Chapter 6
In This Chapter
Looking at the best research resources
Figuring out what those annual reports really mean
Deciphering 10-Ks, 10-Qs, and proxies
Placing stock trades
This chapter provides a crash course in researching individual companies and their stocks. Be sure you consider your reasons for taking this approach before you head down the path of picking and choosing your own stocks. If you haven’t already done so, take a look at Chapter 5 to better understand the process of purchasing stocks on your own.
If you decide to tackle the task of researching your own stocks, you don’t have to worry about finding enough information: The problem to worry about is information overload. You can literally spend hundreds of hours researching and reading information on one company alone. Therefore, you need to focus on where you can get the best bang for your buck and time.
If you were going to build a house, you probably wouldn’t try to do it on your own. Instead, you’d likely find some sort of kit or a set of plans drawn up by people who have built many houses. You can do the same when picking individual stocks. In the following sections, I highlight useful resources that allow you to hit the ground running when you’re trying to pick the best stocks. In addition to the resources I cover here, check out Part V for other useful resources for researching individual stocks.
The beauty of Value Line’s service is that it condenses the key information and statistics about a stock (and the company behind the stock) to a single page. Suppose you’re interested in investing in Starbucks, the retail coffeehouse operator. You’ve seen all its stores, and you figure that if you’re going to shell out more than $3 for a cup of its flavored hot water, you may as well participate in the profits and growth of the company. You look up the recent stock price (I explain how to do so later in this chapter if you don’t know how) and see that it’s about $75 per share.
Take a look at the important elements of the Value Line Investment Survey page for Starbucks in Figure 6-1.
This section of the report describes the business(es) that Starbucks participates in. You can see that Starbucks is the largest retailer of specialty coffee in the world. Although 88 percent of the company’s sales come from retail, note that 12 percent come from other avenues — such as mail-order, online, and supermarket sales. You also find details about joint ventures, such as Starbucks’ partnerships with Pepsi and Dreyer’s to develop and sell bottled coffee drinks and ice creams, respectively. This section also shows you that the senior executives and directors of the company own a sizeable stake (3.3 percent) of the stock; seeing that these folks have a financial stake in the success of the company and stock is a good thing.
A securities analyst (in this case, Justin Hellman) follows each Value Line Investment Survey stock. An analyst focuses on specific industries and follows a few dozen stocks. This section of the Value Line report provides the analyst’s summary and commentary of the company’s current situation and future plans.
The Value Line Investment Survey provides a numerical ranking for each stock’s Timeliness (expected performance) over the next year. One is highest and 5 is lowest, but only about 5 percent of all stocks receive these extreme ratings. A 2 rating is above average and a 4 rating is below average; about one-sixth of the ranked stocks receive each of these ratings. All remaining stocks — a little more than half of the total ranked — get the average 3 rating.
The Safety rating works the same way as the Timeliness rating, with 1 representing the best and least volatile stocks and the most financially stable companies. Five is the worst Safety ranking; it denotes the most volatile stocks and least financially stable companies.
Starbucks’ current ratings are 3 for Timeliness, which is average, and 2 for Safety, which is above average. I’ve never been a fan of predictions and short-term thinking. (One year is a very short period of time for the stock market.) However, historically, Value Line’s ranking system has held one of the best overall track records according to the Hulbert Financial Digest, which tracks the actual performance of investment newsletter recommendations. Even so, you shouldn’t necessarily run out and buy a particular stock because of its high ranking. Just keep in mind that higher-ranked stocks within the Value Line Investment Survey have historically outperformed those without such ratings.
The graph in Figure 6-1 shows you the stock price’s performance over the past decade or so. The highest and lowest points of the line on the graph indicate the high and low stock prices for each month. At the top of the graph, you see the year’s high and low prices. Starbucks stock has risen significantly since the company first issued stock in 1992, but Starbucks certainly has experienced some down periods. (The small box in the lower-right corner of the graph shows you the total return that an investor in this stock earned over the previous one, three, and five years and compares those returns to the average stock. The graph in Figure 6-1 shows you that Starbucks declined significantly from 2006 through 2008 but has since rebounded smartly.)
The graph also shows how the price of the stock moves with changes in the company’s cash flow (money coming in minus money going out). The solid line in the Starbuck’s graph represents 19.5 times the company’s cash flow. Over time, just as stock prices tend to track corporate profits, so, too, should they generally follow cash flow. Cash flow is an important measure of a company’s financial success and health — it’s different from net profits, which the company reports for tax purposes. For example, the tax laws allow companies to take a tax deduction each year for the depreciation (devaluation) of the company’s equipment and other assets. Although depreciation is good because it helps lower a company’s tax bill, subtracting it from the company’s revenue gives an untrue picture of the company’s cash flow. Thus, in calculating a company’s cash flow, you don’t subtract depreciation from revenue.
This section shows you 12 to 18 years of financial information on the company (in the case of Starbucks, you get information going back to just 1998). The two most helpful pieces of information in this section are
The book value of a bank, for example, can mislead you if the bank makes loans that won’t be paid back, and the bank’s financial statements don’t document this fact. All these complications with book value are one of the reasons full-time, professional money managers exist. (If you want to delve more into a company’s book value, you need to look at other financial statements, such as the company’s annual report, which I discuss in the section “Understanding Annual Reports” later in this chapter.)
This section tells you that Starbucks sells at a P/E (price-to-earnings ratio) of 27.9 because of its recent stock price and earnings. This particular P/E is higher than that of the overall market. (You can see that Starbucks’ P/E is 1.54 times that of the overall market.) To understand the importance of P/E in evaluating a stock, see Chapter 5.
This section summarizes the amount of outstanding stocks and bonds that the company possesses. Remember that when a company issues these securities, it receives capital (money). The most useful number to examine in this section is the company’s debt. If a company accumulates a lot of debt, the burden of interest payments can create a real drag on profits. If profits stay down for too long, debt can even push some companies into bankruptcy.
Figure 6-1 shows you that Starbucks has an outstanding debt of $2,048 million. But how do you know if this is a lot, a little, or just the right amount of debt?
Possessing a larger cushion to cover debt is more important when the company’s business is volatile. You can calculate total interest coverage, which compares a company’s annual profits to the yearly interest payments on its total debt. This number tells you the number of years that the company’s most recent annual profits can cover interest on all the company’s debt.
For example, if a company has a total interest coverage of 4.5x, the company’s most recent yearly profits can cover the interest payments on all debt for about 4½ years. Starbucks’ most recent annual profits of $1,722 million dwarf its interest payments of $60 million by a factor of more than 28 to 1. Warning signs for total interest coverage numbers include a steep decline in this number over time and profits that cover less than one year’s worth of interest.
This section provides a quick look at how the company’s current assets (assets that the company can convert into cash within a year relatively easily) compare with its current liabilities (debts due within the year). Trouble may be brewing if a company’s current liabilities exceed or are approaching its current assets.
This nifty section can save wear and tear on your calculator. The good folks at Value Line calculate rates of growth (or shrinkage) on important financial indicators, such as sales (revenues) and earnings (profits) over the past five and ten years. This section also lists Value Line’s projections for the next five years.
For the most recent years, the Value Line Investment Survey shows you an even more detailed quarterly breakout of sales and profits, which may disclose changes that annual totals mask. In this section of the report, you can also see the seasonality of some businesses. Starbucks, for example, tends to have its slowest quarter in the winter (quarter ending March 31). This trend makes sense if you figure that many of the customers who frequent Starbucks’ coffee shops do so as they walk around town, which people tend to do less of on blustery winter days.
If you’re going to invest in individual stocks, you need a brokerage account. In addition to offering low trading fees, the best brokerage firms allow you to easily tap into useful research, especially through the firm’s website, that you can use to assist you with your investing decisions.
Because discount brokers aren’t in the investment banking business of working with companies to sell new issues of stock, discount brokers have a level of objectivity in their research reports that traditional brokers (ones like Merrill Lynch, Morgan Stanley, and so on) too often lack. Some discount brokers, such as Charles Schwab, produce their own research reports, but most discount brokers simply provide reports from independent third parties. See Chapter 9 for how to select a top-notch brokerage firm.
Mutual fund managers, for example, are required to disclose at least twice a year what stocks they hold in their portfolio. You can call the best fund companies and ask them to send their most recent semiannual reports that detail their stock holdings, or you can view those reports on many fund companies’ websites. (See Chapter 8 for more information on the best stock mutual funds.)
Through its website, Morningstar (www.morningstar.com) allows you to see which mutual funds hold large portions of a given stock that you may be researching and what the success or lack thereof is of the funds that are buying a given stock.
Finally, you can follow what investment legend Warren Buffett is buying through his holding company, Berkshire Hathaway. If you’d like to review Berkshire’s complete corporate filings on your own, visit the Securities and Exchange Commission website at www.sec.gov.
Many publications and websites cover the world of stocks. But you have to be careful. Just because certain columnists or publications advocate particular stocks or investing strategies doesn’t mean you’ll achieve success by following their advice.
After you review the Value Line Investment Survey page on a company and want to dig further into financial documents, the next step is to ask yourself why. Why do you want to torture yourself so?
After successfully completing one of the better MBA programs (Stanford’s), taking more than my fair share of accounting and finance courses, and then living and working in the real world, I’ve gotten to know investment managers and financial analysts who research companies. Although some financial documents aren’t that difficult to read (I show you how in this section), interpreting what they mean in respect to a company’s future isn’t easy.
The first of such useful documents that companies produce is the annual report. This yearly report provides standardized financial statements as well as management’s discussion about how the company has performed and how it plans to improve its performance in the future. If you’re a bit of the skeptical sort, as I am, you may think, “Aren’t the company’s officials going to make everything sound rosy and wonderful?”
To a certain extent, yes, but not as badly as you may think, especially at companies that adhere to sound accounting principles and good old-fashioned ethics. First, a large portion of annual reports include the company’s financial statements, which an accounting firm must audit. However, audits don’t mean that companies and their accounting firms can’t (often legally) structure the company’s books to make them look rosier than they really are. And some companies have pulled the wool over the eyes of their auditors, who then become unwitting accomplices in producing false financial figures.
Also keep in mind that more than a few companies have been sued for misleading shareholders with inflated forecasts or lack of disclosure of problems. Responsible companies try to present a balanced and, of course, hopeful perspective in their annual reports. Most companies’ annual reports are also written by non-techno geeks, so you have a decent chance of understanding them.
The following sections walk you through the three main elements of the standard annual report: financial and business highlights, the balance sheet, and the income statement.
The first section of most annual reports presents a description of a company’s recent financial highlights and business strategies. You can use this information to find out about the businesses that the company is in and where the company is heading. For example, in Figure 6-1, the Value Line Investment Survey report mentions that Starbucks is also in the specialty sales business. Starbucks’ annual report can provide more detail about that specialty sales business.
Okay, enough about the coffee business; it’s time to expose you to another industry. T. Rowe Price is a publicly traded investment management company that offers some good mutual funds.
You can find a company’s hard-core financials in the back portion of most annual reports. (You can find many of these same numbers in Value Line Investment Survey reports, but you get more specific details in the company’s annual report.) All annual reports contain a balance sheet, which is a snapshot summary of all the company’s assets (what the company owns) and liabilities (what the company owes). The balance sheet covers the company’s assets and liabilities from the beginning of the year to the last day of the company’s year-end, which is typically December 31. Some companies use a fiscal year that ends at other times of the year.
A company’s balance sheet resembles a personal balance sheet. The entries, of course, look a little different because you likely don’t own things like manufacturing equipment. Figure 6-2 shows a typical corporate balance sheet.
The assets section of the balance sheet lists the following items that a company holds or owns that are of significant value:
As companies grow, their accounts receivable usually do, too. Watch out for cases where the receivables grow faster than the sales (revenue). This growth may indicate that the company is having problems with its products’ quality or pricing. Unhappy customers pay more slowly or demand bigger price discounts.
Companies can’t put a value on the goodwill that they’ve generated, but when they purchase (acquire) another firm, some of the purchase price is considered goodwill. Specifically, if a company is acquired for $100 million but has a net worth (assets minus liabilities) of just $50 million, the extra $50 million goes to goodwill. The goodwill then becomes an asset on the acquiring company’s balance sheet.
Manufacturing and retail companies also track and report inventory (the product that hasn’t yet been sold) as an asset. Generally speaking, as a business grows, so does its inventory. If inventory grows more quickly than revenue, such growth may be a warning sign. This growth can indicate that customers are scaling back purchases and that the company miscalculated and overproduced. It can also be a leading indicator of an obsolete or inferior product offering.
This section of the balance sheet summarizes all the money that a company owes to other entities:
If accounts payable increase faster than revenue, the company may have a problem. On the other hand, that increase can also be a sign of good financial management. The longer you take to pay your bills, the longer you have the money in your pocket working for you.
The difference between a company’s assets and liabilities is known as stockholders’ equity. Stockholders’ equity is what makes balance sheets always balance.
The other big financial statement in an annual report is the income statement (see Figure 6-3 for a T. Rowe Price income statement). I discuss the elements of a corporate income statement next.
Revenue is simply the money that a company receives from its customers as compensation for its products or services. Just as you can earn income from your job(s) as well as from investments and other sources, a company can make money from a variety of sources. In the case of mutual fund provider T. Rowe Price, the firm collects fees (investment advisory and administrative) for the mutual fund investments that it manages on behalf of its customers as well as privately managed money for wealthy individuals and institutions. The company also receives income from its own money that it has invested.
For companies with multiple divisions or product lines, the annual report may detail the revenue of each product line in a later section. If it doesn’t, check out some of the other financial statements that I recommend in the next section, “Exploring Other Useful Corporate Reports.” Examine what spurs or holds back the company’s overall growth and which different businesses the company operates in. Look for businesses that were acquired but don’t really fit with the company’s other business units as a red flag. Large companies that have experienced stalled revenue growth sometimes try to enter new businesses through acquisition but then don’t manage them well because they don’t understand the keys to their success.
Just as personal income taxes and housing, food, and clothing expenses gobble up much of your personal income, company expenses use up much, and sometimes all, of a company’s revenue.
Even healthy, growing businesses can get into trouble if their expenses grow faster than their revenues. Well-managed companies stay on top of their expenses during good and bad times. Unfortunately, it’s easy for companies to get sloppy during good times.
T. Rowe Price’s total operating expenses relative to total revenues have decreased, while profits (net operating income) relative to total revenues have increased. Not all expense categories necessarily decrease.
The net result of expenses that increase more slowly than revenues is a fatter bottom line. Sometimes companies experience one-time events, such as the sale of a division, which can change profits temporarily. Companies usually list these one-time events in the section under expenses.
Last but not least, and of great importance to shareholders, is the calculation of earnings per share. Higher profits per share generally help fuel a higher stock price, and declining profits feed falling stock prices. Remember, though, that smart financial market participants are looking ahead, so if you run out to buy stock in a company that’s reporting higher profits, those higher profits are old news and likely have already been priced into the company’s current market value.
In addition to annual reports, companies produce other financial statements, such as 10-Ks, 10-Qs, and proxies, that you may want to peruse. You can generally obtain these reports from the companies’ websites, from the companies’ investor relations departments, or from the Securities and Exchange Commission website, www.sec.gov (see Chapter 19 for more on this site).
10-Ks are expanded versions of the annual report. Most investment professionals read the 10-K rather than the annual report because the 10-K contains additional data and information, especially for a company’s various divisions and product lines. Also, 10-Ks contain little of the verbal hype that you find in most annual reports. In fact, the 10-K is probably one of the most objective reports that a company publishes. If you’re not intimidated by annual reports or if you want more company meat, read the 10-Ks from the companies you want to check out.
10-Qs provide information similar to the 10-K but on a quarterly basis. 10-Qs are worth your time if you like to read reasonably detailed discussions by management of the latest business and financial developments at a certain company. However, I recommend leaving the research to Value Line’s analysts (see the earlier section “Discovering the Value Line Investment Survey”).
The financial data in 10-Qs is unaudited and not of great use for the long-term investor. But if you want to watch your investments like a hawk and try to be among the first to detect indications of financial problems (easier said than done), this report is required reading.
The final corporate document that you may want to review is the annual proxy statement, which companies send out to their shareholders in advance of their annual meeting. The proxy statement contains some of the more important financial information and discussions that you can find in the 10-K. It also contains information on other corporate matters, such as the election of the board of directors. (Directors — who are usually corporate executives, lawyers, accountants, and other knowledgeable luminaries — serve as sounding boards, counselors, and sometimes overseers to the management team of a company.)
The proxy statement becomes much more important when a company faces a takeover or some other controversial corporate matter, such as the election of an alternative board of directors. As a shareholder, you get to vote on proposed board members and on select other corporate issues, which you can read about in the proxy statement.
The proxy statement tells you who serves on the board of directors as well as how much they and the executives of the company are paid. At annual meetings, where the board of directors discusses proxy statements, shareholders sometimes get angry and ask why the executives are paid so much when the company’s stock price and business underperform.
There’s always a chorus of self-anointed gurus saying that you can make fat profits if you pick your own stocks.
Keep the amount that you dedicate to individual stock investments to a minimum — ideally, no more than 20 percent of your invested dollars. I encourage you to do such investing for the educational value and enjoyment that you derive from it, not because you smugly think you’re as skilled as the best professional money managers. (If you want to find out more about analyzing companies, read the chapters in Part IV on small business as well as the chapters in Part V on investing resources.)
Just about every major financial and news site on the Internet offers stock quotes for free as a lure to get you to visit the site. To view a stock price quote online, all you need is the security’s trading symbol (which you obtain by using the stock symbol look-up feature universally offered with online quote services). Most major newspapers print a listing of the prior day’s stock prices. Daily business papers, such as The Wall Street Journal and Investor’s Business Daily, also publish stock prices daily.
Cable business channels, such as Bloomberg, CNBC, and Fox Business, have stock quotes streaming across the bottom of the screen. You can stop by a local brokerage office and see the current stock quotes whizzing by on a long, narrow screen on a wall. Many brokerage firms also maintain publicly accessible terminals (that look a lot like personal computers) on which you can obtain current quotes.
The following table is a typical example of the kinds of information that you can find in daily price quotes in papers and online; the quotes in this table are for the information technology giant International Business Machines (also known as Big Blue or IBM). After the name of the company, you see the trading symbol, IBM, which is the code that you and brokers use to look up the price on computer-based quotation systems.
International Business Machines (IBM) | |
52-wk range |
172.19 – 211.98 |
Last trade |
4:00 pm EST (196.47) |
Change |
+1.36 (+0.70%) |
Day’s range |
194.35 – 196.86 |
Open |
194.38 |
Volume |
4,211,284 |
P/E ratio |
13.4 |
Mkt cap |
198.4B |
Div/Shr |
3.80 |
Yield |
2.00% |
Here’s a breakdown of what the information in this table means:
Now you know how to read stock quotes!
Numerous companies sell their stock directly to the public. Proponents of these direct stock purchase plans say that you can invest in stocks without paying any commissions. Well, the commission-free spiel isn’t quite true, and investing in such plans poses other challenges.
If you want to purchase directly from Home Depot, for example, you need a minimum initial investment of $500. Buying stock “direct” isn’t free; in the case of Home Depot, for example, you have to pay a $5 enrollment fee. Although that may not sound like much on a $500 investment, $5 represents 1 percent of your investment. For subsequent purchases, you pay 5 percent up to a maximum of $2.50 per purchase plus 5 cents per share.
If you want to sell your shares, you have to pay a fee to do that, too — $10 plus 15 cents per share. Overall, these fees compare to what you would pay to buy stock through a discount broker (see Chapter 9 for details). In some cases, these fees are actually higher! For example, you can reinvest dividends at no cost through many discount brokers.
Some direct stock purchase plans entail even more hassle and cost than the type I just discussed. With other plans, you must buy your initial shares through a broker and then transfer your shares to the issuing company in order to buy more! Also, you can’t pursue most direct stock purchase plans within retirement accounts.
Unless you decide to buy stock directly, you generally need a broker. As I explain in Chapter 9, discount brokers are the best way to go — they take your orders and charge far less than conventional brokerage firms, which generally pay their brokers on commission.
After you decide which discount broker you want to use (again, I provide all the info you need to make this decision in Chapter 9), request (by phone or via the Internet) an account application package for the type of account that you desire (non-retirement, IRA, Keogh, and so on). Complete the forms (call the firm’s toll-free number or visit a branch office if you get stuck) and mail or take them back to the discounter.
When you’re ready to place your order, simply call the discount broker and explain what you want to do (or use your touch-tone phone or computer to place your order). You have two options: