Question

 

1. Please develop a brief decision-making process to make a recommendation for evaluating a stock (publicly traded) – buy.

2. Now, develop a brief decision-making process to make a recommendation for evaluating a stock (publicly traded) - sell.

3. You are a fresh analyst hired by the CFO of a small to midsized company. She is aware of the fact you wrote a paper of Financial Statement analysis and wants to check your financial knowledge as well as common sense: There are two firms, A and B. A is a healthy, well -funded and profitable firm. B, on the other hand, is cash starved, facing potential (but not yet) bankruptcy. She has information about the following classes of ratios for both firms: Liquidity, Asset Management, Debt Management, Profitability and Market Value Ratios. She said to you,” I don’t have time to look at all these ratios, I would like you to rank order three classes of ratios in each case (One ranking for firm A and another ranking for firm B) based on the particular situation each firm is in (healthy vs. failing). I understand that the two sets could be quite different. I would like you to explain why you choose that particular rank ordering in each case. While ranking, you may simply indicate the class of ratios (for example, profitability), rather than a specific ratio within that class, such as Return on Assets (ROA).”

Answer 1

• The most common measure of a stock is the price/earnings, or P/E ratio, which takes the share price and divides it by a company's annual net income.
• Generally, stocks with P/Es higher than the broader market P/E are considered expensive, while lower-P/E stocks are considered not so expensive.
• Don't automatically go for stocks with low P/Es simply because they are cheaper. Cheap stocks aren't always good stocks.

  Evaluating Stocks

  When you buy a stock, you're buying part ownership of a company, so the questions to ask as you select among the stocks you're considering are the same questions you'd ask if you were buying the whole company:

• What are the company's products?
• Are they in demand and of high quality?
• Is the industry as a whole doing well?
• How has the company performed in the past?
• Are talented, experienced managers in charge?
• Are operating costs low or too high?
• Is the company in heavy debt?
• What are the obstacles and challenges the company faces?
• Is the stock worth the current price?

• Because each company is a different size and has issued a different number of shares, you need a way to compare the value of different stocks. A common and quick way to do this is to look at the stock's earnings. All publicly traded companies report earnings to the Securities and Exchange Commission on a quarterly basis in an unaudited filing known as the 10-Q, and annually in an audited filing known as the 10-K.Even though P/E is the most widely quoted measure of stock value, it's not the only one. You'll also see stock analysts discussing measures such as ROA (return on assets), ROE (return on equity), and so on. While all of these acronyms may seem confusing at first, you may find, as you get to know them, that they can help answer some of your questions about a company, such as how efficient it is, how much debt it's carrying, and so on. 2ans)

  Here are the top twenty factors that go into the Evaluator, with a word of explanation about each.

• Projected earnings growth. This is a combination of four measures: the percent change between the current quarter’s earnings estimate and the same quarter last year; the percent change between this fiscal year’s earnings estimate and that of the most recent fiscal year; the company’s profit margin (with lower numbers better); and the company’s return on assets (with lower numbers better). These last two measures appear counterintuitive, but note that I’m not ranking based on weak earnings but on the potential for strong earnings, which can lead to earnings surprises and upward price movement. See my article on this here.
• Sales growth, acceleration, and stability. I use some complex formulae to look for companies whose sales don’t jump around a lot from quarter to quarter, whose year-to-year sales growth is above average but not unsustainably high, but whose recent sales growth is accelerating. Like the previous factor, this is a combination of four different measures, each of which works well on its own.
• Price to sales. This metric, especially when looked at in combination with other value ratios, has long been invaluable for comparing companies in the same industry; Jim O’Shaughnessy discussed it well in What Works on Wall Street. I look at both actual sales and projected sales (analyst estimates).
• Dividend yield, dividend growth, earnings yield, and payout ratio. Using several formulae I compare the indicated annual dividend to the dividend paid last year; calculate the dividend yield and the earnings yield; examine five-year dividend growth; and look at the payout ratio (dividends paid to net income). Companies that pay no dividends get ranked right in the middle between companies with good dividend practices and those with bad (for example, those whose dividend payments exceed their income).
• Low net operating assets. I look at the ratio of net operating assets to total assets. See my article on this measure here.
• Low accruals. I look at the two basic measures of accruals: cash flow accruals, which is the ratio of net income minus operating cash flow to total assets; and balance sheet accruals, which is the change in net operating assets divided by average total assets. I look not only at the last year, but at the last three years too.
• The ratio of R&D expenses to market cap, with higher numbers better. This is a very unusual metric that surprised me when I learned about it. I use it only for stocks in certain sectors; my testing has confirmed that it’s a terrific value ratio for those stocks. Indeed, a paper published in The Journal of Finance back in 2002 found that “companies with high R&D to equity market value (which tend to have poor past returns) earn large excess returns.”
• Gross profit to enterprise value. My backtests have shown that this is another terrific measure of value. I look mostly at the last three years, but weight it more heavily on the last year.
• Low share turnover. The ratio of share volume to float is a great measure of volatility. A recent study has demonstrated a very good correlation between beta and share turnover. I plan to devote a future article to this measure.
• Price to tangible book value. This is an especially valuable measure for companies in the financial sector, but it can profitably be applied to other companies as well.
• Operating margin stability. Companies that are growing their income but shrinking their sales are companies to avoid. Companies that are growing their sales but shrinking their income are also companies to avoid. I favor companies whose sales growth and operating income growth are in sync. See my article on this measure here.
• Low short interest. I compare this to other companies in the same industry. Especially in the world of small caps, strong short interest can be a real sign of trouble ahead.
• Accounting stability. I look primarily at the difference between last year’s cash conversion cycle and this year’s—that difference should be minimal. But I also look at the ratio of the change in accounts receivables to sales. Companies with unstable accounting can be unsafe investments.
• Low price volatility. Technically, this should be called price variability, but everyone calls it volatility these days. (Properly speaking, volatility is beta.) This is simply the standard deviation of daily price returns.
• Unlevered free cash flow to enterprise value. The basis for discounted cash flow valuation, this is an extremely important but often overlooked ratio; my research indicates that it works a lot better than the more common EV/EBITDA. Once again I look at both three-year and one-year figures.