Intelligent Investor Ch. 17- 20 Flashcards
Taxes: a red flag
When taxes aren’t paid over a long period of time this is a red
Flag pertaining to validity of the company’s earnings
Recommended coverage of interest charges before taxes?
5 times earnings
Transportation ratio AKA operating ratio (for railroads)
Transportation ratio = (expenses of running its trains)/total revenues
The higher the ratio, the less efficient the railroad
Restructuring charges
Allow company to hide its true earnings, by placing these losses
In one bad year (kitchen sink accounting)
Goodwill, accounting rule
Can be written off over multiple years, minimizing the impact
Of goodwill charges on future earnings
Volume
Sales or revenues
Asset backing
Book value
What 2 things does a very low book value signify?
1 company is earning high return on its capital, a sign of strength
And prosperity
2 the investor at the current price would be especially vulnerable
To an important adverse change in company’s earnings situation
Showing profitability per dollar of capital, what is this measured by (ratio)?
Earnings/book value
Good will component
Refers to when price exceeds book value (determined from the
Price/book value ratio)
Shareholders are justified in raising questions as to the competence of management when results are. 3 things
1 unsatisfactory in themselves
2 poorer than those obtained by other companies similarly
Situated
3 have resulted in unsatisfactory market price for long duration
Valuation of dividend stocks vs. growth stocks (2 extremes, note that they don’t apply to all stocks)
Dividend stocks are valuated primarily on their dividend growth
Rate
Growth stocks are valuated on expected growth over the next
Decade and cash dividend is left out of the reckoning
2 demands shareholders should have of managements pertaining to earnings
1 managers should payout a normal share of earnings as dividends
Or
2 clearly demonstrated reinvested earnings have produced
Satisfactory increase in per share earnings
Rule 703 of the New York Stock Exchange governing stock splits and stock dividends
Designates stock dividends of greater than 25% and less than
100% as partial stock splits
These Splits trigger the NYSE’s accounting requirement That the amount of the dividend be capitalized from retained earnings
Why are special dividends not paid as often today?
Managers are afraid that investors may interpret special dividends
As a sign that future earnings of the company will decline
Subscription rights
Less common today, still prevalent among closed end funds,
Insurance companies and other holding companies
Give existing shareholder right to buy new shares, sometimes
At a discount of market price, to maintain % ownership of
company
2 basic questions investors should draw attention too regarding management
1 is management reasonably efficient?
2 are the interests of the average outside shareholder receiving
Proper recognition
How do you judge the efficiency of a company’s management? 3 things
Comparing each company’s
1 profitability
2 size
3 competitiveness against similar firms in the industry
Proxy material
Used to weigh arguments of management
In order to evaluate you company, it is important to know how…
It has been unsuccessful
Engineering firms
Assess when how a management has performed poorly, that
Shareholders higher and company must pay
Investors today can choose among consulting firms, restructuring
Advisers, and members of entities like risk management association
Detecting fraud at Enron
Read the proxy under the heading Certain Transactions
Proxy statement
Essential to evaluate conflicts of interest and detect fraud in the company you’re investing in
Has agenda for annual meeting, discloses details about
compensation and stock ownership of managers, shows
Transactions between insiders and company
Voting on proxies
33% individual investors don’t vote
institutional investors including pension funds and insurance companies are required by law To vote
If you see a proxy and it disturbs you: 3 actions you should take
1 vote against every director to let them know you disapprove
2 attend an annual meeting and speak up for your rights
3 find an online message board and rally other stockholders
For your cause
The objective of efficient operation
Produce at low cost and find most profitable articles to sell
The typical management will operate with more capital than necessary
This is bad for stock holders and often permitted by them
Instead of paying cash dividends some companies waste the
Money and others pile it up without putting it to use
Mergers 1995-2001
61% ended up destroying wealth for shareholders of acquiring
Companies
Acquirers using stock rather than cash, underperformed
Competitors by 8%
Acquisitions of private companies and subsidiaries of a public company
Have more often lead to positive returns
When a company piles up cash and interest rates are low
Produces lousy returns for shareholders if the cash just sits
Around, better if company pays a dividend
Higher dividends and dividend increases
Often lead to higher earnings growth
Dividend increases are associated with higher future profitability
For at least 4 years after dividend change
Stock options granted by company
Give executives and employees the right to buy shares in the
Future at a discounted price
Exercising the options
Conversion of options to shares
Repurchase of shares
Good when stock price is low
Bad when it is merely done to offset dilution of stock options,
Because company is wasting its money
Share repurchases in 2000
In 2000, companies were spending 41.8% of their net income
To repurchase their shares, up from 4.8% in 1980
Option exercising: taxes and income statement
Companies get a tax break when executives and employees
Exercise stock options (IRS considers compensation expense)
Stock options are not counted as an expense on the income
Statement, but are counted as an expense on the tax return
Stock options and dividends
Dividends decrease the volatility of a stock, which decreases
The value of stock options for managers
This is why managers prefer to buy back shares at high prices
Over paying dividends
Earning power AKA earnings yield
What a company can earn year after year if business conditions Stayed unchanged (usually 5 years or more)
Earning power calculation
Inverse of the PE ratio
Ex. PE of 11, has earning power of 9%
Margin of safety for bonds and preferred stock
Total enterprise value - debt = margin of safety, also pretax
Earnings must be 5 times interest charges
Ex if a business owes $10 million and is fairly worth $30 million,
Theoretically there is room for shrinkage of 2/3s of value before
Bond holders suffer a loss
When a company has outstanding only common stock, that in depression conditions is selling for less than the amount of bonds that could be safely issued against the property and earning power
In this case investor can obtain the margin of safety associated
With a bond and chances of larger income and principal
appreciation in common stock
Why does the market have a stubborn habit of valuing earnings disbursed as dividends more generously than the portion retained in the business?
In many cases reinvested earnings fail to add commensurately
to the earning power and value of the stock
Chief losses to investors come from buying…
Low quality securities in favorable market conditions
Bargain issues worth buying
Have a margin of safety
Have prospects neither promising or unpromising
Margin: in margin of safety
Margin guarantees a better chance for profit than for loss
Diversification
Demonstrates investor’s acceptance of the margin of safety
Principle
Business principles: know your business
You must know the business if you intend to make business
Profits in excess of normal interest and dividend income
Business principle: don’t let anyone else run your business unless… 2 things
1 you can supervise his performance with adequate care and comprehension
2 you have unusually strong reasons for placing implicit
Confidence in his integrity and ability
What business operations should the investor avoid?
Avoid ventures where you have little to gain and much to lose
Operations for profit should be based on arithmetic rather than
Enthusiasm
Have courage of your knowledge and experience
If you have formed a conclusion from the facts and you know
Your judgement is sound, act on it
In the world of securities, courage becomes the supreme virtue
After adequate knowledge and tested judgement are at hand
How must an investor limit their ambition
Investor must realistically assess what they have capacity in
And limit investment activity to those confines
What 2 factors characterize good investment decisions according to psychologist Daniel kahneman
1 well calibrated confidence
2 correctly anticipated regret
Well calibrated confidence
Do I understand the investment as well as I think I do?
Correctly anticipated regret
How will I react if my analysis turns out to be wrong
Probability
Before you invest, you must assess your probability of being right
And how you react to the consequences of being wrong
Margin of safety equation
Margin of Safety = Actual Sales - Break Even Sales
