Cash Flow vs Owner Earnings

Cash Flow

Net income after taxes + Depreciation + Depletion + Amortization + Other non-cash charges = Cash flow

Owner Earnings

Net income + Depreciation + Depletion + Amortization – Capital Expenditures – Other Working Capital = Owner Earnings

Cash Flow vs Owner Earnings

The problem with relying on cash flow figures is that they leave out a critical economic fact, capital expenditures.

How much of the year’s earnings must the company use for new equipment, plant upgrades, and other improvements needed to maintain its economic position and unit volume?

According to Buffett approximately 95% of American businesses require capital expenditures which are require roughly equal to their depreciation rates. If such (necessary) expenditures are ignored for a year or so, the business will surely decline. These capital expenditures are, therefore, as necessary to the business as utility and labor costs.

Buffett's View of Intrinsic Value

Paraphrasing Williams's theory, Buffett tells us the value of a business is the total of the net cash flows (owner earnings) expected to occur over the life of the business, discounted backwards to today by an appropriate interest rate.

Owner Earnings

Net income + Depreciation + Depletion + Amortization – Capital Expenditures – Other Working Capital = Owner Earnings

This is Buffett’s equation for determining a more accurate cash flow.

Discount Rate

The rate offered by long-term treasury bonds. This is referred to as being “risk-free” because the guarantee that the government will pay back the initial principal (initial investment) with interest is virtually 100%. This guarantee comes from the fact that the government has the ability to impose taxation (on goods, services, income, etc…)

According to Buffett, since all investments ultimately compete with one another the risk-free rate should be used as the benchmark in comparing investment returns.

Reversion To The Mean

“Reversion to the mean” is a simple idea that large companies have a natural, or steady state. No matter how much the stock moves higher or lower, it will sooner or later move back to this “golden mean.” Investors that can catch these stocks as they move back up can have a nice pay day. Charles Carlson, editor of the DRIP Investor, is a believer of this concept, and offers three companies that he believes are still in the process of “reverting to the mean.”

This concept states that, while things can move to extremes in the short run, most things — be it weather patterns, human emotions, and, yes, even stock prices — tend to exist at some steady state, some “golden mean.” Thus, when certain stocks move sharply in either direction, mean reversion says that the stocks will eventually return to some long-run equilibrium level. To be sure, mean reversion generally works well with large companies that have a long track record of performance and decent finances. Mean reversion in stocks does not work very well for new companies that have little history and lousy finances.

Significance Of Analyst Projections*

On Wall Street great emphasis is placed on research carried out by analysts.
Though their estimates usually aren’t worth the paper they are written on, they are closely gauged by Street professionals. If the business misses their estimates by more than 5% the stock gets hammered, unless it is already of the out-of-favor, low-P/E, low-valuation group. If the company exceeds analysts’ estimates by greater than 5% the stock will soar, unless it is was highly favored before the fact with future prospects largely discounted into the price.

Analysts’ earnings estimates and growth projections usually exceed actuality because of several major (limiting) factors:

1. Analysts are, on the whole, overconfident in their abilities to predict future outcomes.

2. Analyst are, on the whole, overly optimistic about the industries they research.

3. There tends to be great external, implied, pressure on analysts from companies they research to be so optimistic because it is in the favor of the company (being ‘researched’) that investors continually buy their stock.

4. If the analyst goes the other way buy issuing (truthful) negative recommendations about a business, his/her firm (investment bank/brokerage house) will usually get the cold shoulder from the company and be excluded from future lucrative deals – i.e., issuance of more stock, spinning-off of a division, issuance of corporate bonds, etc… As a result the investment bank will fire the analyst for “other reasons”. So, fearful of such a blow to their careers, analysts tend to “go with the flow” and do what is “appropriate” with respect to their employers even though it may be morally inappropriate. And there is “good” reason for doing so in the analyst’s own opinion – personal benefit. In other words, the perks of being an analyst for a major brokerage house are so seductive – the pay, media limelight, the admiration and even envy of peers – that few would chose to opt for putting it all on the line over a “insignificant” recommendation on their part. And so the analyst continues to do best what they’re actually paid to do – be a master salesperson for their firm.

5. Analysts are bombarded by too much information, 90% of which they have difficulty applying to their projections. The “information age” has, thus, made the analyst’s jobs even tougher because there are only so many variable one can focus upon without distorting the actual prospects of a business. Nowadays, analysts are required to keep in touch with as many as 50+ media sources their firms subscribe to for every stock they are researching, and to do this on a daily basis.

6. Many analysts have difficulty garnering information crucial to their projections from the company (being researched) directly due to the “code of silence” required of such organizations by governing bodies as the SEC, NYSE, NASDAQ, AMEX, other stock exchanges, and the law. And the top management of most businesses tend to become irritated by estimate related inquires by analysts that analysts tend to “accept” whatever bits and pieces of information management throws them without knowing its validity until the event actually plays itself out.

7. Analysts, like “ordinary people”, are prone to error in judgment. Just as the fund and institutional managers are notorious for getting in and out of investments at the wrong places, analysts too make such mistakes with respect to their research and recommendations. For example, an analyst might, legitimately, project a growth rate which is later is found to be too high.

8. Point 4 above says that analysts are under pressure from their own firms to issue “strong buys” and make forecast superior growth for the company being researched because of future interests of their brokerage house/investment bank. However, there may also be pressure on the analyst to do such things because of present interests of their respective firms. It doesn’t make a whole lot of sense to recommend a “strong sell” and project poor future earnings growth on a business (even if is true) if your investment bank (boss) owns 10% of it to which a large percentage of your retirement pay and stock options are tied. In other words, analysts themselves may be crooked (for self benefit).

9. The “consensus” of analyst estimates (of everything) regarding an enterprise are deemed more accurate future predictors by the Street than predictions of a single analyst among the group. In other words, the most accurate analyst’s estimate may be skewed up or down because it is averaged with estimates from other analysts.

10. Investment banks place great emphasis on their analysts to make the “all star research team”. This is the classification given by Institutional Investor magazine to analysts who’s estimates are closest to real results for the year. Investment banks and brokerages houses want “all star” analysts performing for them because it can deliver greater profitability to the firm. Such profitability is the result of bank trust departments, mutual funds, and institutional investors wanted to do business with (generate transaction fees and commissions for) the broker/investment bank who can provide the “best of the best” analysis on investments. For example, if a Merrill Lynch analyst makes the No. 1 spot in the “Institutional Investor All Star Research Team” for the year, a mutual fund manager would want to keep the analyst at an arms length for consultation and to do so makes sense if the fund can provide something of return, like a verbal agreement to do business with Merrill Lynch as a way of saying, “thanks”. It then becomes the obligation of the analyst to keep the fund well-informed while also appeasing his firm’s other clients (the company being researched) in efforts to meet their personal bottom lines – higher salaries, more stock options, greater media exposure, the envy and admiration of their peers, and most importantly, a pleased boss. Therefore, an analyst cannot provide accurate projections of a company because he/she is, in a way, a “slave” to several masters.

*David Dreman, "Contrarian Investment Strategies in the Next Generation"

The Paradox Of Investment Advice*

There is a fundamental paradox about the usefulness of investment advice with respect to all types of investments in general. If the advice reaches enough people and they act on it, knowledge of the advice will destroy its own usefulness. If everyone knows of a “strong buy” and they all rush to buy it, it will no longer be a “strong buy” because its price would rise so quickly that getting into the investment would no longer be attractive as the projected return would largely have been “taken” by others; thus, the risk may also have increased.

As mentioned above, this paradox holds true not only for securities, but for business in general. For example, if everyone starts selling the same merchandise or working the same business model (i.e., current dilemma in the online-dvd-rental market), then who will be left to buy, and where will be the profits (customers)?

*David Dreman, "Contrarian Investment Strategies in the Next Generation"

Risk Depends On Holding Period*

ACTUAL RISK IN BUSINESS DEPENDS ON THE HOLDING PERIOD

“Staying power”, the length of time you hold onto your investment, plays a critical (perhaps most critical) role in the actual risk you assume from that investment.

In some cases a shorter holding period may be more suitable to maximize the return on a particular investment – like “flipping” in the IPO market.

However, generally the longer you hold onto a superior business the larger will be the reward and the lower will be the risk – assuming you buy in at a sensible price.

This can be explained by paraphrasing Buffett in a lecture he gave to MBA grads back in 1995, “In the stock market it is very easy to know what will happen, but almost impossible to know when something will happen.”

Therefore, if you know something great will become of an enterprise (some time in the future) you can diminish risk in the investment substantially by sticking with it long enough (several years) to allow the wonderful even to play out.

There are obviously tax advantages to holding onto a business longer as well.

*David Dreman, "Contrarian Investment Strategies in the Next Generation"

Conclusions Of The Efficient Market Theory*

• The Efficient Market Theory is flawed because it does not function the way it is “supposed to” (as dictated by theorists).

• This is because markets are made of billions of daily transactions (buys/sells/shorts, etc…), and these transactions are the result of the entity (investors) which has the ability (money) to carry them out.

• Since “the entity” is human, it can be concluded that the markets are as efficient as they are inefficient because people are prone to error and inefficiency – especially of judgment.

• The bottom line is that the larger (and longer) “the entity” errs, the greater the probability there is that there lays inefficiency somewhere within the markets – while the broader markets will (collectively) display inefficiency on occasion as well.

• Thus, the markets are “efficient” in the long run – as valuations tend to “normalize” given a longer time horizon – and can be anything but in the short run. In other words, efficiency in the markets is to found in many sections (but not all sections) of the market on a regular basis, however, it is largely to be found nowhere on occasion.

• In the end, “…[w]hatever mispricing there is usually is only recognizable after the fact… because things are never as clear prospect as they are in retrospect.” – David Dreman, Contrarian Investment Strategies.

*Burton G. Malkiel, "A Random Walk Down Wall Street"

Conclusions Of The Firm-Foundation Theory*

1. P/E multiples are higher for stocks for which high growth is anticipated – for “fast growers”. This is because “share prices must reflect differences in growth prospects if any sense is to be made of market valuations. Also, the probable length of the growth phase is very important. If one company expects to enjoy a rapid 20% growth rate for ten years, and another growth company expects to sustain the same rate for only five years, the former company is, other things being equal, more valuable to the investor than the latter.” – Burton G. Malkiel, A Random Walk Down Wall Street, 109.

2. The market should be willing to pay a modest premium above the growth rate for a fast grower. For example, Microsoft sold at 36 times earnings when the street expected 20% growth for the company in the early 2000’s. Some might regard this as an overvaluation and disregard the stock. This is such a time as when to “get out”.

3. Stocks are valued on (future) expectations – not facts. These expectations are based on analyst estimates and the estimates and favorability of the market towards the stock. However, the future (earnings) is not easily estimated, even by market professionals.

*Burton G. Malkiel, "A Random Walk Down Wall Street"

Technical vs Fundamental Analysis*

• Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those adhering to the “castle-in-the-air” view of stock picking.

• Fundamental analysis is the method of applying tenets of the “firm-foundation” theory to the selection of securities.

• Technical analysts are normally chartists who rely on the making and interpreting of stock charts. They study the past – both the movements of common stock prices and the volume of trading – for a clue to the direction of future change.

• Most chartists believe that the market is only 10% logical and 90% psychological. Chartists study charts because charts show what other players have been doing. From this, chartists hope to decode the crowd’s future movements.

Fundamental analysts take the opposite track, believing that the markets are 90% logical and only 10% psychological. Therefore, fundamentalists seek to determine a stock’s true value, placing little emphasis on past price movement. They use growth rate, dividend payout, interest rates, risk, etc… (the fundamentals of security analysis) to determine an intrinsic value of the security at hand. 90% of Street analysts consider themselves fundamentalists.

*Burton G. Malkiel, "A Random Walk Down Wall Street"

Investment Theories*

EFFICIENT MARKET THEORY

• States that all known information about a security’s past, present, and future fundamentals is already factored into its price.

• And that the development of an unforeseen surprise surrounding the security, good or bad, cannot be profited from because the markets are quick to adjust to such information should it present itself. Moreover, the costs of carrying out such a transaction for a would-be profit seeker would reduce his return to nothing.

FIRM-FOUNDATION THEORY (FUNDAMENTAL SECURITES ANALYSIS)

“Go where the crowd just came from.”

• Growth and value oriented investors who carry out fundamental analysis on securities generally subscribe to this school of thought.

• Theory argues that each investment (stocks, real estate, bonds, etc…) has a “firm foundation” of something called intrinsic value.

• Intrinsic value can be determined by careful analysis of present conditions and future prospects.

• When the market price falls below (or rises above) this “firm foundation) of intrinsic value, a buying (or selling) opportunity arises, because this fluctuation will eventually be corrected as the markets are – as Buffett suggests – a frequently efficient mechanism which adjust to new issues surrounding a businesses very rapidly.

• Therefore, there are times when the markets tend to be inefficient. As markets are made up of investors, and investors are people, and people are prone to error (especially error of judgment).

• Thus, lucrative opportunities do present themselves from time to time.

• The business being invested in must carry strong past and future fundamentals (earnings growth and solvency) and have superior management.

CASTLE-IN-THE-AIR-THEORY (TECHNICAL SECURITIES ANALYSIS)

“Go where the crowd will be.”

• Chartist and day traders are generally linked as followers of this theory.

• The basis of this theory lies in the belief that “a thing is worth only what someone else will pay for it”. Therefore, sound valuation (of the security) is unnecessary as long as an unsuspecting “greater fool” is willing to pay more for it. The more suckers that fall prey to the baseless castle, the more the castle (stock) can rise (appreciate in price) with every pass.

• This theory, therefore, uses market psychology in timing the buy/sell decision rather than fundamental valuation.

• This is kin to a hypothetical beauty pageant in which the girl with the prettiest face and hottest figure is not necessarily chosen the winner, but rather the girl most admired collectively by the judges gets crowned.

*Burton G. Malkiel, "A Random Walk Down Wall Street"

Hot Stocks

When a “hot stock” tanks it is usually followed by an army of class action lawsuits in which top management is held accountable and accused of many wrong-doings. Such claims are usually baseless, and require small fines from the business (if any) upon the “class” winning the suit. This sends the stock down further to a point where an attractive buying opportunity may exist.

The Excellent Business*

One of the great things about owning superior businesses is that they tend to generate cash flow primarily because of the enormous “goodwill” built up in the mind of the consumers regarding the company’s goods and/or services. This differs from the conventional “accounting goodwill”, and could be referred to as “consumer goodwill”.

The benefit of this is the fact that sine the profits of a superior business are largely tied up with “consumer goodwill” (or intangibles rather), the business is subject to federal taxation primarily on earnings. In other words, the taxes paid by such a business tend to vary with profits.

The inferior business, on the other hand, is usually committed to continual and large investments in such expense incurring plant and equipment which is frequently necessary to replace/update with the advancement of its industry, and in order to become the low-cost competitor. If the (inferior) business does not adapt to such change promptly it will lose customers and market share to the competition. Therefore, fixed charges and taxation with respect to companies of this nature are fairly large compared to that owed by the superior enterprise.

*Mary Buffett, "The New Buffettology"

Problems with Relying Solely on ROE

The problem with looking at high rates of return on shareholders' equity is that some businesses have purposely shrunk their equity base with large dividend payments or share repurchase programs. They do this because increasing the return on shareholders' equity makes the company's stock more enticing to investors.

Thus, you will find companies in a price-competitive business, like General Motors, reporting high rates of return on shareholders' equity. To solve this problem, you must look at the return on total capital to help screen out these types of companies.

Return on total capital is defined as the net earnings of the business, minus dividends, divided by the total capital in the business. Like this,

ROTC = (Net Income - Dividends) / Total Capital

Look for a consistently high rate of return on total capital AND a consistently high rate of return on equity.

The Value of a Company Relative to Bonds

- Price / Earnings = P/E Ratio
- Earning / Price = Rate-of-Return (%)

An important question these ratios provide an answer to is, “how long will it take to break-even on the investment?” In other words, if a business continues to grow its earnings at a rate of “x” % annually, how long would it take for the earnings to amount to the investment initially placed in the business (i.e., its stock)?

The P/E ratio (at the time of purchase) tells us this information about the business. For example, if a stock sells for $25 per share, and the business is generating $5 per share in earnings then the P/E ratio of 5 ($25 / $5 = 5) tells us that investors in the market are willing to pay 5 times whatever the company earns ($5 in the example above). Therefore, if the company has stable and predictable earnings and it continuously grows them at a satisfactory rate, then the investor can expect to receive his initial investment of $25 per share back in roughly 5 years. Put another way, the P/E ratio can tell you how ling it would take to break-even on your purchase of shares in a business.

Another important question to ask is, “how will the investment compare with the return that can be achieved through a long-term government bond?”

This is an important question to ask regarding any investment because ultimately all investments compete with one another – as if they were athletes in a track race. This is logical belief held by Buffett. The answer to this question can be found by figuring out the E/P (earnings-to-price) ratio. This is the exact reverse of the P/E ratio. Therefore, “flipping” the numbers in the P/E will tell you your approximate rate-of-return for the first year of operations (the year you buy the stock).

The E/P ratio is used by Buffett as a comparison tool to determine whether the business in question would yield an adequate return in relation to other investments if it is invested in. To do this, Buffett compares the figure arrived at by the E/P ratio with return offered by the “risk-free-rate”. The risk-free-rate is the after-tax rate of return offered by a long-term (10+ years) government bond, or the bank’s annual interest rate, whichever is higher.

If the E/P figure is approximated at an after-tax rate-of-return which falls short of the risk-free-rate, then it would be foolish to invest in the business.

The bottom line is, the lower the P/E the better. This is because:

1) the lower the P/E ratio
2) the higher the E/P ratio
3) the lesser time is required to break-even on the investment
4) the quicker you will start making a profit
5) the larger will be your after-tax profit
6) and the greater will be your ultimate rate-of-return.

So, by taking a single measure (as looking for a low P/E) you will accomplish five additional, effortless tasks.

Numbers Worth Noticing*

Percent of Sales:
When a company seems of interest because of a particular product/service, the first thing you want to know is what that product/service means in the overall picture of the company in question. What percent of sales does it represent? If the product/service offering is terrific and everyone is buying it, but it represents only a small precentage of the company's sales and earnings, then the company in question should left out as a potential candidate for investment.

The Cash Position:
You have to find out how much cash the company is sitting on (if any). What is the per share figure of the company's bank account? For example, if the company has $10/share of cash and is selling for $15/share with a p/e of 3, it could be a bargain.

More on The Debt Factor:
You have to also find out how much the company owes versus what it owns. The debt-to-equity ratio is commonly used here.

Pay extra attention to the debt factor among turnarounds and troubled companies. More than anything else, it's debt that determins which companies will survive and wich will go bankrupt in a crisis. Young companies with heavy debts are always at risk. There are two major types of debt which can prove to good or bad for a company.

The first is bank debt. This type of debt is usually frowned upon and looked at as being the worst kind of debt a company could have. This is because if the company is having "headaches" the bank can jump in and demand its money back on short notice. This type of aggressive move by banks usually cause many companies to end up in chapter 11.

The second type of debt (the good debt, from a shareholder's point of view) is funded debt. This is labled "good debt" because it is the type of liability that can never be called in no matter how bleak the situation, as long as the borrower continues to pay interest. The principal may not be due fore 15 or 30 years. Funded debt usually takes the form of regular corporate bonds with long maturities. Corporate bonds may be upgraded or downgraded by the rating agencies depending on the financial health of the company, but whatever happens, the bondholders cannot demand immediate repayment of principal the way a bank can. Sometimes even the interest payments can be deferred. Funded debt gives companies time to wiggle out of trouble. The breakdown of the various types of debt the company has can usually be found in the footnotes or notes of its annual report.

Dividends:
An arguement 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.

However, if a company retains all dividends (assuming it makes profitable use of them) then that would be a bigger plus as it would grow the business' book value faster. Smaller and newer companies are usually the types that do not offer dividends.

If a company cannot find any profitable methods of imploying its retained earnings, then it should either pay a dividend or buy back as much stock as possbile; thus, increasing the value to the shareholders that don't sell.

Hidden Assets:
Look for these! These are the types of assets that are stated at a fraction of their true (intrinsic) worth in a company's books. This may include land - which usually appreciates in value - that is worth more today than what is was recorded on the balance sheet at the time of purchase under the "cost basis" principle stated in the GAAP. Or the company may possess some very powerful intangibles (as brand names) which are usually stated at enormous discounts to true value on the balance sheet. Perhaps the company owens several precious metals which are worth in excess of what their costs were in the past. Drug patents, for example, can also be classified as a company's "hidden gems" - think of Fhyizer's hugely successful "viagra".

The best thing about hidden assets is that they are required to be depreciated on an annual basis as required by GAAP. This can result in a bargain situation, because these are the types of assets you would be getting for free! This could include a fully depreciated piece of valuable land or any of the other elements metioned above.

(Accounting) Goodwill:
Goodwill is the amount paid for an asset over and beyond its orginal cost. This is listed under the asset column in the balance sheet, and must be written off over a period of 40 years under new GAAP regulations. For example, if a tv station sells for $450 million (at fair market price), but is actually worth $2.5 million on paper, the extra $447.5 million paid for the staion has to be classified as "goodwill" and carried on the (new) books as an asset, and eventually it, too, will be written off. This in turn creates a potentaial asset play (#6 above).

Subsidiaries:
There can also be hidden assets in the subsidiary businesses owned wholly or in part by a large parent company. For example, La Senza has large interest in Wet Seal which is carried on La Senza's books at cost, not on the basis of present or future worth.

Partial Interests:
Sometimes the best way to invest in a company is to buy into a separate owner of it. For example, a company may sell for $8/share, and might have a 25% interest in another profitable company worth an additional $12/share to the business. You'd be getting this hidden asset for minus $4.

Tax Breaks:
Tax breaks turn out to be a wonderful hidden asset in turnaround companies. The tax-loss carryforward allows a company emerging from bankruptcy the ability of not having to pay taxes on profits generated by acquisitions.

Cash Flow:
Cash flow is the amount of money a company takes in as a result of doing business. All companies take in cash, but some have to spend more than others to get it. In cases where you have to spend more cash to make cash, you aren't going to get very far. The hint here is to look for companies that don't have to spend a bundle to make a bundle.

This is easier said than done, but try to find a business that needs very little in the way of capital expendituers - expenses incurred in updating tangible asset basis as plant and equipment. Since the assets of a business are what help it generate revenue and earnings, the less a business has to spend in the way of their maintainence and repair the more it will get to keep in the form of earnings. An example of such a business is Hershey Foods.

A measure which can help determine how much a company is "wasting" as a result of capital expenditures is the "asset-turnover ratio". The smaller the number the lesser the company is having to replace its asset base. If the asset-turnover ratio is 20, that would mean that the company is having to replace (turnover) its tangible asset base 20 times a year - VERY EXPENSIVE!

Inventories:
Look for high-turnover here. If inventories are building up it might mean that no one wants to buy it. This fact would be kept concealed from the average investor, as inventory is listed as an asset under the balance sheet. Therefore, all may look well until the stock plumets in price. The sophisticated investor knows that a buildup of inventory is not neccessarily a good sign unless, of course, the company is headed for rapid expansion and needs to fill up empty shelves in the new centres it plans to open.

The inventory-turnover figure is very helpful here. If this amount to 100+ (as it is with Dell Corp.) then that means the business is having to replenish its warehouse 100 times in the course of a fiscal year - meaning it is selling a lot of its product.

Manufacturing businesses with high-turnover inventory are, however, at a small risk when it comes to delievery of parts or inventory. This as true for Wal-Mart and Dell as it is for Mc Donalds, and General Motars. If delivery of parts doesn't arrive on time, or if the power goes out and the manufacturing equipment stops working as a result then customer's orders wont get filled, and the company will begin to lag behind on them. In the meanwhile, the inventory already present may start to rot. Examples of this include the 9/11 attacks that called for a sieze of all air flights which caused a temporary blow to FedEx's opperations. And when the power grid stoped working.

The bottom line is that if a business has high-inventory-turnover and is relying on heavily on prompt delivery of parts, then it is preferrable that the business be "vertically integrated" in nature (as is Wal-Mart and Dell) as this would allow it to streamline all of its own operations - from delievery to manufacturing. The other side of this could be that if a company heavily relies on quick delivery from a major supplier, and that supplier goes bankrupt, then the business in question will be affected very negatively. Therefore, if the business is not one which is vertically integrated then it should also not be one that solely relies on a single supplier and/or customer.

Pension Plans and Unions:
These tend to be "unnessary expenses" and "dangers" in the opinion of the sophisticated investor. Each of these tends to "eat up" the earnings of a business. Be weary of a business if it has any part of either of these.

If a company does have a pension plan find out whether it is a "defined benefit plan" or a "defined contribution plan" - otherwise known as "DB" and "DC" pension plans. The latter is preferred over the primer.

As for stock options, they are required to be "expensed" by a business under new GAAP in Canada (the US may soon follow).

Growth Rate:
On Wall Street, "growth" and "expansion" are believed to be synonymous, but this is a popular misconception. For example, the cigarette consumption in the U.S. is going down, but its increasing outside the U.S. and this tends to be a major plus for Philip Morris (Altria Group).

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

*Peter Lynch, "One Up On Wall Street"

Evaluating Long-Term Debt of a Business*

The debt-to-equity ratio tends to be a poor measure in evaluating the financial strength of a business. The reason for this is that the equity in any business acts as a piece of “security” or “collateral” for the bank loaning the funds, and that is, unfortunately, about all it ever amounts to.

In other words, the equity of a business is not really what a bank is after when granting a loan. It only acts as something for the bank to fall back on in case the company defaults on the loan. What banks are really after is the ability of the company of being able to make the interest payments on the loan well into the future. This ability on the part of the company is directly dependant on its ability to generate positive cash flow and high earnings.

Buffett and Lynch have also found that the assets of a business which help it secure the bank loan are usually so unique to the enterprise that, in truth, they tend to be worthless to anyone else, even thought they may well be carried on the books at considerable value.

The wealth of a company is in its ability to earn a profit, not what it could sell its assets for. Companies that have superior business economics typically have long-term debt burdens of fewer than five times current net earnings. And of this debt it is preferable that it not be bank debt, but rather funded debt.

*Mary Buffett, "Buffettology"

More Details on the P/E ratio*

The p/e ratio of any company that's fairly priced will equal its growth rate. That is, the growth rate of the company's year-to-year earnings. For example, if the p/e of Coca-Cola is 15, you'd expect the company to be growing at about 15% a year, etc. Therefore, a company selling at a p/e ratio that is less than its growth rate MAY be a bargain - and vice versa.

Here's how to compare growth rates to earnings, while also taking the dividends into account:

Find the long-term growth rate by averaging the company's historic earnings growth for the last 5 to 10 years. Next, add the dividend yield, and divide by the p/e ratio. Here's, an example,

-Company X's growth rate is 12%
-Company X pays a 3% yield
-Company X has a p/e of 10

This would give you the following: (12 + 3) / 10 = 1.5

Evaluating the Resulting Figure:
Here's an approximate scale of how to rank the result from the previous step,
-Less than 1 is poor
-1.5 is okay
-2+ is what you should be looking for

For example, a company with a 15% growth rate, a 3% dividend, and a p/e of 6 would result in a fabulous 3.

*Peter Lynch, "One Up On Wall Street".

The Lynch Stock Groups

Fast Growers
These companies have little debt, are growing earnings at 20% to 50% a year, and have a stock price-to-earnings ratio below the company's earnings growth rate. Investing in these types of stocks makes sense for investors who want to find solidly financed, fast-growing companies at reasonable prices.

Slow Growers
Here Lynch is looking for companies with high dividend payouts, since dividends are the main reason for investing in slow-growth companies. Among other things, he also requires that such companies have sales in excess of $1 billion, sales that generally are growing faster than inventories, a low yield-adjusted price/earnings-to-growth ratio, and a reasonable debt-to-equity ratio. Investing in these types of stocks makes sense for income-oriented investors.

Stalwarts
Stalwarts have only moderate earnings growth but hold the potential for 30%-to-50% stock price gains over a two-year period if they can be purchased at attractive prices. Characteristics include positive earnings; a debt to equity ratio of .33 or less; sales rates that generally are increasing in line with, or ahead of, inventories; and a low yield-adjusted price/earnings-to-growth ratio. Investing in these types of stocks makes sense for investors who aren't willing to pay up for high-growth companies but still want the chance to enjoy significant capital gains.

Cyclicals
Companies whose earnings rise and fall as the economy booms and busts
Turnarounds - companies with temporarily depressed earnings, but good prospects for recovery.

Asset plays
Companies whose shares are worth less than their assets, provided these assets could be sold off for at least book value.

Evaluating Management’s Capability

Meeting with the management of a company, explains Hawkins, is not always necessary. Much of what is needed is available on the Internet. "I think investors can get a tremendous amount of information about the company and its management team by reading proxy statements, the past five years' worth of annual reports, and the interviews with management that are available in magazines and newspapers. And the company's Web site is usually stocked full of useful insights."

The Effect of Share Repurchases by a Company

When stock is bought back by a company it is taken out of circulation (from the stock market). Thus, decreasing both the number of shares outstanding, and the equity base (at present) due to cash expenditures needed for the buy back (which create a corresponding decrease in the asset column, hence, shrinking the equity.

This kind out situation proves to be economic brilliance on the part of the company, and the remaining holders for three main reasons:

1. The company would cause, as a result of the buy back, a significant increase in per share earnings in the future; due to the shrinkage in equity.

2. The company obviously has great expectations of itself in the future, so, why not invest in itself?

3. The future earnings multiples the company’s stock would trade at will quite possibly increase as a result of the “unexpected increase” in the (future) per share earnings.

5 Basic Ways a Company Increases Earnings

1. Reduce costs
2. Raise prices
3. Expand into new markets
4. Sell more of its product/service in the old markets
5. Revitalize, close, or otherwise dispose of a losing operation.

Stock Split Effect on Options

Though stock splits have no effect on stocks, they do affect two other factors: Your wallet, and the options market (assuming options are traded on the stock).

What do you mean it affects my wall?!!

Well... Put simply, since you would own an increased number of shares you once did (imagine if the stock split 10-for-1, lol) you would have to pay more in commissions to sell them (or buy the equivalent dollar amount worth before the split) because most discount brokers charge a higher commission on trades in excess of 1,000 shares.

Regarding marketable stock options... The logical assumption of the affect of a stock split on the corresponding options would be that the options are split as well and the holders own twice as many after the split. However, the effect of stock splits on options is slightly more complicated.

Firstly, you have to keep in mind that an option is primarily a tradable contract.

Second, the premium (time value and intrinsic value) ONLY splits by the stock split factor for NEWLY ISSUED contracts. In other words, the old premiums are unaffected by the stock split - only normal factors as volatility and time-decay affect the old options premiums.

Third, the old options continue to trade as well and are not taken off or converted into "split adjusted" amounts by the Options Clearing Corporation. So if you held 100 options contracts at a premium of 0.05 with a striking price of $20, then after the split you'll still own the exact same with no split effect. Some people mistakenly think that the option "splits", and become confused when they see bid premiums of $0.05 existing before the split (as premiums cannot drop below $0.05). This is not the case because the options do NOT split, instead new striking price zones are opened up (in simulation with pre-stock-split strike zones) for trading on the exchange by the O.C.C. as an option is a binding contract by definition. Unlike the underlying stock, the options are unlimited except by market demand.

Lastly, the split only affects new strike zone options which are written (by the seller) after the split. If buyers want to buy the newly opened options or sell newly opened positions they can while also being allowed to trade the old options. However, the old is NOT interchangable for the new.

Stock Splits

Put simply, there is absolutely no financial affect (gain/loss) on a company's EPS or P/E (or other ratios) as a result of having it's stock split.

The reason for this is that once a stock is split it's price is cut by the split factor and the number of shares outstanding increases by the same factor as well.

Therefore, the company's EPS are divided amongst the newly split shares, which means that both the EPS figure and BV (per share) will chproportionatelynatly. However, the net income and the business equity figures will remain unchanged.

This is one reason Buffett suggests looking for the owner earnings instead of focusing on EPS (and other per share figures) when analyzing a business.

• Stock Split of 2-to-1 = Outstanding after split are now twice in number and half in price.
• eg. Pixar (NASD: PIXR) annouced a 2-for-1 stock split on April 19, 2005. PIXR finished the previous trading day at a price of $92.93 with approximately 59,060,000 share outstanding. After the split PIXR's price was cut in half to $46.47, and the outstanding stock doubled to 118,120,000.

The Almighty P/E Ratio

• The P/E ratio is the current stock price of a company divided by its earnings per share (EPS).
  
• Variations exist using trailing EPS, forward EPS, or an average of the two.
  
• Historically, the average P/E ratio in the market has been around 15-25.
  
• Theoretically, a stock's P/E tells us how much investors are willing to pay per dollar of earnings.
  
• A better interpretation is that the P/E ratio is actually a reflection of the market's optimism concerning a firm's growth prospects.
  
• The P/E ratio is a much better indicator of the value of a stock than the market price alone.
  
• It's difficult to say in general whether a particular P/E is high or low without taking into account growth rates and the industry.
  
• Changes in accounting rules as well as differing EPS calculations can make analysis difficult.
  
• P/E ratios are generally lower during times of high inflation.
  
• There are many interpretations as to why a company has a low P/E.
  
• Don't base any buy or sell decision only on the multiple.

Interest Rates and Inflation

Interest Rates

• A rise in interest rates (for example, to 12%) make other investment alternatives, as the stock market, unattractive to the majority of investors. Why put money in a system that is prone to business risk and economic downturn and get a return of 10% when you can get 12% risk free (i.e., the “risk free rate”)? Most people would opt-out of such a situation.
  
• With more and more money being removed from the market and invested into savings accounts the trading volume in the stock market decreases significantly – creating some wonderful buying opportunities.
  
• Thus, with the rise in interest rate people tend to become “savers” as opposed to spenders and investors in times of low interest rates.
  
• The mortgage/savings & loans (SNLs) or banking industries usually experience a slow down. This is because interest rates are so high (like 12%+) that people tend to borrow less in business loans, car loans, mortgages, etc… Therefore, the banking system’s profits tend to decline as more and more people start pulling money out of investments and “saving” it.
  
• This usually leads to a recession which is where bear markets are given birth – the perfect opportunity for sophisticated investors.
  
• To revive the economy the chairman of the Federal Reserve (currently Allan Greenspan) lowers interest rates, sometimes to decade lows.
  
• The corporate world adds to the solution by starting the lay-off process to increase their “tight” profits further. These lower profits are the result of lower sales revenue which was caused by massive savings on the part of consumers due to high interest rates.
  
• The market, which had already started its decline due to low volume, tends to plummet further on the bad news of corporate budget cuts, lay-offs, stalled profits, etc... This creates the opportunities for investment dreamt by the true investor, as stocks which traded at P/Es of 50+ are decimated to the single-digits to low-teens.
  
• Once the Fed reduces interest rates people being spending and “investing” once again.
  
• Since interest rates are low people are easily seduced into mortgaging homes, taking out business loans, car loans, and start “investing” back into the stock market.
  
• However, they do not chase the once hot tech stocks this time. Those stocks are dead until the companies start generating earnings. This time they put money in famous blue chips like Proctor & Gamble.
  
• The fast growers that were successful before the recession/market correction are where the unearthly profits will come from, and the true investor knows this.
  
• The market starts its recovery and then, once again, bubbles. The sophisticated investor gets out at the right time, and waits for the process to repeat itself. That is, the process of buying low and selling high because of an economic downturn coupled with bad news about the corporate world portrayed by the media.
  
• The bottom line is that there is an inverse relationship between interest rates and the stock market. When one goes up, the other goes down.

Inflation
Inflation is the general rising of prices throughout the economy. The true investor is an expert at staying many percentage points above this economic dilemma. This is because the true investor invests in businesses that can raise the prices of their goods and services along with inflation.

Therefore, inflation actually makes the investor “richer” as the company he/she invests in can generate twice as much profit due to their monopolistic control over price.

32 Rules of Investing

1. The business being invested in must fall within your “circle of competence”. In other words, it must be of a nature which can be easily understood. “The business must be so good, that an idiot could run it, and it would still work.”

2. The business must have a consistent operating history.

3. The business must have favorable long-term prospects – i.e., sharp growth rates in the future.

4. In addition to having the stable business economics stated above, management must also be evaluated. Management must be rational.

5. Management must be sincere with its shareholders.

6. Management must resist the “institutional imperative”.

7. The business must also have stable financial tenets. The key financial ratios (debt/equity, current ratio, etc…) must be satisfactory.

8. The business must consistently produce high returns on shareholder’s equity (book value) – e.g., above 15%.

9. The business must be able to grow its book value (shareholder’s equity) at a satisfactory rate over the long-run.

10. Return on total capital (net earnings/total capital) must be consistently high – e.g., above 15%.

11. The business must be able to consistently grow its revenues and net earnings year-over-year at a satisfactory rate – e.g., above 15%.

12. The business must have either high profit margins or high inventory-turnover or both.

13. For every dollar retained within the business, the business must create at least one dollar of value in the marketplace. The “value-added” by retained earnings should increase the market value of the company.

14. The various price ratios, like the P/E and P/S ratios, of a share in the business must be in single-digits to low-teens.

15. The business should preferably trade below book value, so as to provide a margin of safety in the unforeseen event of a bankruptcy or liquidation.

16. The business must always be trading below intrinsic value – i.e., the business must be undervalued in the market.

17. If the entire company isn’t worth buying at the current market price, than a single share must also not be purchased.

18. The business must be in an industry in which little (if any) competition exists, so as to allow the business to reap monopoly-like profits.

19. Insiders of the business (i.e., top management) should preferably have a reasonable ownership of the company’s shares.

20. The company should preferably be repurchasing shares on the open market.

21. Little institutional ownership of the company’s shares is preferred.

22. A business that possesses the “must-haves” in the list above, but has been overly sold and shorted within the market will make for an excellent investment.

23. The business must be bought when the best buying opportunity exists – i.e., when the purchasing of the business makes “business sense”.

24. The business should preferably rely on “intangible assets” (like patents) and services rather than a product mix.

25. The business’ goods/services must be of a (strong) nature which would allow them to be consistently priced above inflation. In other words, the business must have pricing power over its goods/services.

26. The business should preferably be of a nature that requires little in the way of R&D, so as to pass on all excess profits to shareholders, kept for reinvestment within the business, or used towards the purchase of other whole or partial interests in above-average enterprises.

27. The mindset of top management must be such that if it cannot reinvest retained earnings in a profitable manner, then it must return the earnings to its shareholders in the form of dividends – rather than placing the earnings in sub-par investments.

28. The business must be of a nature which can be maintained without much in the way of operational costs. For example, maintenance costs must be so small that most of the earnings can either be retained or paid out as dividends without damage to the business.

29. If the business being invested in is known to be bidding for the acquisition of another business the target must:

i) also possess strong business economics

ii) be within the businesses’ “circle of competence”

iii) not be overpaid for above and beyond its estimated intrinsic and book values.

iv) have a business-model of related nature to the parent, e.g. a drug company should not buyout a sneaker manufacturer, as the conglomerate form-of-business can sometimes lead to sub-par results. However, certain corporations, as Berkshire Hathaway and Proctor & Gamble, have proven themselves otherwise.

30. Be very cautious if the business in questions has recently announced news of a merger with another company. Mergers have proven to result in poor performance and below-average returns -- at least in the first few years proceeding the merger -- in most historic cases.

31. If the business being invested in is said to have been targeted for acquisition by another firm, then an arbitrage position of potentially high return may exist. The bid price by the acquiring firm must be satisfactory though.

32. Invest only in arbitrage positions know to have a fixed “closing date”. To do so otherwise is to take on unnecessary risk.

Requirements for Investing

What You Need
There's basically three things you need in order to start benefiting from the financial markets: Knowledge, savings, and a broker. The first two are self-explanatory in that you should know what to invest in by formulating a strategy and have money to see that strategy to fruition.

How To Place A Trade
The third one often complicates people who are trying to get into the market. Most potential investors know that they can use their PC or cell phone to invest money in stocks, but don't know exactly how its done. The laptop is, however, merely a tool which allows you to place a trade. Someone who sits in loud and messy downtown office called a stock broker is the missing link to your order execution. Though these days the majority of trades occur online you still need to open an account with a broker for your stock buy/sell order to be routed to the exchange trading floor.

The Stock Broker
Many people who would like to invest in the market mistakenly believe they can send their order directly to the exchange floor from their computer. You cannot send your order directly to the exchange floor. The order must be executed indirectly (through the broker) for which you are charged a commission.

Can't I Buy Shares Directly From The Company?
Other would-be investors mistakenly think that the company who's stock they'd like to purchase is the actual party selling them the stock. Though such a scenario would occur in something called an "Initial Public Offering" (IPO) - a time when a company sells its shares to the general public for the very first time - within the "primary market", the majority of trades occur in the "secondary market" - i.e., the shares you buy would come from other traders who are selling the same stock.

Types of Stock Brokers
Back to the broker... There are two primary types of brokers you can open an account with: 1] Discount broker, or 2] full-service broker. A discount broker only offers order execution service and some online trinkets like charts, stock screening tools, and business newswires. The trinkets are usually found better elsewhere on free sources on internet, like Yahoo! Finance and MSN Money. A full-service broker provides all the offerings of a discount broker with the addition of investment advice and financial planning advice.

Selecting A Broker
Most people opt for discount brokers because of the cheaper commissions and the fact that they choose to work their own investment strategies rather than being spoonfed by someone sitting in a high-rise who puts his commission ahead of their financial interests.

Opening An Account
After you've decided whether you prefer the services of a discount broker or a full-service broker you have to find one. Google and Yahoo! ads related to keywords "discount broker" are often helpful in find a broker. Some American brokerages offer trading services outside of the United States (like E*trade and Ameritrade which offer services in Canada as well).

Also, most banks offer investment brokerage services too. Therefore, if you have a checking or savings account visit your bank's website or call it to know if it offers investment brokerage services.

The Checklist
Commissions are a major question on every new investor's checklist. However, it rarely pays to bargain hunt for the cheapest discount broker because in this day and age the big guys know they can't fool the little guys by over-charging because the client will soon discover the service cheaper elsewhere. Once you do the math on commission rates charged by various brokers you'll soon discover that you'll be charged pretty much the same by every brokerage no matter how cheap one ad may appear in comparison to another.

The more important thing to evaluate (espeically for day traders) is order execution time. Though most brokers are up to par with having orders filled quickly the "5 second guarantee" ads you see can sometimes be slightly misleading so read the fine print!

Some brokers also have "inactivity fees" and charge slightly different interest rates on investment loans. Such loans are only available to investors who are approved for a margin account (more about that later) and are collateralized against stocks you hold within the account, so be sure you are familiar with your level of risk tolerance.

Also, interest rates the broker pays you for "idle money" in your account also vary slightly from broker to broker though this rate is very small percentage wise.

Evaluating The Broker
You can open trading accounts with several brokerages at the same time for evaluation purposes if you like, and then close the accounts of the ones you don't like. If you do this quickly (close the poorly serviced accounts within a month or so) it shouldn't affect your credit rating or credit score, but be weary of closing old accounts without first inquiring with your broker about the ramifications it will have on your credit history and credit score.

Your Credit Report and Score
You can order a free copy of your personal credit report by writing a written request to the credit bureau(s) with two pieces of photo-copied ID - one of which must contain your picture. There are three credit reporting bureaus in the United States: Equifax, Experian, and Trans Union. (Equifax and Trans Union also operate in Canada). You can also order an instant copy of your credit report and score online, however, you will be charged a fee for the service by the bureaus.

Inaccurate Info in Your Credit File
Requesting a report from each of the bureaus is wise because sometimes one bureau may have inaccurate or suspicious information about you on file. Such information can often be cleaned up with a phone call, but you should write them a signed and dated letter for assurance.

Then order your report again within a few weeks/months to see if the neccessary adjustments have been made. For more serious matters, like credit fraud committed against you, you'll need to go through a fairly tedious process to restore your credit score. You may even require the services of an attorney.

Types of Trading Accounts
There are two primary types of discount or full-service trading accounts you can open with a stock broker: Cash account or margin account. A cash account only permits you to execute orders for which you will settle in cash through funds previously deposited in your account. A margin account gives you the services of a cash account with the addition of providing you with the ability to pay for part of your trade with funds which are lent to you by your broker.

With a margin account you also have the privilege of opening an options trading account. Options are not the same as stocks, but a highly lucrative trading market administered by the "Options Clearing Corporation" OCC - a government body - exists for options trading. A highly recommened book and Audio CD called "Getting Started In Options" by Michael C. Thomsett about the subject may be available from your local library.

Good Luck on Your First Trade!
Once you have opened a cash or margin account with an investment brokerage you can begin initiating your investment strategies from your notebook PC, mobile phone, or handheld organizer!

Take caution to follow your broker's online security instructions when executing a trade over the internet, however - i.e., public library, internet cafe PC.

Government and Business

The government is (supposed to be) a benefactor to society and an equalizer of wealth and opportunity in that it possesses the legal authority of taxation and lawmaking. For example, the government imposes and collects taxes and then spends those taxes for society's benefit - though sometimes money is lost or wasted "accidentally". Or the government may launch anti-trust suits and create laws to promote more efficient competition within the business world as it has done with several large corporations in recent years.

The government is also a sort of "business partner" in that it can provide opportunities, funding, and legal benefits to businesses. Lobbyists working for a drug company like Merck (NYSE: MRK), for example, can gain permission for the selling of a new drug by negotiating with the FDA (a government body).

The Business Pyramid

It's ironic how the majority of people get paid so little to do the most undesirable things in a corporation (i.e., janitor) while a minority in the enterprize literally owns and dominates the labor and decision making process and gets paid big bucks to do it! If drawn on paper this would such a structure would look fairly similar to a an Egyptian pyramid - both literally and physically. By physically it is meant that the 90% which creates the pyramid is the large mass occupying the bottom half while the 10% which stand to reap the most sends orders from the top just like a Pharoh.

In the business world mid-low level employees commonly tend to be the losers in the enterprize as they are usually the least paid, and sometimes looked upon as a mere “expense” by top management. If this wasn’t the case then so many pink layoff slips would not be handed out during a recession, for instance, rather than a pay cut in management's salaries or restriction of stock options.

Though hard work in the work place is also a major contributing factor towards the internal promotion the final decision lies with the various levels of management. At the top promotional levels (executive class) management and/or the board of directors decide which employees are valuable, contributing assets to the business as a whole, and which are not and the employees favoured are given promotions and made executives.

Business Success

Growing Profits = Business Success

Most business owners and investors aren't geniuses but rather average people who have achieved above-average success in one area of life - wealth.

Profits provide business people and investors with a feeling of success and accomplishment. This is because they realize that the primary reason they have amassed such wealth is that they rendered useful products and/or services to individuals or have picked up bargains overlooked by market participants and, in return, society has rewarded them with money. Therefore, acquisition of money is often linked with the definition of success. Money is not success in itself, however, but rather a form of success.

The primary difference between business owners and investors lies in the fact that investors do not directly provide something of value to society. Instead of providing the end product, investors usually provide the means by which the end product is derived - cash. According to "Rich Dad, Poor Dad" co-author, Robert Kiyosaki, another difference between investors and business owners is that investors primarily have their money (or that beloning to other people) work for them, while business owners have systems work for them.

The two fields are obviously interrelated and similar as well. For example, both business owners and investors benefit society directly through the payment of taxes. And the world's most famous investor and second-richest man alive, Warren Buffett, has been known to say, “I am a better investor because I am a businessman, and a better businessman because I am an investor.” Buffett's mentor and friend of thirty-years, Benjamin Graham, also said something along the same lines, “investing is most professional when it is most businesslike.”

When an investor buys or sells a stock, for example, nothing of (direct) value gets created in society. This is because the only person directly gaining benefit from the purchase/sale of the stock is the one who obtains a capital gain on it.

Investors in the stock and real estate markets are said to be suspected of playing a "zero-sum game" by some. This is because the stock market does not (in most cases) offer a “win-win” solution. One person's gain is usually someone else's loss.

Why People Start Businesses

Answers with respect to Abraham Maslow's Hierarchy of Needs:

1. To meet Physiological Needs
2. To meet Safety Needs
3. To assist or compliment Love Needs
4. To build Esteem
5. To aid Self-Actualization

Other General Answers:

People primarily build businesses so they can obtain more and more goods and services because they want to keep pace with the latest trend so as to keep ourselves feeling new and young... Most people nowadays have a tendency of getting bored quickly.

Some individuals may want to provide solutions to problems and needs existing in society for its betterment.

Some people we want fullfil the desire to feel powerful and in control. Excessive wealth brings these feelings with it.

10 Ways To Get Rich

1. Inheritance
2. Marrying a rich person
3. Stardom
4. Gambling
5. Fraud, theft, robbery
6. Employment
7. Invention
8. Innovation
9. Business ownership
10. Investing