Wednesday, September 22, 2010

Investing: Terms

In my last investing blog (Investment Choices), I discussed the different assets in which you could invest. Before proceeding with investment strategies, I’d like to discuss some of the common terms.

Investing: Terms
1. Introduction
2. Summary page
3. Key statistics
4. Insider transactions


1. Introduction

I’m basing these terms on those available on the yahoo finances pages. Many other on-line resources have their own resources but they all tend to use the same terms.

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2. Summary page
These are the main terms from the Yahoo finance summary page:

P/E
Price to earnings ratio – this number is the stock price divided by the earnings per share. This provides a standard measure of how expensive your stock is. For example a stock with a share price of $0.55 / share could far more expensive for the amount of earnings it represents than one with a share price of $100 / share.

An alternative perspective on this number is to invert it (divide 1 by the P/E value). In a very loose sense this earnings to price ratio is analogous to a bond’s interest rate and it can give you a relative comparison between the bonds and stocks. For example for a stock with a P/E ratio of 12.5 could roughly be compared to a bond paying 8% interest. Just remember that bonds represent less capital risk (chances that the investment will lose value) but also have less opportunity for growth.

Historically speaking the price to earnings ratio has averaged between 10 and 15 for large “blue chip” stocks.

Stocks with P/E ratios below the average are often called “value” stocks. In this case “value” means you get a lot of current earnings for a smaller price. Value investors look for good companies with low P/E ratios. You should also be aware that sometimes there’s a very good reason for a stock’s P/E ratio to fall (e.g. AIG).

Stocks with P/E ratios above the average are often called “growth” stocks. The assumption is that people are not buying this stock for its current earning potential. Instead they are attempting to purchase the stock because it’s earning potential is expected to grow. A good example of this type of stock would be Apple or Google.

EPS
Earnings per share ratio – this number is the total corporate earnings divided by the total number of shares. This number shows how much money each share of stock will earn in a year.

As you probably know, earnings are good so the bigger is better.

Div & Yield
Dividend and Yield – the dividend is how much cash is paid out by the company in cash per year (typically ¼ of this amount is paid out each quarter). The yield can roughly be calculated by dividing the dividend by the stock price and directly compares to interest rate of a bond (be aware a dividend can grow but is not guaranteed while bond interest is pretty constant). In today’s market (9/2010) many stocks offer higher the dividend yield than is available from AAA bonds.

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3. Key Statistics
Market Cap
Market Capital – This is the value of all outstanding shares of stock. It is one measure of the size of the company. Often investors use a $1 billion market cap as the dividing line between large and small stocks.

Enterprise Value
Enterprise value – this can be thought of as the “take-over” price of the company. It includes the market cap plus all outstanding debts, plus any preferred shares, minus any cash on hand. It provides a better measure of the actual size of the investment.

Trailing P/E
Trailing price to earnings – this number divides the current stock price by past earnings.

Forward P/E
Forward price to earnings – this number divides the current stock price by the predicted future earnings. Note that this is an educated guess. Theoretically you’d like to see this number lower than the trailing P/E but this might not always happen.

PEG ratio
Price to earnings growth – this is the P/E ratio divided by the projected earnings growth. However, it provides a better measure of stock’s value because it incorporates both the earnings and the stock’s growth potential. Note this is an estimated value.

Since you want to purchase shares on sale (low price) and want earnings and growth to be high, you will want this number to be small. A PEG of 1 or less is much better than average. A PEG value of 1.2 or so is more typical.

Price/Sales
Price to sales ratio – compares the price of the stock to the revenue per share of that stock. Note that this number varies greatly between industries so this number is best used as a comparison between stocks in the same industry.

When comparing stocks in the same industry, smaller Price/sales ratio is better than a higher one.

A Price/sales of 1 or less would is much better than average.

Price/book
Price to book ratio – compares the price of the stock to the total value of the company’s assets (minus intangible assets) minus any liabilities. The book value represents what the individual assets of the company are worth.

As with the Price/sales, the size of this value is highly dependent upon industry. When using this number to compare companies, ensure that you compare companies within the same industry.

A price/book of 1.75 or less is much better than average.

Enterprise value/revenue
Enterprise value per revenue – is calculated by dividing the company’s enterprise value by the company’s revenue. This compares the amount of money invested in the company by the amount of money it generates.

This size of this number varies between different industries. However, when comparing companies within a single industry, a lower number is preferable.

An enterprise value per revenue of less than 1 is much better than average for most industries.

Enterprise value/EBITDA
Enterprise value per “Earnings before income taxes, depreciation, and amortization” – first let me comment on EBITDA: EBITDA (Earnings before income taxes, depreciation, and amortization) is an attempt to standardize the earnings by removing some of the variables (income taxes, depreciation, and amortization).

This is supposed to be a more precise view of the P/E ratio of the company and should provide additional insight into the performance of the stock

This size of this number varies between different industries. However, when comparing companies within a single industry, a lower number is preferable.

An enterprise value per revenue of less than 4.5 is much better than average for most industries.

Profit margin
Profit margin (ratio) – is calculated by dividing the earnings by the total revenues.

Profit margin varies greatly between industries. However, within a single industry a higher profit margin is considered better than a lower profit margin.

A profit margin (sometimes just called “margin”) larger than 8.5% is much better than average.

Operating Margin
Operating margin (ratio) – is calculated by dividing the operating income by the net sales.

I consider operating margin an important measure to consider when viewing corporate earnings. The reason is that one time sales assets or other financial transactions can dramatically alter the earnings over a short period of time. The operating margin tends to provide a better long-term view of the profitability of the company’s operations.

Operating margins, like other ratios mentioned above vary greatly between industries, however, when comparing companies in an industry, higher margins are better than lower ones.

An operating margin larger than 9.5% is much better than average.

Return on assets
Return on Assets (ratio) – is calculated by dividing the net income by the company’s total assets (both the debt and equity). It measures the management’s ability to create income from the company’s assets and measures the management’s effectiveness.

Return on assets is best used to compare companies in the same industry.

Higher return on assets is better than lower return on assets.

Return on assets larger than 5.5% is much better than average.

Return on equity
Return on Equity (ratio) – is calculated by dividing the net income by the total value of the company’s market capital.

Return on equity is best used to compare companies in the same industry.

Higher return on equity is better than lower return on equity.

Return on equity larger than 13.5% is much better than average.

Revenue
Revenue – is the total income generated by the company.

Revenue per share
Revenue per share – is the total revenue divided by the total number of shares.

Qtrly revenue growth
Quarterly revenue growth – measures the growth of revenue from the previous year and is expressed as a fraction. Revenue growth (represented as a positive number) is good and the bigger the number the better.

Gross profit
Gross profit – is the revenue minus the cost incurred by the company to produce those goods. Note that gross profit is NOT net profit! Profit is good so a large gross profit is good too.

EBITDA
EBITDA (Earnings Before Income Tax, Depreciation, and Amortization) – is the earnings (gross profit minus cost of sales) before taking out these other variables. Once again, bigger is better.

Net Income Avl to Common
Net income available to common shares – is the net income (which is EBITDA minus any other costs incurred by the company, including the costs of preferred shares and other things). In other words, first the company pays off its taxes, then it pays all people who have a more important claim (preferred shares) and then if anything is left, that is earning available to the common shares.

This number is often significantly lower than the EBITDA.

Once again, bigger is better.

Diluted EPS
Diluted earnings per share – is calculated by taking the net income available to common shares and dividing it by the number of common shares.

Bigger is better.

Quarterly earnings growth
Quarterly earnings growth – compares the current earnings from the quarter to that of a year ago. It is expressed as a percentage with positive numbers indicating growth. Bigger is better.

Total cash
Total cash – is a statement of the total cash and short-term investments which can readily be converted to cash. This is an absolute number and in an ideal world bigger is better. However, some argue that companies with large piles of cash sitting around aren’t using that money to increase the stock owner’s earnings.

Many companies use their piles of cash to “di-worsify” meaning purchasing other companies that are not synergistic with the core competencies of your company.

Total cash per share
Total cash per share – is just the total cash divided by the total number of shares. Some people subtract this number from the share price when comparing one stock to another as means of showing that there’s lower risk to companies with large cash reserves.

I do not recommend using this simplified comparison. Instead if you intend to adjust your numbers for risk, you should first add in any short-term debt before subtracting the short-term cash. You may also wish to apply a factor representing the wisdom of the management in utilizing such resources – since so many otherwise intelligent management teams fail to make good investments with corporate cash.

Total debt
Total debt – is an absolute measurement of the debt issued by the company. Often this number is significantly larger than the cash but this number includes long-term debt which is generally not going to cause cash flow crises.

Less debt is better than more debt.

Total debt/equity
Total debt to equity – is a ratio of the total amount of debt (and other liabilities) divided by the shareholder’s equity. In this case it gives an idea of how much of the company is owned by debt holders vs. that owned by stock holders. Large well-established companies often can accommodate higher debt/equity ratios than smaller and newer companies.

I generally consider debt as a (sometimes necessary) drag on earnings so that means that a lower debt to equity ratio is preferred to higher values.

Current ratio
Current ratio – is a ratio of short-term assets (cash, receivables, and inventory) to its current liabilities (debt and accounts payable). A large current ratio is preferable to a low current ratio. What constitutes a good current ratio depends upon the industry and so current ratio is better used to compare companies in the same industry.

For instance a good current ratio for a large oil company might be anything above a 1.5 while in other industries a current ratio of 4.5 or above might be more typical.

Book value per share
Book value per share – is the value of the company if it was liquidated divided by the number of shares. This gives you an idea of whether the company is over or under valued when compared to the market value.

If you intend to use the number as a measure of the security of investment, I’d first subtract all debt from the book value since debt holders get paid first. This number is best used as a means of comparing one company in an industry to another rather than companies across industries.

A large value is better than a smaller value.

Operating cash flow
Operating cash flow – is in many ways a better means of determining the viability of company. A company can perform financial tricks to improve earnings in a quarter but it cannot fudge the operating cash flow (the amount of money generated by doing the company’s business). If a company reports positive earnings and negative cash flow then I would skip that company and move on to another.

Cash flow is a good thing so a bigger cash flow is better.

Levered free cash flow
Levered free cash flow – is the amount of cash thrown off of a company usually calculated by adding net income to amortization and depreciation and then subtracting capital expenses and all debt payments. A company with positive levered free cash flow is in no danger of defaulting on debts, bankruptcies, etc. However, a company with negative free cash flow may still be a good investment if the company is spending a lot of money on capital expenditures.

A high free cash flow is a good thing and a negative free cash flow should make you concerned.

I don’t use most of the rest on the page except for the following:

Shares short
Shares short – is the number of options betting that the stock will decline in value.

Shares short (prior month)
Shares short (prior month) – shows the number of options betting that the stock will decline in value from the prior month.

By comparing the two above numbers you can determine whether options traders are betting for or against a company.

Short % of float
You can use this to see if a large number of options traders are betting against a company. If there is a high percent of shares are short (say 10% or more) and you know the company well and are sure that it’ll bounce back, you can begin to purchase shares of the stock.

When the stock price begins to bounce back the people with short shares will be forced to purchase shares at a higher price to cover their margins. This can lead to a snowball effect in which the now higher stock price can force a second tier of short sellers to purchase stocks at a higher price, etc. This phenomenon can lead to what’s call the “short squeeze” and can lead to sudden surges in a stock’s price very much out of proportion to any news on the company.

Dividend Yield
Dividend yield – the absolute dividend number (expressed as dollars per share) isn’t as valuable for comparing to other stocks as the dividend yield (the dividend divided by the stock price).

A high dividend is generally better than a low dividend but you must not depend upon the dividend yield as the only measure of a company’s value.

Statistical analysis have shown that companies with higher dividend yields provide a better rate of return than those with a low dividend yields.

Payout ratio
Payout ratio – is the portion of earnings consumed by the dividend payments. As long as the payout ratio is below 50% (or 75% for some companies) the dividend payouts are probably secure. Some companies show outsized dividends but have payout ratios above 100%. This situation screams “unsustainability” and something is going to have to change. Generally that change is the dividend is cut.

Statistical analysis have shown that companies with lower payout ratios provide a better rate of return than those with a high payout ratio.

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4. Insider transactions
I always like to view the insider transactions prior to purchasing a stock. Although I do not view a net decline in the number of insider shares owned as a negative, I view a net increase in insider shares as a positive.

When insiders start buying their own stock, it is often a sign that the insiders have confidence that the shares will provide them with substantial gains.

The most interesting number is the % Net shares purchased. Anything with a zero, “N/A”, or negative number (one in parentheticals) means nothing interesting. One with a positive number is a positive.

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Proceed to my next investing blog on developing investing rules for yourself.


Return to my previous blog on Investment Choices.

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