Topics on Stock Trading (Part 2)

Five Investing Pitfalls To Avoid, According to Investor's Business Daily
Big stock market winners look a lot alike -- they have strong earnings and sales growth, a dynamic new product or service, leading price performance and rising mutual fund ownership. Interestingly, successful investors share similar traits.

Top investors always keep their losses small; they never average down in price; they don't immediately shun a stock because it has a high price-earnings ratio (P/E Ratio); and finally, they pay attention to the general health of the market when they buy and sell stocks.

Yet, at the same time, many investors still operate using unsound principles. Successful investors learn to avoid the common pitfalls, and follow these insights that can put you well on your way to becoming a better investor.

Buying Low-Priced Stocks
What sounds better? Buying 1,000 shares of a $1 stock or buying 20 shares of a $50 stock? Most people would probably say the former because it seems like a bargain, with more opportunity for big increases from owning more shares. But the money you make in a stock isn't based on how many shares you own. It's based on the amount of money invested.

Many investors have a love affair with cheap stocks, but low-priced stocks are generally missing a key ingredient of past stock market winners: institutional sponsorship.

A stock can't make big gains without the buying power of mutual funds, banks, insurance companies and other deep-pocketed investors fueling their price moves. It's not retail trades of 100, 200 or 300 shares that cause a stock to surge higher in price, it's big institutional block share trades of 10,000, 20,000 or more that cause these great jumps in price when they buy -- as well as great price drops when they sell.

Institutional investors account for about 70% of the trading volume each day on the exchanges, so it's a good idea to fish in the same pond as they do. Stocks priced at $1, $2 or $3 a share are not on the radar screens of institutional investors. Many of these stocks are thinly traded so it's hard for mutual funds to buy and sell big volume shares.

Remember: Cheap stocks are cheap for a reason. Stocks sell for what they’re worth. In many cases, investors that try to grab stocks on the cheap don’t realize that they're buying a company mired in problems with no institutional sponsorship, slowing earnings and sales growth and shrinking market share. These are bad traits for a stock to have. Institutions have research teams that seek out great opportunities, and because they buy in huge quantities over time, consider piggybacking their choices if you find these fund managers have better-than-average performance.

The reality is that your prospect of doubling your money in a $1 stock sure sounds good, but your chances are better of winning the lottery. Focus on institutional quality stocks.

Avoiding Stocks With High P/E Ratios
"Focus on stocks with low P/E ratios. They're attractively valued and there’s a lot of upside." How many times have you heard this statement from investment pros?

While it's true that stocks with low P/E ratios can go higher, investors often misuse this valuation metric. Leaders in an industry group often trade at a higher premium than their peers for a simple reason: They're expanding their market share faster because of outstanding earnings and sales growth prospects.

Stocks on your watch list should have the traits of past big stock market winners we mentioned earlier: leading price performance in their industry group, top-notch earnings and sales growth and rising fund ownership, to name a few. A dynamic new product or service doesn't hurt either.

Stocks with "high" P/E ratios share a common trait: their performance shows there's plenty of bullishness about the company's future prospects. For example: In Aug 2003, stun-gun maker Taser International had a P/E of 44 before a 900% increase. At the time, the market was bullish about the firm's earnings and sales growth prospects. The market turned out to be right. For five straight quarters, Taser has posted triple-digit earnings and sales gains.

More great examples come from the medical, retail, and oil and gas sector, which were all strong performers in the 2003-2004 period. The table below shows leading stocks in the sectors that staged big price runs from seemingly high P/E ratios. In every case, it was explosive fundamentals that drove their stock price.

At end-Oct 2004, the average P/E Ratio of stocks in the S&P 500 Index was around 17.


Letting Small Losses Turn Into Big Ones
Insurance policies help us minimize risk when it comes to our health, home or car. In the stock market, most people don't even think about buying insurance policies with individual stocks but it's a good practice.

Cut your losses in any stock at 7% or 8% and you'll never get hit with a big loss. This is your insurance policy. If you buy stocks at the right time, they should never fall 7-8% below your purchase price.

A small loss in a stock can easily be overcome. It’s the big ones that can do serious damage to a portfolio. Take a 50% loss on a stock, and it would need to rise 100% to get back to break-even. But if you cut your losses at 7% or 8%, a single 25% gain can wipe out three 7%-8% losses.

Here's a set of hypothetical trades to illustrate the point. Even if you had made these seven trades over a period of time - and taken losses on five of them - you would still come out ahead by more than $3,700. That's because the two stocks that worked out resulted in a combined profit of $5,500. And the five losses - all capped at 7% or 8% - added up to $1,569.


The rationale for that 7% Sell Rule was never clearer than in the bear market that began in Mar 2000. It caused unnecessary, severe damage to many investors' portfolios. Small losses in tech stocks snowballed into huge ones. Some stocks lost 70%-80% or more of their value. Some will never reclaim their old highs. Others may, but it'll be a long road back. All successful investors share one trait: they firmly recognize the importance of protecting hard-earned capital by selling fast when a stock declines 7% or 8% from where they bought it.

If a stock you own starts to fall on expanding trading volume, it's usually better to sell first and ask questions later, rather than the other way around. Keep losses small to avoid severe damage. You can always re-enter the game if you've only lost 7%. Don't ever look back after a smart sell, even if the stock rebounds. You have no way of knowing its future, so you are best off reacting to what your stock is telling you right now. Learning this trait is hard -- but it will save you a great deal in the long run.

Averaging Down
Averaging down means you're buying stock as the price falls in the hopes of getting a bargain. It's also known as throwing good money after bad or trying to catch a falling knife. Either way, trying to lower your average cost in a stock is another risky proposition.

For example, take Amazon.com between June and Oct of 2004. Its chart revealed much institutional selling by mutual funds and other big investors.

In June, it was a $54 stock. In July, it was a $45 stock. Investors who bought in at $45 may have thought they were getting a bargain, but they weren’t paying attention to multiple heavy-volume declines in the stock. What's the sense of buying a stock when mutual funds and other big investors are selling big blocks of shares? That's a tough tide to swim against.

When Amazon released its earnings on Oct 21, it fell another 10% to around $37. In general, stock charts tell bullish or bearish stories long before headlines do. In Amazon's case, heavy volume declines between July 8 to 23 told a bearish story.

Buying Stocks In A Down Market
Some investors don't pay any attention to the current state of the market when they buy stocks. And that's a mistake.

The goal is to buy stocks when the major indexes are showing signs of accumulation (buying: heavy volume price increases) and to sell when they're showing signs of distribution (selling: heavy volume price declines). Three-fourths of all stocks follow the market's trend, so watch it each day, and don't go against the trend. It's not hard to tell when the indexes start to show signs of duress.

Distribution days will start to crop up in the market where the indexes close lower on heavier volume than the day before. In this case, a strong market opening will fizzle into weak closes. And leading stocks in the market's leading industry groups will start to sell off on heavy volume. This is exactly what happened at the start of the bear market in Mar 2000.

When you're buying stocks, make sure you're swimming with the market tide, not against it.

CAN SLIM™ and the IBD Way
If you are a reader of Investor's Business Daily (IBD) or any other of William O'Neil's writings, you may have noticed that these five pitfalls compliment the CAN SLIM methodology of stock selection. By avoiding low-priced stocks, looking beyond the P/E, implementing a stop-loss plan, not averaging down and monitoring the overall market, you'll be well on your way to a sound investing strategy based on years of studies and research from IBD.
Doing More with Less: The Sales-Per-Employee Ratio

Investment analysts use a variety of key ratios, such as return on equity (ROE), return on assets (ROA), and price-earnings ratio (P/E), to gauge a company's well being. One number that doesn't get a lot of attention is the sales-per-employee ratio. While it does have its limitations, this ratio does give investors some sense of a company's productivity and financial health.
What Is the Sales-per-Employee Ratio?
The name indicates how the sales/employee ratio is calculated: a company's annual sales divided by its total employees. Annual sales and employee numbers are easily located in published statements and annual reports.

The sales-per-employee ratio provides a broad indication of how expensive a company is to run. It can be especially insightful when measuring the efficiency of businesses such as banks, retailers, consultants, software companies and media groups. "People businesses" lend themselves to the sales per employee ratio.

Interpreting the ratio is fairly straightforward: companies with higher sales-per-employee figures are generally considered more efficient than those with lower figures. A higher sales-per-employee ratio indicates that the company can operate on low overhead costs, and therefore do more with less employees, which often translates into healthy profits.

Consider the software maker Qualcomm. In 2003, the company generated $690,000 in sales per employee. By comparison, software giant Microsoft generated about $500,000 in sales per employee. This suggests that Qualcomm is making more of its workforce and demonstrates why the stock market consistently awards Qualcomm a higher valuation than other technology stocks.

Compare Apples with Apples
The sales-per-employee ratio is best used to compare companies that are similar. Retailers and other service-oriented companies that employ a lot of people, for instance, will have dramatically different ratios than software firms. For example, Starbucks Coffee is a highly efficient retailer, but because it employs nearly 74,000 full and part-time staff, its sales-per-employee figure of $55,000 seems to pale in comparison to Qualcomm's $690,000 per employee.

Companies that concentrate on selling and distributing products will typically enjoy much higher sales-per-employee figures than firms that manufacture goods. Manufacturing is typically very labor intensive, while sales and marketing activities rely on fewer people to generate the same sales numbers. In manufacturing, each employee can usually assemble only a certain number of products. Increasing production requires more employees. By contrast, marketing and sales activities can increase without necessarily adding staff. Take the sports footwear maker Nike: since making the decision to outsource its manufacturing to other companies, the firm's sales-per-employee ratio has skyrocketed.

Early-stage businesses typically have low sales-per-employee numbers. Companies involved in developing new technology, for example, often have meager sales-per-employee figures in their early years. Sonus Pharmaceuticals, for instance, generated only $610 per employee in 2003. But the firm's sales-per-employee multiple will grow as its lead drug products, which are still in the trial stage, are expected to gain wider sales eventually.

You should also be careful about employee numbers stated in the financial reports. Some companies employ sub-contractors, which are not counted as employees. This kind of discrepancy can put a wrinkle in your analysis and comparison of sales-per-employee figures.


Trends Are Important
Be sure to watch sales-per-employee ratios over several years to get a reliable idea of performance. Don't jump to conclusions without examining trends over time. A jump in sales-per-employee efficiencies can be just a blip. For instance, big job cuts often translate into a temporary ratio boost as remaining employees work harder and take on extra tasks. But research shows such a boost can quickly reverse as workers burn out and work less efficiently.

A steadily rising sales-per-employee ratio can mean a number of things:

• increasingly streamlined organizations;
• recent capital investment that improves efficiency;
• great products that are selling faster than those of competitors.

Also, a company that consistently generates rising sales with a stable or shrinking work force can usually boost profits more rapidly than one that can't make additional sales without adding more workers. An improving sales-per-employee ratio frequently precedes growth in profit margins. A climbing sales-per-employee number could mean that the company is growing but has not hired more employees to handle the added workload.

Again, be careful. If numbers change dramatically, it's worthwhile to take a closer look.

Conclusion
Although you need to be careful when using this ratio, you can tell a lot about a company and its future from its sales-per-employee figures. Investors can get a quick sense of the company's financial health and of how the company fares against its peers. While the ratio doesn't tell the whole story, it certainly helps.
Uncovering Hidden Debt

Is the company whose stock you own carrying more debt than the balance sheet is showing? Most of the information about debt can be found on the balance sheet--but many debt obligations are not disclosed there. Here is a review of some off-balance-sheet transactions and what they mean for investors.

The term "off-balance-sheet" debt has recently come under the spotlight. The reason, of course, is Enron, which used underhanded techniques to shift debt off its balance sheet, making the company's fundamentals look far stronger than they were. That said, not all off–balance-sheet finance is shady. In fact, it can be a useful tool that all sorts of companies can use for a variety of legitimate purposes--such as tapping into extra sources of financing and reducing liability risk that could hurt earnings.

As an investor, it's your job to understand the differences between various off-balance-sheet transactions. Has the company really reduced its risk by shifting the burden of debt to another company, or has it simply come up with a devious way of eliminating a liability from its balance sheet?
Operating Leases
A lot of investors don't know that there are two kinds of leases: capital leases, which show up on the balance sheet, and operating leases, which do not.

Under accounting rules, a capital lease is treated like a purchase. Let's say an airline company buying an airplane sets up a long-term payment lease plan and pays for the airplane over time. Since the airline will ultimately own the plane, it shows up on its books as an asset, and the lease obligations show up as liabilities.

If the airline sets up an operating lease, the leasing group retains ownership of the plane; therefore, the transaction does not appear on the airline's balance sheet. The lease payments appear as operating expenses instead. Operating leases, which are popular in industries that use expensive equipment, are disclosed in the footnotes of the company's published financial statements.

Consider Federal Express Corp. In its 2004 annual report, the balance sheet shows liabilities totaling $11.1 billion. But dig deeper, and you will notice in the footnotes that Federal Express discloses worth of non-cancelable operating leases. So, the company's total debt is clearly much higher than what's listed on the balance sheet. Since operating leases keep substantial liabilities away from plain sight, they have the added benefit of boosting--artificially, critics say--key performance measures such as return-on-assets and debt-to-capital ratios.

The accounting differences between capital and operating leases impact the cash flow statement as well as the balance sheet. Payments for operating leases show up as cash outflows from operations. Capital lease payments, by contrast, are divided between operating activities and financing activities. Therefore, firms that use capital leases will typically report higher cash flows from operations than those that rely on operating leases.

Synthetic Leases
Building or buying an office building can load up a company's debt on the balance sheet. A lot of businesses therefore avoid the liability by using synthetic leases to finance their property: a bank or other third party purchases the property and rents it to the company. For accounting purposes, the company is treated like a tenant in a traditional operating lease. So, neither the building asset nor the lease liability appears on the firm's balance sheet. However, a synthetic lease, unlike a traditional lease, gives the company some benefits of ownership, including the right to deduct interest payments and the depreciation of the property from its tax bill.

Details about synthetic leases normally appear in the footnotes of financial statements, where investors can determine their impact on debt. Synthetic leases can become a big worry for investors when the footnotes reveal that the company is responsible for not only making lease payments but also guaranteeing property values. If property prices fall, those guarantees represent a big source of liability risk.

Securitizations
Banks and other financial organizations often hold assets--like credit card receivables--that third parties might be willing to buy. To distinguish the assets it sells from the ones it keeps, the company creates a special purpose entity (SPE). The SPE purchases the credit card receivables from the company with the proceeds from a bond offering backed by the receivables themselves. The SPE then uses the money received from cardholders to repay the bond investors. Since much of the credit risk gets offloaded along with the assets, these liabilities are taken off the company's balance sheet.

Capital One is just one of many credit card issuers that securitize loans. In its 2004 first quarter report, the bank highlights results of its credit card operations on a so-called managed basis, which includes $38.4 billion worth of off-balance-sheet securitized loans. The performance of Capital One's entire portfolio, including the securitized loans, is an important indicator of how well or poorly the overall business is being run.

Conclusion
Companies argue that off-balance-sheet techniques benefit investors because they allow management to tap extra sources of financing and reduce liability risk that could hurt earnings. That's true, but off-balance-sheet finance also has the power to make companies and their management teams look better than they are. Although most examples of off-balance sheet debt are far removed from the shadowy world of Enron's books, there are nonetheless billions of dollars worth of real financial liabilities that are not immediately apparent in companies' financial reports. It's important for investors to get the full story on company liabilities.
The Two Sides of Dual-Class Shares
It sounds too good to be true: own a small portion of a company's total stock, but get most of the voting power. That's the truth behind dual-class shares. They allow shareholders of non-traded stock to control terms of the company in excess of the financial stake. While many investors would like to eliminate dual-class shares, there are several hundred companies in the U.S. with dual "A" and "B" listed shares, or even multiple class listed shares. So, the question is, what's the impact of dual-class ownership on a company's fundamentals and performance?
What Are Dual-Class Shares?
When the Internet company Google went public, a lot of investors were upset that it issued a second class of shares to ensure that the firm's founders and top executives maintained control. Each of the class-B shares reserved for Google insiders would carry 10 votes, while ordinary class-A shares sold to the public would get just one vote.

Designed to give specific shareholders voting control, unequal voting shares are primarily created to satisfy owners who don't want to give up control but do want the public equity market to provide financing. In most cases, these super-voting shares are not publicly traded, and company founders and their families are most commonly the controlling groups in dual-class companies.

Who Lists Them?
The New York Stock Exchange allows U.S. companies to list dual-class voting shares. Once shares are listed, however, companies cannot reduce the voting rights of the existing shares or issue a new class of superior voting shares.

Many companies list dual-class shares. Ford's dual-class stock structure, for instance, allows the Ford family to control 40% of shareholder voting power with only about 4% of the total equity in the company. Berkshire Hathaway Inc., which has Warren Buffett as a majority shareholder, offers a B share with 1/30th the interest of its A-class shares, but 1/200th of the voting power. Echostar Communications demonstrates the extreme power that can be had through dual-class shares: founder and CEO Charlie Ergen has about 5% of the company's stock, but his super-voting class-A shares give him a whopping 90% of the vote.

Good or Bad?
It's easy to dislike companies with dual-class share structures, but the idea behind it has its defenders. They say that the practice insulates managers from Wall Street's short-term mindset. Founders often have a longer-term vision than investors focused on the most recent quarterly figures. Since stock that provides extra voting rights often cannot be traded, it ensures the company will have a set of loyal investors during rough patches. In these cases, company performance may benefit from the existence of dual-class shares.

That said, there are plenty of reasons to dislike these shares. They can be seen as downright unfair. They create an inferior class of shareholder and hand over power to a select few, who are then allowed to pass the financial risk onto others. With few constraints placed upon them, managers holding super-class stock can spin out of control. Families and senior managers can entrench themselves into the operations of the company, regardless of their abilities and performance. Finally, dual-class structures may allow management to make bad decisions with few consequences.
Hollinger International presents a good example of the negative effects of dual-class shares. Former CEO Conrad Black controlled all of the company's class-B shares, which gave him 30% of the equity and 73% of the voting power. He ran the company as if he were the sole owner, exacting huge management fees, consulting payments, and personal dividends. Hollinger's board of directors was filled with Black's friends who were unlikely to forcefully oppose his authority. Holders of publicly traded shares of Hollinger had almost no power to make any decisions in terms of executive compensation, mergers and acquisitions, board construction poison pills, or anything else for that matter. Hollinger's financial and share performance suffered under Black's control.

Academic research offers strong evidence that dual-class share structures hinder corporate performance. A Wharton School and Harvard Business School study shows that while large ownership stakes in managers' hands tend to improve corporate performance, heavy voting control by insiders weakens it. Shareholders with super-voting rights are reluctant to raise cash by selling additional shares--that could dilute these shareholders' influence. The study also shows that dual-class companies tend to be burdened with more debt than single-class companies. Even worse, dual-class stocks tend to under-perform the stock market.

Conclusion
Not every dual-class company is destined to perform poorly--Berkshire Hathaway, for one, has consistently delivered great fundamentals and shareholder value. Controlling shareholders normally have an interest in maintaining a good reputation with investors. Insofar as family members wield voting power, they have an emotional incentive to vote in a manner that enhances performance. All the same, investors should keep in mind the effects of dual-class ownership on company fundamentals.
Appreciating Depreciation


Be aware: companies work hard to make their fundamentals look good. So investors need to exercise judgment when examining numbers on financial statements. It's not enough to know simply whether a company has, say, great-looking earnings per share or low book value. Investors need to be aware of the assumptions and accounting methods that produce the figures.

Here we look at how to achieve this awareness when analyzing depreciation, which can represent a big portion of the expenses found on a company's income statement, and which can impact the value of the investment opportunity in the short term. While there are rules governing how depreciation is expensed, there is still plenty of room for management to make creative accounting decisions that can mislead investors. It pays to examine depreciation closely.
What Is Depreciation?
Depreciation is the process by which a company allocates an asset's cost over the duration of its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate a portion of the cost of the buildings, machines or equipment it has purchased to the current fiscal year. The purpose of recording depreciation as an expense is to spread the initial price of the asset over its useful life. For intangible assets - such as brands and intellectual property - this process of allocating costs over time is called amortization. For natural resources - such as minerals, timber and oil reserves - it's called depletion.

Assumptions
Critical assumptions about expensing depreciation are left to the company's management. Management makes the call on the following things:
• Method and rate of depreciation
• Useful life of the asset
• Scrap value of the asset
Calculation Choices
Depending on their own preferences, companies are free to choose from several methods to calculate the depreciation expense. To keep things simple, we'll summarize the two most common methods:
Straight-line method - This takes an estimated scrap value of the asset at the end of its life and subtracts it from its original cost. This result is then divided by management's estimate of the number of useful years of the asset. The company expenses the same amount of depreciation each year. Here is the formula for the straight-line method:

Straight line depreciation = (original costs of asset – scrap value)/est'd asset life

Accelerated Methods - These methods write-off depreciation costs more quickly than the straight-line method. Generally, the purpose behind this is to minimize taxable income. A popular method is the 'double declining balance', which essentially doubles the rate of depreciation of the straight-line method:

Double declining depreciation = 2 x straight line rate
Double Declining Depreciation = 2 x (original costs of asset – scrap value / est'd asset life)

The Impact of Calculation Choices
As an investor, you need to know how the choice of depreciation method affects an income statement and balance sheet in the short term.

Here's an example. Let's say The Tricky Company purchased a new IT system for $2 million. Tricky estimates that the system has a scrap value of $500,000 and reckons it will last 15 years. According to the straight-line depreciation method, Tricky's depreciation expense in the first year after buying the IT system would be calculated as the following:

($2,000,000 - $500,000)/15 = $100,000

According to the accelerated double-declining depreciation, Tricky's depreciation expense in the first year after buying the IT system would be this:
2 x straight line rate = 2 x($2,000,000 - $500,000)/15
2 x straight line rate = $200,000

So, the numbers show that if Tricky uses the straight-line method, depreciation costs on the income statement will be significantly lower in the first years of the asset's life ($100,000 rather than the $200,000 rendered by the accelerated depreciation schedule).

That means there is an impact on earnings. If Tricky is looking to cut costs and boost earnings per share, it will choose the straight-line method, which will boost its bottom line.

A lot of investors believe that book value, or net asset value, offers a fairly precise and unbiased valuation metric. But, again, be careful. Management's choice of depreciation method can also significantly impact book value: determining Tricky's net worth means deducting all external liabilities on the balance sheet from the total assets--after accounting for depreciation. As a result, since the value of net assets doesn't shrink as quickly, straight-line depreciation gives Tricky a bigger book value than the value a faster rate would give.


The Impact of Assumptions
Tricky chose a surprisingly long asset life for its IT system - 15 years. Information technology typically becomes obsolete quite quickly, so most companies depreciate information technology over a shorter period, say, five to eight years.

Then there's the issue of the scrap value that Tricky chose. It's hard to trust that a used, five-year-old system would fetch a quarter of its original value. But perhaps we can see the reason for Tricky's decision: the longer the useful life of an asset and the greater the scrap value, the less its depreciation will be over its life. And a lower depreciation raises reported earnings and boosts book value. Tricky's assumptions, while questionable, will improve the appearance of its fundamentals.

Conclusion
A closer look at depreciation should remind investors that improvements in earnings per share and book value can, in some cases, result from little more than strokes of the pen. Earnings and net asset value that are boosted thanks to the choice of depreciation assumptions have nothing to do with improved business performance, and, in turn, don't signal strong long-term fundamentals.
In Position

To understand and value a company, look at its financial position. If you borrow money from a bank, you have to list the value of all your significant assets, as well as all your significant liabilities. Your bank uses this information to assess the strength of your financial position; it looks at the quality of the assets, such as your car and your house, and places a conservative valuation upon them. The bank also ensures that all liabilities, such as mortgage and credit card debt, are properly disclosed and fully valued. The total value of all assets less the total value of all liabilities gives your net worth, or equity.

Evaluating the financial position of a listed company is quite similar, except investors need to take another step and consider financial position in relation to market value.
Starting with the Balance Sheet
Like your own financial position, a company's financial position is defined by its assets and liabilities. (But a company's financial position also includes shareholder equity.) All this information is presented to shareholders in the balance sheet.

Let's look at the 2003 financial statements of publicly-listed retailer, The Gap, to provide a real world example of evaluating financial position. The company's annual report can be downloaded from The Gap's website. The standard format for the balance sheet is assets, followed by liabilities, then shareholder equity. (For more on the balance sheet, see the article Reading the Balance Sheet.)

Current Assets and Liabilities
Assets and liabilities are broken into current and non-current items. Current assets or liabilities are those with an expected life of less than 12 months. For example, the inventories that The Gap reported as of Jan 31, 2004, are expected to be sold within the following year, whereupon the level of inventory will fall and the amount of cash will rise.

Like most other retailers, The Gap's inventory represents a big proportion of its current assets, and so should be carefully examined. Since inventory requires a real investment of precious capital, companies will try to minimize the value of inventory for a given level of sales, or maximize the level of sales for a given level of inventory. The Gap appears to have managed its inventory well, as it saw a 20% fall in inventory value together with a 23% jump in sales over the prior year. This reduction makes a positive contribution to the company's operating cash flows.

Current liabilities are the obligations the company has to pay within the coming year, and includes existing (or accrued) obligations to suppliers, employees, the tax office and providers of short-term finance. Companies try to manage cash flow to ensure that funds are available to meet these short-term liabilities as they come due.

The Current Ratio
The current ratio - which is total current assets divided by total current liabilities - is commonly used by analysts to assess the ability of a company to meet its short-term obligations. An acceptable current ratio varies across industries, but should not be so low that it suggests impending insolvency, or so high that it indicates an unnecessary build-up in cash, receivables or inventory. Like any form of ratio analysis, the evaluation of a company's current ratio should take place in relation to the past: for The Gap, the current ratio is 2.68 - up from 2.11 the previous year.

Non-Current Assets and Liabilities
Non-current assets or liabilities are those with lives expected to extend beyond the next year. For The Gap, the biggest non-current asset is the property, plant and equipment the company needs to run its business. The $3.3 billion shown in its balance sheet is the written-down or depreciated value of the property, plant and equipment.

The Gap's biggest long-term liabilities are $1.178 billion in long-term debt and $1.38 billion in convertible notes. The footnotes at the back of the annual report reveal that most of this amount relates to obligations under property, plant and equipment leasing contracts, but importantly the note also shows that the company has access to around $732 million in borrowings.

Financial Position: Book Value
If we subtract $5.56 billion in total liabilities from $10.34 billion in total assets, we are left with shareholder equity of $4.78 billion. Essentially, this is the book value, or accounting value, of the shareholders' stake in the company. It is principally made up of the capital contributed by shareholders over time and profits earned and retained by the company, including that portion of the 2003 profit not paid to shareholders as a dividend.

While the book value of The Gap was just $4.78 billion at Jan 31, 2004, the market value of the company (900 million shares x the share price of $22.53) was around 4.2 times that, or $20.3 billion.

Market-to-Book Multiple
By comparing the company's market value to its book value, investors can in part determine whether a stock is under or over-priced. The market-to-book multiple, while it does have shortcomings, remains a key tool for value investors. (You can read more about the market-to-book multiple in the article Value by the Book.) Extensive academic evidence shows that companies with low market-to-book stocks perform better than those with high multiples. This makes sense since a low market-to-book multiple signals the company has a strong financial position in relation to its price tag.

Determining what can be defined as a high or low market-to-book ratio also depends on comparisons. To get a sense of whether The Gap's book-to-market multiple of 4.2 is high or low, you need to look at the multiples of other publicly-listed retailers.

Conclusion
Financial position, embodied by its accounting value, tells investors about a company's general well being. A study of it (and the footnotes in the annual report) is essential for any serious investor wanting to understand and value a company properly.
It's In Your Interest
If you're ever looking for a topic to kill conversation so that you can be left alone to think about your investments, start talking about interest rates. Your listener's eyes are guaranteed to glaze over, and you'll be alone in no time.
The topic may be dry, but it is something investors should make an effort to understand. According to financial theory, interest rates - which change all the time - are fundamental to company valuation, playing an important role in how we put a price on stocks. Here we take a look at how financial theory defines this relationship between interest rates and stock price.

The Cost of Money
Think of an interest rate as the cost of money, which - just like the cost of production, labor, and other expenses - is a factor of a company's profitability.

The fundamental cost of money to an investor is the Treasury note rate, whose return is guaranteed by the 'full faith and credit' of the U.S. government. According to financial theory, a stock's value proposition starts there: stocks are risky assets, even riskier than bonds because bondholders are paid their capital before stockholders in the event of bankruptcy. Therefore, investors 'require' a higher return for taking on extra risk by investing in stocks instead of Treasury notes, which are guaranteed to pay a certain return.

The extra return that investors can theoretically expect from stocks is referred to as the "risk premium". Historically, the risk premium runs at around 7%. This means that if the risk-free rate (the Treasury note rate) is 4%, then investors would demand a return of 11% from a stock. (For a more in depth look at equity risk premium models, exploring their calculations and their assumptions, see The Equity Risk Premium - Part 1 and Part 2.)Therefore, the total return on a stock is the sum of two parts: the risk-free rate and the risk premium. If you want higher returns, you must invest in riskier stocks because they offer a higher risk premium than, say, stronger blue chip companies. In theory, rational investors will select an investment with a return that is high enough to compensate for the lost opportunity of earning interest from the guaranteed Treasury note and for taking on additional risk.

Inverse Relationship
If the required return rises, the stock price will fall, and vice versa. This makes sense: if nothing else changes, the price needs to be lower for the investor to have the required return. There is an inverse relationship between required return and the stock price investors assign to a stock.

The required return might rise if the risk premium or the risk-free rate increases. For instance, the risk premium might go up for a company if one of its top managers resigns or if the company suddenly decides to lower its dividend payments. And the risk-free rate will increase if interest rates rise.

So, changes in interest rates impact the theoretical value of companies and their shares: basically, a share's fair value is its projected future cash flows discounted to the present using the investor's required rate of return. If interest rates fall and everything else is held constant, share value should rise. That's why the market cheers when the U.S. Federal Reserve announces a rate cut. Conversely, if the Fed raises rates (holding everything else constant), share values ought to fall.

Companies Too
Interest rates impact a company's operations too. Any increase in the interest rates that it pays will raise its cost of capital. Therefore, a company has to work harder to generate higher returns in a high interest environment. Otherwise, the bloated interest expense will eat away at its profits. Lower profits, lower cash inflows and a higher required rate of return for investors all translate into depressed fair value for the company's stock.

Moreover, if interest rate costs shoot up to such a level that the company has problems paying off its debt, then its survival may be threatened. In that case, investors will demand an even higher risk premium. As a result, the fair value will fall even further.

Finally, high interest rates normally go hand in hand with a sluggish economy. They prevent people from buying things and companies from investing in growth opportunities. As a result, sales and profits drop, and so do share prices.

Conclusion
In financial theory, valuation begins with a simple question: if you put money into this company, what are the chances you will get a better return than if you invest in something else? Interest rates play an important part in determining what that 'something else' might be.
Spotting Disaster


Few people seem to spot the early signs of a company in distress. Remember WorldCom and Enron? Not long ago, these companies were worth hundreds of billions of dollars. Today, they no longer exist. Their collapses came as a surprise to most of the world, including their investors. Even large shareholders, many of them with an inside track, were caught off guard.
This doesn't mean it's impossible to see a corporate train wreck before it happens. Sure, it involves some work, but by digging into a company's activities and financial statements, even the average investor can identify potential problems. Here are some general guidelines for spotting companies that may be headed for trouble.

Cash Flows
Keeping a close eye on cash flow, which is a company's life line, can guard against holding a worthless share certificate. When a company's cash payments exceed its cash receipts, the company's cash flow is negative. If this occurs over a sustained period, it's a sign that cash in the bank may become dangerously low. Without fresh injections of capital from shareholders or lenders, a company in this situation can quickly find itself insolvent.

Bear in mind that even profitable companies can have negative cash flows and find themselves in trouble. This can happen, for example, when a rapidly growing business with strong sales makes large investments in stock, staff and manufacturing plants. At best, there will be a delay between when the company forks out cash for these business costs and when it collects cash from resulting sales. But this delay can severely stretch cash flow. At worst, the sales growth is not be sustained, and large quantities of stock (and staff) end up idly sitting in warehouses, causing a devastating impact on cash flow. Either way, you should steer clear of companies that report both profits and negative operating cash flows period after period.

Examine the company's cash burn rate. If a company burns cash too fast, it runs the risk of going out of business. Enron's cash flow fell from negative $90 million in Q1 2000 to a very troubling negative $457 million a year later. (For more details on this measure of cash, check out the article Don't Get Burned by the Burn Rate.)

Debt Levels
Interest repayments place pressure on cash flow, and this pressure is likely to be exacerbated for distressed companies. Because they a higher risk of default to banks, struggling companies must pay a higher interest rate. Debt therefore tends to shrink their returns.

Total debt-to-equity (D/E) ratio is a useful measure of bankruptcy risk. It compares a company's combined long- and short-term debt to shareholders' equity or book value. High-debt companies have higher D/E ratios than companies with low debt. According to debt specialists, companies with D/E ratios below 0.5 carry low debt. And that means that conservative investors will give companies with D/E ratios of 0.5 and above a closer look.

Let's consider Enron's debt-to-equity levels before it declared bankruptcy in Dec 2001. At year-end Dec 2000, its D/E ratio stood at 0.9. At June 2001, it grew to 1.1. Finally, its Sept 2001 quarterly report showed a D/E ratio of 1.4. Enron would have qualified as a risky debt prospect each time.

At the same time, the D/E ratio doesn't always say much on its own. It should be accompanied by an examination of the debt interest coverage ratio. For example, say a company had a D/E ratio of 0.75, which signals a low bankruptcy risk, but it had an interest coverage ratio of 0.5. An interest coverage ratio below 1 means that the company is not able to meet all of its debt obligations with the period's earnings before interest and tax (operating income), and it's a sign that a company is having difficulty meeting its debt obligations.

Share Price Decline
The savvy investor should also watch out for unusual share price declines. Almost all corporate collapses are preceded by a sustained share price decline. Enron's share price started falling two years before it went bust. The same holds true for WorldCom.

A big share price decline might signal trouble ahead, but it may also signal a valuable opportunity to buy an out-of-favor business with solid fundamentals. Knowing the difference between a company on the verge of collapse and one that's undervalued isn't always straightforward. Looking at the other factors we discuss below can help you tell them apart.

Profit Warnings
Investors should take profit warnings very, very seriously. While market reaction to a profit warning may appear swift and brutal, there is growing academic evidence to suggest the market systematically under-reacts to bad news. As a result, a profit warning is often followed by a gradual share price decline. See this article on market under-reaction by Harvard finance professor Jeremy Stein.


Insider Trading
Companies are required to report, by way of company announcement, purchases and sales of shares by substantial shareholders and company directors. Executives and directors have the most up-to-date information on their company's prospects, so heavy selling by one or both groups can be a sign of trouble ahead. While recommending that investors buy his company's stock, Enron Chairman Kenneth Lay sold $123 million in shares in 2000. That was nearly three times his gains in 1999, and nearly 10 times what he made in 1998. Admittedly, insiders don't always sell simply because they think their shares are about to sink in value, but insider selling should give investors pause.

Resignations
The sudden departure of key executives (or directors) can also signal bad news. While these resignations may be completely innocent, they demand closer inspection. Warning bells should ring the loudest when the individual concerned has a reputation as a successful manager or a strong, independent director.

You should also be wary of the resignation or replacement of auditors. Naturally, auditors tend to jump ship at the first sign of corporate distress or impropriety. Auditor replacement can also mean a deteriorating relationship between the auditor and the client company, and perhaps more fundamental difficulties within the client's business.

SEC Investigations
Formal investigations by the Securities and Exchange Commission (SEC)normally precede corporate collapses. That's not surprising since, many companies guilty of breaking SEC and accounting rules do so because they are facing financial difficulties. Unfortunately for most Enron and WorldCom investors, the SEC didn't spot problems in these companies before it was too late. However, the SEC has a pretty good nose for detecting corporate and financial misdeeds. While many SEC investigations turn out to be unfounded, they still give investors good reason to pay closer attention to the financial situations of companies that are targeted by the SEC.

Conclusion
Just as a seriously ill person can make a full recovery and go on to lead a fulfilling life while a seemingly healthy person can drop dead without warning, some very sick companies can make miraculous recoveries while apparently thriving ones can collapse overnight. But the probability of this is very low. Typically, when a company is struggling, the warning signs are there. Your best line of defense as an investor is to be informed - ask questions, do your research, be alert to unusual activities. Make it your business to know a company's business and you'll minimize your chances of getting caught in a corporate train wreck.
The Bottom Line on Margins
Let's face it, the most important goal of a company is to make money and keep it, which depends on liquidity and efficiency. Because these characteristics determine a company's ability to pay investors a dividend, profitability is reflected in share price. As such, investors should know how to analyze various facets of profitability, including how efficiently a company uses its resources and how much income it generates from operations. Calculating a company's profit margin is a great way to gain insight into these and other aspects of how well a company generates and retains money.
Why Use Profit-Margin Ratios?
The bottom line is the first thing many investors look at to gauge a company's profitability. It's awfully tempting to rely on net earnings alone to gauge profitability, but it doesn't always provide a clear picture of the company, and using it as the sole measure of profitability can have big repercussions.

Profit-margin ratios, on the other hand, can give investors deeper insight into management efficiency. But instead of measuring how much managers earn from assets, equity or invested capital, these ratios measure how much money a company squeezes from its total revenue or total sales.

Margins, quite simply, are earnings expressed as a ratio - a percentage of sales. A percentage allows investors to compare the profitability of different companies, while net earnings - an absolute number - cannot.

Consider this example. In its final quarter of 2003, personal computer-maker Dell had an annual net income of $749 million on sales of about $11.5 billion. Its major competitor, HP, earned about $990 million for the year on sales of about $19.9 billion. Comparing HP's net earnings of $990 million and Dell's $749 million shows that HP earned more than Dell, but it doesn't tell you very much about profitability. If you look at the net profit margin, or the earnings generated from each dollar of sales, you'll see that Dell produced 6.5 cents on each dollar of sales, while HP returned less than 5 cents. That difference wasn't huge, but it was one of the reasons why the market valued Dell more than HP.

There are three key profit-margin ratios: gross profit margins, operating profit margins and net profit margins.

Gross Profit Margin
The gross profit margin - or gross margin for short - tells us the profit a company makes on its cost of sales, or cost of goods sold. In other words, it indicates how efficiently management uses labor and supplies in the production process.

Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales
Let's say a company has $1 million in sales and the cost of its labor and materials amounts to $600,000. Its gross margin rate would be 40% ($1,000,000 - $600,000/$1,000,000).

Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing. So be on the lookout for downward trends in the gross margin rate over time. This is a telltale sign of future problems facing the bottom line. When labor and material costs increase rapidly, they are likely to lower gross profit margins - unless, of course, the company can pass these costs onto customers in the form of higher prices.

It's important to remember that gross profit margins can vary drastically from business to business and from industry to industry. For instance, the airline industry has a gross margin of about 5%, while the software industry has a gross margin of about 90%.

Operating Profit Margin
By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins show how successful a company's management has been in generating income from the operation of the business:

Operating Profit Margin = EBIT/Sales

If EBIT amounted to $200,000 and sales equaled $1 million, the operating profit margin would be 20%.

This ratio is a rough measure of the operating leverage a company can achieve in the conduct of the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs.

Operating profit also gives investors an opportunity to do profit-margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures (which are needed to do gross margin analysis). Operating profit measures how much cash the business throws off, and some consider it a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings.

Naturally, because the operating profit-margin accounts for not only costs of materials and labor, but also administration and selling costs, it should be a much smaller figure than the gross margin.

Net Profit Margin
Net profit margins are those generated from all phases of a business, including taxes. In other words, this ratio compares net income with sales. It comes as close as possible to summing-up in a single figure how effectively managers run the business:

Net Profit Margins = Net Profits after Taxes/Sales

If a company generates after-tax earnings of $100,000 on its $1 million of sales, then its net margin amounts to 10%.

To be comparable from company to company and from year to year, net profits after tax must be shown before minority interests have been deducted and equity income added. Not all companies have these items, and investment income, wholly dependent upon the whims of management, can change dramatically from year to year.

Again, just like gross and operating profit margins, net margins vary between industries. By comparing a company's gross and net margins, we can get a good sense of its non-production and non-direct costs like administration, finance and marketing costs.

You'll recall that the international airline industry - comprising companies such as British Airways, United and Quantas - has a gross margin of just 5%. Its net margin is just a tad lower, at about 4%. On the other hand, discount airline companies such as Southwest Airlines and JetBlue generate average gross margins of about 29%. Their net margin is about 11%. These differences provide some insight into these industries' distinct cost structures: compared to its bigger, international cousins, the discount airline industry spends proportionately more on things like finance, administration and marketing, and proportionately less on items such as fuel and flight crew salaries.

Then there is the software business. It has an exceedingly high gross margin of 90%, but a net profit margin of 27%. This shows that its marketing and administration costs are very high, while its cost of sales and operating costs are relatively low.
When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times - leaving them even better positioned when things improve again.

Conclusion
Margin analysis is a great way to understand the profitability of companies. It tells us how effectively management can wring profits from sales, and how much room a company has to withstand a downturn, fend off competition and make mistakes. But, like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that gets fed into them, and analyzing them also depends on a consideration of the company's industry and its position in the business cycle.

Remember, margin ratios highlight companies that are worth further examination. Knowing that a company has a gross margin of 25% or a net profit margin of 5% tells us very little without further information. As with any ratio used on its own, margins tell us a lot, but not the whole story, about a company's prospects.