Financial Education

Asset allocation is the process of determining how much of your porfolio should be invested in each type of investment security, such as stocks, bonds or real estate. This decision must be made before selecting individual securities.
Your optimal asset allocation will depend upon the return you desire to earn in order to meet your investment objectives and the risk you are comfortable with taking. Generally, investments which have a low degree of risk (such as bank savings accounts) offer a relatively low return. Investments which have a higher level of risk must offer a higher return to compensate you for this risk. For investment securities it is common to talk about long term average returns and measure risk as the standard deviation (variation about the average) of returns. A higher standard deviation means higher risk. Risk can also be measured as the percentage of years in which a loss would have occured. Long term average returns, standard deviations and percentage of years in which there was a loss for selected types of investments have been:

This data includes large and small stocks and a composite of long term and short term bonds.
Since not all investments perform the same in every year, you can improve the risk/return relationship by allocating a portion of your porftfolio into the different investment types. For example, by allocating 75% to stocks and 25% to bonds you could have acheived during this same time period an average return of about 10.5%, a standard deviation of 19% and about 25% of the years would have been losses. Alternatively if you invested 50% in each, the average return would have been about 9%, standard deviation 13% and about 23% of the years would have been losses. The asset allocation reduces return a little, but risk quite a bit.
Diversification accross different types of investments is important if you desire to acheive a better return relative to the risk of the investments. The optimal asset allocation depends upon a number of factors such as risk tolerance, time horizon and investment objective.
Please note the data presented above are based on long term historical returns and are not indicative of future returns. In fact the additional return of stocks over bonds has declined over time and stock returns are expected to be more modest in the near term.

Once an appropriate allocation between different investment types (for example, stocks, bonds and real estate) has been determined, individual securities (or mutual funds) must be selected within each investment type.
There are two basic approches to individual security selection: top-down and bottom-up.
In a top-down approach the analyst examines the overall economy and market and selects sectors (for example, healthcare or financial) that are expected to perform well in the current environment. Individual companies are then selected within each sector based upon desired characteristics.
In a bottom-up approach the analyst first idenifies individual companies with desired characteristics and then examines the prospects for those companies given current economic and market conditions.
Regardless of which approach is taken it is important that the economy, market and industry conditions are considered when making the desicion to invest in individual securites of any type.
In evaluating individual securities there are also two main approaches: fundamental and technical. Fundamental analysis deals with examining a host of data such as a company’s financial statements, ratios and management in selecting securites for investment. Technical anlaysis involves looking at past trends in market price and volume information to discern the underlying trend in a security. These trends reflect underlying supply and demand and investor behavior.Often these two techniques are viewed as mutually exclusive (some people follow one but not the other). Another view is that the approaches are complimentary, a company may look great fundamentally but technical analysis may indicate it is not the best time to buy.

Fundamental analysis is the process of examining the investment characteristics, performance, condition and value of a company in order to make an investment decision (or governmental entity in the case of government bonds).  Company fundamentals include financial statements, ratios and valuation measures, among others.  The impact of the current economic and market environment on these fundamentals is also considered.

Financial Statements

There are three primary financial statements utilized in fundamental analysis (along with scrutiny of footnotes and SEC filings):  the income statement, the cash flow statement and the balance sheet.  The income statement presents the performance of the company during the period and whether it earned a profit from its primary business activities and peripheral activities.  The cash flow statement presents the sources and uses of cash by the company and whether operating cash flow is sufficient to make future investments, repay creditors and make distributions to owners.  Note that net income by itself can not be used to pay employees, suppliers, creditors and others – this takes cash flow.  A company needs to earn both positive profits and positive operating cash flow over the long term.  The balance sheet presents the current financial position of the company; assets or resources and the claims against the resources by creditors and owners.  The company needs to have sufficient assets to operate the business efficiently and if necessary sufficient to repay creditors and owners if the company needs to be dissolved.

Ratios

Ratios are created by using financial data from the financial statements to evaluate the company’s liquidity (ability to pay short term obligations), solvency (ability to pay long term obligations), efficiency (utilization of resources), and profitability (ability to generate profits based on sales, assets or owners’ equity).  There are numerous ratios which can be created.  Here we present one example in each category.

Liquidity:  The current ratio (current assets divided by current liabilities) measures whether the company has sufficient current assets such as cash to pay their current liabilities.  The higher the ratio the more liquidity.

Solvency:  Total liabilities divided by total assets measures how much leverage the company has in their capital structure.  The higher the ratio the higher the financial leverage and risk.   A lower ratio indicates better solvency (however, debt has positive attributes as well).

Efficiency:  Total asset turnover (sales divided by total assets) measures the amount of sales generated per dollar of assets.  A high number means efficient utilization of assets and better efficiency.

Profitability:  Return on equity (ROE) is net income divided by the total equity investment of the owners over time.  For example, an ROE of 12% means the company generates $12 of net income for every $100 previously invested by owners.  Higher ROE means higher profitability.

Valuation

In making an investment decision for all investments (whether stocks, bonds or real estate) it is important to forecast the expected cash flows to be received from the investment.  The value of the investment is the present value of these cash flows discounted from the future back to today using the rate of return you need to get based on the risk of the investment.  This is known as an absolute valuation method.

You should also consider relative valuation which is the value of the security relative to other similar investments.  For stocks a popular relative valuation method is the P/E ratio, measured as the price per share divided by the earnings per share from the income statement.  A high number indicates the company is selling at a high price relative to earnings (perhaps because earnings are expected to grow in the future or the security is overpriced).  A low number indicates the company is selling at a low price relative to earnings (perhaps a good buy or poor growth prospects).  Other relative valuation metrics include price to sales (P/S), price to cash flow (P/CF) and price to book value (P/BV).

In the case of fixed income securities (bonds) you can examine the promised yield to maturity relative to securities of similar risk and maturity to determine if your expected return is sufficient for the risk involved.

Technical analysis involves a study of past price and volume data to discern underlying trends for a security or market. The price of any asset is partly a function of supply and demand factors. If demand exceeds supply the price should rise. Conversely if supply exceeds demand the price should fall. The underlying supply and demand as well as the behavior of all investors is reflected in charts of price and volume data. A technical analyst examines these charts to determine if the current trend is expected to continue or to reverse. Technical analysis can be useful in evaluating individual securities, industries and the market as a whole.

There are many technical indicators; we will discuss only a couple of examples. A support level is a point at which buyers step in an begin buying a security. When a stock falls to this level the buyers typically step in and the security should either stay at that level or rebound (if however, the price falls below a level which has represented a support level in the past this is a negative sign). Conversely, a resistance level is a level at which the security stalls when it is rising. At this point investors are selling. A moving average line is an average of a certain number of days of prior price data. If a price is below the moving average line and moves above it, this is a positive indicator. Conversely, if the price is above the moving average and moves below it this is a negative sign.

Suppose someone told you that a particular company had $1 billion in earnings one year. Is that good or bad? The answer depends on many factors, including:

• How much revenue did the company book in order to achieve those earnings?
• How much did competitors of a similar size earn?
• How much did the company earn last year?

How can an investor fairly compare one company’s earnings to another, given that they cannot be exactly alike in all other respects? How can the firm’s performance be compared to its past performance to determine whether it is improving? Common size analysis is one tool that allows investors to compare companies across time and with other companies.

The following articles explain how to use common size analysis in practice:

1. Vertical Common Size Income Statements shows how to express the income statement as a percentage of sales and use this data to analyze a company’s performance over time.
2. Horizontal Common Size Income Statements demonstrates how to express the financial statements in each year as a percentage of a given base year. This permits an investor to see if certain expenses, assets or liabilities are growing faster than others.
3. Common Size Balance Sheets can be used to compare companies even when they use different currencies.
4. Using Common Size Statements to Forecast Earnings shows how to do just that.

Vertical common size financial statements remove the impact of size by expressing each line item as a percentage of a reference item, usually sales or assets. In a spreadsheet this can be done simply by dividing each line item by that year’s net revenues figure. Consider the following, which is the 3-year income statement presentation for Plantronics, Inc. included in their 10K statement filed June 5, 2006.

We can see right away that in Plantronics’ 2006 fiscal year its net income fell even though revenues increased significantly. However, it is not so easy to tell exactly why the performance deteriorated. Now consider the same statement expressed in a vertical common size format.

Presented in this format, it is easy to see that a significant increase in the cost of sales relative to total sales drove declining profit margins.

See also:
Common Size Financial Statemtents
Vertical Common Size Balance Sheets
Horizontal Common Size Income Statements

A vertical common size income statement expresses expenses in a given year as a percentage of that year’s sales, which allows an investor to evaluate a company’s performance over time. Another approach to this type of analysis is a horizontal common size income statement. In this case, each line item on the income statement in a given year is pegged to a base year, such as the prior year or some arbitrary starting year.

Consider the following, which is the 3-year income statement presentation for Plantronics, Inc. included in their 10K statement filed June 5, 2006.

In the example of a vertical common size statement we discovered that cost of goods sold rose to 56.5 percent of sales in fiscal year 2006 from 48.5 percent in 2005. Now consider the same income statement expressed in the horizontal common size format. In this case, 2004 is used as the base year for each of the subsequent years.

In this format, the same data can be inferred because we see that sales grew 80 percent from 2004 through 2006 while cost of sales grew 111 percent. (In each case taking the ending value and subtracting the 100 percent starting value.) Since cost of sales are rising much faster than sales themselves, it is clear that profitability is falling.

See also:
Common Size Financial Statements
Vertical Common Size Income Statements
Horizontal Common Size Balance Sheets

We have shown how to prepare vertical common size income statements. This article addresses how they can be used to forecast future earnings.

Consider our vertical common size income statement for Plantronics, Inc.

Right away we can see that research and development expense has remained fairly stable between 8.1 and 8.5 percent. This suggests that Plantronics views them at least partially as a variable cost. Higher revenues would result in higher expense, and the company might trim the expense if sales decline. An earnings model might assume that R&D for Plantronics would be 8.3 percent of sales, and the resulting estimate would probably be close to the actual figure.

Now consider the horizontal common size statement.

This shows that selling, general and administrative expense is consistently growing slower than revenue, which in turn suggests that there is a fixed cost component to this expense. As revenues rise, the fixed part of the expense doesn’t rise but the variable portion does. By looking at the relative change (the change in SGA divided by the change in revenues) shows a one year relationship of 65 percent and a two year relationship of 75 percent. In other words, in 2005 SGA grew 65 percent as fast as revenue and in from 2004-2006 they grew 75 percent as fast. We could assume a 70 percent average rate, but the two-year trend is probably more accurate than a single year so perhaps an estimate closer to 75 percent would be more appropriate.

When making this type of estimate, it helps to look into the footnotes to see if there will be any unusual expenses or changes to the historic relationship. An example of this can be found on Stock Market Beat, in a post titled Plantronics Valuation. Plantronics plans to increase both its advertising expense and its capital expenditures (future fixed costs) in 2007. Given this data, we will go with an estimate that SGA will grow 75 percent as fast as sales.

The same method can be used to evaluate cost of sales. Again looking at the footnotes we see that cost of sales is rising due both to increased capital expenditures and to a shift to more consumer products at lower margins. This shift may continue since the recent acquisition added new consumer lines, which might bring cost of sales up to 60 percent of revenues from the current 56.5 percent.

So now we can design an earnings model:

See also:
Common Size Analysis
Vertical Common Size Income Statements
Horizontal Common Size Income Statements

Just as with income statements, common size balance sheets can be presented either vertically or horizontally. A horizontal common size balance sheet expresses each year’s balance sheet items as a percentage of a given base year, while a vertical common size balance sheet expresses them as a percentage of a reference item.

Typically vertical common size balance sheets are presented in reference to total assets. This format allows the investor to compare the capital structure over time and across companies. In fact, creating such a presentation allows an investor to compare two companies even if they use different currencies, as both size and currency exchange issues are negated with the conversion to common size.

For forecasting purposes, it may also be useful to prepare a vertical common size balance sheet referencing each line item to sales. This is because many current assets and liabilities (accounts receivable, inventory, accounts payable, etc.) are influenced by the company’s sales level.