How to Screen Stocks in 10 minutes

Does the firm pass a minimum quality hurdle?…

Avoid mini caps and firms that trade on bulletin boards (or pink sheets); avoid firms that don’t file regular financials with the SEC; avoid initial public offerings (IPO).

Has the company ever made an operating profits?…

Avoid promising (or young start-up) firms. For example: novel treatment abt some rare-disease, exciting new products that the world has never seen.

Does the company generate consistent cash flow from operations?

Are ROE consistently above 10%/12% with reasonable leverage?

Is Earnings growth consistent or erratic?

How Clean is the Balance Sheet?

Firms with a lot of debt require extra care because their capital structures are often very complicated. If a nonbank firm has a financial leverage ratio >4% – or a debt-to-equity ratio over 1.0 – ask yourself the following questions:

• Is the firm in a stable business? Firms in industries such as consumer products and food can withstand more leverage than economically sensitive firms with volatile earnings.
• Has debt been going down as a percentage of total assets?

Does the firm generate free cash flow?

Divide free cash flow by sales, and use 5% as a rough benchmark. Don’t automatically write off firms with negative free cash flow if they have solid ROEs and pass the other tests in this chapter. Just be sure you believe that the firm really is reinvesting the cash wisely.

Is the firm has a habit of making one time charge?

Has the number of Shares outstanding increased markedly over the past several years?

If so, the firm is either issuing new shares to buy other companies or granting numerous options to employees and executives. If shares outstanding are consistently increasing by more than 2% – assuming no big acquisitions – think long and hard before investing in the firm.

However, if the number of shares is actually shrinking, the company potentially gets a big gold star.

Intrinsic Value

The value of a stock is equal to the present value of its future cash flows. Value is determined by the amount, timing, and riskiness of a firm’s future cash flows

Present value calculation is necessary because future value of money is worth less than current ones because:

1. Money we receive today can be invested to generate some kind of return, whereas we can’t invest future cash flows until we receive them. This is the time value of money. Often represented by the interest rates being paid on government bonds.
2. There’s a chance we may never receive those future cash flows, and we need to be compensated for that risk, called the “risk premium“

Discount rate = government bond rate + risk premium. Think of discount rate in this way: what rate of return would you need to make you indifferent between receiving some quantity of money right now versus at some time in the future?

Calculating Present Value (PV)

Example: find PV of $100 future cash flow. Using 10% discount rate

one year in the future = $100 / (1.0 + 0.1)

two years in the future = $100 / (1.0 + 0.1)^2

Determine Discount Rate

As interest rates increase, so will discount rates. As a firm’s risk level increases, so will its discount rate. For interest rates, you can use a long-term average of Treasury rates as a reasonable proxy (10-year bond).

Riskiness factors:

• Size. Smaller firms are generally riskier than larger firms
• Financial Leverage. Firms with more debt are generally more riskier than firms with less debt.
• Cyclicality. Cyclical companies have higher risk.
• Management / corporate governance. Bad management is risky.
• Economic moat. the narrower the moat is, the riskier the stock.
• Complex Structure. The more complex an organization is, the riskier the stock.

As a base use 10.5%. If less risky, you can use 9%. If more risky, you can use 13% to 15%.

Calculating Perpetuity Values

We need a perpetuity because it’s not feasible to project a company’s future cash flows out to infinity, year-by-year, and because companies have theoritically infinite lives.

The most common way to calculate a perpetuity is to take the last cash flow (CF) that you estimate, increase it by the rate at which you expect cash flows to grow over the very long term (g), and divide the result by the discount rate (R) minus the expected long-term growth rate. In formula :

CFn (1 + g) / (R – g)

The result of this calculation then must be discounted back to the present value.

The Basic of Stock Valuation

Over time, the stock market’s returns come from two key components: investment return and speculative return. As Vanguard founder John Bogle has pointed out, the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio

Price Multiples

A. Price-to-Sales (P/S)

P/S ratio = current price of the stock / sales per share

The good thing about P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings. In addition, sales are not as volatile as earnings. Thus, P/S ratio useful for quickly valuing companies with highly variable earnings, by comparing the current P/S ratio with historical P/S ratios. Also the P/S ratio can be used when earnings are negative (P/E ratios cannot be calculated – indicated as N/A).

Biggest flaw: Sales may worth a little or a lot, depending on a company profitability. A company may post billions in sales, but still losing money.

B. Price-to-Book (P/B)

P/B ratio = stock’s market value / book value (also known as shareholder’s equity or net worth).

The main weakness for P/B is that there is increasing trend in intangible assets worth, which may limit the usefulness of P/B ratio. For service firms which depends on brand, dedicated employees, strong customer relationship, efficient internal process, P/B has little meaning.

P/B is tied to ROE (equal to net income / book value), in the same way that P/S is tied to net margin (equal to net income / sales). Given two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio. Therefore, when you are looking at P/B, make sure you relate it to ROE. A firm with a low P/B relative to its peers or to the market and a high ROE might be a potential bargain, but you’ll want to do some digging before making that assessment based solely on the P/B.

P/B is useful for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets. Financial firms trading below book value (a P/B lower than 1.0) are often experiencing some kind of trouble.

C. Price-to-Earnings (P/E)

The Good: accounting earnings are a much better proxy for cash flow than sales, and they’re more up-to-date than book value. Moreover, it is readily available.

The easiest way to use a P/E ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, or the same company at a different point in time.

The Bad: Relative P/E has one drawback, a P/E of 12, for example, is neither good nor bad in a vacuum. Using P/E ratios only on relative basis means that your analysis can be skewed by the benchmark you’re using.

Risk, growth, and capital needs are all fundamental determinants of a stock’s P/E ratio:

• higher growth firms should have higher P/E ratios,
• higher risk firms should have lower P/E ratios,
• and firms with higher capital needs should have lower P/E ratios.

When you’re using the P/E ratio, remember that firms with an abundance of free cash flow are likely to have low reinvestment needs, which means higher P/E. Also:

• If a firm has recently sold off a business or perhaps a stake in another firm, it’s going to have an artificially inflated E, and thus lower P/E.
• If a firm is restructuring or closing down plants, earnings could be artificially depressed, which would push the P/E up. For valuation purposes, it’s useful to add back the charge to get a sense of the firm’s normalized P/E.
• If the firm cyclical? Firms that go through boom and bust cycles – semiconductor companies and auto manufacturers are good examples – require a bit more care. Your best bet is to look at the most recent cyclical peak, make a judgment whether the next peak is likely to be lower or higher than the last one, and calculate a P/E based on the current price relative to what you think earnings per share will be at the next peak.
• Does the firm capitalize or expense its cash-flow generating assets? A firm that makes money by building factories and making products gets to spread the expense of those factories over many years by depreciating them bit by bit. On the other hand, a firm that makes money by inventing new products like drug, has to expense all of its spending on R&D every year. Arguably, it’s that spending on R&D that’s really create value for shareholders. Thus, the firm that expenses assets will have lower earnings – and therefore a higher P/E – in any given year than a firm that capitalizes assets.
• Which type of P/E? There are two kinds of P/Es-a trailing P/E, which uses the past four quarters’ worth of earnings to calculate the ratio, and a forward P/E, which uses analysts’ estimates of next year earnings to calculate ratio. In general, forward P/E < trailing P/E. Forward P/E also tend to be too optimistic.

D. Price-to-Earnings Growth (PEG)

PEG = P/E divided by its growth rate

The problem with this measure is that risk and growth often go hand in glove – fast-growing firms tend to be riskier than average. This conflation of risk and growth is why the PEG is so frequently misused. When you use a PEG ratio, you’re assuming that all growth is equal, generated with the same amount of capital and the same amount of risk.

Don’t just pluck your money to the one with the lower PEG ratio, look at the capital that needs to be invested to generate the expected growth, as well as the likelihood that those expectations will actually materialize.

E. Yield is good

earning yield = 1 / (P/E), or earning per share divided by its market price.

The nice thing about yield, as opposed to P/Es, is that we can compare them with alternative investments, such as bonds, to see what kind of a return we can expect from each investment.

The best yield-based valuation measure is cash return. Cash return = Free Cash Flow / Enterprise Value (Enterprise value is simply a stock’s market capitalization + its long term debt – its cash). The goal of the cash return is to measure how efficiently the business is using its capital – both equity and debt – to generate free cash flow.

Essentially, cash return tells you how much free cash flow a company generates as a percentage of how much it would cost an investor to buy the whole company, including the debt burden.

BEWARE: Cash flow isn’t terribly meaningful for banks and other firms that earn money via their balance sheets.

Analyzing a Company – The Basic

This can be break down into five areas

I. Growth.

Sales growth is more important than earning growth. Sales growth is more difficult to fake. In general, sales growth stems from one of the four areas:

1. Selling more goods or services
2. Raising prices
3. Selling NEW goods or services
4. Buying another company. This is low quality growth.

II. Profitability.

Comparing cash flow from operations to reported earnings per share is another good way to get a rough idea of a firm’s profitability because cash flow from operations represents real profits.

Two tools for assessing corporate profitability are return on capital and free cash flow.

Net margin = net income / Sales. It tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business.

Asset turnover = sales / assets. It tells us roughly how efficient a firm is at generating revenue from each dollar of assets.

ROA = Net Margin x Asset Turnover. It tells us the amount of profits that a company is able to generate per dollar of assets.

Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating assets into profits. ROA helps us understand that there are two routes to excellent opertational profitability: (1) You can charge high prices for your products (high margins), or (2) you can turn over your assets quickly.

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Financial leverage = Assets / Shareholders’ equity. It tells us how much debt a company carries, relative to shareholders’ equity.

Return on Equity = Return on Assets x Financial Leverage.

In general, any nonfinancial firm that can generate consistent ROEs > 10% without excessive leverage is at least worth investigating. Additional two caveats when you’re using ROE to evaluate firms: (1) Banks always have enormous financial leverage ratios, so don’t be scared off by a leverage ratio that looks high relative to a non-bank. (2) for banks, look for consistent ROEs >12%.

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Free Cash Flow = Cash Flow from operations – Capital Spending. Any firm that’s able to convert more than 5% of sales to free cash flow – just divide free cash flow by sales – is doing a solid job at generating excess cash.

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One good way to think about the returns a company is generating is to use profitability matrix.

Profitability Matrix

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Return on Invested Capital (ROIC)

It is a better measures than ROA and ROE. It removes the debt-related distortion that can make highly leveraged companies look very profitable when using ROE.

Higher return on invested capital is preferable to a lower one.

III. Financial Health.

In addition to financial leverage, make sure to examine a few other key metrics:

• Debt to Equity = long-term debt divided by shareholder’s equity.
• Times Interest Earned. Earnings before interest and taxes (EBIT) – look up pretax earnings and add back interest expense. Divide EBIT by interest expense, and you’ll know how many times (hence the name) the company could have paid the interest expense on its debt. The more times that the company can pay its interest expense, the less likely that it will run into difficulty if earnings should fall unexpectedly.

Calculate the ratio (EBIT / interest expense) for the past five years, and you’ll be able to see whether the company is becoming riskier – times interest earned is falling – or whether its financial health is improving

• Current ratio = current assets / current liabilities, simply tells you how much liquidity a firm has – in other words, how much cash it could raise if it absolutely had to pay off its liabilities all at once. As a very general rule, a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble.

• Unfortunately, some current assets, such as inventories might worth less. So there’s an even more conservative test of a company liquidity, the quick ratio = (current assets – inventories) / current liabilities. In general, a quick ratio higher than 1.0 puts a company in fine shape, but always look at other firms in the same industry to be sure.

IV. Risks/Bear Case

Be a skeptic, think WHY the stock is unloved or unpopular. It could be a valid case.

V. Management.

Divide into three parts: (1) Compensation (Be careful on exorbitant salary package, reduce corporate profit target for senior management, reward management for consummating an acquisition); (2) Character (Are there family members among boards, candor – esp in letter to shareholder statements, self-promotional / CEO paints himself as latter-day saints, key officers turnover); and (3) Operations (did the management follow through their plans?, self-confidence for long term prospects).

Financial Reporting: An Overview

Taken from The Five Rules For Successful stock investing by Pat Dorsley.

There are three financial statement that you need to take note:

1. The balance sheet is like a company’s credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities) at a specific point in time. It tells you how strong the framework and foundation of the business is. It must be balanced at all times: Assets = Liabilities.
2. The income statement, tells how much the company made or lost in accounting profits during a year or a quarter. Unlike the balance sheet, which is a snapshot of the company’s financial health at a precise moment, the income statement records revenues and expenses over a set period, such as a fiscal year.
3. The statement of cash flows, which records all the cash that comes into a company and all of the cash that goes out.

Look at the statement of cash flows first when evaluating a company to see how much cash it’s throwing off, then look at the balance sheet to test the firmness of its financial foundation, and only then look at the income statement to check out margins and such.

Further details:

I. The Balance Sheet

• The basic equation underlying a balance sheet is: Assets – Liabilities = Equity.

• Current Assets = those likely to be used up or converted into cash within one business cycle, usually defined as one year. This includes: (a) Cash and equivalents and short-term investments; (b) account receivable

Comparing the growth rate of accounts receivable with the growth rate of sales is a good way to judge whether a company is doing a good job collecting the money that it’s owed by customers.

; (c) inventories. Look for inventory turnover = cost of goods sold (cost of revenue) / inventory level.

• Noncurrent Assets = assets that are not expected to be converted into cash or used up within the reporting period. This includes: (a) property, plant, and equipment (PP&E). If we compare these number to the firms’ total assets, we can get a feel for how capital-intensive the firms are; (b)investment; and (c)intangible assets.

• Current Liabilities = money the company expects to pay out wihin a year. This includes: (a) account payable; (b) short-term borrowings or payables.
• Noncurrent liabilities = They represent money the company owes one year or more in the future. This includes: long-term debt.

• Stockholders’ Equity. The only account worth looking at is retained earnings = profits – dividends and stock buyback. It is a cumulative account. Think of this account as a company’s long-term track record at generating profits.

II. The Income Statement

In a 10-K, you’ll usually see the income statement labeled as the “consolidated statement of income” or the “consolidated statement of earnings”. Important line items in the income statement indicated below:

• Revenue, sometimes labeled as sales.
• Cost of Sales = Cost of goods sold
• Gross profit = revenue – cost of sales. Once you have gross profit, you can calculate a gross margin, which is gross profit as a percentage of revenue. Essentially, this tells you how much a company is able to mark up its goods.
• Selling, General, and Administration Expenses (SG&A). Also known as operating expenses. You can get a feel for how efficient a firm is by looking at SG&A as a percentage of revenues – a lower percentage of operating expenses relative to sales = a tighter, more cost-effective firms.
• Depreciation and Amortization
• Nonrecurring Charges/Gains. Ideally, you’d want to see this area of income statement blank most of the time.
• Operating Income = revenues – cost of sales and all operating expenses.
• Interest Income/Expense
• Taxes.
• Net Income. It is the company’s profit after all expenses have been paid. This figure is less important than cash flow.
• Number of Shares (Basic and Diluted). Ignore basic shares. Diluted shares, however, include security that could potentially be converted into shares of stock, such as stock options and convertible bonds.
• Earning per Share (Basic and Diluted). This number represents net income = number of shares.

III. The Statement of Cash Flows

The cash flow statement is divided into three parts: cash flows from operating activities, from investing activities, and from financing activities.

From Operating Activities:

• Tax Benefit from Employee Stock Plan. Employee compensation is generally tax deductible.
• Net cash provided by operating activities. Also known as operating cash flow. Pay attention to this figure.

From Investing Activities:

• Capital Expenditure. It represents money spent on items that last a long time, such as PP&E. Free Cash Flow = Opearting Cash Flow – Capital Expenditure.

From Financing Activities:

• Issuance/Purchase of Common Stock. It indicates how a company is financing its activities.
• Issuance/Repayment of Debt. It indicates whether the company has borrowed money or repaid money it previously borrowed.

Stock – General tips

Taken from The Five Rules For Successful Stock Investing, by Pat Dorsley

When not to sell a stock:

1. The Stock has dropped
2. The Stock has skyrocketed

When to sell a stock:

1. Did you make a mistake?
2. Have fundamentals deteriorated?
3. Has stock risen too far above its intrinsic value?
4. Is There Something better you can do with the money?
5. Do you have too much money in one stock?

Seven mistakes to avoid:

1. Swinging for the fences. This means that buying risky stocks (like small caps), finding the next Microsoft when it’s still a tiny start-up is next to impossible.
2. Believing that it’s different this time. History does repeat itself, bubbles do burst, and not knowing market history is a major handicap.
3. Falling in love with the products. For example: Palm was the first company to invent a handheld organizer that was relatively easy to use and affordable, but consumer electronics is simply not an attractive business. Margins are thin, competition is intense, and it’s very tough to make a consistent profit.
4. Panicking when the market is down. In the words of Sir John Templeton, “The time of maximum pessimism is the best time to buy.
5. Trying to time the market.
6. Ignoring valuation. The only reason you should ever buy a stock is that you think the business is worth more than it’s selling for – not because you think a greater fool will pay more for the shares a few months down the road.
7. Relying on Earnings for the whole story. Cash flow is what matters, not earnings.

If operating cash flows stagnate or shrink even as earnings grow, it’s likely that something is rottern

Economic Moat – What makes great company great.

To analyze a company’s economic moat, follow these four steps:

I. Evaluate the firm’s historical profitability.

• Look for line item labeled “cash flow from operations” and subtract with “capital expenditure”.
• Next, divide free cash flow by sales (or revenues), which tells you what proportion of each dollar in revenue the firm is able to convert into excess profits.

If a firm’s free cash flow as a percentage of sales in around 5% or better, you have found a cash machine.

• Look for Net Margin = Net income as a percentage of sales.

Firms that post net margins > 15% are doing something right

• Look for Return in Equity (ROE) = net income as a percentage of shareholders’ equity, and it measures profits per dollar of the capital shareholders have invested in a company.

Firms that are able to consistently post ROEs above 15% are generating solid return on shareholder money.

• Look for Return on Assets (ROA) = net income as a percentage of a firm’s assets, and it measures how efficient a firm is at translating its assets into profits

Use 6% to 7% as a rough benchmark

II. If the firm has solid returns on capital and consistent profitability, assess the sources of the firm’s profits.

The key question here is : WHY. Why no competitor on horizon?, why customer keep on accepting price increase?

In general, there are 5 ways that an individual firm can build sustainable competitive advantage:

1. Creating real product differentiation through superior technology or features (NARROW MOAT).
2. Creating perceived product differentiation through a trusted brand or reputation (DEEP MOAT).
3. Driving costs down and offering a similar product or service at a lower price. This especially works in commodity industries, in which products are tough to differentiate. Also, it worth to mention that firms can create cost advantage by either inventing a better process (e.g. Dell) or achieving a larger scale / economy of scale (e.g. Intel). (DEEP MOAT)
4. Locking in customers by creating high switching costs. You can make it difficult in terms of either money or time for a customer to switch to a competing product. Ask the following questions: (a) need significant amount of client training?; (b) tightly integrated into customers’ businesses?; (c) is it industry standard?; (d) is the benefit to be gained from switching small relative to the cost of switching?; (e) any long term contract with client? (DEEP MOAT)
5. Locking our competitors by creating high barriers to entry or high barriers to success. The most obvious way to lock out competitors is to acquire some king of regulatory exclusivity, like licenses, patents. A much more durable strategy for locking out competitors is to take advantage of the network effect like e-bay, western union. (DEEP MOAT)

III. Estimate how long a firm will be able to hold off competitors. Some can do it in years, some in months.

IV. Analyze the industry’s competitive structure. Hint: Use porter five forces.