Stock Investing (Part 3)

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 business plan.

Do Your Homework
The key to keeping free from relative value traps is extra homework. The challenge for investors is to spot the difference between companies and figure out whether a company deserves a higher or lower multiple than its peers.

For starters, investors should be extra careful when picking comparable companies. It is not enough simply to pick companies in the same industry or businesses. Investors need also to identify companies that have similar underlying fundamentals.

Aswath Damadoran, author of the "The Dark Side Of Valuation" (2001), argues that any fundamental differences between comparable firms that might affect the firms' multiples need to be thoroughly analyzed in relative valuation. All companies, even those in the same industries, contain unique variables - such as growth, risk and cash flow patterns - that determine the multiple. Kmart investors, for instance, would have benefited from examining how fundamentals like earnings growth and bankruptcy risk translated into trading-multiple discounts.

Next, investors will do well to examine how the multiple is formulated. It is imperative that the multiple be defined consistently across the firms being compared. Remember, even well-known multiples can vary in their meaning and use.

For example, let's say a company looks expensive relative to peers based on the well used P/E multiple. The numerator - share price - is loosely defined. While the current share price is typically used in the numerator, there are investors and analysts who use the average price over the previous year. There are also plenty of variants on the denominator. Earnings can be those from the most recent annual statement, the last reported quarter, or forecasted earnings for the next year. Earnings can be calculated with shares outstanding, or it can be fully diluted, and it can also include or exclude extraordinary items. We've seen in the past that reported earnings leave companies with plenty of room for creative accounting and manipulation. Investors must discern on a company-by-company basis what the multiple means.

Conclusion
Investors need all the tools they can get their hands on to come up with reasonable assessments of company value. Full of traps and pitfalls, relative valuation needs to be used in conjunction with other tools like DCF for a more accurate gauge of how much a firm's shares are really worth.
How to Read Footnotes - Part 3: Evaluating the Board of Directors

You'd be surprised at what you can learn from looking at the disclosures made about a company's board of directors. All it takes is a little time and a little knowledge. In the third part of our series on how to read footnotes we will look at some guidelines that will help you read between the lines and spot the red flags on a company's board of directors.
Overview
In theory, the board is responsible to the shareholders and is supposed to govern a company's management. In reality, the board has become a servant of the CEO, who is typically also the chairman of the board. But the role of the board of directors has come under scrutiny in light of the excesses of Enron, WorldCom, Healthsouth and their ilk. Since the passage of the Sarbanes-Oxley Act increased the risk of litigation and criminal charges, boards have become more concerned about their roles and composition.

The Checklist
There is a checklist that investors can use to evaluate the objectivity and effectiveness of a board. This list was developed from a study done by the Corporate Library ("the study") and was reported in the Oct 27, 2003, edition of the Wall Street Journal (page R7).

1. Size of the Board
A large board is a sign that membership is a payback of some kind, a "thank you" for good service or for getting the CEO on another board. On the other hand, a small board could be just as ineffective if it is stacked with sycophants. According to the Corporate Library's study, the average board size is 9.2 members, ranging from 3 to 31 members.

As an analyst, I think the ideal size is seven, and here is why. There are two critical board committees that must be comprised of independent members: the compensation committee and the audit committee. Based upon our research, the minimum number for each committee is three. This means a minimum of six board members is needed so that no one is on more than one committee - having members doing double duty may compromise the important wall between audit and compensation, which should help avoid any conflicts of interest. Furthermore, if members are serving on a number of other boards it may increase the risk that the members cannot devote adequate time to their responsibilities.

Rounding out the ideal board is the seventh member, the chairperson of the board. It's the responsibility of the chairperson to make sure the board is functioning properly and the CEO is fulfilling his or her duty and following the directives of the board. Obviously, if the CEO is also the chairperson of the board, a conflict of interest is created.

Two or three additional people may be necessary to staff any additional committees, such as nominating or governance, but more than nine members makes the board too big to function effectively.

2. Insider/Outsider (Degree of Independence)
A key attribute of an effective board is that it is comprised of independent outsiders. An outsider is someone who has never worked at the company, is not related to any of the key employees and does not/did not work for a major supplier or customer. The WSJ study found that independent outsiders comprised 66% of all boards and 72% of S&P boards.

While this definition of independent outsiders seems clear enough, you'd be surprised at the number of times it is misapplied. Too often, the 'outsider' label is given to the retired CEO or a relative, when they are in fact insiders with material conflicts of interest.

3. Committees
There are three important committees that each board should have: audit, compensation and nominating. There may be more committees depending on corporate philosophy (which is determined by an ethics committee) or if the company wants to combat current negative headlines. Let's take a closer look at the three main committees:
The Audit Committee
The audit committee is charged with working with the auditors to make sure that the books are correct and that there are no conflicts of interest between the auditors and the other consulting firms employed by the company. Ideally, the chair of the audit committee is a CPA. But too often there is not a CPA anywhere on the audit committee, let alone on the board. The NYSE requires that the audit committee include a financial expert, but this qualification is typically met by a retired banker, even though that person's ability to catch fraud may be questionable. The audit committee should meet at least four times a year in order to review the most recent audit. An additional meeting should be held if there are other issues that need to be addressed.

The Compensation Committee
The compensation committee is responsible for setting the pay of top executives. While it seems obvious that the CEO (or other people with conflicts of interest) should not be on this committee, you'd be surprised at the number of companies that allow just that. Because of the 'I'll scratch your back if you scratch mine' conflict of interest, it is important to check to see if the members of the compensation board are also on the compensation committees of other firms. Also, the compensation committee should meet at least twice a year: one meeting is a sign that the committee meets just to approve a pay package that was created by the CEO or a consultant without much debate.

The Nominating Committee
This committee is responsible for nominating people to the board. The nomination process should aim to bring on people with independence and a skill set currently lacking on the board.

4. Other Commitments/Time Constraints
A key consideration in determining the effectiveness of a board member is the number of other boards and committees they are on.

The following chart from the survey shows the time commitments of board members of the 1,700 largest U.S. public companies. This indicates that the majority of board members sit on no more than three boards. What this data does not indicate is the number of committees that these people are on.

You'll often find that the key board members (the independent ones) serve on both the audit and the compensation committees and are also on three or more other boards. You have to wonder how much time a board member can devote to a company's business if he or she is on multiple boards. This situation also raises questions about the supply of independent outside directors. Are these people pulling double duty because there's a lack of qualified outsiders?
5. Paybacks
The apparent shortage of independent outsiders also makes one wonder if a board seat is not a form of corporate welfare for retired CEOs - especially when you consider that the board member usually gets paid for each meeting and may receive an annual salary as well as stock options. You have to question the rationale of having a board composed of CEOs of other companies and 70 year olds who are also on several other boards.

6. Related Transactions
Companies must disclose any transactions with executives and directors in a footnote entitled "Related Transactions". This can prove to be very enlightening reading because it discloses some actions that cause conflicts of interest, such as doing business with a director's company or having the CEO's wife on the payroll.

Conclusion - the Bottom Line
The composition of the board of directors says a lot about corporate management and governance. A company loses credibility if its board is stacked with insiders that rubber stamp accounting and compensation issues that were decided by the CEO.

Value by the Book

What price should you pay for a company's shares? If the goal is to unearth high-growth companies selling at low-growth prices, the price-to-book ratio offers investors a handy, albeit fairly crude, approach to finding undervalued companies. It is, however, important to understand exactly what the ratio can tell you and when it may not be an appropriate measurement tool.
Difficulties of Determining Value
Let's say you identify a company with strong profits and solid growth prospects. How much should you be prepared to pay for it? To answer this question you might try using a fancy tool like discounted cash flow analysis to provide a fair value. But DCF can be tricky to get right, even if you can manage the math. It requires an accurate estimate of future cash flows, but it can be awfully hard to look more than a year or two into the future. DCF also demands the return required by investors on a given stock, another number that is difficult to produce accurately.

What Is P/B?
There is an easier way to gauge value. Price-to-book value (P/B) is the ratio of market price of a company's shares (share price) over its book value of equity. The book value of equity, in turn, is the value of a company's assets expressed on the balance sheet. This number is defined as the difference between the book value of assets and the book value of liabilities.

Assume a company has $100 million in assets on the balance sheet and $75 million in liabilities. The book value of that company would be $25 million. If there are 10 million shares outstanding, each share would represent $2.50 of book value. If each share sells on the market at $5, then the P/B ratio would be 2 (5/2.50).

What Does P/B Tell Us?
For value investors, P/B remains a tried and tested method for finding low price stocks that the market has neglected. If a company is trading for less than its book value (or has a P/B less than 1), it normally tells investors one of two things: either the market believes the asset value is overstated, or the company is earning a very poor (even negative) return on its assets.

If the former is true, then investors are well advised to steer clear of the company's shares because there is a chance that asset value will face a downward correction by the market, leaving investors with negative returns. If the latter is true, there is a chance that new management or new business conditions will prompt a turnaround in prospects and give strong positive returns. Even if this doesn't happen, a company trading at less than book value can be broken up for its asset value, earning shareholders a profit.

A company with a very high share price relative to its asset value, on the other hand, is likely to be one that has been earning a very high return on its assets. Any additional good news may already be accounted for in the price.

Best of all, P/B provides a valuable reality check for investors seeking growth at a reasonable price. Large discrepancies between P/B and ROE, a key growth indicator, can sometimes send up a red flag on companies. Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios. If a company's ROE is growing, its P/B ratio should be doing the same.

No Magic Bullet
Despite its simplicity, P/B doesn't do magic. First of all, the ratio is really only useful when you are looking at capital-intensive businesses or financial businesses with plenty of assets on the books. Thanks to conservative accounting rules, book value completely ignores intangible assets like brand name, goodwill, patents and other intellectual property created by a company. Book value doesn't carry much meaning for service-based firms with few tangible assets. Think of software giant Microsoft, whose bulk asset value is determined by intellectual property rather than physical property; its shares have rarely sold for less than ten times book value. In other words, Microsoft's share value bears little relation to its book value.

Book value doesn't really offer insight into companies that carry high debt levels or sustained losses. Debt can boost a company's liabilities to the point where they wipe out much of the book value of its hard assets, creating artificially high P/B values. Highly leveraged companies - like those involved in, say, cable and wireless telecommunications - have P/B ratios that understate their assets. For companies with a string of losses, book value can be negative and hence meaningless.


Behind-the-scenes, non-operating issues can impact book value so much that it no longer reflects the real value of assets. For starters, the book value of an asset reflects its original cost, which doesn't really help when assets are aging. Secondly, their value might deviate significantly from market value if the earnings power of the assets has increased or declined since they were acquired. Inflation alone may well ensure that book value of assets is less than the current market value.

At the same time, companies can boost or lower their cash reserves, which in effect changes book value, but with no change in operations. For example, if a company chooses to take cash off the balance sheet, placing it in reserves to fund a pension plan, its book value will drop. Share buybacks also distort the ratio by reducing the capital on a company's balance sheet.

Conclusion
Admittedly, the P/B ratio has shortcomings that investors need to recognize. But it offers an easy-to-use tool for identifying clearly under or overvalued companies. For this reason, the relationship between share price and book value will always attract the attention of investors.
The "True" Cost of Stock Options


How to value employee stock options (ESO)? This is possibly the central issue in the debate on whether these options should be expensed. According to basic accounting rules, if a value can be placed on this form of compensation, it should be expensed.

Proponents of expensing employee stock options say there are many models that can be used to place a value on options. Opponents argue these models are not applicable to employee stock options. This article will take a look at the argument of the opponents and then explore the possibility of a different approach to determining the cost of employee stock options.
The Arguments Against
Several models have been developed to value options that are traded on the exchanges, such as puts and calls. The models use assumptions and market data to estimate the value of the option at any point in time. Perhaps the most widely known is the Black-Scholes Model, which is the one most companies use when they discuss employee options in the footnotes to their SEC filings.

There are two main drawbacks to using these types of valuation models:
1. Assumptions - Like any model, the output (or value) is only as good as the data/assumptions that are used. If the assumptions are faulty, you will get faulty valuations regardless of how good the model is. The key assumptions in valuing employee stock options are the risk-free rate, stock volatility, dividends (if any) and life of the option. These are hard things to estimate because of the many underlying variables involved. More importantly, they can be manipulated: by adjusting any one or a combination of these assumptions, management can lower the value of the stock options and thus minimize the options' adverse impact on earnings.
2. Applicability - Another argument against using an option-pricing model for employee stock options is that the models were not created to value these types of options. The Black-Scholes model was created for valuing exchange-traded options on financial instruments (such as stocks and bonds) and commodities. The data used in these options are based on the expected future price of the underlying asset (a stock or commodity) that is to be set in the marketplace by buyers and sellers. Employee stock options, however, cannot be traded on any exchange, and option-pricing models were created because the ability to trade an option is valuable.
An Alternative Viewpoint
Outside of these theoretical debates, there is a real hard-dollar cost to employee stocks options and it is already disclosed in the financial statements. The real cost of employee options is the stock buyback program, used to manage dilution.

Companies use stock buyback programs to reduce and therefore manage the number of shares outstanding: a reduction in shares outstanding increases earnings per share. Generally, companies say they implement buybacks when they feel their stock is undervalued.
Most companies that have large employee stock option programs have stock buyback programs so that, as employees exercise their options, the number of shares outstanding remains relatively constant, or undiluted. If you assume that the main reason for a buyback program is to avoid earnings dilution, the cost of the buyback is a cost of having an employee stock option program, which can be expensed on the income statement.

If a company does not have a stock buyback program, then earnings will be reduced by both the cost of the options issued and dilution.

Conclusion - The Bottom Line
Stock options are used in lieu of cash wages, period. As such, they should be expensed in the period they are awarded. The cost of a stock repurchase program can be used as a way to value those options because in most cases management uses a repurchase program to prevent EPS from declining.

Even if a company does not have a share repurchase program, you can use the average annual share price times the number of shares underlying the options (net of shares expected to be un-exercised or expired) to derive an annual cost.

Show and Tell: The Importance of Transparency

Ask investors what kind of financial information they want companies to publish and you'll probably hear two words: more and better. Quality financial reports allow for effective, informative fundamental analysis.

But let's face it, the financial statements of some firms are designed to hide rather than reveal information. Investors should steer clear of companies that lack transparency in their business operations, financial statements or strategies. Companies with inscrutable financials and complex business structures are riskier and less valuable investments.
Transparency Is Assurance
The word "transparent" can be used to describe high-quality financial statements. The term has quickly become a part of business vocabulary. Dictionaries offer many definitions for the word, but those synonyms relevant to financial reporting are "easily understood", "very clear", "frank", and "candid".

Consider two companies with the same market capitalization, same overall market-risk exposure, and the same financial leverage. Assume that both also have the same earnings, earnings growth rate and similar returns on capital. The difference is that Company A is a single-business company with easy-to-understand financial statements. Company B, by contrast, has numerous businesses and subsidiaries with complex financials.

Which one will have more value? Odds are good the market will value Company A more highly. Because of its complex and opaque financial statements, Company B's value will be discounted.

The reason is simple: less information means less certainty for investors. When financial statements are not transparent, investors can never be sure about a company's real fundamentals and true risk. For instance, a firm's growth prospects are related to how it invests. It's difficult if not impossible to evaluate a company's investment performance if its investments are funneled through holding companies, making them hidden from view. Lack of transparency may also obscure the company's level of debt. If a company hides its debt, investors can't estimate their exposure to bankruptcy risk.

High-profile cases of financial shenanigans, such as those at Enron and Tyco, showed everyone that managers employ fuzzy financials and complex business structures to hide unpleasant news. Lack of transparency can mean nasty surprises to come.

Blurry Vision
The reasons for inaccurate financial reporting are varied: a small but dangerous minority of companies actively intends to defraud investors; other companies may release information that is misleading but technically conforms to legal standards.

The rise of stock option compensation has increased the incentives for companies to misreport key information. Companies have increased their reliance on pro forma earnings and similar techniques, which can include hypothetical transactions. Then again, many companies just find it difficult to present financial information that complies with fuzzy and evolving accounting standards.

Furthermore, some firms are simply more complex than others. Many operate in multiple businesses that often have little in common. For example, analyzing General Electric - an enormous conglomerate with dozens of businesses, from GE Plastics to NBC - is more challenging than examining the financials of a firm like Amazon.com, a pure play online retailer.

When firms enter new markets or businesses, the way they structure these new businesses can result in greater complexity and less transparency. For instance, a firm that keeps each business separate will be easier to value than one that squeezes all the businesses into a single entity. Meanwhile, the increasing use of derivatives, forward sales, off-balance-sheet financing, complex contractual arrangements and new tax vehicles can befuddle investors.

The cause of poor transparency, however, is less important than its effect on a company's ability to give investors the critical information they need to value their investments. If investors neither believe nor understand financial statements, the performance and fundamental value of that company remains either irrelevant or distorted.
Transparency Pays
Mounting evidence suggests that the market gives a higher value to firms that are upfront with investors and analysts. Transparency pays, according to Robert Eccles, author of "Building Public Trust – The Value Reporting Revolution". Eccles shows that companies with fuller disclosure win more trust from investors. Relevant and reliable information means less risk to investors and thus a lower cost of capital, which naturally translates into higher valuations. The key finding is that companies that share the key metrics and performance indicators that investors consider important are more valuable than those companies that keep information to themselves.

Of course, there are two ways to interpret this evidence. One is that the market rewards more transparent companies with higher valuations because the risk of unpleasant surprises is believed to be lower. The other interpretation is that companies with good results usually release their earnings earlier. Companies that are doing well have nothing to hide and are eager to publicize their good performance as widely as possible. It is in their interest to be transparent and forthcoming with information, so that the market can upgrade their fair value.

Further evidence suggests that the tendency among investors to mark down complexity explains the conglomerate discount. Relative to single-market or pure play firms, conglomerates are discounted by as much as 20%. The positive reaction associated with spin-offs and divestment can be viewed as evidence that the market rewards transparency.

Naturally, there could be other reasons for the conglomerate discount. It could be the lack of focus of these companies and the inefficiencies that follow. Or it could be that the absence of market prices for the separate businesses makes it harder for investors to assess value.

It's worth noting that, even if a company's financial statements are totally transparent, investors may still not understand them. If biotech specialist Amgen and semiconductor maker Intel were totally forthcoming about their R&D spending, investors might still lack the knowledge to properly value these companies.

Conclusion
Investors should seek disclosure and simplicity. The more companies say about where they are making money and how they are spending their resources, the more confident investors can be about the companies' fundamentals.

It's even better when financial reports provide a line-of-sight view into the company's growth drivers. Transparency makes analysis easier and thus lowers an investor's risk when investing in stocks. That way you, the investor, are less likely to face unpleasant surprises.

Why There Are Few Sell Ratings on Wall Street

Why are there so few sell recommendations on Wall Street? This has been a matter of much debate in the media, and with good reason. Read on and discover the answer to this popular question - you may be surprised!
Bull Market Explanation
The current view is that analysts tend to be wildly optimistic and possibly criminal in how they rate stocks during a bull market. Researchers have published data showing that, during the late 1990s, sell ratings were as scarce as value investors. And while the ratio of sell ratings to other ratings has increased since then, the sells remain in the minority.

Research Requires Compensation
The reason there are so few sells is that it is not economical to follow a stock with a sell rating. Providing research coverage requires a large investment of time and money. In order to remain profitable and cover the cost of providing research, brokerage firms need to be able to make money on transactions made by customers trading the stock or get investment banking business. A stock that is going up has the potential to generate profit for researchers because investors may buy the stock many times and will need more information throughout the time they own the stock. A sell rating results in just one trade.

Historically, it was a very rare occurrence to find research initiated on a company with a sell or hold rating because the cost of initiating coverage is not justified by the potential revenue of that research coverage. Coverage is usually initiated and maintained on companies that have the potential to be long-term winners, thereby generating income for a longer period than it took the brokerage to initiate coverage. Of course, investors want to buy stocks that are expected to rise, sometimes several times, which generates fee income that (hopefully) more than offsets the brokerage's cost of providing that research.

When Sell Ratings Are Issued
Sell ratings are issued if a company's profitability starts to falter or if it has issues that indicate that its stock is no longer a good investment. When a company reaches such a point, its stock may be placed on a monitor status, at which time fewer reports are issued, if any. Indeed, the brokerage is more likely to quietly drop the stock and publish no further research.

However, in post-Spitzer Wall Street, there is a new game in town and it's called a quota system. Brokerage firms are now required to have a certain percentage of sell ratings. While this is meant to prevent future abuses, it actually increases the operating costs of brokerage firms and, possibly more damaging, regretful research on firms that previously had no coverage.


Regretful research is the result of analysts trying to increase their number of sells (to keep up with their quota) by finding some small/micro-cap firm and doing a brief report on why it is not a good investment. The method and motivation behind this research is regretful because it may not be in depth, stemming from a desire to meet the quota rather than a commitment to providing investment information. The unlucky company used to fulfill the sell quota could be in the early stages of improving profitability and may be a great long-term investment, but the superficial sell rating assigned to it will taint it and keep investors away because it is likely to be the only research on that company.

Conclusion - The Bottom Line
Investors want to know more about stocks that can go up and not so much about stocks that might go down. To meet this demand, analysts spend more time looking for stocks that will go up than analyzing stocks that may or will go down. This market dynamic can be summed up by two classic Wall Street sayings:
• An analyst is only as good as their last idea.
• A stock can be bought many times but sold only once.
The quota system may do more harm than good because it encourages research that, regretfully, may not present an accurate analysis of a company's investment potential.

Evaluating Retained Earnings: What Gets Kept Counts

When sizing up a company's fundamentals, investors need to look at how much capital is kept from shareholders. Making profits for shareholders ought to be the main objective for a listed company and, as such, investors tend to pay most attention to reported profits. Sure, profits are important. But what the company does with that money is equally important.

Typically, a portion of the profit is distributed to shareholders in the form of a dividend. What gets left over is called retained earnings or retained capital. Savvy investors should look closely at how a company puts retained capital to use and generates a return on it.
The Job of Retained Earnings
In broad terms, capital retained is used to maintain existing operations or to increase sales and profits by growing the business.

Life can be hard for some companies - such as those in manufacturing - that have to spend a large chunk of profits on new plants and equipment just to maintain existing operations. Decent returns for even the most patient investors can be elusive. For those forced to constantly repair and replace costly machinery, retained capital tends to be slim.

Some companies need large amounts of new capital just to keep running. Others, however, can use the capital to grow. When you invest in a company, you should make it your priority to know how much capital the company appears to need and whether management has a track record of providing shareholders with a good return on that capital.

Retained Earnings for Growth
If it has any chance of growing, a company must be able to retain earnings and invest them in business ventures that, in turn, can generate more earnings. In other words, a company that aims to grow must be able to put its money to work, just like any investor. Say you earn $10,000 each year and put it away in a cookie jar on top of your refrigerator. You will have $100,000 after 10 years. However, if you earn $10,000 and invest it in a stock earning 10% compounded annually, then you will have $159,000 after 10 years.

Retained earnings should boost company value and, in turn, boost the value of the amount of money you invest into it. The trouble is that most companies use their retained earnings for maintaining the status quo. If a company can use its retained earnings to produce above-average returns, then it is better off keeping those earnings instead of paying them out to shareholders.

Determining the Return on Retained Earnings
Fortunately, for companies with at least several years of historical performance, there is a fairly simple way to gauge how well management employs retained capital. Simply compare the total amount of profit per share retained by a company over a given period of time against the change in profit per share over that same period of time.

For example, if Company A earns 25 cents a share in 1993 and $1.35 a share in 2003, then per-share earnings rose by $1.10. From 1993 through 2003, Company A earned a total of $7.50 per share. Of the $7.50, Company A paid out $2 in dividends, and therefore had a retained earnings of $5.50 a share. Since the company's earnings per share in 2003 is $1.35, we know the $5.50 in retained earnings produced $1.10 in additional income for 2003. Company A's management earned a return of 20% ($1.10 divided by $5.50) in 2003 on the $5.50 a share in retained earnings.

When evaluating the return on retained earnings, you need to determine whether it's worth it for a company to keep its profits. If a company reinvests retained capital and doesn't enjoy significant growth, investors would probably be better served if the board of directors declared a dividend.

Evaluating Retained Earnings by Market Value
Another way to evaluate the effectiveness of management in its use of retained capital is to measure how much market value has been added by the company's retention of capital. Suppose shares of Company A were trading at $10 in 1993, and in 2003 they traded at $20. Thus, $5.50 cents per share of retained capital produced $10 per share of increased market value. In other words, for every $1 retained by management, $1.82 ($10 divided by $5.50) of market value was created. Impressive market value gains mean that investors can trust management to extract value from capital retained by the business.

Conclusion
For stable companies with long operating histories, measuring the ability of management to employ retained capital profitably is relatively straightforward. Before buying, investors need to ask themselves not only whether a company can make profits, but whether management can be trusted to generate growth with those profits.

Can You Count On Goodwill?
Goodwill is hard to count on because its value can come from abstract and often unreliable things, like ideas and people, neither of which are guaranteed to work for a company forever. Determining goodwill also involves some time to work around accounting conventions. When analyzing company fundamentals, investors should try hard to get a sense of where the value of a company's goodwill is coming from and where it might be going.

What Is Goodwill?
Given its hazy nature, goodwill is designated as an intangible asset. It is a blanket term that represents, in one lump sum, the value of brand names, patents, customer base loyalty, competitive position, R&D and other hard-to-price assets a company might own. It encompasses all the factors above and beyond book value that make investors willing to buy a business.

Hazards of Goodwill in M & A
Investors need to worry about goodwill when a company buys another company and pays more than the fair market value of net assets. Let's say you invest in Thunder Inc. The company has $100 million in cash with no other assets or liabilities, and therefore a book value of $100 million. Now, imagine that Thunder Inc. buys Lightning Inc. for $100. Lightning Inc. has a whole host of different assets with a fair market value of $100 million, liabilities of $50 million and a book value of $50.

Before the deal, Thunderbolt's book value amounted to $100 million. Post-purchase, Thunderbolt emerges with $100 million in assets and $50 million in liabilities, which means its book value (assets minus liabilities) is just $50 million. Here is where the goodwill accounting convention makes its appearance. Goodwill is the amount over and above the fair market value of Lightning's net assets. To account for the purchase price of $100 million, a total of $50 million worth of goodwill will be tacked onto Thunderbolt's balance sheet.
The Equity Risk Premium - Part 1
In theory, stocks should provide a greater return than safe investments like Treasury bonds. The difference is called the equity risk premium: it is the excess return that you can expect from the overall market above a risk-free return. There is vigorous debate among experts about the method employed to calculate the equity premium and, of course, the resulting answer. In this article, we take a look at these methods - particularly the popular supply-side model - and the debates surrounding equity premium estimates.

Why Does it Matter?
The equity premium helps to set portfolio return expectations and determine asset allocation policy. A higher premium, for instance, implies that you would invest a greater share of your portfolio into stocks. Also, the capital asset pricing relates a stock's expected return to the equity premium: a stock that is riskier than the market - as measured by its beta - should offer excess return above the equity premium.
Greater Expectations
Compared to bonds, we expect extra return from stocks due to the following risks:
1. Dividends can fluctuate, unlike predictable bond coupon payments.
2. When it comes to corporate earnings, bond holders have a prior claim while common stock holders have a residual claim.
3. Stock returns tend to be more volatile (although this is less true the longer the holding period).
And history validates theory. If you are willing to consider holding periods of at least 10 or 15 years, U.S. stocks have outperformed treasuries over any such interval in the last 200 years.

But history is one thing, and what we really want to know is tomorrow's equity premium. Specifically, how much extra above a safe investment should we expect for the stock market going forward? Academic studies tend to arrive at lower equity risk premium estimations - in the neighborhood of 2-3%, or even lower! Later in this article, we'll explain why this is always the conclusion of an academic study, whereas money managers often point to recent history and arrive at higher estimations of premiums.

Getting at the Premium
Here are the four ways to estimate the future equity risk premium:

What a range of outcomes! Opinion surveys naturally produce optimistic estimates, as do extrapolations of recent market returns. But extrapolation is a dangerous business: first, it depends on the time horizon selected, and second, we cannot know that history will repeat itself. Professor William Goetzmann of Yale has cautioned, "History, after all, is a series of accidents; the existence of the time series since 1926 might itself be an accident." For example, one widely accepted historical accident concerns the abnormally low long-term returns to bondholders that started right after World War II (and subsequently low bond returns increased the observed equity premium); bond returns were low in part because bond buyers in the 1940s and 1950s - misunderstanding government monetary policy - clearly did not anticipate inflation.

Building a Supply Side Model
Let's review the most popular approach, which is to build a supply-side model. There are three steps:
1. Estimate the expected total return on stocks.
2. Estimate the expected risk-free return (bond).
3. Find the difference: expected return on stocks minus risk-free return equals the equity risk premium.
We'll keep it simple and sidestep a few technical issues. Specifically, we are looking at expected returns that are long-term, real, compound and pre-tax. By long-term, we mean something like 10 years, as short horizons raise questions of market timing. (That is, it is understood that markets will be over or under-valued in the short run.) By 'real', we mean net of inflation. Even if we estimated the stock and bond returns in nominal terms, inflation would fall out of the subtraction anyhow. And by 'compound', we mean to ignore the ancient question of whether forecasted returns ought to be calculated as arithmetic or geometric (time-weighed) averages.

Finally, although it is convenient to refer to pre-tax returns as do virtually all academic studies, individual investors should care about after-tax returns. Taxes make a difference. Let's say the risk-free rate is 3% and the expected equity premium is 4%; we therefore expect equity returns of 7%. Say we earn the risk-free rate entirely in bond coupons taxed at ordinary income tax rates of 35%, whereas equities may be deferred entirely into a capital gains rate of 15% (i.e., no dividends). The after-tax picture in this case makes equities look even better.
Step One: Estimate the Expected Total Return on Stocks
Dividend-Based Approach
The two leading supply-side approaches start with either dividends or earnings. The dividend-based approach says that returns are a function of dividends and their future growth. Consider an example with a single stock that today is priced at $100, pays a constant 3% dividend yield (dividend per share divided by stock price), but for which we also expect the dividend - in dollar terms - to grow at 5% per year.

In this example, you can see that if we grow the dividend at 5% per year and insist on a constant dividend yield, the stock price must go up 5% per year too. The key assumption is that the stock price is fixed as multiple of the dividend. If you like to think in terms of P/E ratios, it is the equivalent to assuming that 5% earnings growth and a fixed P/E multiple must push the stock price up 5% per year. At the end of five years, our 3% dividend yield naturally gives us a 3% return ($19.14 if the dividends are reinvested). And the growth in dividends has pushed the stock price to $127.63, which gives us an additional 5% return. Together, we get a total return of 8%.

That's the idea behind the dividend-based approach: the dividend yield (%) plus the expected growth in dividends (%) equals the expected total return (%). In formulaic terms, it is just a re-working of the Gordon Growth Model, which says that the fair price of a stock (P) is a function of the dividend per share (D), growth in the dividend (g) and the required or expected rate of return (k):

Earnings-Based Approach
Another approach looks at the price-to-earnings (P/E) ratio and its reciprocal: the earnings yield (earnings per share ÷ stock price). The idea is that the market's expected long-run real return is equal to the current earnings yield. For example, at the end of 2003, the P/E for the S&P 500 was almost 25. This theory says that the expected return is equal to the earnings yield of 4% (1 ÷ 25 = 4%). If that seems low, remember it's a real return. Add a rate of inflation to get a nominal return.

Here is the math that gets you the earnings-based approach:


Whereas the dividend-based approach explicitly adds a growth factor, growth is implicit to the earnings model. It assumes the P/E multiple already impounds future growth. For example, if a company has a 4% earnings yield but doesn't pay dividends, then the model assumes the earnings are profitably reinvested at 4%.

Even experts disagree here. Some "rev up" the earnings model on the idea that, at higher P/E multiples, companies can use high-priced equity to make progressively more profitable investments. Arnott and Bernstein - authors of perhaps the definitive study - prefer the dividend approach precisely for the opposite reason. They show that, as companies grow, the retained earnings they often opt to reinvest result in only sub-par returns - in other words, the retained earnings should have instead been distributed as dividends.
Handle with Care
Let's remember that the equity premium refers to a long-term estimate for the entire market of publicly-traded stocks. Lately several studies have cautioned that we should expect a fairly conservative premium in the future. There are two reasons why academic studies, regardless of when they are conducted, are certain to produce low equity risk premiums. The first is that they make an assumption that the market is correctly valued. In both the dividend-based approach and earnings-based approach, the dividend yield and earnings yield have reciprocal valuation multiples:

Both models assume that the valuation multiples - the price-to-dividend and P/E ratio - are correct in the present and will not change going forward. This is understandable, for what else can these models do? It is notoriously difficult to predict an expansion or contraction of the market's valuation multiple. The earnings model might forecast 4% based on a P/E ratio of 25. And earnings may grow at 4%, but if the P/E multiple expands to, say, 30 in the next year, then the total market return will be 25%, where multiple expansion alone contributes 20%! (30/25 -1 = +20%)

The second reason low equity premiums tend to characterize academic estimates is that the total market growth is limited over the long-term. You'll recall that we have a factor for dividend growth in the dividend-based approach. Academic studies assume that dividend growth for the overall market - and, for that matter, earnings or EPS growth - cannot exceed the total economy's growth over the long term. If the economy - as measured by gross domestic product (GDP) or national income - grows at 4%, then studies assume that markets cannot collectively outpace this growth rate. Therefore, if you start with an assumption that the market's current valuation is approximately correct and you set the economy's growth as a limit on long-term dividend growth (or earnings or earnings per share growth), a real equity premium of 4 or 5% is pretty much impossible to exceed.

Conclusion
Now that we have explored the risk premium models and their challenges, it is time to look at them with actual data. This we do in the second part of this series. The first step is to find a reasonable range of expected equity returns; step two is to deduct a risk-free rate of return and; and step three is to try to arrive at a reasonable equity risk premium.
ROA on the Way
Sure, it's interesting to know the size of a company. Each year Fortune Magazine publishes a list of the 500 biggest companies by asset base. But ranking companies by the size of their assets is rather meaningless unless one knows how well those assets are put to work for investors.
As the name implies, return on assets (ROA) gauges how efficiently a company can squeeze profit from its assets, regardless of size. A high ROA is a telltale sign of solid financial and operational performance.

Calculating ROA
The simplest way to determine ROA is to take net income reported for a period and divide that by total assets. To get total assets, calculate the average of the beginning and ending asset values for the same time period.
ROA = Net Income/Total Assets

Some analysts take earnings before interest and taxation, and divide over total assets:
ROA = EBIT/Total Assets

This is a pure measure of the efficiency of a company in generating returns from its assets, without being affected by management financing decisions.

Either way, the result is reported as a percentage rate of return. An ROA of, say, 20% means that the company produces $1.00 of profit for every $5.00 it has invested in its assets. You can see that ROA gives a quick indication of whether the business is continuing to earn an increasing profit on each dollar of investment. Investors expect that good management will strive to increase the ROA - to extract greater profit from every dollar of assets at its disposal.

A falling ROA is a sure sign of trouble around the corner, especially for growth companies. Striving for sales growth often means major upfront investments in assets, including accounts receivables, inventories, production equipment and facilities. A decline in demand can leave an organization high and dry, and overinvested in assets it cannot sell to pay its bills. The result can be financial disaster.

ROA Hurdles
Expressed as a percentage, ROA identifies the rate of return needed to determine whether investing in a company makes sense. Measured against common hurdle rates like the interest rate on debt and cost of capital, ROA tells investors whether the company's performance stacks up.

Compare ROA to the interest rates companies pay on their debts: if a company is squeezing out less from its investments than what it's paying to finance those investments, that's not a positive sign. By contrast, an ROA that is better than the cost of debt means that the company is pocketing the difference.

Similarly, investors can weigh ROA against the company's cost of capital to get a sense of realized returns on the company's growth plans. A company that embarks on expansions or acquisitions that create shareholder value should achieve an ROA that exceeds the costs of capital; otherwise, those projects are likely not worth pursuing. Moreover, it's important that investors ask how a company's ROA compares to those of its competitors and to the industry average.

Getting Behind ROA
There is another, much more informative way to calculate ROA. If we treat ROA as a ratio of net profits over total assets, then two telling factors determine the final figure: net profit margin (net income divided by revenue) and asset turnover (revenues divided by average total assets).

If return on assets is increasing, then either net income is increasing or average total assets are decreasing.
ROA = (Net Income/Revenue) X (Revenues/Average Total Assets)
A company can arrive at a high ROA either by boosting its profit margin or, more efficiently, by using its assets to increase sales. Say a company has an ROA of 24%. Investors can determine whether that ROA is driven by, say, a profit margin of 6% and asset turnover of 4 times, or a profit margin of 12% and an asset turnover of 2 times. By knowing what's typical in the company's industry, investors can determine whether or not a company is performing up to par.

This also helps clarify the different strategic paths companies may pursue - whether a low-margin, high-volume producer or a high-margin, low-volume competitor.

ROA also resolves a major shortcoming of return on equity (ROE). ROE is arguably the most widely used profitability metric, but many investors quickly recognize that it doesn't tell you if a company has excessive debt or is using debt to drive returns. Investors can get around that conundrum by using ROA instead. The ROA denominator - total assets - includes liabilities like debt (remember total assets = liabilities + shareholder equity). Consequently, everything else being equal, the lower the debt, the higher the ROA.

A Couple of Things to Watch For
Still, ROA is far from being the ideal investment evaluation tool. There are a couple of reasons why it can't always be trusted. For starters, the 'return' numerator of net income is suspect (as always), given the deficiencies of accrual-based earnings and the use of managed earnings.

Also, since the assets in question are the sort that are valued on the balance sheet - namely, fixed assets and not intangible assets like people or ideas - ROA is not always useful for comparing one company against another. Some companies are 'lighter', having their value based on things such as trademarks, brand names and patents, which accounting rules don't recognize as assets. A software maker, for instance, will have far fewer assets on the balance sheet than a car maker. As a result, the software company's assets will be understated, and its ROA may get a questionable boost.

Conclusion
ROA gives investors a reliable picture of management's ability to pull profits from the assets and projects into which it chooses to invest. The metric also provides a good line of sight into net margins and asset turnover - two key performance drivers. ROA makes the job of fundamental analysis easier, helping investors recognize good stock opportunities and minimizing the likelihood of unpleasant surprises.

Z Marks the End

How do you know when a company is at risk of corporate collapse? To detect any signs of looming bankruptcy, investors calculate and analyze all kinds of financial ratios: working capital, profitability, debt levels and liquidity. The trouble is, each ratio is unique and tells a different story about a firm's financial health. At times they can even appear to contradict each other. Having to rely on a bunch of individual ratios, the investor may find it confusing and difficult to know when a stock is going to the wall.

In a bid to resolve this conundrum, NYU Professor Edward Altman introduced the Z-score formula in the late 1960s. Rather than search for a single best ratio, Altman built a model that distills five key performance ratios into a single score. As it turns out, the Z-score gives investors a pretty good snapshot of corporate financial health.
The Z-score Formula
Here is the formula (for manufacturing firms), which is built out of the five weighted financial ratios:
Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:
Z = score
A = Working Capital/Total Assets
B = Retained Earnings/Total Assets
C = Earnings Before Interest & Tax/Total Assets
D = Market Value of Equity/Total Liabilities
E = Sales/Total Assets
Strictly speaking, the lower the score, the higher are the odds of bankruptcy. A Z-score of lower than 1.8 indicates that the company is heading for bankruptcy. Companies with scores above 3 are unlikely to enter bankruptcy. scores in between 1.8 and 3 lie in a gray area.

Breaking Down the Z
Now that we know the formula, it's helpful to examine why these particular ratios are included. Let's take a look at the significance of each one:
• Working capital/total assets (WC/TA) is a ratio that is a good test for corporate distress. A firm with negative working capital is likely to experience problems meeting its short-term obligations - because there are simply not enough current assets to cover them. By contrast, a firm with significantly positive working capital rarely has trouble paying its bills.
• Retained earnings/total assets (RE/TA) measures the amount of reinvested earnings or losses, which reflects the extent of the company's leverage. Companies with low RE/TA are financing capital expenditure through borrowings rather than through retained earnings. Companies with high RE/TA suggest a history of profitability and the ability to stand up to a bad year of losses.
• Earnings before interest and tax/total assets (EBIT/TA ) is a version of return on assets (ROA), an effective way of assessing a firm's ability to squeeze profits from its assets before factors like interest and tax are deducted.
• Market value of equity/total liabilities (ME/TL) is a ratio that shows - if a firm were to become insolvent - how much the company's market value would decline before liabilities exceed assets on the financial statements. This ratio adds a market value dimension to the model that isn't based on pure fundamentals. In other words, a durable market capitalization can be interpreted as the market's confidence in the company's solid financial position.
• Sales/total assets (S/TA) tells investors how well management handles competition and how efficiently the firm uses assets to generate sales. Failure to grow market share translates into a low or falling S/TA.

WorldCom Test
To demonstrate the power of the Z-score, let's look at how it holds up with a tricky test case. Consider the infamous collapse of telecommunications giant WorldCom. Declared bankrupt in July 2002, WorldCom lost investors more than $100 billion in value after management falsely recorded billions of dollars as capital expenditures rather than operating costs.

Here we calculate Z-scores for WorldCom using annual 10-K financial reports for years ending December 31 1999, 2000 and 2001. Indeed, WorldCom's Z-score suffered a sharp fall. Also note that the Z-score moved from the gray area into the danger zone in 2000 and 2001, before declaring bankruptcy in 2002.
Input Financial Ratio 1999 2000 2001
X1 Working capital/ Total Assets -0.09 -0.08 0
X2 Retained earnings/Total Assets -0.02 0.03 0.04
X3 EBIT/Total Assets .09 .08 .02
X4 Market Value/Total Liabilities 3.7 1.2 .50
X5 Sales/Total Assets 0.51 0.42 0.3
Z-score 2.5 1.4 .85

But WorldCom management cooked the books, inflating the company's earnings and assets in the financial statements. What impact do these shenanigans have on the Z-score? Overstated earnings likely increase the EBIT/total assets ratio in the Z-score model, but overstated assets would actually shrink three of the other ratios with total assets in the denominator. So the overall impact of the false accounting on the company's Z-score is likely to be downward.

Where Z Falls Short
Alas, the Z-score is not perfect and needs to be calculated and interpreted with care. For starters, the Z-score is not immune to false accounting practices. As WorldCom demonstrates, companies in trouble may be tempted to misrepresent financials. The Z-score is only as accurate as the data that goes into it.

The Z-score also isn't much use for new companies with little or no earnings. These companies, regardless of their financial health, will score low. Moreover, the Z-score doesn't address the issue of cash flows directly, only hinting at it through the use of the net working capital-to-asset ratio. After all, it takes cash to pay the bills.

Finally, Z-scores can swing from quarter to quarter when a company records one-time write-offs. These can change the final score, suggesting that a company that's really not at risk is on the brink of bankruptcy.

Conclusion
To keep an eye on their investments, investors should consider checking their companies' Z-score on a regular basis. A deteriorating Z-score can signal trouble ahead and provide a simpler conclusion than the mass of ratios. Given its shortcomings, the Z is probably better used as a gauge of relative financial health rather than as a predictor. Arguably, it's best to use the model as a quick check of financial health, but if the score indicates a problem, it's a good idea to conduct a more detailed analysis.
Retirement Plan Tax Forms You May Need to File - Part 1
In most cases, the only way to receive the proper tax treatment for your income, including income you receive as a distribution from your retirement plan or education savings account (ESA), is by filing the proper forms. In fact, failure to file the appropriate form could result in you paying more taxes than you owe or owing the IRS an excise penalty. In this two-part series we give an overview of some important forms you should know about.

IRS Form 5329
Form 5329, entit