While these 4 categories are standard I find myself continually performing a secondary financial analysis for growth potential. As such I am now updating this series to include the 5th category of Growth and have also updated the excel template

for anyone that wishes to use it.

The new growth category is broken into 2 sections; Historical Growth and Future Growth. Historical Growth is a collection of trending data that used to be part of the Profitability & Shareholder Value analysis but I have since relocated them. The Historical Growth trends include:

- Net Sales Growth Trend
- Net Income Growth Trend
- Dividends Growth Trend

The Future Growth analysis consists of only two measures. The first is just a % trend analysis of research and development costs and is somewhat self-explanatory. The second measure is a ratio called the Capital Expenditure to Depreciation & Amortization (Capex Ratio for short).

The Capex Ratio is calculated by dividing Capital Expenditures by Depreciation & Amortization and both values can easily be found on the Cash Flow statement.

**Capex Ratio = Capital Expenditures / Depreciation & Amortization**

*Note: Some companies combine depreciation & amortization into one value while others list the two separately, for the items listed separately the formula would be:*

**Capex Ratio = Capital Expenditures / Depreciation + Amortization**

Value | Meaning |
---|---|

<0.9 | Assets are aging |

0.9 to 1.1 | Assets are being kept current (maintenance & modernization) |

1.1 to 1.4 | Assets are being procured for growth |

>1.4 | Assets are being procured for aggressive growth |

Of course a one year analysis can be misleading so do your homework and look at a minimum of 3 years of data.

by Ken Kash

]]>As a reminder, to perform this exercise you will need the financial statements from your selected stock and one of its top competitors. Throughout this series we will be comparing Johnson & Johnson (JNJ) to Pfizer (PFE) as our example.

The shareholder value analysis will go over some of the more widely used valuation measures used by shareholders of common stock.

It is important to note that many of the shareholder valuations are calculated using the amount of outstanding shares. Results can be manipulated by decreasing or increasing the number of shares through buybacks or new share issuance.

**Price to Earnings Ratio (P/E)** – A measure of investor’s expectations in relation to current market stock price. There is no standard measure for good or bad and numbers can vary based on investor expectations. A recommended approach is to determine the standard P/E for a given sector or to only compare similar companies in the same sector. The P/E ratio is calculated by dividing Stock Price by Earnings per Share (EPS)

**P/E = Stock Price / EPS**

**Book Value** – Is the minimum asset value of a company. Book value is calculated subtracting Total Liabilities from Total Assets. This value can be further defined by dividing the Book Value by the Number of Outstanding Shares to provide a Book Value per Share. If a book value per share is below its stock price it may represent a value opportunity.

**Book Value = Total Assets – Total Liabilities**

**Book Value per Share = Book Value / Outstanding Number of Shares**

**Dividends** – An amount that a company returns to shareholders in the form of cash for investing in their company. Dividends are usually displayed as a Dividends per Share value and also expressed as a yield percentage.

**Dividend per Share = Total Dividends / Outstanding Number of Shares**

**Dividend Yield = Dividend per Share / Stock Price**

Another measure of dividends popular among investors is dividend growth or the ability of a company to increase dividend payouts to shareholder. There are two ways to measure growth, the first is based on pure total dividends paid and the second is based on dividends per share. What is the difference? The later can change dramatically based on the number of outstanding shares.

**Dividends Paid Year over Year Growth = (Dividends Current Year – Dividends Prior Year) / Dividends Prior Year**

**Dividends Per Share Year over Year Growth = (Dividends per Share Current Year – Dividends per Share Prior Year) / Dividends per Share Prior Year**

Now we can try putting these to use by comparing Johnson & Johnson (JNJ) to Pfizer (PFE)

Which company looks to be the better value? Johnson & Johnson (JNJ) maintains a better and more consistent P/E. Pfizer (PFE) has a stronger book value. Both have similar dividend per share YoY growth rates but the real difference lies within the actual dividend paid.

PFE’s actual dividends paid only increased 0.44% and 0.77% in 2014 and 2013. So how can their dividend per share growth be so much larger? The answer to a larger portion of the increases is due to the massive share buybacks. By reducing the number of shares available they are artificially generating growth. The other contributor to their dividend growth was increasing the percentage of income allocated towards dividend payments.

Considering from our earlier analysis that PFE had a Return on Assets of only 5% during 2014 it beckons the question if PFE is adequately spending their surplus cash in the best interest of shareholders. Due to these facts I would be concerned over how sustainable their continued Dividend per Share Growth Rate is going forward.

In this round JNJ is the winner.

So now we have completed our last analysis so it’s time to see who the overall winner was

Analysis | Winner |
---|---|

Liquidity | EVEN |

Profitability | JNJ |

Credit Risk | JNJ |

Shareholder Value | JNJ |

There you have it, JNJ is our overall winner!

I realize there were a lot of numbers and formulas and as promised to make this easier the spreadsheet used throughout is available for download and available on our Resources Page under Tools.

DISCLAIMER: This analysis only evaluates the financial strength of a company and will not predict stock prices or speculation on where stock prices will go.

by Ken Kash

]]>As a reminder, to perform this exercise you will need the financial statements from your selected stock and one of its top competitors. Throughout this series we will be comparing Johnson & Johnson (JNJ) to Pfizer (PFE) as our example.

The benefit of performing a credit risk analysis will determine how much a creditor can claim if a company declares bankruptcy. An additional benefit of a credit analysis will yield how well a company is managing debt which will allow them to negotiate for better loan debt rates. This is no different than your personal credit scores, if you have a high FICO score you can get a low yield loan but if you have a low FICO you will get a high yield loan.

*Total Assets and Liabilities can be found on the Balance Sheet Statement*

**Debt Ratio** – A measure of how much assets can be liquidated to recover investments. This is not a liquidity measure but a measure of a creditor’s long term risk. The smaller amount of assets financed the less the risk. Companies with a low risk ratio will score at or below 1. Most financially sound companies will have debt ratios of 0.5 or lower. The debt ratio is calculated by dividing Total Liabilities by Total Assets.

**Debt Ratio = Total Liabilities / Total Assets**

**Interest Coverage Ratio** – A measure that determines how large (or small) of a margin that income can cover interest payments. Strong companies will have a ratio that exceeds 4.

**Interest Coverage Ratio = Income Before Interest & Taxes / Annual Interest Expense**

**Net Cash Provided by Operating Activities Trend** – A measure that trends a company’s ability to generate cash over time.

*Net Cash Provided by Operating Activities Trend = (Current Net Cash Provided by Operating Activities - First Year Net Cash Provided by Operating Activities) / Net Cash Provided by Operating Activities + 1*

Now we can try putting these to use by comparing Johnson & Johnson (JNJ) to Pfizer (PFE)

Which company had overall better credit numbers? Both Johnson & Johnson (JNJ) and Pfizer (PFE) have strong Debt Ratios and Interest Coverage Ratios. But JNJ's strong and steady growth of increasing cash flow from year to year gives them a clear advantage.

In this round JNJ is the winner.

by Ken Kash

]]>As a reminder, to perform this exercise you will need the financial statements from your selected stock and one of its top competitors. Throughout this series we will be comparing Johnson & Johnson (JNJ) to Pfizer (PFE) as our example.

The formal definition of profitability refers to a company’s ability to retain a percentage of its income as profit and the ratio of said profit in relation to sales, assets, and equity.

Performing the Profitability analysis will require not just the evaluation of calculation ratios but also the trending of values over time to detect growth or shrinkage trends.

**Net Sales Change Trend** – A measure that trends the total % of sales trend over a period of time, usually over 3, 5, or 10 years.

*Net Sales Change Trend = (Current Year Net Sales - First Year Net Sales) / First Year Net Sales + 1*

**Net Sales Change Year over Year Trend** – A measure that trends the % of sales from year to year.

*Net Sales Change YoY = (Current Year Net Sales - Prior Year Net Sales) / Prior Year Net Sales*

**Net Income Change Trend** – A measure that trends the total % of net income trend over a period of time, usually over 3, 5, or 10 years.

*Net Income Change Trend = (Current Year Net Income - First Year Net Income) / First Year Net Income + 1*

**Net Income Change Year over Year Trend** – A measure that trends the % of net income from year to year.

*Net Income Change YoY = (Current Year Net Income - Prior Year Net Income) / Prior Year Net Income*

**Gross Profit Rate** – Sometimes referred to as gross margin. This calculation refers to how profitable a company’s products are. This ratio calculated by dividing the Gross Profit by Net Sales. (The higher the % result the better)

*Note: Gross Profit is calculated by subtracting Sales from Costs of Goods Sold. Costs of Goods Sold can be found on the Income Statement*

**Gross Profit Rate = Gross Profit / Net Sales**

**Operating Expense Ratio** – This calculation refers to % of net sales required to produce product or services. This ratio can be valuable for comparing companies with similar assets. This ratio calculated by dividing the Operating Expense by Net Sales. (The lower the % result the better)

*Operating Expense and Net Sales (or Revenue) can be found on the Income Statement*

**Operating Expense Ratio = Operating Expense / Net Sales**

**Operating Income** – This calculation represents the total income before interest and taxes, sometimes referred to as EBIT. EBIT is calculated by subtracting the Operating Expense from the Gross Profit.

*Operating Expense and Gross Profit can be found on the Income Statement*

**Operating Income = Gross Profit – Operating Expenses**

**Net Income as a % of Sales** – This calculation represents the percent of each dollar in sales that the company keeps as profit after interest and taxes. Net Income as a % of Sales is calculated by dividing Net Income by Net Sales. (The higher the % result the better)

*Net Income and Net Sales (Revenue) can be found on the Income Statement*

**Net Income as a % of Sales = Net Income / Net Sales**

**Return on Equity (ROE)** – This calculation represents how well a company uses investments to generate earnings growth before distributing dividends to shareholders. High or rapid growth companies should see a high ROE while mature companies typically operate with 15 to 25% ROE. ROE is calculated by dividing Net Income by Average Total Equity. (The higher the % result the better)

*Net Income and Net Sales (Revenue) can be found on the Income Statement*

**Return on Equity = Net Income / Average Total Equity**

**Return on Assets (ROA)** – This calculation represents how well a company earned a reasonable return on the assets under their control. This metric is useful when comparing companies to determine which is more efficient and if trended over time can indicate potential issues such as mismanagement, declining market share or obsolescence of assets if the ROA is dropping.

*Net Income can be found on the Income Statement and Total Assets can be found on the Balance Sheet Statement*

**Return on Assets = Net Income / Average Total Assets**

**Earnings per Share (EPS)** – This calculation represents a company’s profit on a per share of stock basis. This a popular metric used by investors to determine income growth but unlike other calculations used throughout this analysis it can be manipulated by decreasing or increasing the number of shares through buybacks or issuance. A more effective method would be to trend net income for true growth. EPS is calculated by dividing the Net Income by the Total Number of Outstanding shares.

*Net Income can be found on the Income Statement. Outstanding shares is not directly found on the Income Statement and is usually annotated as note where you can get the average number of shares.*

**EPS = Net Income / Total Outstanding Number of Shares**

Now we can try putting these to use by comparing Johnson & Johnson (JNJ) to Pfizer (PFE)

Which company had overall better profitability numbers? Pfizer (PFE) has slightly better gross profit rates and operating expense ratios but its sales and income growth are inconsistent. Additionally, Pfizer’s 2014 ROA of only 5% causes concerns and the need for further investigations.

Johnson and Johnson (JNJ) on the other hand demonstrates consistent income and sales growth from year to year as well as improved year to year ROE. In this round JNJ is the winner.

by Ken Kash

]]>Buried in a company’s Annual Report you are likely to find their financial statements. The financial statements are divided into three sections; Income Statement, Cash Flow Statement, and Balance Sheet Statement. If you are new to investing, seeing all of these financial numbers and terms may seem intimidating. Yet, hopefully this blog series can help simplify what numbers to extract and how to analyze those using financial ratios.

At the end of this series I will share the spreadsheet used throughout the exercise which will include all of the formulas to calculate the ratios and on which statement to find the values to populate.

When analyzing a Company’s financial statement we will split the analysis into 4 parts:

- Liquidity
- Profitability
- Long Term Credit Risk
- Stock Holder Value

Before we kick this series off there are a few basic accounting concepts you need to understand before we continue.

- Revenue and cash are not the same thing. Revenue is recorded when a customer takes possession of a product and not when they receive payment. Here is a simple example;

You receive a mail order product in December worth $50 but do not pay cash. You receive a bill for the product in January and pay in full the $50 bill in February. In this scenario a Company records $50 of revenue for the month of December and not in February when it received payment because you took possession of the product in December.

- Revenue and Sales are interchangeable terms
- Income and Earnings are interchangeable terms
- Do not use generic rules of thumb to determine if a ratio is good or bad. Ratios will vary from industry to industry. For example, would you expect an aircraft manufacturer to have an inventory turnover ratio the same as a toilet paper manufacturer? I think people buy toilet paper on a more routine basis than they would buy airplanes.
- When performing an analysis of a company always compare it to their top competitor to help determine if a ratio in a given industry is normal, good, or bad.

With these concepts out of the way let us start reviewing Liquidity and ratios to evaluate a company.

The formal definition of liquidity refers to a company’s ability to meet its continuing obligations. A simpler way to state this would be “How capable is the company to pay its bills and make debt payments”.

This is no different than valuating how well capable you are paying your monthly bills based on your salary, savings, and investments. And to help us understand what is meant by “capable” we have liquidity ratios.

**Current Ratio** – A measure of short term debt paying ability. The current ratio is calculated by dividing total current assets by total current liabilities. The result of the ratio will tell you how many times assets are more or less than liabilities.

*Both items can be found on the Balance Sheet Statement.*

**Current Ratio = Total Current Assets / Total Current Liabilities**

**Quick Ratio** – The quick ratio is similar to the current ratio but instead does not use total current assets but only the most liquid assets (cash, accounts receivable, and marketable securities). Quick ratios are most useful for companies with slow moving merchandise like trains, real estate or aircraft.

*All items can be found on the Balance Sheet Statement.*

**Quick Ratio = Cash + Marketable Securities + Accounts Receivable / Total Current Liabilities**

**Cash Flows from Operations to Current Liabilities** – This calculation refers to a company’s abilities to pay its obligations rom normal operations. This ratio calculated by dividing Cash Flow from Operations divided by Current Liabilities.

*Cash flow from operations can be found on the Cash Flow Statement and current liabilities can be found on the Balance Sheet Statement.*

**Cash Flows from Operations to Current Liabilities = Net Cash Provided by Operating Activities / Total Current Liabilities**

**Receivables Turnover Rate** – The rate of how many times a year that a company can convert receivables into cash. The rate is calculated by dividing Net Sales (or Revenue) by Accounts Receivable.

*Net sales can found on the Income Statement and accounts receivable can be found on the Balance Sheet Statement.*

**Days to Collect Accounts Receivable** - This calculation represents how many calendar days it takes to convert a receivable into cash. This is calculated by dividing Days of the Year by the Receivables Turnover Rate.

**Days to Collect Receivables = 365 / Receivables Turnover Rate**

**Inventory Turnover Rate** – The rate of how many times a year that a company can sell and replace their inventory. The rate is calculated by dividing Costs of Goods Sold by Average Inventory.

*Cost of goods sold (or Cost of Sales) can found on the Income Statement and average inventory can be found on the Balance Sheet Statement.*

**Inventory Turnover Rate = Cost of Goods Sold / Average Inventory**

**Days to Sell Inventory** – This calculation represents how many calendar days it takes to sell and replace inventory. This is calculated by dividing Days of the Year by the Inventory Turnover Rate.

**Days to Sell Inventory = 365 / Inventory Turnover Rate**

**Operating Cycles** - The number of days that inventory can be converted into cash (not revenue). This is calculated by adding Days to Collect Receivables and Days to Sell Inventory.

**Operating Cycles = Days to Collect Receivables + Days to Sell Inventory**

**Free Cash Flow** - Represents the cash flow available to management, after meeting obligations, to allow for investment. If free cash flow is negative it represents that the company did not generate enough cash from operations to meet obligations. This is calculated by summing Net Cash Provided by Operating Activities, Cash used for Investing Activities, and Dividends.

*All three items can be found on the Cash Flow Statement*

**Free Cash Flow = Net Cash Provided by Operating Activities + Cash used for Investing Activities + Dividends**

Now we can try putting these to use by comparing Johnson & Johnson (JNJ) to Pfizer (PFE)

Which company had overall better liquidity numbers? Both companies scored similar but I’d have to give a slight edge to JNJ because it is much more efficient at turning over inventory and converting it into sales and cash and creating a lower operating cycle.

But there are questions that need to be investigated with JNJ with its negative 2014 Free Cash Flow. Looking historically at the free cash flow it is not hard to see in 2014 a spike of an additional $8B towards investments over its average of $4B for a total of $12B. This may not be a bad thing but at least it is a clue to conduct further research as to what JNJ spent $12B on.

Though JNJ has a slight edge there is no clear winner in this round as both companies demonstrate strong liquidity measures.

by Ken Kash

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