Great Expectations: Forecasting Sales Growth
Predicting a company’s top line growth is arguably the most important part of determining its stock growth. Unfortunately, unless you are a company insider with accurate order and shipment data, it’s awfully difficult to know precisely how many products a company will sell in, say, the next five years. But by working through a few key questions, investors can improve the accuracy of their guesswork: How quickly is the market for the company’s products growing? What is the company’s share of the market? Is the company likely to win or lose market share?
Market Growth
Take some time to examine the market growth rate. Is the company doing business in a mature market or a growth market? Let’s say you are trying to gauge the future growth of consumer product giant Proctor & Gamble. It’s worth remembering that the market for P&G’s goods is fairly mature, which means that it probably won’t be growing much faster than the overall economy or the GDP.
Players in the technology industry typically operate in faster growth markets. Take for example the company Research in Motion. A few years ago, you wouldn’t have seen too many people using the company’s Blackberry handheld computers, but you see plenty of them today. To get a sense of Research in Motion’s prospects, you need to estimate the percentage of people who already have handheld computers, the percentage of new handheld computer buyers, and the percentage of customers that Research in Motion may be able to grab from competitors in the years to come.
Market Share
A company’s market share can also have a big impact on its future sales growth. Does the firm–like the computer chip giant, Intel–dominate its market? It’s hard for Intel to grow sales by, say, 10% a year when its annual sales are already $33 billion and it owns over 80% of the chip market. For some dominant players, there is only so much room for growing sales via gains in market share.
Other times, major market players use already strong market positions to make even more gains. Coffee retailer Starbucks and auto maker Honda are good examples of companies that have used their brand power to grow market share consistently over the years.
“Up-and-comers” can very quickly take large market share percentages from those companies who were traditionally dominant competitors. Think of Southwest Airlines. Thanks to an innovative, low-cost business model, in just a few years Southwest grabbed a big chunk of the airline business from industry leaders such as American Airlines and United Airlines.
Some companies are constantly “trading” market share with competitors. If you are considering sales growth at Coca-Cola, you might want to estimate growth from gains in market share; however, when market share swings back and forth between rivals, say Coca-Cola and Pepsi, you shouldn’t put too much weight in share gains when estimating future sales growth trends.
Pricing
Pricing of products and services can have a big impact on sales revenue growth. If a company increases its prices and manages to maintain unit sales volume, then sales revenue will grow. On the other hand, higher prices can lead to fewer units sold if customers turn to less expensive alternatives.
The effect of prices on sales revenue all depends on the company’s pricing power. Pharmaceutical companies, for instance, have enormous pricing power when their drugs are under patent. The same goes for companies with a lot of brand recognition and customer loyalty. Starbucks and Honda can charge higher prices than their competitors and still maintain sales revenue growth. By contrast, in technology and consumer electronics markets, it’s almost inevitable that prices will fall. For companies like Sony and Intel, pricing pressure over time can be so strong that sales revenue may fall even when units sold rises.
Finally, don’t forget to think about the product mix. Let’s say General Motors decided it was going to focus on selling its high-end Cadillac cars over its lower-end Chevrolets. The higher average selling price of the luxury cars could end up having a favorable impact on sales growth–assuming that GM’s focus on the high-end doesn’t translate into fewer total cars sold.
Conclusion
For investors looking at a company from the outside, forecasting sales growth rates–even in the near term–is a bit like looking through the fog. These simple questions about market growth, market share, and pricing power are just a start. But they can get investors a long way.
Measuring Company Efficiency
Analyzing a company’s inventories and receivables is a reliable means of helping to determine whether it is a good investment play or not. Companies stay efficient and competitive by keeping inventory levels down and speeding up collection of what they are owed. In this article, we’ll take you through the process step by step.
Getting Goods Off the Shelf
As an investor, you want to know if a company has too much money tied up in its inventory. Companies have limited funds available to invest in inventory – they can’t stock a lifetime supply of every item. To generate the cash to pay bills and return a profit, they must sell the merchandise they have purchased from suppliers. Inventory turnover measures how quickly the company is moving merchandise through the warehouse to customers.
Let’s look at U.S. retail giant Wal-Mart, known for its super-efficient operations and state-of-the-art supply chain system which keeps inventories at a bare minimum. In fiscal 2003, inventory sat on its shelves for an average 45 days. Like most companies, Wal-Mart doesn’t provide inventory turnover numbers to investors, but they can be flushed out using data from Wal-Mart’s financial statements.
Inventory Days = 365 Days / (Average Cost of Goods Sold/Average Inventory)
Obtaining Average COGS
To get the necessary data, find its ‘Consolidated Statements of Income’ on its website (see http://investor.walmartstores.com and look for the 2003 Annual Report) and locate cost of goods sold (COGS), or “cost of sales” found just below the top-line sales (revenue). For the 2003 fiscal year, Wal-Mart’s COGS totaled US$191.8 billion.
Obtaining Average Inventory
Then look at the ‘Consolidated Balance Sheet’ (the next page after ‘Statements of Income’). Under assets, you will find the inventory figure. For 2003, Wal-Mart’s inventory was $25 billion, and in 2002, it was $22.7 billion. Average the two numbers ($25bn + $22.7bn / 2 = $23.9bn), then divide that inventory average for 2003, $23.9 billion, into the average cost of goods sold in 2003. You will arrive at the annual turnover ratio 8.0. Now, divide the number of days in the year, 365, by the annual turnover ratio, 8.0, and that gives you 45.3. That means it takes Wal-Mart just over 45 days, or about a month and a half, to cycle through its inventory. This number of inventory days is also known as the “days-to-sell” figure.
Broadly speaking, the smaller number of days, the more efficient a company – inventory is held for less time and less money is tied up in inventory. Instead, money is freed up for things like research and development, marketing or even share buybacks and dividend payments. If the number of days is high, that could mean that sales are poor and inventories are piling up in warehouses.
But remember, it’s not enough to know the number at any specific time. Investors need to know if the days-to-sell inventory figure is getting better or worse over several periods. To get a decent sense of the trend, calculate at least two years worth of quarterly inventory sales numbers. You will see that Wal-Mart’s inventory days gradually declined from 2001 to 2003.
If you do spot an obvious trend in the numbers, it’s worthwhile asking ‘why?’ Investors would be pleased if the number of inventory days were falling as a result of greater efficiencies gained through tighter inventory controls. On the other hand, products might be moving off the shelf more quickly simply because the company is cutting its prices.
To get an answer, flip to the ‘Income Statement’ and look at Wal-Mart’s gross margin (top-line revenue, or net sales, minus cost of sales).
Check to see whether gross margins as a percentage of revenue/net sales are on an upward or downward trajectory. Gross margins which are consistent or on-the-rise offer an encouraging sign of improved efficiencies. Shrinking margins, on the other hand, suggest the company is resorting to price cuts to boost sales. Looking back at the numbers, you will find that Wal-Mart’s gross margins, as expressed as a percentage of net sales, bumped up 1% from 21.0% in 2002 to 22.1% in 2003 (gross margin = net sales – COGS / net sales).
If inventory days are increasing, that’s not necessarily a bad thing. Companies normally let inventories build up when they are introducing a new product in the market or ahead of a busy sales period. However, if you don’t foresee an obvious pick up in demand coming, the increase could mean that unsold goods will simply collecting dust in the stockroom.
Collecting What’s Owed – Soon!
Accounts receivable is the money that is currently owed to a company by its customers. Analyzing the speed at which a company collects what it’s owed can tell you a lot about its financial efficiency.
If a company’s collection period is growing longer, it could mean problems ahead. The company may be letting customers stretch their credit in order to recognize greater top-line sales and that can spell trouble later on especially if customers face a cash crunch. Getting money right away is preferable to waiting for it – especially since some of what is owed may never get paid. The quicker a company gets its customers to make payments, the sooner it has cash to pay for salaries, merchandise and equipment, loans and, best of all, dividends and growth opportunities.
So, investors want to determine how many days, on average, the company takes to collect its accounts receivable. Here is the formula:
Receivables Days = 365 Days / (Revenues/Average Receivables)
On the top of the ‘Income Statement’, find revenues; on the ‘Balance Sheet’ under current assets, you will find accounts receivable. Wal-Mart generated $244.5 billion in net sales in 2003. At the end of 2003, its accounts receivable stood at $2.11 billion, and in 2002, it was $2 billion, yielding an average accounts receivable figure of about $2.0 billion.
Dividing revenue by average receivables gives a receivables turnover ratio of 122. This shows how many times the company turned over its receivables in the annual period. Three hundred and sixty-five days of the year divided by the receivables turnover ratio of 122 gives a receivables turnover rate of three days. On average it took about three days for Wal-Mart to receive payment for the goods it sold.
Sizing-Up Efficiencies
It’s good news when you see a shortening of both inventory days and the collection period. Still, that’s not enough to full understand how a company is running. To gauge real efficiency, you need to see how the company stacks up against other players in the industry.
Let’s see how Wal-Mart compared in 2003 with Target Stores, another large, publicly-listed retail chain. Dramatic differences can be seen. While Wal-Mart on average turned over its inventory every 45 days during that period, Target’s inventory turnover took nearly 60 days. Wal-Mart collected payments in just three days. Meanwhile Target, which relied heavily on slow-to-collect credit card revenues, required almost 40 days to get its money. As Wal-Mart shows, using competitors as a benchmark can enhance investors’ sense of a company’s real efficiency.
Still, comparative numbers can be deceiving if investors don’t do enough research. Just because one firm’s numbers are lower than a rival’s doesn’t always translate to more efficient performance. Business models and product mix need to be taken into account. Inventory cycles differ from industry to industry.
Keep in mind that these efficiency measures apply largely to companies that make or sell goods. Software companies, firms that sell intellectual property as well as many service companies do not carry inventory as part of their day-to-day business, so the inventory days metric is of little value when analyzing these kinds of companies. However, you can certainly use the days receivables formula to examine how efficiently they collect what’s owed.
For further reading on related subjects, see The Bottom Line on Margins, Working Capital Works, as well as other articles in our Fundamental Analysis Archive.
Conclusion
Getting behind the scenes at a company means more than simply knowing its earnings per share (see Types of EPS and How To Evaluate The “Quality” Of EPS and our tutorial Understanding The P/E Ratio). Finding out where a firm’s cash is tied up in inventories and receivables can help shed light on its how efficiently it is being managed. Of course, it takes time and effort to extract the information from company financial statements. But doing the analysis will certainly help you find which companies are worthy of investment.
Introduction to Small Caps
Small-cap stocks have a bad reputation. The media usually focuses on the negative side of small caps, saying they are risky, frequently fraudulent and lacking in quality that investors should demand in a company. Certainly these are all valid concerns for any company, but in the wake of the Enron and Worldcom scandals, there is certainly an argument that company size is by no means the only factor when it comes to getting scammed. In this article we’ll lay out some of the most important factors comprising the good and the bad of the small-cap universe. Knowing these factors you will be better able to decide whether investing in smaller-capitalized companies is right for you.
Background
Before we get into the pros and cons of small caps let’s just recap (no pun intended) what exactly we mean by small cap. The term refers to stocks with a small market capitalization, between US$250 million and $2 billion. Stocks with a market cap below $250 million are referred to as micro caps, and those below $50 million are called nano caps. Small-cap stocks can trade on any exchange although a majority of them are found on the Nasdaq or the OTCBB because of more lenient listing requirements. It is important to make the distinction between small caps and penny stocks, which are a whole different ball game. (See the Lowdown on Penny Stocks.) You can be a small cap without being a penny stock. There are plenty of small caps trading at more than $1 per share, with more liquidity than the average penny stock.
The Pros
When you are eyeing small-cap stocks, a number of positive factors weigh against some negative attributes. Below we have outlined three of the most compelling reasons why small caps deserve representation in many investors’ portfolios.
1) Huge growth potential
Most successful large-cap companies started at one time as small businesses. Small caps give the individual investor a chance to get in on the ground floor. Everyone talks about finding the next Microsoft, Wal-Mart or Home Depot, because at one point these companies were small caps, diamonds in the rough if you will. Had you possessed the foresight to invest in these companies from the beginning, even a modest investment would have ballooned into an extravagant sum.
Because small caps are just that, companies with small total values, they have the ability to grow in ways that are simply impossible for large companies. A large company, one with a market cap in the $1 billion to $2 billion range doesn’t have the same potential to double in size as a company with a $500 million market cap. At some point you just can’t keep growing at such a fast rate or you’d be bigger than the entire economy! So if you are looking for high-growth companies, small caps offer this.
2) Most mutual funds don’t invest in them It isn’t uncommon for mutual funds to invest hundreds of millions of dollars in one company. Most small caps don’t have the market cap to support this size of investment. In order to buy a position large enough to make a difference to their fund’s performance, a fund manager would have to buy 20% or more of the company. The SEC places heavy regulations on mutual funds that make it difficult for funds to establish positions of this size. This gives an advantage to individual investors who have the ability to spot promising companies and get in before the institutional investors do. When institutions do get in, they’ll do so in a big way, buying many shares and pushing up the price.
3) They are often under-recognized
This third attribute of small caps is very important. What we are saying here is that small caps often have very little analyst coverage and garner little to no attention from Wall Street. What this means to the individual investor is that, because the small-cap universe is so under-reported or even undiscovered, there is a high probability that small-cap stocks are improperly priced, offering an opportunity to profit from the inefficiencies caused by the lack of coverage devoted to a particular area of the market.
The Cons
1) Risk
Despite the fact that small caps demonstrate attractive characteristics, there is a flip side. The money you invest in small caps should be money you can expose to a much higher degree of risk than that of proven cash-generating machines like large caps and blue chips.
Often much of a small cap’s worth is based on their propensity to generate cash, but they have yet to scale their business model. This is where much of the risk comes in. Not many companies can replicate what U.S. retail giant Wal-Mart has done, expanding from essentially a mom-and-pop store in Arkansas to a nation-wide chain with thousands of locations. Small caps are also more susceptible to volatility, simply due to their size – it takes less volume to move prices. It’s common for a small cap to fluctuate 5% or more in a single trading day, something some investors simply cannot stomach.
2) Time
Finding time to uncover that small cap is hard work – investors must be prepared to do some serious research, which can prove a deterrent. Financial ratios and growth rates are widely published for large companies, but not for small ones. You must do all the number crunching yourself, which can be very tedious and time consuming. This is the flip side to the lack of coverage that small caps get: there are few analyst reports on which you can start to construct a well-informed opinion of the company.
And because there is a lack of readily available information on the small-cap company, compared to large caps like GE and Microsoft which are regularly covered by the media, you won’t hear any news for weeks from many smaller firms. By law these companies must release their quarterly earnings, but investors looking for more information will be hard pressed to find anything.
Conclusion
There is certainly something to be said for the growth opportunities that small-cap stocks can provide investors; however, along with these growth opportunities come increased risk. If you are able to take on additional levels of risk relative to large-cap companies, exploring the small-cap universe is something you should look into. Alternatively, if you are extremely risk averse, the rollercoaster ride that is the stock price of a small-cap company may not be appropriate for you. If you many any small-cap investments, use only risk capital.
Is Your Dividend at Risk?
Dividend cuts can surprise investors, even the big players. But that doesn’t mean it’s impossible to know ahead of time whether your dividend is at risk of being reduced. There are several factors that can indicate how safe your dividend income is.
Unlike safe investments such as bank deposits or Treasury bonds, dividends are not guaranteed. If a company runs into a cash crunch, cutting or eliminating dividend payment is one way it can try to save itself, but such action can send the wrong signals to the market. Even safe-haven companies can become dividend investment sinkholes.
Consider the U.S. telecom AT&T. Long regarded as a stable business with seemingly risk-immune dividends, AT&T shocked investors in Dec 2000 when it slashed its dividend by 83%. Shareholders expecting to receive $0.22/share each quarter were forced to accept just $0.0375/share.
Looking back at AT&T’s financial statements, let’s go over some of the points to consider when sizing up dividend risk.
Earnings Trends and Payout Ratio
Watch out for inconsistent or declining profitability. If a company can’t make a steady profit, it may not stick to its dividend payouts.
In the late 1990s, AT&T started to feel squeezed as deregulation opened up the telecom industry to new entrants, severely impacting its bottom line. If you look at AT&T’s income statements in the run-up to Dec 2000 dividend cut, it’s hard to miss the dramatic erosion in AT&T’s earnings between 1998 and 2000. Annual earnings per share fell by more than 50% in the period.
To find the figures yourself, go to http://www.att.com/, and in the ‘Investor Relations’ section look at its 10-K (annual) reports, which are statements filed with the Securities and Exchange Commission (SEC) giving a comprehensive overview of the company’s financial position. In AT&T’s 10-K for the year ended Dec 2000, you can find AT&T common stock group earnings on its Consolidated Statement of Income. AT&T’s annual basic earnings per share from 1998-2000 was $1.96, $1.74 and $0.88. (For most companies, you can find frequent and up-to-date earnings information in quarterly 10-Q reports, which are filed with the SEC and normally published on company websites.)
Falling profits like those faced by AT&T between 1998 and 2000 are not likely to cover the cost of paying the dividend. A good indicator of whether falling earnings pose a risk to dividend payments is the dividend payout ratio, which simply measures how much of a company’s earnings are paid to shareholders in the form of dividends. The dividend payout ratio is calculated by dividing a company’s dividends by its earnings:
Dividend Payout Ratio = Dividend Payment per Share / Earnings per Share
Examining AT&T’s 10-Q (quarterly) report for the quarter ended Sept 2000 (the last report before AT&T announced its dividend cut), you will see from the Consolidated Statement of Income for the quarter that AT&T earned $0.35 per share and offered a quarterly dividend of $0.22/share, giving it a payout ratio of 0.63. In other words, AT&T was paying out 63% of its earnings in the form of dividends. Significant earnings erosion pushes the payout ratio closer to 1, which means the dividend is claiming almost all of the company’s earnings. When earnings are not sufficient to cover dividends, a ratio of 1 is a signal that a dividend cut could be on the way.
Cash Flows
Dividends are paid from a company’s cash flow. Free cash flow (FCF) tells investors the actual amount of cash a company has left from its operations to pay for dividends, among other things, after paying for other items such as salaries, research and development and marketing.
To calculate FCF, make a beeline for the AT&T’s cash flow statement. Again, you can find an annual cash flow statement in the 10-K document and quarterly cash flows in the 10-Q reports. Take a look at AT&T’s Consolidated Statement of Cash Flows for the year to Dec 2000, found in its 10-K. AT&T’s net cash flow provided by operating activities (operating cash flow) totaled $13.3 billion. From this number subtract $15.5 billion, the capital expenditure required for current operations, which is shown lower down on AT&T’s cash flow statement. This gets you FCF:
Cash Flow from Operations – Capital Expenditure = FCF
AT&T’s free cash flow was negative $2.2 billion for the 2000 financial year – more cash was going out than coming in – it was nowhere near generating sufficient cash flow to cover its dividend payments. Hustling to find cash, AT&T was forced to slash its dividend payment. Investors, however, should have started getting worried before FCF reached this dire level. If you go back and do the same FCF calculation for the previous periods, you will spot a substantial downward trend.
Another important factor to consider in relation to cash flow is debt. If a cash-flow crunch forces a company to choose between paying dividends and paying interest, invariably shareholders lose out since failure to pay interest could force a company into bankruptcy. Furthermore, failure to meet debt obligations can damage a company’s credit rating, so, depending on the conditions attached to its debt, a company can be forced to pay it off immediately in full.
Notice AT&T’s debt levels soared in the run-up to its dividend cut. At the end of 2000, AT&T’s long-term debt on the 10-K’s Consolidated Balance Sheet was $33.1 billion; compared to $23.28 billion in 1999. Looking up a few lines, you will see that at the end of 2000, $31.9 billion of AT&T’s debt was due to mature the following year.
High Yield
When assessing dividend risk, be sure to look at the company’s dividend yield, which measures the amount of income received in proportion to the share price. The dividend yield, expressed as a percentage, is calculated as the annual dividend income per share, divided by the share’s current price:
Dividend Yield = Annual Dividend Income per Share / Share Price
When analyzing dividend yield, look at how the company’s dividend compares to other companies in the industry. A higher-than-average yield is likely to be a harbinger of dividend cuts.
Consider AT&T’s dividend yield on Nov 22, 2000 – just a month before its dividend cut. You can find AT&T’s historical share prices under its ‘Investor Relations’ section by clicking on ‘Stock Information’. Type in the date information and you’ll find that AT&T closed at $18.67 on Nov 22, 2000. Dividing AT&T’s dividend of $0.88 by $18.67 gives a dividend yield of 5%.
While 5% may not seem excessive, at the time, normal yields in the telecom industry were in the 2-4% range. On the day that AT&T announced the dividend cut (Dec 22, 2000), its share price fell to $16.68, translating into a yield of just 1% for investors.
Conclusion
Investors should be on the constant lookout for potential problems with their dividend-paying stocks. Determining a stock’s dividend payout ratio, backing it up with earnings and cash-flow trends, and scrutinizing dividend yield can help investors spot potential trouble. Although you might not necessarily need to sell your dividend-paying stock at the first sign of weakness, it is a good idea to thoroughly investigate for potential hazards.
Short Interest: What It Tells Us
As some of you may already know, short selling allows a person to profit from a falling stock. The existence of this ability to short sell a stock should not come as a surprise as stock prices are constantly rising and falling. Thus, there are brokerage departments and firms whose sole purpose is to research deteriorating companies that are prime short-selling candidates. These firms pore over financial statements looking for weaknesses that the market may not have discounted yet or a company that is simply overvalued. One factor they look at is called short interest, which serves as a market-sentiment indicator, and we’ll cover it in detail in this article.
A Review of Short Selling
Essentially, short selling is the opposite of buying stocks – it’s the selling of a security that the seller does not own, done so in the hope the price will fall. If you feel a particular security’s price, let’s say the stock of a struggling company, will fall, you can borrow the stock from your broker-dealer, sell it and get the proceeds from the sale. If, after a period of time (e.g. 1, 2, 20 days) the stock price declines, you can “close out” the position by buying the stock on the open market at the lower price, return the stock to your dealer-broker and realize a gain.
The catch is, if the stock price rises, you lose money since you have to buy the stock back at a higher price. And the dealer-broker has the discretion to demand that the position be closed out at any time, regardless of the stock price. However, this demand typically occurs only if the dealer-broker feels that the creditworthiness of the borrower is too risky for the firm. (See our Short Selling tutorial for further reading on the subject.)
Short Interest
Short interest is the total number of shares of a particular stock that have been sold short by investors but have not yet been covered or closed out. This can be expressed as a number or as a percentage.
When expressed as a percentage short interest is the number of shorted shares divided by the number of shares outstanding. For example, a stock with 1.5 million shares sold short and 10 million shares outstanding has a short interest of 15% (1.5 million/10 million = 15%).
Most stock exchanges track the short interest in each stock and issue reports at month’s end. These reports are great because, by showing what short sellers are doing, they allow investors to gauge overall market sentiment surrounding a particular stock. Or alternatively most exchanges provide an online tool to calculate short interest for a particular security. For example check out the Nasdaq’s short interest calculator; it’s very easy to use.
Reading Short Interest
A large increase or decrease in a stock’s short interest from the previous month can be a very telling indicator of investor sentiment. Let’s say that Microsoft’s (MSFT) short interest increased by 10% in one month. This means that there was a 10% increase in the amount of people who believe the stock will decrease. Such a significant shift provides good cause for us to find out more. We would need to check the current research and any recent news reports to see what is happening with the company and why more investors are selling its stock.
A high short-interest stock should be approached for buying with extreme caution but not necessarily avoided at all cost. Short sellers (like all investors) aren’t perfect and have been known to be wrong from time to time.
In fact, many contrarian investors use short interest as a tool to determine the direction of the market. The rationale is that if everyone is selling, then the stock is already at its low and can only move up. Thus, contrarians feel that a high short-interest ratio (which we will discuss below) is bullish – because eventually there will be significant upward pressure on the stock’s price as short sellers cover their short positions (i.e. buy back the stocks they borrowed to return to the lender).
Short-Interest Ratio
The short-interest ratio is the number of shares sold short (short interest) divided by average daily volume. This is often called the “days-to-cover ratio” because it tells, given the stock’s average trading volume, how many days it will take short sellers to cover their positions if positive news about the company lifts the price.
Again, let’s assume Microsoft has a short interest of 75 million shares, while the average daily volume of shares traded is 70 million. Doing a quick and easy calculation (75,000,000/70,000,000) we find that it would take 1.07 days for all of the short sellers to cover their positions. The higher the ratio, the longer it will take to buy back the borrowed shares – an important factor upon which traders or investors decide whether to take a short position. Typically, if the days to cover stretch past eight or more days, covering a short position could prove difficult.
The NYSE Short-Interest Ratio
The NYSE short-interest ratio is another great metric used to determine the sentiment of the overall market. The NYSE short-interest ratio is the same as short interest except it is calculated as monthly short interest on the entire exchange divided by the average daily volume of the NYSE for the last month.
For example, say there are five billion shares sold short in August and the average daily volume on the NYSE for the same period is one billion shares per day. This gives us a NYSE short-interest ratio of five (five billion /one billion). This means that, on average, it will take five days to cover the entire short position on the NYSE. In theory a higher NYSE short-interest ratio indicates a more bearish sentiment towards the exchange.
Short Squeeze
Some bullish investors see a high short interest as an opportunity. This outlook is based on the short-interest theory. The rationale is, if you are short selling a stock and the stock keeps rising rather than falling, you’ll most likely want to get out before you lose your shirt. A short squeeze occurs when short sellers are scrambling to replace their borrowed stock thereby increasing demand and decreasing supply, forcing prices up. Short squeezes tend to occur more often in smaller cap stocks, which have a very small float (supply), but large caps are certainly not immune from this situation.
If a stock has a high short interest, short positions may be forced to liquidate and cover their position by purchasing the stock. If a short squeeze occurs and enough short sellers buy back the stock, the price could go even higher. Unfortunately, however, this is a very difficult phenomenon to predict.
Conclusion
Although it can be a telling indicator, an investment decision should not be based entirely on a stock’s short interest; however, investors often overlook this ratio despite its widespread availability. Unlike the fundamentals of a company, the short interest requires little or no calculations. Half a minute of time to look up short interest can help provide valuable insight into what sentiment investors have towards a particular company or exchange.
Spotting Profitability With ROCE
Think of return on capital employed (ROCE) as the Clark Kent of financial ratios. Most investors don’t take a second look at a company’s ROCE, but savvy investors know that, like Kent’s alter ego, ROCE has a lot of muscle. In fact, ROCE can help investors see through growth forecasts, and it can often serve as a reliable measure of corporate performance. In this article we’ll reveal the true nature of ROCE and how to calculate and analyze it. Read on to find out how this often overlooked ratio can be a superhero when it comes to calculating the efficiency and profitability of a company’s capital investments.
Defining ROCE
Put simply, ROCE reflects a company’s ability to earn a return on all of the capital that the company employs. ROCE is calculated by determining what percentage of a company’s utilized capital it made in pre-tax profits, before borrowing costs. To calculate ROCE, you determine what percentage of a company’s invested capital it made in pre-tax profit before borrowing costs. The ratio looks like this:
= Profit Before Interest and Taxation
Capital Employed
The numerator, or the return, includes the profit before tax, exceptional items, interest and dividends payable. These items are located on the income statement. The denominator, the capital employed, is the sum of all ordinary and preferred-share capital reserves, all debt and finance lease obligations, as well as minority interests and provisions. These items are all found on the balance sheet. The denominator shows how much capital is being employed in the operation of the business. (For further reading, see Reading The Balance Sheet and Understanding The Income Statement.)
What Does ROCE Say?
For starters, ROCE is a useful measurement for comparing the relative profitability of companies. But ROCE is also an efficiency measure of sorts; ROCE doesn’t just gauge profitability as profit margin ratios do, it measures profitability after factoring in the amount of capital used. To understand the significance of factoring in employed capital, let’s look at an example. Say Company A makes a profit of $100 on sales of $1,000, and Company B makes $150 on $1,000 of sales. In terms of pure profitability, B, having a 15% profit margin, is far ahead of A, which has a 10% margin. However, let’s say A employs $500 of capital and B $1,000. A has an ROCE of 20% [100/500] while B has an ROCE of only 15% [150/1,000]. The ROCE measurements show us that Company A makes better use of its capital. In other words, it is able to squeeze more earnings out of every dollar of capital it employs. A high ROCE indicates that a larger chunk of profits can be invested back into the company for the benefit of shareholders. The reinvested capital is employed again at a higher rate of return, which helps to produce higher earnings-per-share growth. A high ROCE is, therefore, a sign of a successful growth company. (See, The Bottom Line On Margins.)
ROCE in Relation to the Cost of Borrowing
A company’s ROCE should always be compared to the current cost of borrowing. If an investor puts $100 into a bank for a year at 5% interest, the $5 received in interest represents a reasonable return on the capital. To justify putting the $100 into a business instead, the investor must expect a return that is significantly higher than 5%. To deliver a higher return, a public company must raise more money in a cost effective way, which puts it into a good position to see its share price increase; ROCE measures a company’s ability to do this. There are no firm benchmarks, but as a very general rule of thumb, ROCE should be at least double the interest rates. An ROCE any lower than this suggests that a company is making poor use of its capital resources.
Some Guidelines for Analyzing ROCE
Consistency is a key factor of performance. In other words, investors should resist investing on the basis of only one year’s ROCE. Take a look at how ROCE behaves over several years and follow the trend closely. A company that, year after year, earns a higher return on every dollar invested in the business is bound to have a higher market valuation than a company that burns up capital to generate profits. Be on the lookout for sudden changes; a decline in ROCE could signal the loss of competitive advantage. (For more insight, see Competitive Advantage Counts.)
Because ROCE measures profitability in relation to invested capital, ROCE is important for capital-intensive companies, or firms that require large upfront investments to start producing goods. Examples of capital-intensive companies are those in telecommunications, power utilities and heavy industries. ROCE has emerged as the undisputed measure of profitability for oil and gas companies, which also operate in a capital-intensive industry. In fact, there is often a strong correlation between ROCE and an oil company’s share price performance.
Things to be Aware Of
While ROCE is a good measure of profitability, it may not provide an accurate reflection of performance for companies that have large cash reserves, which could be funds raised from a recent equity issue. Cash reserves are counted as part of capital employed even though these reserves may not yet be employed. As such, this inclusion of the cash reserves can actually overstate capital and reduce ROCE.
Consider a firm that has turned a profit of $15 on $100 capital employed, or 15% ROCE. Of the $100 capital employed, let’s say $40 was cash it recently raised and has yet to invest into operations. If we ignore this latent cash in hand, the capital is actually around $60. The company’s ROCE, then, is a much more impressive 25%. Furthermore, there are times when ROCE may understate the amount of capital employed. Conservatism dictates that intangible assets – such as trademarks, brands and research and development – are not counted as part of capital employed. Intangibles are too hard to value with reliability, so they are left out. Nevertheless, they still represent capital employed.
Conclusion
Like all performance metrics, ROCE has its difficulties, but it is a powerful tool that deserves attention. Think of it as a tool for spotting companies that can squeeze a high a return out of the capital they put into their businesses. ROCE is especially important for capital-intensive companies. Top performers are the firms that deliver above-average returns over a period of several years and ROCE can help you to spot them.
Investing Beyond Your Borders
One of the thorniest decisions investors have to make is whether to put money into foreign stocks. Investing in foreign companies can be lucrative, but the rewards come with additional risks, and spotting worthwhile investments overseas can take a tad more work than finding them at home.
International Opportunity
There are plenty of good reasons to invest abroad. International stocks represent added opportunity: as of 2004, U.S. stocks represent only about half of the total value of global markets. In fact, not one of the 10 largest companies that make steel, electronics or consumer appliances are based in the United States. There are about 21 major stock markets outside of the U.S. that have more than a thousand companies of substantial size. Many of those companies operate in rapidly growing economies with extraordinary rates of return. Why pass them up?
From a portfolio management perspective, investing in foreign companies is a way to diversify. For instance, U.S. and foreign shares do not always move in sync. When one is up, the other may be down, and vice versa. In technical terms, such markets are said to lack correlation. A diversified portfolio balances uncorrelated assets to spread the risk.
Of course, that doesn’t mean that U.S. and foreign shares always move in opposite directions. Many countries rely heavily on the U.S. for imports and exports, and can be susceptible to U.S. market shifts. In today’s global economy, stocks often move in the same direction, especially when the U.S. is experiencing a big bear or bull market. Nevertheless, academic research shows that over the long term, U.S. and foreign shares are sufficiently independent so that investing overseas can smooth portfolio returns.
International Risk
Investors, however, need to appreciate the serious risks involved with international stocks. For starters, there is exchange rate risk. A U.S. investor’s return on a stock from a foreign country is tied to changes in the currency values between the U.S. dollar and that country’s currency. If you buy a Japanese stock and the Japanese yen rises against the dollar between the time you buy and sell the stock, your return is worth more. On the other hand, if the yen weakens, your investment return weakens.
Beyond upheavals in currency markets, there is country risk. Many countries suffer from political, social and economic instability, which makes investing in those places risky.
If you think that investing in your home country is hard, spotting companies in foreign lands can be even tougher. Foreign governments have different reporting and tax regulations on securities. In many cases, foreign companies are not required to provide the same detailed information U.S. companies must provide, and overseas companies may use different accounting procedures, which can make stock analysis trickier. Before putting money into an overseas stock, it’s critical to get a good sense of its investment environment.
Buying Overseas
For investors with the patience to do their research, international stocks can offer big rewards. The trick is to understand the opportunities as well as the risks. Here are some straightforward ways to buy into foreign companies:
ADRs
While many investors appreciate the rationale for investing abroad, they may be deterred by the mechanics of purchasing shares on a foreign exchange. American depositary receipts (ADRs) can simplify the access of U.S. investors to foreign markets. Listed on the New York Stock Exchange and Nasdaq, they can be traded, settled and held as if they were ordinary shares of U.S.-based companies. Foreign companies with ADRs issue financial reports that generally conform to U.S. accounting conventions and SEC rules. Companies with ADRs include Finland’s Nokia, GlaxoSmithKline of the U.K. and Japan’s Sony.
Although they trade on U.S. exchanges, ADRs still offer the potential benefits of diversification. Studies suggest that ADR prices tend to behave like the foreign stocks they represent. For more on ADRs, take a look at ADR Basics or What Are Depositary Receipts?
U.S.-Traded International Stocks
There are a few foreign stocks that trade on U.S. markets. These stocks have met the listing requirements of either the New York Stock Exchange or Nasdaq. Consider the Canadian telecommunications equipment-maker Nortel. It is listed on the Toronto Stock Exchange and Nasdaq. Nortel has two sets of shares that trade on the two markets in different currencies at values that are roughly on par with the currency exchange rate.
U.S. Multinationals
Before you jump into foreign stocks, it’s worthwhile considering domestic stocks with exposure to foreign markets. Plenty of U.S. companies generate the bulk of their revenue from outside the U.S. Take McDonald’s, Coca-Cola, and Gillette. More than half of their revenues come from overseas business. Buying shares of U.S. multinationals can be an effective way for investors to get exposure to the global economy.
Conclusion
Because foreign markets lack direct correlation, investing outside the U.S. can be an effective way to diversify your portfolio. However, investing abroad can also expose you to risks associated with exchange rates, political or economic instability, and differences in reporting and tax regulations. Still, in understanding these risks in relation to the potential rewards, investors have the opportunity to access foreign markets through instruments such as ADRs, international stocks traded on U.S. exchanges, and U.S. multinationals.
Beta: Know the Risk
How should investors assess risk in the stocks they buy or sell? As you can imagine, the concept of risk is hard to pin down and factor into stock analysis and valuation. Is there a rating–some sort of number, letter, or phrase–that will do the trick?
One of the most popular indicators of risk is a statistical measure called beta. Stock analysts use this measure all the time to get a sense of stocks’ risk profiles. To learn about the basics of beta, take a look at Beta: Gauging Price Fluctuations. Here we shed some light on what the measure means for investors. While beta does say something about price risk, it does have its limits for investors looking for fundamental risk factors.
Beta
Beta is a measure of a stock’s volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock’s beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.
Beta is a key component for the ‘capital asset pricing model’ (CAPM), which is used to calculate cost of equity. Recall that the cost of capital represents the discount rate used to arrive at the present value of a company’s future cash flows. All things being equal, the higher a company’s beta is, the higher its cost of capital discount rate. The higher the discount rate, the lower the present value placed on the company’s future cash flows. In short, beta can impact a company’s share valuation.
Advantages of Beta
To followers of CAPM, beta is a useful measure. A stock’s price variability is important to consider when assessing risk. Indeed, if you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.
Intuitively, it makes plenty of sense. Think of an early-stage technology stock with a price that bounces up and down more than the market. It’s hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta.
Besides, beta offers a clear, quantifiable measure, which makes it easy to work with. Sure, there are variations on beta depending on things such as the market index used and the time period measured, but broadly speaking, the notion of beta is fairly straightforward to understand. It’s a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows.
Disadvantages of Beta
However, if you are investing in a stock’s fundamentals, beta has plenty of shortcomings.
For starters, beta doesn’t incorporate new information. Consider the electrical utility company American Electric Power (AEP). Historically, AEP has been considered a defensive stock with a low beta. But when it entered the merchant energy business and assumed high debt levels, AEP’s historic beta no longer captured the substantial risks the company took on. At the same time, many technology stocks, such as Google, are so new to the market they have insufficient price history to establish a reliable beta.
Another troubling factor is that past price movements are very poor predictors of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead.
Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. But for investors with long-term horizons, it’s less useful.
Re-Assessing Risk
The well-worn definition of risk is the possibility of suffering a loss. Of course, when investors consider risk, they are thinking about the chance that the stock they buy will decrease in value. The trouble is that beta, as a proxy for risk, doesn’t distinguish between upside and downside price movements. For most investors, downside movements are risk while upside ones mean opportunity. Beta doesn’t help investors tell the difference. For most investors, that doesn’t make much sense.
There is an interesting quote from Warren Buffett in regards to the academic community and its attitude towards value investing: “Well, it may be all right in practice, but it will never work in theory.” Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell. A value investor would argue that a company represents a lower-risk investment after it falls in value–investors can get the same stock at a lower price despite the rise in the stock’s beta following its decline. Beta says nothing about the price paid for the stock in relation to its future cash flows.
If you are a fundamental investor, consider some practical recommendations offered by Benjamin Graham and his modern adherents. Try to spot well-run companies with a “margin of safety”–that is, an ability to withstand unpleasant surprises. Some elements of safety come from the balance sheet, like having a low ratio of debt to total capital. Some come from consistency of growth, in earnings or dividends. An important one comes from not overpaying. Stocks trading at low multiples of their earnings are safer than stocks at high multiples.
Conclusion
It’s important for investors to make the distinction between short-term risk–where beta and price volatility are useful–and longer-term, fundamental risk, where big-picture risk factors are more telling. High betas may mean price volatility over the near term, but they don’t always rule out long-term opportunities.
Lifting the Lid on CEO Compensation
It’s hard to read the business news without coming across reports about the salaries, bonuses, and stock option packages awarded to chief executives of publicly traded companies. Making sense of the numbers to assess how companies are paying their top brass isn’t always easy. Is executive compensation working in the favor of investors? Here are a few guidelines for checking a company’s compensation program.
Risk and Reward
Company boards, at least in principle, try to use compensation contracts to align executives’ actions with company success. The idea is that CEO performance provides value to the organization. “Pay for performance” is the mantra most companies use when they try to explain their compensation plans.
While everyone can support the idea of paying for performance, it implies that CEOs take on risk: CEOs’ fortunes should rise and fall with companies’ fortunes. When you are looking at a company’s compensation program, it’s worth checking to see how much stake executives have in delivering the goods for investors. Let’s take a look at how different forms of compensation put a CEO’s reward at risk if performance is poor.
Cash/Base Salaries
These days, it’s common for CEOs to receive base salaries well over $1 million. In other words, the CEO gets a terrific reward when the company does well, but still receives the reward when the company does badly. On their own, big base salaries offer little incentive for executives to work harder and make smart decisions.
Bonuses
Be careful about bonuses. In many cases, an annual bonus is nothing more than a base salary in disguise. A CEO with a $1 million salary may also receive a $700,000 bonus. If any of that bonus, say $500,000, does not vary with performance, then the CEO’s real salary is $1.5 million.
Bonuses that vary with performance are another matter. It’s hard to argue with the idea that CEOs who know they’ll be rewarded for performance tend to perform at a higher level. CEOs have an incentive to work hard.
Performance can be gauged by any number of things, such as profits or revenue growth, return on equity, or share price appreciation. But using simple measures to determine appropriate pay for performance can be tricky. Financial metrics and annual share price gains are not always a fair measure of how well an executive is doing his or her job. Executives can get unfairly penalized for one-time events and tough choices that might hurt performance or cause negative reactions from the market. It’s up to the board of directors to create a balanced set of measures for judging the CEO’s effectiveness.
Stock Options
Companies trumpet stock options as the way to link executives’ financial interests with shareholders’ interests.
But options are far from perfect. In fact, with options, risk can get badly skewed. When shares go up in value, executives can make a fortune from options–but when they fall, investors lose out while executives are no worse off than before. Indeed, some companies let executives swap old option shares for new, lower priced shares when the company’s shares fall in value.
Worse still, the incentive to keep the share price motoring upward so that options will stay in-the-money encourages executives to focus exclusively on the next quarter and ignore shareholders’ longer term interests. Options can even prompt top managers to manipulate the numbers to make sure the short-term targets are met. That hardly reinforces the link between CEOs and shareholders.
Stock Ownership
Academic studies say that common stock ownership is the most important performance driver. So, one way for CEOs to truly have their interests tied with shareholders is for them to own shares, not options. Ideally, that involves giving executives bonuses on the condition they use the money to buy shares. Face it: top executives act more like owners when they have a stake in the business.
Finding the Numbers
You can find a whole host of information on a company’s compensation program in its regulatory filing. Form DEF 14A, filed with the Securities and Exchange Commission, provides summary tables of compensation for a company’s CEO and other highest paid executives.
When evaluating the base salary and annual bonus, investors like to see companies award a bigger chunk of compensation as bonus rather than base salary. The DEF 14A should offer an explanation of how the bonus is determined and what form the reward takes, whether cash, options, or shares.
Information on CEO stock option holdings can also be found in the summary tables. The form discloses the frequency of stock option grants and the amount of awards received by executives in the year. It also discloses re-pricing of stock options.
The proxy statement is where you can locate numbers on executives’ “beneficial ownership” in the company. But do not ignore the table’s accompanying footnotes. There you will find out how many of those shares the executive actually owns and how many are unexercised options. Again, it’s reassuring to find executives with plenty of stock ownership.
Conclusion
Assessing CEO compensation is a bit of a black art. Interpreting the numbers isn’t terribly straightforward. All the same, it’s valuable for investors to get a sense of how compensation programs can create incentives–or disincentives–for top managers to work in the interests of shareholders.