Some Famous Numbers

 





PERCENT OF SALES

What percent of sales does it represent? L’eggs sent Hanes stock soaring because Hanes was a relatively small company. Pamper was more profitable than L’eggs, but it didn’t mean as much to the huge Procter & Gamble.

Let’s say you’ve gotten excited about Lexan plastic, and you find out that General Electric makes Lexan. Next, you discover from your broker that the plastics division is part of the material division, and that entire division contributes only 6.8% to GE’s total revenues. So what if Lexan is the next pampers.

 

THE PRICE/EARNINGS RATIO

The P/E ratio of any company that is fairly priced will equal its growth rate. I’m talking about growth rate of earnings here. Ask your broker what is the growth rate, as compared to the P/E ratio.

If Coca-Cola is 15, you’d expect the company to be growing at about 15% a years, etc. But if the P/E ratio is less than the growth rate, you may found yourself a bargain. A company, say, with growth rate 12 percent a year (also known as 12 percent grower) and P/E ratio of 6 is very attractive prospect. On the other hand, a company with a growth rate of 6 percent a years and a P/E ratio of 12 is an unattractive prospect and headed for a comedown.

A slightly more complicated formula enables us to compare growth rates to earning, while also taking the dividends into account. Find the long term growth rate (say, company X’s is 2 percent), add the dividend yield (company X pay 3 percent), and divide by P/E ratio (company X’s is 10).

12+3/10 =1.5

Less than 1 is poor, and 1.5 is okay, but what you’re really looking for is a 2 or better. A company with a 15 percent growth rate, a 3 percent dividend, and a P/E of 6 would have fabulous 3.

 

CASH POSITION

When a company is sitting on million or billion in cash, it’s definitely something you want to know about.

A P/E ratio of 3.1 is a tantalizing number, cycles or no cycles. The $5 doesn’t count for much with the stock selling for over $40. If stock dropped to $15, it would be a big deal.

 

THE DEBT FACTOR

A normal corporate balance sheet has two sides. On the left side are the assets. The right side shows how the assets are financed. This debt to equity ratio is easy to determine. A normal corporate balance sheet has 75 percent equity and 25 percent debt. An even stronger balance sheet might have 1 percent of debt and 99 percent of equity; weak balance sheet might have 80 percent of debt and 20 percent of equity.

Bank debt (the worst kind and the kind that GCA had) is due on demand. Creditors strip the company, and there’s nothing left for the shareholders after they get through with it. Funded debt can never be called in no matter how bleak the situation. I pay particular attention to debt structure, as well as to the amount of the debt.

 

DIVIDENDS

Stocks that pay dividends are often favoured over stocks that don’t pay dividends by investor who desire the extra income. There is nothing wrong with that.

Another argument in favour of dividend paying stocks is that the presence of the dividend can keep the stock price from falling as far as it would if there were no dividend. In the wipe-out of 1987, the high dividend payers fared better then the non dividend payers and suffered less than half the decline of the general market. When a stock sell for $20, a $2 per share dividend result in a 10 percent yield, but drop the stock price to $10, and suddenly you’ve got 20 percent yield.

The smaller companies that don’t pay dividends are likely to grow much faster because of it. They are plowing the money into expansion. The reason that companies issue stock in first place is so they can finance their expansion without having to burden themselves with debt from bank.

If you do plan to buy a stock for its dividend, find out if the company is going to be able to pay it during recessions and bad times.

 

CASH FLOW

Cash flow is the amount of money a company takes in a result of doing business. All companies take in cash, but some have to spend more than other to get it. This is a critical difference that makes a Philip Morris such a wonderfully reliable investment, and steel company such a shaky one.

In case where you have to spend cash to make cash, you aren’t going to get very far. A ten percent return on cash corresponds nicely with the ten percent that one expects as a minimum reward for owning stocks long term. A $20 stock with a $4 per-share cash flow gives you a 20 percent return on cash, which is terrific. And if you find a $20 stock with sustainable $10 per share cash flow, mortgage your house and buy the entire share you can find.

Free cash flow is what is left after the normal capital spending is taken out. It is the cash you have taken in that you don’t have to spend.

A company that has modest earnings and yet is a great investment because of the free cash flow. Usually it’s a company with a huge depreciation allowance for old equipment that doesn’t need to be replaced in the immediate future. The company continues to enjoy the tax breaks as it spends as little as possible to modernize and renovate.

Coastal had $10-11 per share in total cash flow in a depressed gas environment, and $7 was left over after capital spending. That $7 a share was free cash flow. On the books this company could earn nothing for the next ten years, and share holders would get the benefit of the $7 a share annual influx, resulting in a $70 on their $20 investment. This stock had great upside potential on cash flow alone.


INVENTORIES

When inventories grow faster than sales, it’s a red flag. There are two basic accounting methods to compute the value of inventories, LIFO and FIFO. LIFO actually stands for “last in, first out”, and FIFO stand for “first in, first out.” If Handy and Harman bought some gold thirty years ago for $40 an ounce, and yesterday they bought some gold for $400 an ounce, and today they sell some gold for $450 an ounce, then what is profit? Under LIFO, it’s $50 ($450 minus $400), and under FIFO it’s $410 ($450 minus $40).

A company may brag that sales are up 10 percent, but if inventories are up 30 percent, you have to say to yourself: “Wait a second”.

In an auto company an inventory build-up is not so disturbing because a new car is always worth something, and the manufacturer doesn’t have to drop the price very far to sell it. A $35,000 Jaguar is not going to be marked down to $3,500. But a $300 purple miniskirt that’s out of style might not sell for $3. On the bright side, if a company has been depressed and the inventories are beginning to be depleted, it is the first evidence that things have turned around.

Companies must now publish balance sheets in their quarterly report to shareholders, so that the inventory numbers can be regularly monitored.

 

PENSION PLAN

Companies don’t have pension plan, but if they do, the plans must comply with federal regulations. These plans are absolute obligations to play- like bonds. Even if a company goes bankrupt and cases normal operation, it must continue to support the pension plan.

 

GROWTH RATE

That “growth” is synonymous with “expansion” is one of the most popular misconceptions on Wall Street, leading people to overlook the really great growth companies such as Philip Morris.

The industry raises prices every year. If the company’s cost increases 4percent, it can raises 6 percent, and adding 2 percent to its profit margin. This may not seem like much, but if your profit margin is 10% a 2 percentage-point raise in the profit margin mean a 20 percent gain in earnings. The company’s costs were greatly reduced after the government told cigarette companies they couldn’t advertise on television!

One more thing about growth rate: all else being equal, a 20 percent grower selling at 20 times earnings (P/E of 20) is much better buy than 10 percent grower selling at 10 times earnings (P/E of 10).

Base Year

Company A

(20% earnings growth)

$1 a share

Company B

(10% earnings growth)

$1 a share

Y1

$1.20

$1.10

Y2

$1.44

$1.21

Y3

$1.73

$1.33

Y4

$2.07

$1.46

Y5

$2.49

$1.61

Y7

$3.58

$1.95

Y10

$6.19

$2.59

 

At the beginning of our exercise, Company A is selling of $20 a share (20 times earnings of $1), and by the end it sells for $123.80 (20 times earnings of $6.19). Company B starts out selling for $10 a share (10 times earnings of $1) and ends up selling for $26 (10 times earnings of $2.60).

This in a nutshell is the key to the big baggers, and why stocks of 20 percent growers produce huge gains in the market, especially over a number of years. It’s all based on the arithmetic of compounded earnings.

 

THE BOTTOM LINE

Everywhere you turn these days you hear some reference to the “bottom line” “what is the bottom line?” is a common refrain in sport, business deals, and even courtship. It is the final number at the end of the end of an income statement: profit after taxes.

In a survey I once saw, collage students and other young adults were asked to guess the average profit margin on the corporate dollar. Most guessed 20-40 percent. In the last few decades the actual answer has been closer to 5%.

Profit before taxes, also known as the pre-tax profit margin, is a tool I use in analysing companies. That is what left of a company’s annual sale dollar after all the costs, including depreciation and interest expenses, have been deducted.

 


COMPANY A

Status Quo

Business Improves

$100 in sales

 $88 in costs

$110.00 in sales (prices up 10%)

$92.40 in costs (up 5%)

$12 pre-tax profit

$17.60 pre-tax profit

 

COMPANY B

Status Quo

Business Improves

$100 in sales

$98 in costs

$110.00 in sales (prices up 10%)

$102.90 in costs (up 5%)

$2 pre-tax profit

$7.10 pre-tax profit

 

In the recovery, company A’s profits have increased almost 50 percent, while Company B’s profits have more than tripled. This explains why depressed enterprises on the edge of disaster can become very big winners on the rebound.

What you want, then, is a relatively high profit margin in a long term stock that you plan to hold through good times and bad, and a relatively low profit margin in a successful turnaround.

 

RECHECKING THE STORY

There are three phases to grow company’s life: the start-up phase, during which it works out the kinks in the basic business; the rapid expansion phase, during which it moves into new markets; and the mature phase, also known as the saturation phase, when it begins to prepare for the fact that there is no easy way to continue to expand.

The first phase is the riskiest for investor, because the success of the enterprise isn’t yet established. The second phase is the safest, and also where the most money made, because the company is growing simply by duplicating its successful formula. Third phase is the most problematic, because the company runs into its limitations. Other ways must be found to increase earnings.  

 

Next blog is coming about The Final Checklist.

Thank you again for your Patience.

Keep supporting as always.

 

Congratulation you take one more step towards your financial freedom.

This summary from Book-“ONE UP ON WALL STREET”

 

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