WV Executive

Times are challenging for investors, and trying to decide which investment is appropriate can be difficult. Sometimes it is beneficial to review the basics and consider the tried and true ways that investors have used to analyze investments throughout the years. By identifying the approach that seems most comfortable, most executives will have a basis for decision-making.

The three basic analytical approaches are: fundamental; quantitative and technical.

Fundamental Analysis

With fundamental analysis, investors evaluate a stock by looking at the company's financials in terms of per-share values. This allows investors to calculate how much the stock's proportional share of the business is worth. Methods of evaluation, such as value, growth, income, GARP (growth at a reasonable price) and quality investing, involve fundamental analysis.

The goal of the value investor is to buy stock at a discount to its intrinsic value-what the business would be worth if it were liquidated. In selecting investments, value investors use strict focus on ratios that illustrate relationships between the current market price of the company and certain business fundamentals. Some examples include: price/earnings ratios; dividend yields above a certain absolute limit; book value per share relative to the share price and total sales at a certain level relative to the company's market capitalization, or market value.

With growth investing, the idea is to buy stock in companies with excellent potential for growth in sales and earnings. Growth investors tend to focus more on the company's value as an ongoing concern rather than its liquidation value. Many plan to hold these stocks for long periods of time, although this is not always the case. Excited by new companies, new industries and new markets, growth investors normally buy companies they believe are capable of increasing sales, earnings and other important business metrics by a minimum amount each year.

Many people continue to buy stocks primarily because of their dividend-paying ability. Called income investors, these individuals tend to forego stocks with the potential for capital appreciation in favor of high-yielding, dividend-paying companies in slow-growth industries. These investors may focus on utilities and real estate investment trusts. They may also invest in companies undergoing significant business problems whose share prices have sunk so low that the dividend yield is relatively high.

GARP investors combine the value and growth approaches. They look for companies with solid growth prospects and current share prices lower than the intrinsic value of the business.

One of the most common GARP approaches is to buy stocks when the price/earnings ratio is lower than the rate at which earnings per share can grow in the future. As the company's earnings per share grow, the price/earnings of the company will fall if the share price remains constant. Because fast-growing companies normally can sustain high price/earnings, the GARP investor is buying a company that will be cheap tomorrow if the growth occurs as expected. If the growth does not come, however, the GARP investor's perceived bargain can disappear very quickly.

Most investors today use a hybrid of value, growth and GARP approaches. They look for high-quality stocks selling for reasonable prices. They share a philosophy of looking at the company's valuation and at the inherent quality of the company as measured quantitatively by concepts like return on equity and qualitatively by the competence of management.

Fundamental analysis is just one of three methods of analysis. Those who do not use fundamental analysis have two major arguments against it. The first is they believe this type of investing is based on exactly the kind of information everyone already knows, thus they say it provides no real advantage. The second is that much of the fundamental information is "fuzzy" or "squishy," meaning it is often up to the person looking at it to interpret its significance. Unless you are an expert, so the argument goes, you would be better served by not paying attention to this kind of information.

Quantitative Analysis

By contrast, quantitative analysis looks only at the numbers. Considerations such as a company's management skill, its products and services and the competition are viewed as too subjective to be taken into account. The quantitative analyst heads straight for the annual report. The focus is on the balance sheet and income statement and certain key ratios.

The balance sheet sets forth a company's assets, liabilities and net worth at a moment in time-typically the fiscal year end. Assets and liabilities are listed with the most liquid first and least liquid last. Thus, cash assets and accounts receivable are placed at the top while buildings and machinery are at the bottom of the asset listing. Similarly, liabilities payable in the short term, such as accounts payable, precede long-term debt such as mortgages. Assets that can be liquidated within a year are considered "current" assets while those that are less liquid are considered long-term assets. Liabilities payable within a year are called "current" liabilities while longer term liabilities are called just that-long-term liabilities.

A starting place for quantitative analysis is to calculate a couple of key indicators of a company's ability to meet its current liabilities: the current ratio and net working capital. All of the numbers needed for these ratios are derived from the balance sheet. To find working capital, simply subtract liabilities from assets. The difference is what is left over after payroll is met and utilities and rent are paid. Companies that fail to maintain adequate working capital are always teetering on the edge. Sooner or later, they are unable to make a payment and bring their creditors to the door.

To find the current ratio, divide the total current assets by current liabilities. Many analysts like to see a ratio of two, but this scenario depends on the business. High-growth companies need a larger cushion to finance rapid expansion while larger, established firms can get away with less.

Another important ratio is the price-to-book value ratio. Book value is simply the difference between total assets and total liabilities. It is similar to shareholder's equity, which is another entry on the balance sheet. Once the book value is calculated, it is then possible to figure the price-to-book ratio by dividing book value by the number of shares outstanding. Comparison of the price-to-book ratio of one company to other comparable companies provides an idea of how the company compares with others. Generally, the lower the price-to-book value relative to the rest of the industry, the greater the stock's growth potential.

For example, if a company has a book value of $250 million and 25 million shares outstanding for a price-to-book ratio of $10. This means every dollar of equity costs $10. Another company in the same industry with a price-to-book ratio of $3.20 is probably a better buy because a person only needs to pay $3.20 for every dollar of equity.

Another useful ratio derived from the balance sheets is the debt-to-equity ratio. This is obtained by dividing long-term debt by shareholder equity. In general, the higher the ratio of debt to equity, the more leveraged the company. A company that is too dependent on debt suffers from exposure to interest rate shifts and is at risk of default. Some value-oriented investors avoid any stocks with a debt-to-equity ratio above one on the theory that it is not prudent to have more liability than asset.

While the balance sheet is like a snap shot, the income statement is often likened to a motion picture. The balance sheet illustrates a company's financial solvency at one point in time. The income statement shows how much revenue, expenses and profits a company generated throughout the fiscal year. Because the aim is to use past performance to try and predict future profits, it makes sense to consider two to three years of data.

Much attention in recent years has been given to earnings per share (EPS). EPS are calculated by dividing a company's net earnings by the number of shares outstanding. For example, a company with $10 million in net earnings and 10 million outstanding shares has an EPS of $1. If the company has shown an increase in EPS during the last few years, the positive trend bodes well for the future and suggests that the stock value may increase.

Use of the EPS as a measure of a company's performance has come under scrutiny recently. Some companies have engaged in fancy financial accounting tricks to overstate earnings. This does not mean that EPS should be disregarded. It does mean, however, that earnings and expenses have to be closely dissected. One question to ask is whether the company's earnings were massaged to include investment gains or gains from employee pension funds. Most people want to buy companies with earnings derived primarily from the products they sell, not other activities. Another question to ask is whether expenses are fairly disclosed. For example, some investors, including Warren Buffet, want to see stock options treated as an expense.

Closely akin to earnings per share is the price/earnings ratio which is calculated by dividing the market price of the stock by its current EPS. For example, a stock with a market price of $40 and EPS of $8 has a price/earnings ratio of five. Looked at another way, the company is selling at five times earnings. This multiple provides a short-hand method for comparing stocks. In general, a company with a low price/earnings ratio represents a better bargain than a company with a high price/earnings ratio.

Two other indicators of performance are profit margin and interest coverage ratio. Profit margin is net income divided by the gross revenues (or sales). The resulting figure shows the percentage of each dollar of revenue that survived as profit. In general, a trend of increasing profits throughout several years is a good indicator of future profitability that will probably be rewarded by the market.

The interest coverage ratio is used to determine whether a company has enough income to meet its interest obligations to bond holders. A company in danger of missing an interest payment is likely to take a beating in the market. The interest coverage ratio takes the earnings before interest and taxes and divides it by the interest expense. This depicts how easily interest obligations could be met with current income. Just like when it comes to paying a mortgage, the higher the ratio of income to interest expense, the sounder a company is and the more attractive it is likely to be to investors.

Quantitative analysis is not for everyone. But I believe many investors find that taking a hard look at the numbers provides a peace of mind they cannot find anywhere else.

Technical Analysis

Technical analysis involves evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value. Instead, they use stock charts to identify patterns to suggest positive performance potential. Although the day traders of the go-go 1990s depended largely on technical analysis, technical analysis is not just for day traders.

Technical analysis assumes that the chart formations indicate market psychology about either an individual stock or the market as a whole. Unfortunately, much of the faith in technical analysis hinges on anecdotal experience, not long-term statistical evidence. In my opinion by contrast, certain quantitative and fundamental methodologies have been shown in many instances to be reliable. While proponents of technical analysis believe it is a far better approach than fundamental or quantitative analysis, critics argue that it is about as useful as reading tea leaves.

Below are some of the indicators technical analysts attempt to define from their charts:

-Sentiment Indicators: One of the things technical analysts attempt to measure is investor sentiment. The term sentiment refers to the expectations and emotions of participants in the market. Investors can include odd lotters, corporate insiders, NYSE members, advisory services, mutual funds, institutional traders and floor traders. Not surprisingly, most investors are optimistic at a market top and pessimistic at a market bottom. The more optimistic or pessimistic the majority of investors appear to be, the higher the top or the lower the bottom is likely to be. For example, investor optimism was at its highest in the fall of 2000, which was when the market began its downward trek.

Investors who are better informed seem to buy and sell in a contrary manner to the majority-and consequently, in my experience, seem to enjoy greater success than their investing peers. When the minority of informed investors considers the economy and the market to be at its worst, a small minority is buying. Conversely, when things look great, this small minority is selling.

-Flow of Funds Indicators: This seeks to measure the capacity of various investor groups to buy or sell stocks. These indicators consider where funds are flowing by tracking trends in bank accounts and foreign and domestic investment accounts. Initial public offering activity and investment by institutional investors like insurance companies, mutual funds and pension funds is also taken into account.

-Market Indicators: The emphasis in technical analysis is on market indicators that reveal trends of price indexes and individual securities. The theory underlying these indicators is that once a trend is in motion it will continue in that direction. By understanding the movement and strength of a trend, the technical analyst hopes to make informed buying and selling decisions.

Technical analysis is at the opposite end of the spectrum from fundamental analysis. While fundamental analysts are concerned about fundamentals like what product a company is selling, how it is made and distributed and how the experience of management, technical analysis focuses on market psychology. Each investor must decide which approach is best suited to his or her personal style.