Financial health

May 17, 2020

Long-term investors depend on their stocks to remain viable during economic recessions.  In today’s Coronavirus Pandemic, businesses of all sizes are losing income from the forced reduction of consumer spending, which may destabilize companies to the brink of bankruptcy.  Investors can assess stability by reviewing the financial health of their companies.

Financial health is the ability to pay all obligations in a timely matter.  Credit ratings and analyst reports use propriety methods to measure financial health.  You can independently rate the financial health of a public company using a single numerical score from 0 to 10 based on liquidity and solvency; the higher the score, the healthier the company (eq. 1).

equation 1:    Health = Liquidity + Solvency

Liquidity

Liquidity refers to the ease of converting current assets into cash for payments of current liabilities.  Current assets are considered convertible to cash within one year.  Some assets are more liquid than others. Savings accounts, checking balances, money market funds, and receivables [i.e., customers’ IOUs] represent liquid assets. Inventory [i.e., unused supplies and unsold products] is considered an illiquid asset.  Current liabilities are the costs of paying business expenses such as wages, payables, and interest on short-term credit.  The following ratios provide useful measurements of liquidity:

  • Current ratio = Current assets / Current liabilities.
  • Quick ratio = (Current assets – Inventory) / Current liabilities
  • Interest coverage = EBIT / Interest  [EBIT is the company’s earnings before accounting for the charges of interest and tax; EBIT is a measure of recurring income]

 

liquidity

chart 1

Solvency

Solvency refers to the liquidation value of a company in case the company must pay all of its short-term and long-term liabilities. I use the shareholders’ equity [aka net worth or book value] as a common denominator for the measurement of solvency.  Solvency ratios and free cash flow provide useful measurements:

  • Debt-to-Equity = Long-term debt / Shareholders’ equity.
  • Financial Leverage = Total assets / Shareholders’ equity.
  • Free Cash Flow = Operating cash flow – Capital expenses

 

solvency

chart 2

Examples

Chart 3 displays health scores for a list of companies identifiable by stock tickers; they are the current holdings of my investment club.  The data were calculated with the formula in eq. 1 using open source data for liquidity and solvency.  Three stocks received low health scores of 2.

health

chart 3

From chart 3, I selected five strong competitors of VZ and CMCSA to determine if the low health score represents a larger group of 7 competitors listed in the trading sector of Communication Services.  The additional competitors are listed below in chart 4. Three of the additional competitors matched the scores of CMCSA and VZ, inferring that most companies in that select group operate with low liquidity and solvency.

competitors

chart 4

Another comparison was made using a sample of stocks with an open-source, proprietary grade of low financial health (chart 5).  One stock, JCP, recently filed for chapter 11 bankruptcy.

others

 chart 5

Risk management

The health scores in chart 3 are based on historical data at least 3 months old.  Stocks with the lowest scores are considered more unstable.  If, in your informed opinion, there’s a credible risk of bankruptcy and delisting, you can protect your investment by either selling the stock or placing a stop-loss order on it.

Conclusion

Open-source financial data can be used to assess the risk of potential bankruptcy and delisting among publicly traded stocks, especially during an economic recession.  Combined assessments of liquidity (chart 1) and solvency (chart 2) additively form a health score of 0 to 10, with lower scores implying poor financial health.  The scoring system is easy to implement, but unreliably predicts financial failure of public companies with low scores.  Additional fundamental analysis of the company is strongly recommended and meanwhile, if you wish to protect your investment from a substantial loss, place a temporary stop-loss order on the holding.

Copyright © 2020 Douglas R. Knight 

 

 

 

 

 

 


What is a stock and how much is it worth?

August 21, 2018

A stock is an offering of part ownership in a company.  Each part, — called a share—, is worth the price that buyers are willing to pay.  

A new stock is sold for the first time in the primary market.  The primary market is a private one comprised of the company’s founders, venture capitalists, and third parties such as banks and advisors.  Venture capitalists take a big risk that the company might fail.  In return, they have considerable influence on how the company is governed and operated.  They hope to earn a generous profit from selling their shares.

The stock may be sold again in the secondary market by public auction.  The secondary market is the familiar stock market where thousands of investors, —like us—,  trade cash for stocks and other exchange-traded securities.  We also hope to earn a generous profit from selling shares. Some companies may occasionally choose to pay us a cash bonus called a dividend.

Wise buyers seek the best price for a good company.  The best price is determined by ‘valuation’ and the quality of the company is assessed by ‘fundamental analysis’.

Copyright © 2018 Douglas R. Knight


Ways to invest in stocks

July 19, 2018

There are thousands of  investors who want to own ‘good’ companies that avoid ‘trouble’.

  • they invest in stock shares [stock shares are equal units of part ownership]
  • a good company
    • operates a profitable, growing business
    • avoids financial distress and regulatory penalties

Investors purchase and sell shares in the stock market.  They hope to sell their stock at a desirable price and may also receive cash rewards from companies that pay dividends.  Investors earn a profit (called a capital gain) when the sales price is above their cost of investment or lose money (called a capital loss) when the sales price is below cost.  

Stock Analysis

Two ways of evaluating a stock are called technical analysis and fundamental analysis.  Technical analysis measures the performance of share prices and share volumes in the stock market.

  • Shares are units of part ownership which are traded in the stock market.
  • Price: the price of a share in the stock market.
  • Volume: the total number of shares traded in the stock market 

Fundamental analysis evaluates the business performance of a company by way of searching through its quarterly and annual filings.  The business description, financial statements, and CEO’s annual letter to shareholders are important sections of the filings.

  • CEO: Chief Executive Officer; top manager of the company.
  • Filings: periodic reports to shareholders that are required by the U.S. Securities and Exchange Commission (SEC).

Business performance is also assessed by the company’s market share and competitive advantage within its industry.  This information is available online.

Investment Strategies

The most common investment strategies for stocks are swing trading, value investing, and growth investing.  

Swing trading (cyclic trading) uses brief upward or downward trends in share prices to determine when to buy or sell stocks.  The typical holding period is from one day to several weeks.  The investor hopes to earn a capital gain (–if seeking a profit–) or capital loss (–if seeking to reduce the short term capital gains tax–).  The investor uses either a technical analysis or guesswork to judge the price trend.  The main risks of incurring a loss are due to price volatility and taxation of returns.

  • Hold: to own.
  • Short term: one year or less.
  • Short term capital gains tax: the taxation of a capital gain at the regular income tax rate.
  • Price volatility: the random fluctuation of prices based on the market forces of supply and demand.
  • Return: the profit or loss from an investment.

Value investing seeks a capital gain by purchasing the stock at an unusually low price (e.g., 60% of intrinsic value) and then selling it at approximately double the purchase price.  The holding period depends on the length of time for the stock price to become profitable. During the holding period, an investor will receive any dividends paid by the company.  The informed investor uses a fundamental analysis to assess the quality of the company and the intrinsic value of its stock.  The causes of an unusually low price include a market downtrend (e.g., economic recession) and poor company performance.  The main risks of incurring a loss are due to an eventual delisting of the company and taxation of returns.  

  • Intrinsic value: the share price calculated by a professional analyst’s secret formula.  However, you can estimate the intrinsic value as the net worth of the company (book value) per share, based on the idea that a wealthy investor could acquire the company at its intrinsic price by puchasing all shares of stock at the book value per share.   
  • Dividend: a cash reward paid to share holders from the company’s profits or cash reserves.
  • Delisting: removal of the stock from the stock market for various regulatory reasons, including bankruptcy of the company.    

Growth investing is a long term strategy for using the upward momentum of share prices to earn a capital gain. The capital gain is earned by simply holding the stock and reinvesting all dividends.  The rule of 72 estimates the holding period needed to double the purchase price of the stock at an assumed rate of annual return.  The growth investor uses a fundamental analysis of the company and market valuation to judge the fairness of the stock price.  The main risks of incurring a loss are due to deterioration of the company, decline in market value, and taxation of the returns.

  • Long term: after one year.
  • Momentum: an upward trend of share prices.
  • Rule of 72: [ Years to double the price = 72/percentage annual rate of return ] For example, a 15% annual rate of return will double the share price in 4.8 years. 
  • Annual rate of return: a constant percentage change in value every year that accelerates the growth of an investment; CAGR is an acronym for the annual rate of return.
  • Valuation: the art of judging if the price is low (discounted, undervalued) or high (expensive, overvalued). 

disclaimer: this article may not increase your investment profits.

Copyright © 2018 Douglas R. Knight


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