Learn Stocks (Part 2)

A Breakdown of Stock Buybacks

There are a number of ways in which a company can return wealth to its shareholders. Although stock price appreciation and dividends are the two most common ways of doing this, there are other useful, and often overlooked, ways for companies to share their wealth with investors. In this article, we will look at one of those overlooked methods: share buybacks. We’ll go through the mechanics of a share buyback and what it means for investors.
The Meaning of Buybacks
A stock buyback, also known as a "share repurchase", is a company's buying back its shares from the marketplace. You can think of a buyback as a company investing in itself, or using its cash to buy its own shares. The idea is simple: because a company can’t act as its own shareholder, repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. When this happens, the relative ownership stake of each investor increases because there are fewer shares, or claims, on the earnings of the company.
Typically, buybacks are carried out in one of two ways:

1. Tender Offer
Shareholders may be presented with a tender offer by the company to submit, or tender, a portion or all of their shares within a certain time frame. The tender offer will stipulate both the number of shares the company is looking to repurchase and the price range they are willing to pay (almost always at a premium to the market price). When investors take up the offer, they will state the number of shares they want to tender along with the price they are willing to accept. Once the company has received all of the offers, it will find the right mix to buy the shares at the lowest cost.

2. Open Market
The second alternative a company has is to buy shares on the open market, just like an individual investor would, at the market price. It is important to note, however, that when a company announces a buyback it is usually perceived by the market as a positive thing, which often causes the share price to shoot up.

Now let’s look at why a company would initiate such a plan.

The Motives
If you ask its management, they’ll likely tell you that a buyback is the best use of capital at a particular time. After all, the goal of a firm's management is to maximize return for shareholders, and a buyback generally increases shareholder value. The prototypical line in a buyback press release is "we don't see any better investment than in ourselves". Although this can sometimes be the case, this statement is not always true.

Nevertheless, there are still sound motives that drive companies to repurchase shares. For example, management many feel the market has discounted its share price too steeply. A stock price can be pummeled by the market for many reasons like weaker-then-expected earnings results, an accounting scandal or just a poor overall economic climate. Thus, when a company spends millions of dollars buying up its own shares, it says management believes that the market has gone too far in discounting the shares - a positive sign.

Improving Financial Ratios
Another reason a company might pursue a buyback is solely to improve its financial ratios – metrics upon which the market seems to be heavily focused. This motivation is questionable. If reducing the number of shares is not done in an attempt to create more value for shareholders but rather make financial ratios look better, there is likely to be a problem with the management. However, if a company’s motive for initiating a buyback program is sound, the improvement of its financial ratios in the process may just be a byproduct of a good corporate decision. Let’s look at how this happens.

First of all, share buybacks reduce the number of shares outstanding. Once a company purchases its shares, it often cancels them or keeps them as treasury shares, and reduces the number of shares outstanding in the process.

Moreover, buybacks reduce the assets on the balance sheet (remember cash is an asset). As a result, return on assets (ROA) actually increases because assets are reduced; return on equity (ROE) increases because there is less outstanding equity. In general, the market views higher ROA and ROE as positives. (See Reading The Balance Sheet.)

Suppose a company repurchases one million shares at $15 per share for a total cash outlay of $15 million. Below are the components of the ROA and earnings per share (EPS) calculations and how they change as a result of the buyback.

As you can see, the company’s cash hoard has been reduced from $20 million to $5 million. Because cash is an asset, this will lower the total assets of the company from $50 million to $35 million. This then leads to an increase in its ROA, even though earnings have not changed. Prior to the buyback, its ROA was 4% ($2 million/$50 million) but after the repurchase, ROA increases to 5.71% ($2 million/$35 million). A similar effect can be seen in the EPS number, which increases from $0.20 ($2 million/10 million shares) to $0.22 ($2 million/9 million shares).

The buyback also helps to improve the company’s price-earnings ratio (P/E). The P/E ratio is one of the most well-known and often-used measures of value. At the risk of oversimplification, when it comes to the P/E ratio, the market often thinks lower is better. Therefore, if we assume that the shares remain at $15, the P/E ratio before the buyback is 75 ($15/$0.2); after the buyback, the P/E decreases to 68 ($15/$0.22) due to the reduction in outstanding shares. In other words, fewer shares + same earnings = higher EPS!

Based on the P/E ratio as a measure of value, the company is now less expensive than it was prior to the repurchase despite the fact there was no change in earnings.


Dilution
Another reason that a company may move forward with a buyback is to reduce the dilution that is often caused by generous employee stock option plans (ESOP). (See Option Compensation - Part 1, Part 2 and The “True” Cost Of Stock Options.)

Bull markets and strong economies often create a very competitive labor market - companies have to compete to retain personnel and ESOPs comprise many compensation packages. Stock options have the opposite effect of share repurchases, as they increase the number of shares outstanding when the options are exercised. As was seen in the above example, a change in the number of outstanding shares can affect key financial measures such as EPS and P/E. In the case of dilution, it has the opposite effect of repurchase: it weakens the financial appearance of the company.

Continuing with the previous example, let’s assume, instead, that the shares in the company had increased by one million. In this case, its EPS would have fallen to $0.18 per share from $0.20/share. After years of lucrative stock option programs, a company may feel the need to repurchase shares to avoid or eliminate excessive dilution.

Tax Benefit
In many ways, a buyback is similar to a dividend because the company is distributing money to shareholders. Traditionally, a major advantage that buybacks had over dividends was that they were taxed at the lower capital-gains tax rate, whereas dividends are taxed at ordinary income tax rates. However, with the passing of the Jobs and Growth Tax Relief Reconciliation Act of 2003, the tax rate on dividends is now equivalent to the rate on capital gains.

Conclusion
Are share buybacks good or bad? As is so often the case in finance, the question may not have a definitive answer. If a stock is undervalued and a buyback truly represents the best possible investment for a company, the buyback - and its effects - can be viewed as a positive sign for shareholders. Watch out, however, if a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price or to get out from under excessive dilution.
Finding Profit In Troubled Stocks

Contrarian investors will tell you that the biggest profits come from buying beaten down stocks that eventually turn around. But investing in companies that have seen their share price plummet can be tricky and full of risk; after all, a lot of companies that fall down never get back up.

Spotting a troubled company with the potential to right itself can indeed be profitable. Consider Hilton Hotels (HLT). In late 2001, terrorism fears had an adverse effect on the travel and hotel industries. Its stock value collapsed. But this proved to be a superb time to buy Hilton stock. Within a year, Hilton management turned the company around. As we can see in the chart below, between the end of 2001 and 2004, Hilton stock delivered more than 250% return to investors. On Dec 31, 2001, HLT closed at only $10.92. Three years later, on Dec 31, 2004, HLT was trading at $22.74.

Then again, troubled companies can also spell trouble for investors. The same terrorism fears that knocked down Hilton also hit UAL, the parent of United Airlines. But the airline was unable to make a turnaround, and UAL declared bankruptcy in 2002. Its investors were left with worthless shares. While the stock continues to trade on the OTCBB, its value has been crushed.

Investing in troubled companies requires careful analysis to distinguish the stocks that will rise again from those that will never move off the bottom. Here are a few guidelines that can help you separate temporarily troubled stocks from the permanently down-and-out.

Diagnosis
When analyzing companies that have seen their share price plunge, start by identifying the problem(s) facing the company. Normally, there are two sources of trouble:

1. Poor operating performance, resulting in a downturn in earnings or cash flow. When assessing operating results, turn to the company's income statement and cash flow statements. Revenues, operating income and operating cash flow that decrease quarter after quarter are strong signs of operating weakness.

2. Stretched financial position, resulting in excessive debt. You can find out about a company's debt level, or leverage, from its balance sheet. Escalating debt levels are rarely a promising sign. The debt-to-equity ratio offers one of the clearest pictures of a company's leverage. (To learn more about the debt-to-equity ratio, see Debt Reckoning.) The debt-equity formula is straightforward:

Debt-to-Equity = Total Liabilities / Shareholder Equity

A high debt-to-equity ratio translates into higher risk for shareholders.

It is possible for a troubled company to have a reasonably solid balance sheet, while its operating results experience a serious decline. This was the situation at Hilton. While the company's debt-to-equity level remained in the normal range for hoteliers, its earnings shrank over several quarters after Sept 11, 2001.

By contrast, UAL suffered from a combination of poor operating performance and excessive debt. Long-term debt at UAL was $700 million at the end of 2002 with accounts payable equal to $4 billion. Its 2002 cash and cash equivalents of $1.3 billion were absorbed by interest expenses and accounts payable. Its continued poor operating performance as a result of the downturn following Sept 11, 2001, meant lower revenue and an inability to finance debt.

Prognosis
Once the problem has been spotted, you'll want to know whether the company has the wherewithal to overcome it. Does the company have the financial strength to survive until it can turn itself around?

As Hilton's experience shows, poor operating performance can be remedied, provided the company has sufficient cash and assets on its balance sheet to tide it over while it is making a turnaround.

Going back to Hilton's Q4 2001 balance sheet, the company had $35 million cash, giving management the time and flexibility to survive the industry-wide downturn and reorganize its business. At the time, Hilton owned valuable real estate that offered a cushion against cash flow strains due to the revenue slump. Although you won't find brand assets listed on the balance sheet, the Hilton brand name is likely to have given it a competitive advantage. The sale of some of the company's less profitable properties also provided some cash flow to help make ends meet.

A weak balance sheet can be remedied too, provided the company's business is still viable. Troubled companies with strong core businesses are almost always restructured, by using cash flow from operations to pay down debt.

But if the company suffers from both anemic operating performance and a flimsy balance sheet, like UAL, a turnaround is much tougher to accomplish. The company had to grapple with not only a severe slump in air passenger traffic in the wake of Sept 11, 2001, but also a slowing domestic economy amid rising costs and increased competition. Looking at UAL's income statements after 2000, you'll notice falling revenues and a string of deepening quarterly losses. UAL's balance sheets over the same period point to mounting debt levels.

Price Matters
Valuation is critical when contemplating investing in beaten down stocks. Remember, there is a big chance that a turnaround may never come, so it's always best to identify stocks that are trading well below their net asset value (NAV). Book value offers one of the simplest and safest methods for valuing stocks that have seen their share price tank.

The book value, or NAV, roughly represents what shareholders would receive if the company were liquidated. When a stock trades at a price less than its book value, the market is essentially saying that the company is worth more broken up and sold off than as a single operating business. So, buying a troubled stock at less than book value minimizes your investment risk. The formula for calculating book value is:

Book Value = Assets – Liabilities


Bankruptcy Beware
As a general rule, you should steer clear of companies that are in the process of filing or that have filed for bankruptcy. The bankruptcy process can be very complicated. If you're a shareholder, what you need to know is fairly simple: holders of common shares go to the bottom of the list of creditors when the assets of a corporation get divvied up in Chapter 11 or Chapter 7 liquidations. (For further reading, see An Overview of Corporate Bankruptcy.)

To be sure, a company can emerge from bankruptcy stronger - and more profitable. But the "new" company will issue "new" stock, so any stock purchased before it emerges from bankruptcy usually has no value. Moreover, the information flow from companies in bankruptcy proceedings can be very unreliable.

Conclusion
You can never know for sure whether a pummeled or troubled stock will ever recover. However, there are some ways of distinguishing those companies that will make a turnaround from those destined for the dustbin. When analyzing troubled stocks, investors should steer clear of companies with a weak balance sheet and poor operating performance.
Spotting Cash Cows
Cash cows are just what the name implies - companies that can be milked for further ongoing profits with little expense. Producing plenty of cash, these companies can reinvest in new systems and plants, pay for acquisitions and support themselves when the economy slows. They have the capacity to increase their dividend or reinvest that cash to boost returns further. Either way, shareholders stand to benefit. To help you spot cash cows that are worthy of your investment, we look at what sets these companies apart and offer some guidelines for assessing them.
The Cash Cow: An Overview
A cash cow is a company with plenty of free cash flow - that is, the cash left over after the company meets its necessary yearly expenses. Smart investors really like this kind of company because it can fund its own growth and value. A cash cow can reinvest free cash to grow its own business - thereby boosting shareholder returns - without sacrificing profitability or turning to shareholders for additional capital. Alternatively, it can return the free cash flow to shareholders through bigger dividend payments or share buybacks.

Cash cows tend to be slow-growing, mature companies that dominate their industries. Their strong market share and competitive barriers to entry translate into recurring revenues, high profit margins and robust cash flow. Compared to younger companies - which tend to reinvest their profits more aggressively to fuel future growth - more mature businesses (with less room for growth) often generate more free cash since the initial capital outlay required to establish their businesses has already been made.

Finally, a cash cow can often be a tempting takeover target. If a cash cow company seems like it can no longer use its excess cash to boost value for shareholders, it is likely to attract acquirers that can. (For more on what this means, see The Basics of Mergers and Acquisitions.)

The Life of the Cash Cow: Free Cash Flow
To see if a company is worthy of cash-cow status, you of course need to calculate its free cash flow. To do so, you take cash from operations and subtract capital expenditures for the same period:

Free Cash Flow = Cash Flow from Operations - Capital Expenditure

(For more on calculating free cash flow, see Free Cash Flow: Free, But Not Always Easy.)

The more free cash the company produces the better. A good rule of thumb is to look for companies with free cash flow that is more than 10% of sales revenue.

Consumer products giant Procter & Gamble (PG), for example, fits the cash cow mold. Procter & Gamble's brand name power and its dominant market share have given it its cash-generating power. Take a look at the company's Form 10-K 2004 Annual Report's (filed on Sept 9, 2004) Consolidated Statement of Cash Flows (scroll to sec. 39, p.166). You'll see that the company consistently generated high free cash flows - these even exceeded its reported net income: at end-2004, Procter & Gamble's free cash flow was $7.34 billion (operating cash flow - capital expenditure = $9.36B - $2.02B), or more than 14% of its $51.4 billion sales revenue (net sales on the Consolidated Statements of Earnings). In 2004, PG produced real cash for its shareholders - a lot of it.

Cows That Stand Apart from the Herd: Price and Efficiency
A Low Cash Flow Multiple
Once you've spotted a cash cow stock, is it worth buying? For starters, look for companies with a low free cash flow multiple: simply, divide the company's stock price (more precisely, its market capitalization) by its underlying free cash flow. With that calculation, you can compare how much cash power the share price buys - or, conversely, you see how much investors pay for one dollar of free cash flow.

To find PG's free cash flow multiple, we'll look at its stock price on the day it filed its 2004 10-K form, which was Sept 9, 2004. On that day, the stock closed at $56.09 (see PG's trading quote that day on Investopedia's stock research resource). With about 2.5 billion shares outstanding, Procter & Gamble's market value was about $140.2 billion.

So, at the financial year-end 2004, PG was trading at about 19 times its current free cash flow ($140.2 billion market value divided by 2004 free cash flow of $7.34 billion). By comparison, direct competitor Unilever traded at about 25 times free cash flow, suggesting that Procter & Gamble was reasonably priced.

Free cash flow multiples are a good starting point for finding reasonably priced cash cows. But be careful: sometimes a company will have a temporarily low free cash flow multiple because its share price has plummeted due to a serious problem. Or its cash flow may be erratic and unpredictable. So, take care with very small companies and those with wild performance swings.

High Efficiency Ratios
Besides looking for low free cash flow multiples, seek out attractive efficiency ratios. An attractive return on equity (ROE) can help you ensure that the company is reinvesting its cash at a high rate of return.

Return on Equity = (Annual Net Income / Average Shareholders' Equity)

You can find net income (also known as "net earnings") on the income statement (also known as "statement of earnings"), and shareholders' equity appears near the bottom of a company's balance sheet.


On this front, PG performed exceedingly well. The company's 2004 net earnings was $6.5 billion - see the Consolidated Statement of Earnings p.35 (p.161 in the PDF) on the 10-K - and its shareholders' equity was $17.28 billion - see the Consolidated Balance Sheets p.37 (p.163 in the PDF). That means ROE amounted to nearly 38%. In other words, Procter & Gamble was able to milk 38 cents worth of profits from each dollar invested by shareholders. (For more on evaluating this metric, see Keep Your Eyes On The ROE.)

To double check that the company is not using debt leverage to give ROE an artificial boost, you may also want to examine return on assets (ROA). (For more on this topic, see Understanding The Subtleties Of ROA Vs ROE.)

ROA = Return on Assets = (Annual Net Income / Total Assets)

Turning again to Procter & Gamble's 2004 Consolidated Statement of Earnings and Balance Sheets, you'll see that the company delivered an impressive 11.4% ROA (net earnings / total assets = $6.5B / $57.05B). An ROA higher than 5% is normally considered a solid performance for most companies. Procter & Gamble's ROA should have reassured investors that it was doing a good job of reinvesting its free cash flow.

Conclusion
Cash cows generate a heap of cash. That's certainly exciting, but not enough for investors. If they provide other attractions, such as high return on equity and return on assets, and if they trade at a reasonable price, then cash cows are worth a closer look.
Beta: Gauging Price Fluctuations


In investing, beta does not refer to fraternities, product testing or VHS' old competition - in investing, beta is a measurement of market risk, or volatility. It is because of this risk that some people don't want to invest in stocks. These risk-averse investors can't stomach stocks' greater tendency to fluctuate in price. Sure, there is always the possibility that a stock will lose some or all of its value, but volatility also makes it possible for investors to make a great deal of money - if they make the right choices.
What Is the Beta?
Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the overall market. In other words, it gives a sense of the stock's market risk compared to the greater market. Beta is used also to compare a stock's market risk to that of other stocks. Investment analysts use the Greek letter 'ß' to represent beta.

This measure is calculated using regression analysis. A beta of 1 indicates that the security's price tends to move with the market. A beta greater than 1 indicates that the security's price tends to be more volatile than the market, and a beta less than 1 means it tends to be less volatile than the market. Many utility stocks have a beta of less than 1, and, conversely, many high-tech Nasdaq-listed stocks have a beta greater than 1.

Essentially, beta expresses the fundamental tradeoff between minimizing risk and maximizing return. Let's give an illustration. Say a company has a beta of 2. This means it is two times as volatile as the overall market. Let's say we expect the market to provide a return of 10% on an investment. We would expect the company to return 20%. On the other hand, if the market were to decline and provide a return of -6%, investors in that company could expect a return of -12% (a loss of 12%). If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: a market return of 10% would mean a 5% gain for the company. (For further reading, see Beta: Know The Risk.)

Here is a basic guide to various betas:
• Negative beta - A beta less than 0 - which would indicate an inverse relation to the market - is possible but highly unlikely. Some investors used to believe that gold and gold stocks should have negative betas because they tended to do better when the stock market declined, but this hasn't proved to be true over the long term.
• Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of which way the market moves, the value of cash remains unchanged (given no inflation).
• Beta between 0 and 1 - Companies with volatilities lower than the market have a beta of less than 1 (but more than 0). As we mentioned earlier, many utilities fall in this range.
• Beta of 1 - A beta of 1 represents the volatility of the given index used to represent the overall market, against which other stocks and their betas are measured. The S&P 500 is such an index. If a stock has a beta of one, it will move the same amount and direction as the index. So, an index fund that mirrors the S&P 500 will have a beta close to 1.
• Beta greater than 1 - This denotes a volatility that is greater than the broad-based index. Again, as we mentioned above, many technology companies on the Nasdaq have a beta higher than 1.
• Beta greater than 100 - This is impossible as it essentially denotes a volatility that is 100 times greater than the market. If a stock had a beta of 100, it would be expected to go to 0 on any decline in the stock market. If you ever see a beta of over 100 on a research site it is usually the result of a statistical error, or the given stock has experienced large swings due to low liquidity, such as an over-the-counter stock. For the most part, stocks of well-known companies rarely ever have a beta higher than 4.
Why You Should Know What Beta Is
Are you prepared to take a loss on your investments? Many people are not and therefore opt for investments with low volatility. Other people are willing to take on additional risk because with it they receive the possibility of increased reward. It is very important that investors not only have a good understanding of their risk tolerance, but also know which investments match their risk preferences.

And, by using beta to measure volatility, you can better choose those securities that meet your criteria for risk. Investors who are very risk averse should put their money into investments with low betas such as utility stocks and Treasury bills. Those investors who are willing to take on more risk may want to invest in stocks with higher betas.

Many brokerage firms calculate the betas of securities they trade and then publish their calculations in a beta book. These books offer estimates of the beta for almost any publicly-traded company. The problem is that most of us don't have access to these brokerage books, and the calculation for beta can often be confusing, even for experienced investors.


However, there are other resources. One of the better websites that publishes beta is yahoo! finance (enter your company name then, click on Key Statistics and look under Stock Price History). The beta that is calculated on Yahoo compares the activity of the stock over the last five years and compares it to the S&P 500. A beta of "0.00" simply means that the stock either is a new issue or doesn't yet have a beta calculated for it.

Warnings about Beta
The most important caveat for using beta to make investment decisions is that beta is a historical measure of a stock's volatility. Past beta figures or historical volatility does not necessarily predict future beta or future volatility. In other words, if a stock's beta is 2 right now, there is no guarantee that in a year the beta will be the same. One study by Gene Fama and Ken French called "The Cross-Section of Expected Stock Returns" (published in 1992 in the Journal of Finance) on the reliability of past beta concluded that for individual stocks past beta is not a good predictor of future beta. An interesting finding in this study is that betas seem to revert back to the mean. This means that higher betas tend to fall back towards 1 and lower betas tend to rise towards 1.

The second caveat for using beta is that it is a measure of systematic risk, which is the risk that the market as a whole faces. The market index to which a stock is being compared is affected by market-wide risks. So, as beta is found by comparing the volatility of a stock to the index, beta only takes into account the effects of market-wide risks on the stock. The other risks the company faces are firm-specific risks, which are not grasped fully in the beta measure. So, while beta will give investors a good idea about how changes in the market affect the stock, it does not look at all the risks the company alone faces.

The following is a chart of IBM's stock for the trading period of June 2004 to June 2005. The red line is the IBM percent change over the period and the green line is the percent change of the S&P 500. This chart helps to illustrate how IBM moved in relation to the market, as represented by the S&P 500 during the one-year period.

Data Source: Barchart.com

On June 8, 2005 the beta for IBM on Yahoo was 1.636, meaning that up to that point, IBM had the tendency to move more sharply in either direction compared to the S&P 500 - and the chart above demonstrates IBM's tendency for higher volatility. When the market moved up IBM (red line) tended to move up more (see the Oct-to-Dec range), and IBM's stock fell more than the market when it declined (see the Jan-to-Mar range). The large drop in IBM stock from Mar to Apr 2005, while coinciding with a smaller drop in the S&P, resulted from a firm-specific risk: the company missed earnings estimates.

By showing IBM's behavior over this period, this chart demonstrates both the value that comes with the use of beta and the caution that needs to be shown when using it. It helps measure volatility, but it is not the whole story.

Conclusion
We hope this has helped shed some light on an often-underestimated financial ratio. Analysts, brokers and planners have used beta for decades to help them determine the risk level of an investment, and you should be aware of this risk measure in your investment decision-making.

Venturing Into Early-Stage Growth Stocks
For investors, young growth stocks can trigger dreams of wealth - and nightmares of poverty. These companies are often early-stage ventures that offer rapid revenue growth, but have yet to deliver earnings growth or much of a business track record. As such, the potential returns can be enormous, but investing in these stocks can also be risky. There are several points investors should consider when analyzing early-stage growth stocks.
Overview
The key features of early-stage growth stocks are rapid revenue growth but no earnings. Spending heavily to gain a market foothold, many growth companies - even those with strong sales revenue growth - can lose a lot of money in their early years. At the same time, these companies normally have a limited operating history, making it even more difficult for investors to judge the companies' current performance and value.

To stay on the safest side, many investors prefer to steer clear of companies with these risky characteristics. On the other hand, the next biggest and most rewarding stocks may be found among these kinds of stocks. The trick is to size up the risk.

To demonstrate how to evaluate an early-stage growth company's risk, let's consider Nasdaq-listed XM Satellite Radio Holdings (XMSR), a company that has been striving to become an established player in the fast-growing global satellite radio broadcasting market. Turning to XM's 2004 Form 10-K Annual Report (released on Mar 4, 2005), let's go over some key points for assessing the risk of an emerging growth stock.

Sales Growth
For starters, consider the growth trend over recent years. XM Satellite Radio delivered staggering sales growth. Scroll down to Selected Consolidated Financial Data (p.28, or Item 6 on the Table of Contents), and you will see that revenues grew from $0 in 2000, when XM Satellite Radio became publicly-listed, to more than $244 million in 2004. With sales growth of 168% in 2004, XM appears to have successfully taken advantage of growth opportunities. Importantly, the pace of sales growth was steadily upward - absent of unexpected swings - giving investors some reason to be confident that successful sales growth would continue.

Still, investors should take care: while the company's sales-growth record over the five-year period was certainly impressive, there is no guarantee that the company will be able to maintain that rate of growth into the future. In fact, the pace of growth could very well decline as the company satisfies demand for its products. (For further reading, see Great Expectations: Forecasting Sales Growth.)

Profitability
You need to determine whether revenue growth is profitable. Look further down at XM's Consolidated Statement of Operations (p. F-5). The net loss shows us that in 2004, XM lost a lot of money - more than $642 million. That's no surprise: the company spent heavily on sales and marketing and invested in new radio programming content to attract subscribers. If those investments pay off, earnings could materialize.

But savvy investors want a clearer indication that one day the company will produce earnings. A good place to look is the company's profit margins. There should be signs that profit margins are steadily getting better - even if that means the margins are simply getting less negative.

Here is the calculation for net profit margin (for further reading, see The Bottom Line on Margins):
Net Profit Margins = Net Profits after Taxes / Sales
Investors should be somewhat reassured. Although the company's losses accelerated between 2002 and 2004, its net margins saw a dramatic improvement, moving from a whopping -2,174.3% to -188.6% over the time period. Judging by its margin performance trend, XM offered heartening signs that it is moving towards profitability.

Cash Generation or Cash Burn?
Cash flow is another serious issue for newer, unprofitable companies in rapidly growing industries. As it can take time for early-stage companies to generate cash from operations, their survival depends on effective cash management so that they have an adequate cash supply to meet expenses. Emerging growth companies can face years of living on their bank balances. If a company eats through cash too fast, it runs the risk of going out of business.

So, it is good practice to look at the company's cash flow from operation.You will find that figure on XM's Consolidated Statement of Cash Flows (p. F-6). Investors may be discouraged to learn that XM's payments exceeded its cash receipts by more than $85.6 million in 2004 (see "net cash used in operating activities"). On the other hand, that number is significantly less than the $245 million of cash consumed the year before. That could signal a move towards cash flow breakeven.

When analyzing companies like XM that are cash flow negative, it's also worthwhile checking their burn rate, the rate at which a company currently uses up its supply of cash over time. (For further reading, see Don't Get Burned By The Burn Rate.)

You will see on XM's Consolidated Balance Sheet (p. F-4) that at end-2004 the company had more than $717 million in cash in the bank. Assuming that annual net cash used in operating activities of $85.6 million and investing activities of $36.3 million (found lower on the Consolidated Statement of Cash Flows) stay at the same level, then XM has nearly six years before it will run out of cash. In other words, XM has a comfortable cushion of cash that will tie it over until it starts to generate cash internally. Investors need not worry about XM being forced to seek additional funds to finance day-to-day operations.

Fair Value
The best way to curb risk is to invest in companies at a fair value. Because a lot of emerging growth stocks like XM have no earnings, investors have to cast aside the traditional price-to-earnings (P/E) ratio for coming up with a fair valuation. In the absence of a P/E ratio, you can calculate the price-to-sales ratio and compare that figure with other, similar companies.

To find XM' price-to-sales ratio, we look at its stock price on the day it filed its 2004 Form 10-K Annual Report, which was on Mar 4, 2005. On that day, the stock closed at $33.11 (see XM's trading quote that day on Investopedia's stock research resource). With 29.11 million shares outstanding, XM's market value was about $7 billion.


So, at the end of 2004, XM traded for more than 28 times its current sales ($7 billion market value divided by 2004 sales of $244 million). At first glance, that appears to be an awfully rich valuation - normally investors look for companies with price-to-sales ratios in the single digits or even lower. However, priced at 28 times sales, XM is still less expensive than its closest peer Sirius Satellite Radio (SIRI), which traded for more than 80 times sales at year-end 2004. New-media technology stocks are typically very pricey - so some investors might argue that the company's rapid rate of growth combined with its steady progress towards profitability justify the high price-to-sales ratio. Then again, a lot of others would steer clear of the stock at that price.

Another way to evaluate fair value is discounted cash flow analysis. It offers a more rigorous approach to valuing emerging growth stocks. The starting point is forecasting the company's free cash flows available to shareholders. These are earnings adjusted for expenses and income that are not in cash (such as depreciation) and adjusted for required investments and changes in working capital. The series of forecasted free cash flows is then brought to current values by discounting with the company's cost of equity or overall cost of capital. (For further reading, see Taking Stock of Discounted Cash Flow Analysis).

Conclusion
Investing in early-stage growth stocks can be a bit of guessing game. These companies are offering new services and products, and in many cases they are creating new markets. It can be awfully difficult to know their prospects with much certainty. That said, there are ways to identify their risks. Analysis of sales revenues, profitability and cash generation can help distinguish winners from losers.

Getting To Know Stock Screeners


We'll be the first to admit that selecting good stocks isn't easy. At last count (summer 2005), there were over 17,000 publicly-traded companies in the United States alone. The sheer volume of companies makes zeroing in on a good stock difficult, and the huge amount of data on the web doesn't make things any easier - it's hard to sort out the useful information from the worthless data. Fortunately, a stock screener can help you focus on the stocks that meet your standards and suit your strategy. Here we look at what a stock screener is and how it can work for you.
Stock Screening Basics
Stock screening is the process of searching for companies that meet certain financial criteria. A stock screener has three components: a database of companies, a set of variables and a screening engine that finds the companies that satisfy those variables and generates a list of matches.

Using a screener is quite easy. First you answer a series of questions such as the following:
• Do you like large-cap or small-cap stocks?
• Are you looking for stock prices at all-time highs, or companies with stocks that have fallen in price?
• What range for the price-to-earning (P/E) ratio is acceptable?
The good screeners will allow you to search using just about any metric or criterion you wish. When you finish inputting your answers, you get a list of stocks that meet your requirements.

By focusing on the measurable factors affecting a stock's price, stock screeners help their users perform quantitative analysis. In other words, screening focuses on tangible variables such as market capitalization, revenue, volatility and profit margins, as well as performance ratios such as the P/E ratio or debt-to-equity ratio. For obvious reasons, you cannot use a screener to search for a company that makes, say, "the best products".

Customizable Screeners
Three of the best free screeners on the web include those offered by Yahoo Finance, MSN Money and Morningstar. All three have basic screeners and advanced screeners.

The basic screeners have a predetermined set of variables whose values you set as your criteria. For example, one of the variables on the Morningstar basic screener is minimum capitalization, for which you choose one of six different values to be the smallest market cap you want to see in a company.

The more advanced screeners demand more from investors. There are three parts to each criterion setting: the criterion (the variable), the value and the condition. The criterion is the given quantitative metric, such as the P/E ratio, and the value refers to the numerical constraint on the measure. The condition refers to how you want your criterion to compare to the value. If you wanted your criterion to equal the value, you would use '='. If you wanted it to be greater than, you'd enter '>=', and if you wanted it to be less than, you'd use '='.

Although there are some good free screeners out there, if you want the very latest and the very best technology you will likely have to break down and get a subscription to a screening service.

Example Screen on Yahoo
To demonstrate how screeners work, let's look at an example using Yahoo Finance's free screener. Let's say we are looking for a life insurance company that trades on the NYSE, has a P/E ratio under 25, has revenue growth of 10% over the last five years and has profit margins of at least 10%. Before the age of computers, searching for companies to meet these criteria would have been a massive undertaking - it could have taken days. With a screener, it's easy.

Here is what the screener looks like on Yahoo Finance:


After we enter these criteria into the screener, it gives us the companies that make it through each of the filters of our search. (Note that these figures were correct at the time of the search, but are likely to change continually as stock prices fluctuate and new financials are reported.)
Type Of Screen Companies Remaining
Look in life-insurance industry 38
Trading on the NYSE 28
P/E ratio under 25 25
One-year revenue growth of at least 25% 7
Profit margins of at least 15% 2

Now that we have the results of the stock screen, we have two candidates that are worthy of further analysis - that is, if we are confident in our criteria and the values we choose for them. The companies that the screener gives us are only as valuable as the searching criteria we enter. Also, it's important to remember that the screen is not the analysis itself. The screen can't guarantee that the two companies that made all our criteria are the best buys, so we have to dig deeper to find out more.


Predefined Screens
The big challenge with using screens is knowing what criteria to search for. The hundreds of variables make the possibilities for different combinations nearly endless.

Screeners are extremely flexible, but if you don't know what you're looking for or why, they can't do much for you. To help investors, some sites have predefined stock screens, which have their variables already entered.

The following sites offer some of the better predefined screens (these are just a few examples of what's out there):
• Yahoo Finance - This site includes nearly 20 predetermined screens covering a large array of investment strategies, including 'strong forecasted growth', 'large-cap value', 'small-cap growth', and 'Dogs of the Dow'. The search criteria of each predetermined screen are clearly explained so you can understand the screens' underlying principles. (For more on these and other strategies, see Guide To Stock-Picking Strategies.)
• MSN Money - This site includes 10 predetermined searches. All of the searches are also clearly explained and cover various strategies, such as the contrarian strategy, and fundamentals, such as the highest dividend-yielding stocks on the S&P 500.
• Morningstar - This site covers a range of trading strategies but also includes a search based on Morningstar stock ratings. By searching according to these ratings, you are accessing analyst research on the quality of a company.
Things to Watch Out for When Using Stock Screeners
Although they are useful tools, stock screeners have some limitations. Here are some things you should keep in mind:
• Most stock screeners include only quantitative factors. There are still many qualitative factors to keep in mind: no screener provides information about things like pending lawsuits, labor problems or customer-satisfaction levels. (For more on qualitative analysis, see The Hidden Value Of Intangibles.)
• Screeners use databases that update on different schedules. Always check how fresh the data is - if a screener's data isn't timely, your search could be meaningless.
• Watch for industry-specific blind spots. For example, if you are searching for low P/E valuations, don't expect very many tech companies to show up.
Conclusion
Remember, stock screeners are not the "magic pill" for selecting stocks. Nothing will ever replace good old-fashioned nose-to-the-grindstone research. However, screens can be a good place to start your research process as they can save time and narrow your options down to a more manageable group.

Understanding Rights Issues


Cash-strapped companies can turn to rights issues to raise money when they really need it. In these rights offerings, companies grant shareholders a chance to buy new shares at a discount to the current trading price. Let's look at how rights issue work, and what they mean for all shareholders.
Defining a Rights Issue and Why It's Used
A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. More specifically, this type of issue gives existing shareholders securities called "rights", which, well, give the shareholders the right to purchase new shares at a discount to the market price on a stated future date. The company is giving shareholders a chance to increase their exposure to the stock at a discount price.

But until the date at which the new shares can be purchased, shareholders may trade the rights on the market the same way they would trade ordinary shares. The rights issued to a shareholder have a value, thus compensating current shareholders for the future dilution of their existing shares' value.

Troubled companies typically use rights issues to pay down debt, especially when they are unable to borrow more money. But not all companies that pursue rights offerings are shaky. Some with clean balance sheets use them to fund acquisitions and growth strategies. For reassurance that it will raise the finances, a company will usually, but not always, have its rights issue underwritten by an investment bank.

How Rights Issues Work
So, how do rights issues work? The best way to explain is through an example.

Let's say you own 1,000 shares in Wobble Telecom, each of which is worth $5.50. The company is in a bit of financial trouble and sorely needs to raise cash to cover its debt obligations. Wobble therefore announces a rights offering, in which it plans to raise $30 million by issuing 10 million shares to existing investors at a price of $3 each. But this issue is a three-for-10 rights issue. In other words, for every 10 shares you hold, Wobble is offering you another three at a deeply discounted price of $3. This price is 45% less than the $5.50 price at which Wobble stock trades. (For further reading, see Understanding Stock Splits.)

As a shareholder, you essentially have three options when considering what to do in response to the rights issue. You can (1) subscribe to the rights issue in full, (2) ignore your rights or (3) sell the rights to someone else. Here we look how to pursue each option, and the possible outcomes.

1. Take up the rights to purchase in full
To take advantage of the rights issue in full, you would need to spend $3 for every Wobble share that you are entitled to under the issue. As you hold 1,000 shares, you can buy up to 300 new shares (three shares for every 10 you already own) at this discounted price of $3, giving a total price of $900.

However, while the discount on the newly issued shares is 45%, it will not stay there. The market price of Wobble shares will not be able to stay at $5.50 after the rights issue is complete. The value of each share will be diluted as a result of the increased number of shares issued. To see if the rights issue does in fact give a material discount, you need to estimate how much Wobble's share price will be diluted.

In estimating this dilution, remember that you can never know for certain the future value of your expanded holding of the shares, since it can be affected by any number of business and market factors. But the theoretical share price that will result after the rights issue is complete - which is the ex-rights share price - is possible to calculate. This price is found by dividing the total price you will have paid for all your Wobble shares by the total number of shares you will own. This is calculated as follows:
1,000 existing shares at $5.50 $5,500
300 news shares for cash at $3 $900
Value of 1,300 shares $6,400
Ex-rights value per share $4.92 ($6,400.00/1,300 shares)

So, in theory, as a result of the introduction of new shares at the deeply discounted price, the value of each of your existing shares will decline from $5.50 to $4.92. But remember, the loss on your existing shareholding is offset exactly by the gain in share value on the new rights: the new shares cost you $3, but they have a market value of $4.92. These new shares are taxed in the same year as you purchased the original shares, and carried forward to count as investment income, but there is no interest or other tax penalties charged on this carried-forward, taxable investment income.


2. Ignore the rights issue
You may not have the $900 to purchase the additional 300 shares at $3 each, so you can always let your rights expire. But this is not normally recommended. If you choose to do nothing, your shareholding will be diluted thanks to the extra shares issued.

3 Sell your rights to other investors
In some cases, rights are not transferable. These are known as "non-renounceable rights". But in most cases, your rights allow you to decide whether you want to take up the option to buy the shares or sell your rights to other investors or to the underwriter. Rights that can be traded are called "renounceable rights", and after they have been traded, the rights are known as "nil-paid rights".

To determine how much you may gain by selling the rights, you need to estimate a value on the nil-paid rights ahead of time. Again, a precise number is difficult, but you can get a rough value by taking the value of ex-rights price and subtracting the rights issue price. So, at the adjusted ex-rights price of $4.92 less $3, your nil-paid rights are worth $1.92 per share. Selling these rights will create a capital gain for you.

Be Warned
It is awfully easy for investors to get tempted by the prospect of buying discounted shares with a rights issue. But it is not always a certainty that you are getting a bargain. But besides knowing the ex-rights share price, you need to know the purpose of the additional funding before accepting or rejecting a rights issue. Be sure to look for a compelling explanation of why the rights issue and share dilution are needed as part of the recovery plan. Sure, a rights issue can offer a quick fix for a troubled balance sheet, but that doesn't necessarily mean management will address the underlying problems that weakened the balance sheet in the first place. Shareholders should be cautious.
Understanding Pro-Forma Earnings
There's a clever way in which companies fudge and fiddle with their earnings figures, and you should know about it. The Securities and Exchange Commission (SEC) will investigate companies suspected of trying to deceive investors in the pro-forma modification of earnings. Let's take a look at what pro-forma earnings are, when they are useful and how companies can use them to dupe investors.
What Are Pro-forma Earnings?
Pro-forma earnings describe a financial statement which has hypothetical amounts, or estimates, built into the data to give a "picture" of a company's profits if certain nonrecurring items were excluded. Pro-forma earnings are not computed using standard generally accepted accounting principles (GAAP), and usually leave out one-time expenses which are not part of normal company operations, such as restructuring costs following a merger. Essentially, a pro-forma financial statement can exclude anything a company believes obscures the accuracy of its financial outlook, and can be a useful piece of information to help assess a company's future prospects. Every investor should stress GAAP net income, which is the "official" profitability determined by accountants, but a look at pro-forma earnings can also be an informative exercise.

For example, net income doesn't tell the whole story when a company has one-time charges that are irrelevant to future profitability. Some companies therefore strip out certain costs that get in the way. This kind of earnings information can be very useful to investors who want an accurate view of a company's normal earnings outlook, but by omitting items that reduce reported earnings, this process can make a company appear profitable even when it is losing money. At Investopedia, we like to call pro forma the "everything-but-the-bad-stuff earnings".

We should stress that pro-forma earnings are designed to give investors a clearer view of a company's operations, and by their nature exclude unique expenses and charges. The problem, however, is that there isn't nearly as much regulation of pro-forma earnings as there is of financial statements falling under GAAP rules, so sometimes companies abuse the rules to make earnings appear better than they really are. Because traders and brokers focus so closely on whether or not the company beats or meets analyst expectations, the headlines that follow their earnings announcements can mean everything. And, if a company missed non-pro-forma expectations but stated that it beat the pro-forma expectations, its stock price will not suffer as badly, and it might even go up - at least in the short term.

Problems with Pro Forma
Companies all too often release positive earnings reports that exclude things like stock-based compensation and acquisition-related expenses. Such companies, however, are expecting people to forget that these expenses are real and need to be included.

Sometimes companies even take unsold inventory off their balance sheets when reporting pro-forma earnings. Ask yourself this: does producing that inventory cost money? Of course it does, so why should the company simply be able to write it off? It's bad management to produce goods that can't be sold, and a company's poor decisions shouldn't be erased from the financial statements.

This isn't to say companies are always dishonest with pro-forma earnings - pro forma doesn't mean the numbers are automatically being manipulated. But by being skeptical when reading pro-forma earnings, you may end up saving yourself big money. To evaluate the legitimacy of pro-forma earnings, be sure to look at what the excluded costs are and decide whether or not these costs are real. Intangibles like depreciation and goodwill are okay to write down occasionally, but if the company is doing it every quarter, the reasons for doing so might be less than honorable. (For further reading, see Impairment Charges: The Good, The Bad and The Ugly.)

The dotcom era of the late 90s saw some of the worst abusers of pro-forma earnings manipulations. Many Nasdaq-listed companies utilized pro-forma earnings management to report more robust pro-forma numbers. Taken cumulatively, the difference between GAAP earnings and pro-forma earnings for the dotcom sector during its heyday exceeded billions of dollars.

One of the more notable occurrences of this that we've heard of is Network Associates. The company went so far as to exclude its dotcom department's operating earnings. The dotcom department wasn't making or spending pretend money, so why did the company exclude these numbers? No doubt the department was losing money and decided to hide this important fact from investors, who need to know about those numbers reflecting poor company strategy.

Benefits of Pro-Forma Analysis
As we mentioned earlier, pro-forma figures are supposed to give investors a clearer view of company operations. For some companies, pro-forma earnings provide a much more accurate view of their financial performance and outlook because of the nature of their businesses. Companies in certain industries tend to utilize pro-forma reporting more than others, as the impetus to report pro-forma numbers is usually a result of industry characteristics. For example, some cable and telephone companies almost never make a net operating profit because they are constantly writing down big depreciation costs.

In cases where pro-forma earnings do not include noncash charges, investors can see what the actual cash profit is. For example, recall AOL Time Warner's massive goodwill write-off of about $54 billion in 2002 to reflect the value of AOL's merger with Time Warner in the previous year. With accounting charges nearing $100 billion, its GAAP earnings for the year probably would not have been a very good predictor of future prospects - those extraordinary expenses would probably never occur again. Analysis of pro-forma earnings is an important exercise to undertake before considering an investment in a company which reports pro-forma numbers, so be sure to do so.

Also, when a company undergoes substantial restructuring or completes a merger, significant one-time charges can occur as a result. These types of expenses do not compose part of the ongoing cost structure of the business, and therefore can unfairly weigh on short-term profit numbers. An investor concerned with valuing the long-term potential of the company would do well to analyze pro-forma earnings, which exclude these non-recurring expenses.

Pro-forma financial statements are also prepared and used by corporate managers and investment banks to assess the operating prospects for their own businesses in the future and to assist in the valuation of potential takeover targets. They are useful tools to help identify a company's core value drivers and analyze changing trends within company operations.

Conclusion
To sum up, pro-forma earnings are informative when official earnings are blurred by large amounts of asset depreciation and goodwill. But, when you see pro forma, it's up to you to dig deeper to see why the company is treating its earnings as such. Remember that when you read pro-forma figures, they have not undergone the same level of scrutiny as GAAP earnings and are not subject to the same level of regulation.

Do your homework and maintain a balanced perspective when reading pro-forma statements. Try to identify the key differences between GAAP earnings and pro-forma earnings, and determine whether the differences are reasonable, or if they are only there to make a losing company look better. You want to base your decisions on as clear a financial picture as possible - regardless of whether it comes from pro-forma earnings or not.