventory. We again divide the Income Statement item, Cost of Goods Sold, by 365 to get a daily value. The shorter a company's DIO, the sooner it turns inventory into sales, and therefore into cash.
At the end of 2002 and 2001, Anheuser-Busch's inventories were $563.6 million and $591.8 million, respectively, for an average of $577.7. Cost of Goods Sold for 2002 totaled $8,131 million.
DIO = 577.7 / (8,131 / 365) = 25.9 days
It took an average of 25.9 days for Anheuser-Busch to convert its raw materials into finished products, and therefore sales.
Days Payables Outstanding
(DPO)
DPO = Average Accounts Payable /
(Cost of Goods Sold/365)
DPO is the final piece of the Cash Conversion Cycle, and represents the time it takes a company to pay for the materials it has received. In contrast to DSO and DIO, a longer DPO is usually a good sign for a company, as it indicates an ability to hold off paying creditors in cash. This can cut two ways, though. If a company's DPO suddenly increases from previous years, it could mean the company isn't paying its bills, and is headed for a cash crunch. Keep an eye out for this.
Anheuser-Busch's Accounts Payable were $987 million and $945 million in 2002 and 2001, respectively, for an average of $966. Cost of Goods Sold for 2002 was $8,131 million, as noted previously.
DPO = 966 / (8,131 / 365) = 43.4 days
In 2002, it took Anheuser-Busch 43.4 days to pay suppliers in cash after receiving the materials.
Now that we've calculated all the pieces, let's see what Anheuser-Busch's Cash Conversion Cycle was for 2002.
Anheuser-Busch's Cash Conversion
Cycle is negative by just less than one day, which means the company essentially
collects cash on its sales the same day it pays for the materials. That's efficient cash
management!
Price to Earnings (P/E)
Stock Price / Earnings per Share
The P/E ratio is the most popular analysis tool, and can be found on any website that offers stock quotes. It represents the price you pay, as an investor, for $1 of the company's earnings. (When you calculate the P/E, use diluted earnings per share, as it's a more conservative number.)
Some analysts will use trailing twelve month earnings in the denominator, while others will use estimated future earnings. I prefer trailing earnings, because they're real, but future earnings are theoretically all that matters. Either way, the P/E is just another valuation measure, and its popularity stems from how easy it is to calculate. I don't put much stock in the P/E, and prefer cash flow measures, which we'll get to in a later issue.
Price to Sales (P/S)
Stock Price / Sales per Share
The P/S ratio is the same as the P/E, only it measures the price per $1 of sales. This was a popular measure during the tech boom of the late nineties, since many companies didn't have earnings to calculate a P/E. The P/S is another simple tool that's useful for general valuation, and comparison to other companies.
Times Interest Earned
EBIT* / Interest Expense
EBIT = Earnings before Interest and Taxes
Times Interest Earned, also known as the Interest Coverage Ratio, is an important liquidity measure used by many of the bond rating agencies. It simply calculates the number of times the company could pay its interest expense out of its EBIT. The higher this number, the more solvent a company is considered.
A ratio less than 2 calls into question a company's ability to make interest payments, and a ratio less than 1 means the company isn't generating enough earnings from operations to pay interest on its debt. A company in that position is only a few steps away from bankruptcy.
In 2002, Anheuser-Busch had EBIT of $2,980 and interest expense of $369 million. Times Interest Earned for Anheuser-Busch in 2002 was 8.1, indicating a very solvent company.
Return on Equity (ROE)
Net Income / Shareholder's Equity
Return on Equity calculates the percentage return on shareholder capital, and is used as a general indication of a company's profitability. ROE can be broken down into a number of component parts that give insight into the company's operations. We'll cover this breakdown in a later issue.
Anheuser-Busch had net income of $1,934 million, and shareholder equity of $3,052 million, for a return on equity of 63.4%.
If you have any questions about statement analysis, or any of the analysis tools presented here, drop me a line at chrismallon@dynamicinvestors.net.
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Thanks for your time this week. I hope you find these tips helpful as you make your way through the maze of financial data. Please take a few minutes to fill out the survey on the Dynamic Investors site, and feel free to forward this newsletter to a friend.
Sincerely,
Christopher M. Mallon
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How about the Required Reading?
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