Assessing Earning Power

The principal method of appraising a stock, according to Graham and Dodd, is to determine its eaming power. The investor should gauge a companys profitability by tracking it over a long period, usually seven to ten years. He or she should carefully analyze its eamings and dividend trends, financial strength, backlogs, capital spending plans, and other pertinent information. Qualitative factors, such as growth prospects, management, position in its industry, and product development should also be assessed. After thorough analysis, the investor should be in a position to work out conservative projections of eamings.

Cash Flow Analysis

Many value analysts today place more emphasis on cash flow than on eamings. Cash flow is normally defined as after-tax eamings, adding back depreciation and other noncash charges. If we take two companies with similar outlooks, markets, products, and management talent, tiie one witii tiie higher cash flow will usually be tiie more rewarding stock. In investing, as in your personal finances, cash is king. The company witii good cash flow can capitahze on market opportunities that a firm with weaker cash flow sadly must let slip by. Firms with strong cash flow can also better ride out economic storms than their weaker competitors.

These analysts regard cash flow as more important tiian eamings because management can reduce eamings by setting up reserves or taking write-offs, or increase tiiem by not taking adequate depreciation or other necessary charges. Altiiough these entries do not show in eamings, they read loud and clear in tiie statement of cash flow, which the Federal Accounting Standards Board (FASB) has required companies to issue since mid-1988. But cash flow is only one of a number of accounting statements that is important to the value analyst.

* For example, a one-time gain from the sale of a plant or land must be excluded from that years operating income, as should a large number of extraordinary or one-time charges. (These items will show up in the statement of cash flow.)

Accounting

The fundamentahst attaches high importance to understanding accounting conventions. To get an accurate picture of earnings, adjustments must be made for each accounting item that could distort them.*

Nor is the analysts emphasis on accounting principles merely an obsession. "Creative" accounting has always been a facile tool in the hands of the adroit 1 manipulator. In the latter half of the eighties, Michael Milken and other junk bond impresarios sold huge amounts of marginal bonds to the public, frequently with little in the way of assets, or even a profitable business to back them. All too often, these bonds were backed by smoke and mirrors and the allure of dazzling interest rates that could be paid only if a minor miracle occurred. The collapse of this market in 1990 caused the loss of hundreds of billions of dollars as well as the insolvency of a number of major financial institutions, including Columbia Savings and Loan and Charles Keatings Lincoln Savings and Loan. More recently, the banlmiptcy of Crazy Eddie and the imprisonment of its chairman, Eddie Antar; of Leslie Fay, a medium-size public apparel manufacturer listed on the New York Stock Exchange; and the 1997 decimation of Mercury Finance underscored the need to sift carefully for signs of financial manipulation.

Graham and Dodd and succeeding value analysts recommend that security analysts use an extensive hst of financial ratios to evaluate a company. One of the more important is the return on equity-the after-tax profit divided by net worth, which is to say the value of all common stock and retained earnings. This is an important ratio to determine how profitable the business is. Another is pretax retum on sales, the income eamed before taxes as a percentage of sales. While there are naturally variations from industry to industry, the higher and more stable these ratios, the better regarded the firm. The two ratios will range from 10 or 12% for the average company to as high as 20 or 30% for the more spectacular growth stocks.

Other ratios show whether a company can meet its debts, since a high debt load can lead to default or bankmptcy. A common rule of thumb for an industrial company is that the common stock should represent at least 40 percent of the capital structure.

The no-nonsense approach of Graham and Dodd stated that the ana-

Price-to-Book Value

A second method of picking stocks is to buy companies trading at a significant discount to their book, or net asset, value (the value of the common stock after deducting all liabilities and preferred shares). Usually, this is calculated per common share by dividing the total by the number of common shares outstanding.

Again, to do this the investor must be famihar with accounting. Book value is often cmcial in evaluating a private company, noted Graham and Dodd, but once the firm goes public the market tums its focus almost exclusively to eamings. Formulas were given for taking advantage of companies selling under book, or for valuing other assets priced nominally on the balance sheet. Many of these techniques have become central to merger and acquisition evaluation today.

Contemporary asset players, however, increasingly use relative book value-the book value of the company relative to the market-rather than absolute value. The reason is that the average company in the S&P

lyst should focus on whether the record of eamings could continue, rather than whether a company could expand rapidly. Today most fundamental analysts start here, but put more emphasis on recent developments and future prospects.

Graham laid out four components of stock evaluation: expected eamings, expected dividends, a method for valuing expected eamings, and asset value. All are still widely used. He repeatedly cautions the practitioner to tie the four firmly to the record of the past.

Once future earnings are estimated, an evaluative measure estabHshes what the price should be. The most commonly used value yardstick is the price/eamings (P/E) ratio-price divided by eamings per share. If a stock trading at $ 10 eamed $ 1.00 last year, and is expected to eam $ 1.25 this year, it is said to be trading at a price/eamings ratio of 10 on the latest full years eamings and at 8 on anticipated eamings for the current year. The higher the P/E ratio, the more favorable the companys prospects; the lower the multiple, the more lackluster they appear.

A cardinal conviction of Graham and Dodd is that investors overemphasize near-term prospects, ove ricing companies for which they are favorable and unde ricing those for which they are poorer. They thus recommended upper limits on the P/E ratio the investor should pay for a stock with excellent prospects and lower limits on the P/E ratios of companies with so-so outlooks. If a company fell below the lower limit, it was probably undervalued and worth a look.