Stock Investing ( Part 2)

Core Earnings Measure Up

Let's face it, numbers in earnings reports mean pretty much what company accountants want them to mean, neither more nor less. That's why investors looking at fundamentals must determine on a company-by-company basis what earnings are really saying. Wouldn't it be great if there were a standard measure that could make earnings evaluation easier, clearer and more meaningful?

Standard & Poor's, the ratings agency, tries to solve the problem with a new earnings metric: core earnings. While the core earnings approach gives investors a first glimpse of what truly "clean" earnings might look like, it also creates its own set of challenges.
Problems with the Traditional Metrics
Investors have lost faith in the three major categories of earnings: reported earnings, operating earnings and pro forma earnings. We've seen in the past that the traditional measure, the GAAP-based reported earnings, leaves companies with plenty of room for creative accounting and manipulation.

Operating earnings, which leaves out one-time gains and expenses from the bottom line, is meant to make the numbers comparable across companies. Unfortunately, many Wall Street analysts now have their own criteria for what should be excluded, so analyzing and comparing companies using operating earnings can be awfully difficult. Meanwhile, the definition of pro-forma earnings - which treats significant corporate transactions "as if" they never occurred - has become so broad that it can hide almost anything from investors.

Core Earnings: an Attempt at Solutions
To restore consistency and credibility to earnings reports and analysis, S&P sets out in a white paper, its stringent new measure. Core earnings includes all the revenues and costs associated with a company's ongoing operations. But it strips out all items that can mask a company's real condition, including goodwill charges, gains or losses from asset sales, hedging operations, litigation settlements, merger expenses and financing costs. These costs might be big, but they are not part of a company's core operations.

Here is a chart detailing the items included/excluded from the core earnings calculation:

What's In What's Out
Employee stock options expenses
Restructuring charges from ongoing operations
Pension fund costs
Purchased R&D expenses
Write-downs or depreciable operating assets Goodwill impairment charges
Gains/losses from the sale of assets
Pension gains
M&A related expenses
Litigation/insurance settlement costs and proceeds
Unrealized gains from hedging activities
Main Differences between Core and Reported Earnings
Two items account for most of the difference between reported earnings and core earnings. A big one is employee stock options. When calculating reported earrings, companies may record the value of stock options granted each year as an expense on the income statement, but most don't. Core earnings automatically includes stock options as an expense. For technology companies and others that rely on stock options to compensate employees, including options as an expense can have a drastic impact on the bottom line.

The other major difference between core and reported earnings stems from accounting for pension plans. This isn't a big issue for technology companies, but it is for large unionized companies with sizable employee pension funds. Under GAAP, a company can, without regard to the fund's actual performance, include each year's net pension gains as profits based on the long-term average return the company expects to realize on the pension assets. GAAP lets companies do this so their earnings do not fluctuate wildly with market swings, but this way of accounting for the pension fund's performance gives a less-than-accurate picture of earnings. Core earnings, by contrast, bases pension gains or losses on the fund's actual performance.

How Do the Differences Measure Up?
All in all, core earnings sounds like a reasonable approach for calculating a reliable and consistent measure of earnings. But it still leaves investors with a few thorny issues.

To start, we must ask whether stock option expenses can be fairly priced. It has been widely acknowledged that the Black-Scholes formula, the most frequently used option-pricing model, produces highly subjective results that can overstate the value of employee stock options. (For a focused look at how volatility fits into the options-pricing model, see the article The ABCs of Option Volatility.) The formula is particularly problematic for companies with volatile stock prices, like emerging growth companies. Subtle changes in variables used in the Black-Scholes equation can produce exaggerated swings in options value - in practice, expensing options creates as many problems for investors as it solves.

The other issue investors need to think about is that while pension fund gains are excluded from core earnings, losses are included in the calculation. This can be misleading. It makes as much sense to penalize a company for pension plan losses as it does to reward it for pension plan gains: neither a gain nor a loss has anything to do with how a company runs its business. Moreover, the policy of excluding gains nearly guarantees that whenever the market has a down year and pension-fund returns are weak, earnings will be penalized even if the pension plan is flush.

Conclusion
Accounting and reporting standards are essential to assessing company fundamentals and value. Investors rely on credible, transparent and comparable financial information. While it is probably impossible to develop a standard that can handle every contingency, S&P's core earnings approach is an important attempt to correct the problems investors have witnessed in the GAAP-based earnings calculations. Although the calculation of core earnings raises some questions about how to calculate employee stock options and how to account for pension plan losses, we can use core earnings as an important supplement and crosscheck to GAAP earnings.

How to Evaluate Pension Risk by Analyzing Annual Costs

In the article Analyzing Pension Risk I define pension risk and explain why it is important to assess this risk posed by a company's defined benefit pension plan. Here in this article I present one way (but not the only way) that can help you evaluate and assess whether or not a company's pension exhibits a high risk of shortfall.

Analyzing a company's pension risk should be as easy as reading the footnotes to compare what is owed (accumulated benefits due employees) to what is owned (the value of the portfolio). Unfortunately, thanks to complicated accounting and IRS rules, evaluating pension risk is a Gordian knot that is not easily unraveled.

However, there is a way to use information in the footnotes to evaluate pension risk. While it involves some work, this process will make you a more informed investor. The goal of this process is to cut through the accounting mumbo jumbo to estimate pension funding and cash risk.
The Process
In General Electric's (NYSE: GE) 2002 annual report, Footnote 6 contains the pension data we need. Under the "effect on operations" section it is disclosed that GE's pension plan contributed $1.556 billion to pre-tax income (before payments for retiree healthcare and other benefits), or $0.12 per share on an after-tax basis.

However, this amount was arrived at after using the smoothing techniques allowed by generally accepted accounting principles (GAAP). The table in Footnote 6 (shown in Table 1 below) shows that the $1.556 billion was the result of the expected return of $4.08 billion, the real costs and smoothing accounting techniques. It is these real costs that will be used to analyze the real cost of GE's pension plan.

In order to gauge the impact of "core" pension expenses on EPS, you need to examine the real annual costs of a pension plan, namely service and interest costs. The service costs represent the pension benefits earned by the employees during that year, and in GE's case, that number is the net of employee contributions. The interest cost represents the interest that accrued on the unfunded part of the projected benefit obligation. Analyzing the impact of these costs in relative isolation helps analyze the impact of pension liabilities without the smoothing allowed by GAAP.

To determine the "real" annual cost of the pension plan, you need to back out the massaged number (in this case the $1.556 billion) and add back the service and interest cost. The real annual, after-tax, per share cost of the pension plan in 2002 is $0.38.

As shown in Table 2, this calculation increases the cost 16.7% in 2001 and 6.1% in 2002. This represents a total "swing" of $0.50 from the GAAP EPS number. GE is unique because its plan contributed income whereas most plans add expense. Generally, when evaluating pension risk plans adding expense, you would add the periodic pension cost and subtract the service and interest costs to get the net effect on EPS, but in GE's case, you subtract everything:

This adjustment reduces GE's EPS growth rate by 38%. As shown in Table 3, the GAAP EPS growth rate for 2002 was 2.9% versus the 1.8% that results from making the adjustments described above.

What about Periodic Investment Gains?
This process does not factor in the return on plan assets for two main reasons. First, the above process focuses on the actual annual costs in order to gauge their impact on earnings. Second, the return on plan assets does not belong to the company but to the retirees. While an accounting convention may allow a company to net the costs against the returns, the company has no legal right to the returns. Factoring the return on plan assets into the process would distort the analysis.

If you wanted to include the return on plan assets, you would need to look at the disclosure of the Fair Value of Plan Assets. In GE's case, the actual loss on plan assets was $5.25 billion (compared to the $4.1 billion return that was expected). Including the actual loss on plan assets would reduce EPS by another $0.42 (after taxes).

The Bottom Line
This approach analyzes the EPS impact of the hard (or undiluted by accounting practices) cost of defined pension plans on EPS. Focusing on the per share impact of annual service and interest costs provides a clear view of annual costs that is unclouded by the actuarial assumptions and smoothing techniques allowed by GAAP.
Is Growth Always A Good Thing?

Rapid growth in revenue and earnings may be top priorities in corporate boardrooms, but these priorities are not always best for shareholders. We are often tempted to invest large amounts in risky or even mature companies that are beating the drum for fast growth, but investors should check that a company's growth ambitions are realistic and sustainable.
Growth's Attraction
Let's face it, it's hard not to be thrilled by the prospect of growth. We invest in growth stocks because we believe that these companies are able to take shareholder money and reinvest it for a return that is higher than what we can get elsewhere.

Besides, in traditional investing wisdom, growth in sales earnings and stock performance are inexorably linked. In his book "One Up on Wall Street", investment guru Peter Lynch preaches that stock prices follow corporate earnings over time. The idea has stuck because many investors look far and wide for the fastest-growing companies that will produce the greatest share-price appreciation.

Is Growth a Sure Thing?
That said, there is room to debate this rule of thumb. In a 2002 study of more than 2,000 public companies, California State University finance professor Cyrus Ramezani analyzed the relationship between growth and shareholder value. His surprising conclusion was that the companies with the fastest revenue growth (average annual sales growth of 167% over a 10-year period) showed, over the period studied, worse share price performance than slower growing firms (average growth of 26%). In other words, the hotshot companies could not maintain their growth rates, and their stocks suffered.

The Risks
Fast growth looks good, but companies can get into trouble when they grow too fast. Are they able to keep pace with their expansion, fill orders, hire and train enough qualified employees? The rush to boost sales can leave growing companies with a deepening difficulty to obtain their cash needs from operations. Risky, fast-growing start-ups can burn money for years before generating a positive cash flow. The higher the rate of spending money for growth, the greater the company's odds of later being forced to seek more capital. When extra capital is not available, big trouble is brewing for these companies and their investors.

Companies often try increasingly big - and risky - deals to push up growth rates. Consider the serial acquirer WorldCom. In the 1990s, the company racked up growth rates of more than 20% by buying up little-known telecom companies. But, it later required larger and larger acquisitions to show impressive revenue percentages and earnings growth. In hopes of sustaining growth momentum, WorldCom CEO Bernie Ebbers agreed to pay a whopping $115 billion for Sprint Corp. But federal regulators blocked the deal on antitrust grounds. WorldCom's prospects for growth collapsed, along with the company's value. The lesson here is that investors need to consider carefully the sustainability of deal-driven growth strategies.

Being Realistic about Growth
Eventually every fast-growth industry becomes a slow-growth industry. Some companies, however, still pursue expansion long after growth opportunities have dried up. When managers ignore the option of offering investors dividends and stubbornly continue to pour earnings into expansion that generates returns lower than those of the market, bad news is on the horizon for investors.

For example, take McDonald's: as it experienced its first-ever losses in 2003, and its share price neared a 10-year low, the company finally began to admit that it was no longer a growth stock. But for several years beforehand, McDonald's had shrugged off shrinking profits and analysts' arguments that the world's biggest fast-food chain had saturated its market. Unwilling to give up on growth, McDonald's accelerated its rate of restaurant openings and advertising spending. Expansion not only eroded profits but ate up a huge chunk of the company's cash flow, which could have gone to investors as large dividends.

CEOs and managers have a duty to put the brakes on growth when it is unsustainable or incapable of creating value. That can be tough since CEOs normally want to build empires rather than maintain them. At the same time, management compensation at many companies is tied to growth in revenue and earnings.

But CEO pride doesn't explain everything: the investing system favors growth. Market analysts rate a stock according to its ability to expand; accelerating growth receives the highest rating. Furthermore, tax rules privilege growth since capital gains are taxed in a lower tax bracket while dividends face higher income-tax rates.

Conclusion
Justifications for fast growth can quickly pile up, even when it isn't the most prudent of priorities. Companies that pursue growth at the cost of sustaining themselves may do more harm than good. When evaluating companies with aggressive growth policies, investors need to determine carefully whether these policies have higher drawbacks than benefits.
Get Tough on Management Puff
Investors examining company fundamentals cannot afford to ignore the role of management. It is critical for investors to see, as much as they can, that management is both capable and honest. The trouble is that it's not always easy to cut through dressed-up conference calls and published financial statements in order to accurately judge the competence of top managers.
Good Management Can Be an Illusion
It's not hard to tell from WalMart's share performance over the decade preceding 2003 that the retail giant's top managers know a thing or two about running a business. From the stellar growth of Dell Computers, investors can recognize the first-class leadership of the company's founder and CEO, Michael Dell. That said, the idea that a rising share price means management must be doing a good job doesn't always hold water; investors who once championed CEO's like Enron's Kenneth Lay or WorldCom's Bernie Ebbers but later suffered the consequences of fraud and bankruptcy can attest to that.

Remember, if company management is set on fooling investors, the cards for doing so are stacked in its favor. Say you went on a tour of a manufacturing company hosted by the firm's CEO. You might be wowed by the CEO's detailed knowledge of new, state-of-the-art factory equipment that would soon boost efficiency and profitability. You might see the CEO put an arm around one of the factory floor technicians and say, "Stan has been with the firm for nearly 15 years. How's the new baby, Stan?" No doubt, you would go home thinking the CEO possessed a valuable combination of technical knowledge and personal relationship skills.

You might be right. On the other hand, it could be that the CEO had studied the details of just one or two pieces of equipment and built his relationship with Stan that morning. Furthermore, one can imagine the CEO steering conversation away from production delays or sluggish growth to more uplifting news like the latest acquisition. The point is that management will present itself in the best light possible, making it awfully difficult for investors to get a clear view of its real capability.

Fortunately, finding good management is not completely hit and miss. There are ways of checking and monitoring management quality to ensure that it is not off track.

Company Visits
Formal tours are rarely possible, especially for individual investors. But a quick, unscheduled visit to one of the company's offices can offer a glimpse of the general behavior and attitude of the executives and employees. Is the telephone answered quickly and courteously? Is the receptionist on the ball? Are employees enthusiastic about the company and its prospects? In other words, is there a sense of team spirit?

Presentations and Conference Calls
In practice most companies allow Wall Street analysts to pose questions first. Increasingly, journalists are also invited to ask questions. Most companies draw the line at letting individual investors ask questions, unless they hold big positions in the company. Mom-and-Pop investors are usually out of luck; they are almost always denied an opportunity to grill the CEO.

Still, it is a good idea to see how well the CEO and top management field the questions of analysts and journalists. How well do the managers answer questions concerning company disappointments? Does management have a decisive plan to remedy the disappointments? Does the management team have answers at the tip of their tongue for every question, or do they fumble through papers and struggle to provide answers to even simple questions? Do the CEO and CFO pass questions to one another seamlessly, or are both unsure of answers? Bear in mind, that, even at analyst presentations, management often prepares a few questions and arranges to have them raised.

Published Reports
Do not be distracted by lavish annual reports filled with color photographs of the CEO and top executives. These glossy documents provide no bearing of the company or management's quality. It is important, however, to read the chairman's statement and compare the cited achievements against those expected in the previous year's report. Of course, the auditor's report should be checked to ensure that there is no qualification of any kind. Always read the notes, as this is frequently where important points are tucked away.

Meeting Forecasts
Management that fails to meet formal performance targets or earnings forecasts could be on its way out. Investor backing will be harder to secure next time it is needed, so additional access to capital might be jeopardized. Failing to meet analysts' forecasts can be dangerous; highly-paid analysts will necessarily want someone to blame.

Conclusion
Because past share performance does not necessarily guarantee quality management, it is important to take a closer look at who is heading the company. Good leadership is essential for any business, so keep an eye on qualitative measures like those mentioned above to get a sense of a company and the management that runs it.
Free Cash Flow: Free, But Not Always Easy

The best things in life are free, and the same holds true for cash flow. Smart investors love companies that produce plenty of free cash flow (FCF). It signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business - all important undertakings from an investor's perspective. However, while free cash flow is a great gauge of corporate health, it does have its limits and is not immune to accounting trickery.

What Is Free Cash Flow?
By establishing how much cash a company has after paying its bills for ongoing activities and growth, FCF is a measure that aims to cut through the arbitrariness and "guesstimations" involved in reported earnings. Regardless of whether a cash outlay is counted as an expense in the calculation of income or turned into an asset on the balance sheet, free cash flow tracks the money.

To calculate FCF, make a beeline for the company's cash flow statement and balance sheet. There you will find the item cash flow from operations (also referred to as "operating cash"). From this number subtract estimated capital expenditure required for current operations:

Cash Flow From Operations (Operating Cash)
- Capital Expenditure
---------------------------
= Free Cash Flow

To do it another way, grab the income statement and balance sheet. Start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes in working capital, which is done by subtracting current liabilities from current assets. Then subtract capital expenditure, or spending on plants and equipment:
Net income
+ Depreciation/Amortization
- Change in Working Capital
- Capital Expenditure
----------------------------
= Free Cash Flow
It might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment, however, is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past. This makes FCF a useful instrument for identifying growing companies with high up-front costs, which may eat into earnings now but have the potential to pay off later.

What Does Free Cash Flow Indicate?
Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF - due to revenue growth, efficiency improvements, cost reductions, share buy backs, dividend distributions or debt elimination - can reward investors tomorrow. That is why many in the investment community cherish FCF as a measure of value. When a firm's share price is low and free cash flow is on the rise, the odds are good that earnings and share value will soon be on the up.

By contrast, shrinking FCF signals trouble ahead. In the absence of decent free cash flow, companies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business.

Is Free Cash Flow Foolproof?
Although it provides a wealth of valuable information that investors really appreciate, FCF is not infallible. Crafty companies still have leeway when it comes to accounting sleight of hand.

Without a regulatory standard for determining FCF, investors often disagree on exactly which items should and should not be treated as capital expenditures. Investors must therefore keep an eye on companies with high levels of FCF to see if these companies are under-reporting capital expenditure and R&D. Companies can also temporarily boost FCF by stretching out their payments, tightening payment collection policies and depleting inventories. These activities diminish current liabilities and changes to working capital. But the impacts are likely to be temporary.

The Trick of Hiding Receivables
Let's look at yet another example of FCF tomfoolery, which involves specious calculations of the current accounts receivable. When a company reports revenue, it records an account receivable, which represents cash that is yet to be received. The revenues then increase net income and cash from operations, but that increase is typically offset by an increase in current accounts receivable, which are then subtracted from cash from operations. When companies record their revenues as such, the net impact on cash from operations and free cash flow should be zero since no cash has been received.

What happens when a company decides to record the revenue, even though the cash will not be received within a year? This question is inspired by telecom equipment maker Nortel Networks' year 2000 financial statements. The receivable for a delayed cash settlement is therefore "non-current" and can get buried in another category like "other investments". Revenue then is still recorded and cash from operations increases, but no current account receivable is recorded to offset revenues. Thus, cash from operations and free cash flow enjoy a big but unjustified boost. Tricks like this one can be hard to catch.

Conclusion
Alas, finding an all-purpose tool for testing company fundamentals still proves elusive. Like all performance metrics, FCF has its limits. On the other hand, provided that investors keep their guard up, free cash flow is a very good place to start hunting.
How to Evaluate the Quality of EPS
EPS manipulation might be the second oldest profession, but there is a relatively easy way for investors to protect themselves. This article will show you how to evaluate the quality of any kind of EPS, whether it's GAAP, pro forma, or otherwise.

Overview
The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors, accompanied by constantly mutating versions that seem to have come out of Alice in Wonderland. Instead of Tweedle-dee and Tweedle-dum we have pro forma EPS and EBITDA. And, despite rumors to the contrary, the whisper number - the cheshire cat of Wall Street - continues to exist as guidance.

To be fair, this situation cannot be totally blamed on management. Wall Street deserves as much blame due to its myopic focus on the near-term and knee-jerk reactions to one-cent misses. A forecast is always only a guess - nothing more, nothing less - but Wall Street often forgets this. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions.
EPS Quality
High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated). I use the word 'relatively' because while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.

A low-quality EPS number does not accurately portray what the company earned. GAAP EPS (earnings reported according to generally accepted accounting principals) may meet the letter of the law but may not truly reflect the earnings of the company. Sometimes GAAP requirements may be to blame for this discrepancy; other times it is due to choices made by management. In either case, a reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions.

How to Evaluate the Quality of EPS
The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with the SEC.

To determine earnings quality, I rely on operating cash flow. The company can show a positive earnings on the income statement while also bearing a negative cash flow. This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected. 'Cash is king' is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long. Want proof? Just look at how many of the dotcom wonders survived!

If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS, earnings are of a high quality because the company is generating more cash than is reported on the income statement. Reported (GAAP) earnings, therefore, understate the profitability of the company.

If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. In this case, EPS is of low quality because it does not reflect the negative operating results of the company and overstates what I feel are the true (cash) operating results.

An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1.00. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS's operating cash flow per share were a negative $0.50, it would indicate that the company really lost $0.50 of cash per share versus the reported $1.00. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The $0.50 negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was $0.50 more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment.

Trends Are Also Important
Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends. It is possible that an entire industry may generate negative operating cash flow due to cyclical causes. Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.

Evaluating trends will also help you spot the worst case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. The appearance of growing GAAP EPS even thought the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover.

The Bottom Line
Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. Luckily, it is relatively easy for investors to evaluate the situation.

Keep Your Eyes on the ROE
It pays to invest in companies that generate profits more efficiently than their rivals. ROE can help investors distinguish between companies that are profit creators and those that are profit burners. On the other hand, ROE might not necessarily tell the whole story about a company, and therefore must be used carefully.
What Is ROE?
By measuring how much earnings a company can generate from assets, ROE offers a gauge of profit-generating efficiency. ROE helps investors determine if a company is a lean, mean profit machine or an inefficient clunker. Firms that do a good job of milking profit from their operations typically have a competitive advantage - a feature that normally translates into superior returns for investors. The relationship between the company's profit and the investor's return makes ROE a particularly valuable metric to examine.

To find companies with a competitive advantage, investors can use five-year averages of the ROEs of companies within the same industry. Think of the PC industry: between 1998 and 2003, Dell Computer's highly-efficient direct sales, high profit-margin strategy paid off in terms of strong earnings and share price appreciation - especially compared with rivals Hewlett Packard and Gateway. The ROE numbers reinforce the differences. Dell enjoyed a whopping five-year ROE of 46% while HP's ROE was only 12%. Over the same period, Gateway's average ROE was negative 2.5%!

ROE Calculation
A company's ROE ratio is calculated by dividing the company's net income by its shareholder equity, or book value. The formula is simple:
Net Income/Average Common Equity*
*Total assets less total liabilities

You can find net income on the income statement, but you can also take the sum of the last four quarters worth of earnings. Shareholders equity, meanwhile, is located on the balance sheet and is simply the difference between total assets and total liabilities. Shareholder equity represents the tangible assets that have been produced by the business. Both net income and shareholder equity should cover the same period of time.

How Should ROE Be Interpreted?
ROE offers a useful signal of financial success since it might indicate whether the company is growing profits without pouring new equity capital into the business. A steadily increasing ROE is a hint that management is giving shareholders more for their money, which is represented by shareholders' equity. Simply put, ROE indicates know how well management is employing the investors' capital invested in the company.

It turns out, however, that a company cannot grow earnings faster than its current ROE without raising additional cash. That is, a firm that now has a 15% ROE cannot increase its earnings faster than 15% annually without borrowing funds or selling more shares. But raising funds comes at a cost: servicing additional debt cuts into net income and selling more shares shrinks earnings per share by increasing the total of shares outstanding.

So ROE is, in effect, a speed limit on a firm's growth rate, which is why money managers rely on it to gauge growth potential. In fact, many specify 15% as their minimum acceptable ROE when evaluating investment candidates.

ROE Isn't Perfect
Still, there are caveats that need to be considered. ROE is not an absolute indicator of investment value. After all, the ratio gets a big boost whenever the value of the shareholder equity, the denominator, goes down.

If, for instance, a company takes a large write-down, the reduction in income (ROE's numerator) occurs only in the year that the expense is charged; the write-down therefore makes a more significant dent in shareholder equity (the denominator) in the following years, causing an overall rise in the ROE without any improvement in the company's operations. Having a similar effect as write-downs, share buy-backs also normally depress shareholders' equity proportionately far more than they depress earnings. As a result, buy-backs also give an artificial boost to ROE.

Moreover, a high ROE doesn't tell you if a company has excessive debt and is raising more of its funds through borrowing rather than issuing shares. Remember, shareholder's equity is assets less liabilities, which represent what the firm owes, including its long and short-term debt. So, the more debt a company has, the less equity it has; and the less equity a company has, the higher its ROE ratio will be.
Suppose that two firms have the same amount of assets ($1,000) and the same net income ($120) but different levels of debt: Firm A has $500 in debt and therefore $500 in shareholder's equity ($1,000 - $500), and Firm B has $200 in debt and $800 in shareholder's equity ($1,000 - $200). Firm A shows an ROE of 24% ($120/$500) while Firm B, with less debt, shows an ROE of 15% ($120/$800). As ROE equals net income divided by the equity figure, Firm A, the higher-debt firm, shows the highest return on equity.

This company looks as though it has higher profitability when really it just has more demanding obligations to its creditors. Its higher ROE may therefore be simply a mask of future problems. For a more transparent view that helps you see through this mask, make sure you examine also the company's return on invested capital (ROIC), which reveals the extent to which debt drives returns.

Another pitfall of ROE concerns the way in which intangible assets are excluded from shareholder's equity. Generally conservative, the accounting profession normally omits a company's possession of things like trademarks, brand names, and patents from asset and equity-based calculations. As a result, shareholder equity often gets understated in relation to its value, and, in turn, ROE calculations can be misleading.

A company with no assets other than a trademark is an extreme example of a situation in which accounting's exclusion of intangibles would distort ROE. After adjusting for intangibles, the company would be left with no assets and probably no shareholder equity base. ROE measured this way would be astronomical but would offer little guidance for investors looking to gauge earnings efficiency.

Conclusion
Let's face it, no single metric can provide a perfect tool for examining fundamentals. But contrasting the five-year average ROEs within a specific industrial sector does highlight companies with competitive advantage and with a knack for delivering shareholder value.

Think of ROE as a handy tool for identifying industry leaders. A high ROE can signal unrecognized value potential, so long as you know where the ratio's numbers are coming from.
How to Read Footnotes - Part 1
Since footnotes contain some of the most important information in the financial statements, it is essential for investors to learn how to read and understand them. There are some basic techniques you can acquire, but reading the footnotes is as much an art as a science.

This series of articles is therefore devoted to providing both a check list as well as an insider's perspective that will help you read between the lines.

In this article we review a few basic rules that all investors can use when trying to decipher any corporate financial statement. This overview will provide a foundation on which we will develop other concepts and tools you can use.

Some Rules of Thumb
Before we get started, we should review some general rules of thumb (ROT) that will help you gain a better picture of the world of financial reporting:
ROT 1: Not all disclosures are created equal
Disclosures in 10-K filings are much more informative than in 10-Qs. This difference is an anachronistic holdover from the pre-digital age, when companies argued that it was too costly to provide full disclosure every quarter. Even though everything is now digital, regulators still haven't made quarterly updates a requirement, so some important information on key areas such as pension data is not updated each quarter.

ROT 2: Rules are meant to be bent
In the beginning the SEC made the rules, but shortly thereafter came lawyers, accountants and other high-paid financial engineers who find ways to circumvent the new disclosure and tax laws. Each economic cycle is followed by a new wave of reform, which helps perpetuate this cycle.

ROT 3: Potential rewards require high effort
If analyzing companies were easy, everybody would do it and there would be nothing disputing the existence of an efficient market. But it takes a good deal of hard work to gain a competitive advantage in business and investing. The harder you work, the more you know. The more you know, the more you can avoid the mistakes of the past and make money.
The Checklist of Rules
Now that we have established these general guidelines for understanding some of the underlying realities of financial statements, let's look at a few more timeless rules that you count on:

Rule # 1: Know the company, industry and weaknesses of both
In order to find the warning signs, you have to know where in the footnotes to focus your reading. To do this, you need to be aware of the possible areas wherein trouble could first develop. For example, the auto industry (and any heavily-unionized industry) carries more of the type of risk created by under-funded pension plans than a high-tech industry. When evaluating a company in the auto industry you would want to spend more time analyzing the pension footnote than the options disclosures (although an auto company may also have 'option risk').

To know how to streamline your approach to any particular company's footnotes, you need to do some primary research, which means reading not just one SEC filing but several years of a company's SEC filings, from cover to cover. This primary research will give you a better feel for how management communicates and how it obfuscates. Don't trust anyone else's summary. Your own experience gained from this preliminary reading will not only cure insomnia but will provide you with a perspective that will make it easier to spot the red flags.

Rule #2: The good stuff is always buried
Rarely does a company admit its mistakes in headlines and tables or make them easily found in required disclosures. Generally, the red flags are buried in long paragraphs filled with legal boilerplate that takes a pot of strong coffee to read and understand. But the hard work it takes to do some digging does pay off with an insight that is often overlooked even by the pros.

Enron, despite its many flaws did provide enough disclosure in its footnotes to make any sane investor worried. Informed investors could therefore have cut their losses by selling at the first sign of trouble. But it was reporters from the Wall Street Journal who made the effort to dig into the footnotes and find the off-balance-sheet partnerships and conflicts of interest. The headlines, however, shouldn't have been the first alarm that Enron investors heard.

Rule # 3: Consistency is NOT the rule; you need to compare disclosures
Because disclosures change from filing to filing as the result of events or changed assumptions, you can't read just one disclosure and expect to have the whole story. You need to analyze any changes, which will provide an insight into the quality/credibility of management thinking.

Take for example the assumptions used in healthcare cost estimations, which are usually found in a section about other post retirement benefits. Start in 1999 and you may see a company whose management assumes that healthcare costs will rise in the mid single-digit range and decline to low single-digits during the next five to seven years.

Now, read the latest 10-K and you may see that these assumptions, including the assumed steady decline, have not changed even though healthcare costs have actually increased in the 15-20% range and are expected to increase in the low double-digit range in 2004. The company's failure to adjust its assumptions indicates that management is either (1) keeping estimates low to minimize the adverse impact on earnings, (2) are out of touch with reality and/or (3) plan to shift more than half of the increase to the employees. A company that assumed increases in the double digit range would have more credibility than the company with the single digit growth assumption.

The Bottom Line
Reading footnotes is hard work, but you will get better the more you do it. Since these skills will help you protect your money, remember to keep them sharp with practice and never to underestimate their value. See How to Read Footnotes - Part 2: Evaluating Accounting Risk and How to Read Footnotes - Part 3: Evaluating the Board of Directors

How to Read Footnotes - Part 2: Evaluating Accounting Risk

Being able to understand accounting disclosures gives investors an ability to recognize early warning signs that can help prevent investment disasters. Companies are required to disclose the impact of adopting new accounting rules and this information sometimes reveals some bad news that could hurt stock prices. The adverse reaction could come from the revelation of off-balance-sheet entities, reduced EPS or increased debt load. The market, however, tends not to read the footnotes too closely (if at all). Being able to read between the lines of these disclosures will give the diligent investor an advantage. This article provides a quick way to evaluate the investment risk that arises from adopting new accounting rules.

(For the first part of this series, see How To Read Footnotes - Part 1.)
Finding the Disclosures
Companies are required to disclose the potential impact of adopting the new accounting regulations. Unfortunately, the disclosures are hard to read due to legalese and boilerplate language.

Accounting disclosures sometimes have their own footnote and/or are discussed in another footnote that is impacted by the new rule (like Pension or Goodwill). Some companies also repeat the disclosures in the "Management Discussion and Analysis" (MD&A) section of their SEC filings (10-K and 10-Q filings). In 10-K filings, the disclosure may be addressed in several areas but the main one is usually one of the footnotes with a title like "Summary of Significant Accounting Policies". In 10-Qs, the discussion of new accounting rules will most likely be limited to a footnote entitled "Recently Adopted Accounting Pronouncements". Generally, each new rule is discussed in its own paragraph.

The quick and dirty way to read these disclosures is to focus on the second and last sentence. The second sentence will talk about what the rule does and the last sentence discloses management's expectation of what impact the new rule will have. The first sentence generally gives the name of the rule and indicates when the company has or will adopt it. While it is best to read the entire disclosure to understand fully the potential ramifications, focusing on both the second and the last sentence tends to provide the most important information.

Determining What the Disclosures Reveal
The last sentence, where management discusses the likely impact of the new accounting techniques on the company, is the key spot on which investors want to focus. There are three key phrases that will be either a green, yellow or red flag to investors:

The Green Flag
'No material impact' indicates the best of all worlds because it means that the change will have no impact on financial reporting. For example, in Huffy Corp.'s (NYSE:HUF) 10-Q for June 2003, footnote 11 discusses recently-adopted accounting standards. The first item discussed is SFAS 143 (accounting for asset retirement obligations). The last sentence reads, "The cumulative effect of implementing SFAS 143 has had an immaterial effect on the Company's financial statements taken as a whole."

The Yellow Flag
The phrases may vary, but generally you want to pay attention if the last sentence tells you there will be an impact of the new rule. You need to be extra careful of elusive language, which management may use because it is loathed to disclose bad news. Look out for statements like "The adoption of SFAS No. 142 did not have an impact on the Company's results of operations or its financial position in 2002." Note that this statement does not address how the new rule may impact future results.

The Red Flag
The absence of any conclusive statement indicating the impact of the accounting changes is a big red flag. If the disclosure is missing this statement, it could mean that management either has not determined the effect of the new accounting or has chosen simply not to break any bad news to investors. If a definitive impact statement is missing, investors will need to read the entire disclosure in order to evaluate the investment risk.

Let's, for example, take a look at GE's 2002 10-K. In the "Accounting Changes" section of footnote 1, GE states:

"In November 2002, the Financial Accounting Standards Board (FASB) issued Interpretation No. (FIN) 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. The resulting disclosure provisions are effective for year-end 2002 and such disclosures are provided in notes 29 and 30. Recognition and measurement provisions of FIN 45 become effective for guarantees issued or modified on or after Jan 1, 2003.

"In Jan 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51. FIN 46's disclosure requirements are effective for year-end 2002 and such disclosures are provided in note 29. We plan to adopt FIN 46's accounting provisions on Jul 1, 2003."
Note that the disclosure only indicates that these changes will become effective in the future and does not provide any information on the impact of the change. Investors then need to determine themselves what this impact may be. GE has significant amounts of off-balance-sheet liabilities that will increase the debt load on their balance sheets. Knowing that this could happen, investors need to evaluate how the market might react when the debt is consolidated. In GE's case, there might be little reaction due to the stature of the company and its management. In other situations such news may be unexpected to those who did not bother to read between the lines.

The Bottom Line
Changes in GAAP are meant to correct accounting rules that resulted in disasters of Enron and others. Companies must disclose when the rules will be adopted and what impact it will have. Being able to read between the lines of disclosures made in SEC filings can give investors an early warning system to spot potential issues such as increased debt load form consolidating off balance sheet entities. Unambiguous impact statements are signs of a credible and competent management team. Lack of a clear impact statement or no statement at all is a warning sign.

For the third and final part of this series see How To Read Footnotes - Part 3: Evaluating the Board of Directors

The Importance of Dividends


"The only thing that gives me pleasure is to see my dividend coming in." --John D. Rockefeller.

One of the simplest ways for companies to communicate financial well-being and shareholder value is to say "the dividend check is in the mail." Dividends, those cash distributions that many companies pay out regularly to shareholders from earnings, send a clear, powerful message about future prospects and performance. A company's willingness and ability to pay steady dividends over time--and its power to increase them--provide good clues about its fundamentals.
Dividends Signal Fundamentals
Before corporations were required by law to disclose financial information in the 1930s, a company's ability to pay dividends was one of the few signs of its financial health. Despite the Securities and Exchange Act of 1934 and the increased transparency it brought to the industry, dividends still remain a worthwhile yardstick of a company's prospects.

Typically, mature, profitable companies pay dividends. However, companies that do not pay dividends are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, the company should keep the profits and reinvest them into the business. For these reasons, few "growth" companies pay dividends. But even mature companies, while much of their profits may be distributed as dividends, still need to retain enough cash to fund business activity and handle contingencies.

The progression of Microsoft through its life cycle demonstrates the relationship between dividends and growth. When Bill Gate's brainchild was a high-flying growth company, it paid no dividends, but reinvested all earnings to fuel further growth. Eventually, this 800-pound software "gorilla" reached a point where it could no longer grow at the unprecedented rate it had maintained for so long. So, instead of rewarding shareholders through capital appreciation, the company began to use dividends and share buybacks as a way of keeping investors interested. The plan was announced in July 2004, nearly 18 years after the company's IPO. The cash distribution plan put nearly $75 billion worth of value into the pockets of investors through a new $0.08 quarterly dividend, a special $3 one-time dividend, and a $30 billion share buyback program spanning four years.

The Dividend Yield
Many investors like to watch the dividend yield, which is calculated as the annual dividend income per share divided by the current share price. The dividend yield measures the amount of income received in proportion to the share price. If a company has a low dividend yield compared to other companies in its sector, it can mean two things: (1) the share price is high because the market reckons the company has impressive prospects and isn't overly worried about the company's dividend payments, or (2) the company is in trouble and cannot afford to pay reasonable dividends. At the same time, however, a high dividend yield can signal a sick company with a depressed share price. For more on this subject, check out the Dogs of the Dow section in the "Guide to Stock Picking."

Dividend yield is of little importance for growth companies because, as we discussed above, retained earnings will be reinvested in expansion opportunities, giving shareholders profits in the form of capital gains (think Microsoft).

Dividend Coverage Ratio
When you evaluate a company's dividend-paying practices, ask yourself if the company can afford to pay the dividend. The ratio between a company's earnings and net dividend paid to shareholders--known as dividend coverage--remains a well-used tool for measuring whether earnings are sufficient to cover dividend obligations. The ratio is calculated as earnings per share divided by the dividend per share. When coverage is getting thin, odds are good that there will be a dividend cut, which can have a dire impact on valuation. Investors can feel safe with a coverage ratio of 2 or 3. In practice, however, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, at which point prospects start to look risky. If the ratio is under 1, the company is using its retained earnings from last year to pay this year's dividend.

At the same time, if the payout gets very high, say above 5, investors should ask whether management is withholding excess earnings, not paying enough cash to shareholders. Managers who raise their dividends are telling investors that the course of business over the coming 12 months or more will be stable. For instance, when Kimberly Clark, the giant of personal care products, increased its dividend by 13% in the first quarter of 2003, the company was telling investors that the punishing price war with Proctor & Gamble was not a long-term problem. The signal was even stronger because KC said it intended to increase its dividend further over the following five years.

The Dreaded Dividend Cut
If a company with a history of consistently rising dividend payments suddenly cuts its payments, investors should treat this as a signal that trouble is looming. Texas Utilities, for instance, once recognized for its consistent payouts, was among the highest-yielding stocks available. Then in 2002, the company cut its quarterly dividend, and the stock price plummeted by nearly a third in a single day.

While a history of steady or increasing dividends is certainly reassuring, investors need to be wary of companies that rely on borrowings to finance those payments. Again, take the utilities industry, which once attracted investors with reliable earnings and fat dividends. As some of those companies were diverting cash into expansion opportunities while trying to maintain dividend levels, they had to take on greater debt levels. Watch out for companies with debt-to-equity ratios greater than 60%. Higher debt levels often lead to pressure from Wall Street as well as debt-rating agencies. That, in turn, can hamper a company's ability to pay its dividend.

Great Disciplinarian
Dividends bring more discipline to management's investment decision-making. Holding onto profits might lead to excessive executive compensation, sloppy management, and unproductive use of assets. Jarad Harford, professor of finance at University of Oregon, finds that the more cash a company keeps, the more likely it will overpay for acquisitions and, in turn, damage shareholder value. In fact, companies that pay dividends tend to be more efficient in their use of capital than similar companies that do not pay dividends. Furthermore, companies that pay dividends are less likely to be cooking the books. Let's face it, managers can be awfully creative when it comes to making earnings look good. But with dividend obligations to meet twice a year, manipulation becomes that much more challenging.

Finally, dividends are public promises. Breaking them is both embarrassing to management and damaging to share prices. To tarry over raising dividends, never mind suspending them, is seen as a confession of failure.

A Way to Calculate Value
Dividends can give investors a sense of what a company is really worth. The dividend discount model is a classic formula that explains the underlying value of a share, and it is a staple of the capital asset pricing model which, in turn, is the basis of corporate finance theory. According to the model, a share is worth the sum of all its prospective dividend payments, 'discounted back' to their net present value. As dividends are a form of cash flow to the investor, they are an important reflection of a company's value.

It is important to note also that stocks with dividends are less likely to reach unsustainable values. Investors have long known that dividends put a ceiling on market declines.

Conclusion
The bottom line is that dividends matter. Evidence of profitability in the form of a dividend check can help investors sleep easily. Profits on paper say one thing about a company's prospects; profits that produce cash dividends say another thing entirely.
Relative Valuation: Don't Get Trapped

Relative valuation is a simple way to unearth low-priced companies with strong fundamentals. As such, investors use comparative multiples like price-earnings ratio (P/E), enterprise multiple (EV/EBITDA) and price-to-book ratio all the time to assess the relative worth and performance of companies and to identify buy and sell opportunities. The trouble is that while relative valuation is quick and easy to use, it can be a trap for investors.
Quick and Easy
The concept behind relative valuation is simple and easy to understand: the value of a company is determined in relation to how similar companies are priced in the market. Here is how to do a relative valuation on a publicly listed company:
• Create a list of comparable companies, often industry peers and obtain their market values.
• Convert these market values into comparable trading multiples, such as P/E, price-to-book, enterprise-value-to-sales and EV/EBITDA multiples.
• Compare the company's multiples with those of its peers to assess whether the firm is over or undervalued.
No wonder relative valuation is so widespread. Key data - including industry metrics and multiples - is readily available from investor services like Multex, Reuters and Bloomberg for a small fee, if not free of charge. In addition, the calculations can be performed with fewer assumptions and less effort than fancy valuation models like discounted cash flow analysis (DCF). (See, Taking Stock Of Discounted Cash Flow.)

Relative Value Trap
Relative valuation is quick and easy, perhaps. But because it's based on nothing more than casual observations of multiples, it can easily go awry.

Consider this: a well-known company surprises the market with exceedingly strong earnings. Its share price deservedly takes a big leap. In fact, the firm's valuation goes up so much that its shares are soon trading at P/E multiples dramatically higher than those of other industry players. Soon investors ask themselves whether the multiples of other industry players look cheap against those of the first company. After all, these firms are in the same industry, aren't they? If the first company is now selling for so many times more than its earnings, then other companies should trade at comparable levels, right?

Not necessarily. Companies can trade on multiples lower than those of their peers for all kinds of reasons. Sure, sometimes it's because the market has yet to spot the company's true value, which means the firm represents a buying opportunity. Other times, however, investors are better off staying away. How often does an investor identify a company that seems really cheap, only to discover that the company and its business is teetering on the verge of collapse?

In 1998, when Kmart's share price was downtrodden, it became a favorite of some investors. They couldn't help but think how downright cheap the shares of the retail giant looked against those of higher-valued peers Walmart and Target. Those Kmart investors failed to see that the business's model was fundamentally flawed. The company's earnings continued to fall and, overburdened with debt, Kmart filed for bankruptcy in 2002.

Investors need to be cautious of stocks that are proclaimed to be "inexpensive". More often than not, the argument for buying a supposed undervalued stock isn't that the company has a strong balance sheet, excellent products or a competitive advantage. Trouble is, the company might look undervalued because it's trading in an overvalued sector. Or, like Kmart, the company might have intrinsic shortcomings that justify a lower multiple.

Multiples are based on the possibility that the market may presently be making a comparative analysis error, whether overvaluation or undervaluation. A relative value trap is a company that looks like a bargain compared to its peers, but is not. Investors can get so caught up on multiples that they fail to spot fundamental problems with the balance sheet, historical valuations and most importantly, the busi