Getting started in security analysis

Page i Getting Started in Security Analysis Page ii The Getting Started In Series Getting Started in Stocks by Alvin D Hall Getting Started in Security Analysis by Peter J Klein Getting Started in Futures by Todd Lofton Getting Started in Mutual Funds by Alan Lavine Getting Started in Metals by Jeffrey A Nichols Getting Started in Rare Coins by Gregory C Roy Getting Started in Bonds by Michael C Thomsett Getting Started in Options by Michael C Thomsett Getting Started in Real Estate Investing by Michael C Thomsett and Jean Freestone Thomsett Page iii Getting Started in Security Analysis Peter J Klein Page iv This book is printed on acid-free paper c00iv01.gif Copyright © 1998 by Peter J Klein All rights reserved Published by John Wiley & Sons, Inc Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744 Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 8506011, fax (212) 850-6008, E-Mail: PERMREQ@WILEY.COM This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that the publisher is not engaged in rendering professional services If professional advice or other expert assistance is required, the services of a competent professional person should be sought Library of Congress Cataloging-in-Publication Data: ISBN 0-471-25487-8 Printed in the United States of America 10 Page v For Sidney "Sonny" E Ackerman, my grandfather, and Irene, Courtney, and Kelly, my world Page vii ACKNOWLEDGMENTS I want to thank the numerous colleagues and professors who have put up with my incessant questions and pondering at the lectures, seminars, and courses that have made up my academic and professional career Special thanks to the following: William Avera, Randall Billingsley, CFA; Vincent Catalano, CFA; Don Chance, CFA; Carl Crego, CFA; Richard DeMong, CFA; Jack Francis; Robert Johnson, CFA; Charles Jones, CFA; Allan Marcus; Richard McEnally, CFA; Jack Rader, CFA; Carl Schwezer, CFA; Vincent Su; and Andy Temte, CFA In addition, The Association of Investment Management and Research (AIMR) deserves a round of applause for their efforts to increase the academic awareness in the investment management profession In addition to my academic mentors, the following colleagues deserve special thanks for their frequent "raising-of-the-bar"; without this push, it would have been too easy to give up midstream: Barry Buchsbaum; Neil Caren; Robert Clark; Al Coletti; Steve Dannhauser; Lawrence Davidow; Elliot Denrich; Larry Doyle; Joseph Fuschillo; Ted Goldman; Ron Goldstein, CPA; Peter and Maris Gordon; David Gutwirth; Marten Hoekstra; Stewart Kamen; Thomas Lukacovic, CFA; Stuart Lustberg; Francis McGrail; Edward Moy; Alan Ripka; Michael Ryan, CFA; Jonathan Sack; Steven Sack; Thomas Salshutz; Andrew Semjen; Greg Sherwood; Scott Sherwood; Robert Singer, CPA; Steven Stern; John Sullivan, CFP; and Anthony Turco For that special ilk of investor known as my client (or more closely defined as partner) a very special thank you is offered for providing business insights often missed by Wall Street analysts, understanding with regard to my hectic schedule, constant efforts at keeping me humble and most importantly, their friendship Most particularly the following receive my kudos: Kelly Chen, Claire Friedlander, Paul Golub, Robert Grajewski, Norm and Sandy Gruber, Murray Kaye and his "boys", Dick Kitts, John Morse, Mitch Nichnowitz, Harry and Lilly Novinson, Joe and Nancy Payne, Peter Perry, Jacob Solome, Brooke Trent, Andy Tunick, Joe Walsh, Paul Watson, Jules Weiss, Carley Zell, and Stacy Sack Zuckerman Page viii No work of this type could be possible without assistance from a topnotch office Monique Abel, Rosemary Davitt, Scott DeLucia, Kevin Dowd, John Hennigan, Mary T Nigro, and Jane Voorhees have all played a special part in bringing this book to completion In addition, a very special acknowledgment is bestowed on Brian Iammartino of The Wharton School at The University of Pennsylvania; Brian's input and technical prowess have been invaluable in completing this project Claudio Campuzano, Mina Samuels, Jacqueline Urinyi, and Mary Daniello at John Wiley & Sons, and the team at Publications Development Company of Texas provided editorial assistance in developing a format for this work that could be understood by the typical investor Robert Zenowich provided valuable editorial reworking Without their help, this book would still be an open file on my laptop Lastly, a great big thank-you goes out to my family—without their understanding, compassion, and faith, I certainly would not have had the mettle to carry on when things looked their most bleak Special thanks to Rose Ackerman, Roland and Deb Buzzard, Mrs Peter Cassia, Michael and Anne DuBois, Rich and Karen Kerr, Mr and Mrs Richard Kerr, Christopher J Klein, Michael and Joanne Klein, Anthony and Christine Petronella, the Schilling Family, Carole Turco, Vinny Turco, Mr and Mrs George Walsh, and Tommy Walsh To my loving wife and wonderful children—"Daddy's home"! P.J.K Page ix CONTENTS Introduction Part One: Tools of the Trade 11 Chapter Accounting 15 Chapter Economics 35 Chapter Investment Mathematics 71 Chapter Quantitative Analysis 89 Part Two: Fundamental Financial Security Analysis 109 Chapter Equity Analysis and Valuation 111 Chapter Credit Analysis 147 Part Three: Portfolio Management 179 Chapter The Investment Management Process 181 Page x Epilogue 255 Appendix A Internet Directory 259 Appendix B Selected Tables 267 Bibliography 279 Index 281 Page 289 Money supply (M2), as economic indicator, 53, 77 Moody's Investor Service, 160 Morale, significance of, Mosaic Theory, 253 MS EAFE (Morgan Stanley Europe Asia Far East) index, 39 Multinational corporation (MNC): international parity conditions, 41 purchasing power parity (PPP), 71 Multistage (2-Stage) Model: application of, generally, 130 defined, 135, 137 equity valuation case study, 141-145 Municipal bonds, 166, 174-175 Mutual funds, 213, 240 N National Association of Purchasing Managers (NAPM), 44, 45 National Association of Realtors, 70 Net income, 21, 33, 114 Net present value (NPV): defined, 19, 72, 76-80 examples of, 77-78 growth evaluation and, 133 positive, 119 New Age, of investment management, 39 New entrants, threat of, 127 New equity, 131 New orders, as economic indicator, 53 New products, 10 Newsgroups, as information resource, 263-264 No-load funds, 214 Noncurrent assets, 17-18 Nondurable goods, 57 Nonfinancially interested individuals (NFIIs), 35, 39, 82 Nonpublic information, 252 Normal distributions, 96 O Offering memorandum, 162 Oligopoly, 177 Operating expenses, 20-21 Operating margin, 117 Operations, equity investments and, 8-9 Outliers, 93 Ownership, equity investments and, P Parity: interest rate, 72-77 international conditions, 39-42, 69-70 purchasing power, 69, 70-72 Passive investor, 190-191 PATIROC, 5, 10 Payout ratio, 131 Pearl Investment Management, AIMR Professional Conduct case studies, 224-234 People, equity investments and, 5-6 PepsiCo, Inc., 9, 124, 274 Performance management, 111-112 Performance ratios, 154-155 Permits, as economic indicator, 52-53 Peters, Tom, 120 PFVA (present value factor of an annuity), 82-83 Philanthropy, 195 Pooling method, merger and acquisition accounting: defined, 28-29 sample, 30-31 Porter, Michael E., 112, 121, 158 Portfolio, generally: efficient, 239 construction and implementation of, 205-207 management, see Portfolio management modern theory, see Modern Portfolio Theory monitoring, 213-214 Portfolio management: Capital Asset Pricing Model (CAPM), 240-241 decision-making, 162 ethics, in financial services industry, 241-250 investment management process, see Investment Management Process Page 290 Modern Portfolio Theory, 234-241 Portfolio Selection Theory, 237-240 Security Market Line (SML), 241 Positive accounting, 13, 155 Premium, bonds, 166 Present/Future Value and Annuity Tables, 73 of annuity, 83 defined, 75-76 net, see Net present value (NPV) sample problems, 75-76, 83-85 samples, 275-277 Present value factor (PVF), 77, 79 Price: bond market, 164 increase in, 131 to sales, 135 stocks, 167 Proactive investors, 5, 119, 138 Proactive treasurer, Producer price index (PPI), 58-59 Profitable pruning, 131 Property, plant, and equipment, 18 Psychographics, individual investors, 190-191 Purchase method, merger and acquisition accounting, 28, 33 Purchasing power parity (PPP): defined, 69, 70-72 equation, 12 mathematical notation, 72 quick math notation, 72 PV (present value), see Present value (PV) Q Qualitative analysis: in credit analysis:, 157-160 equity analysis, 119-121 Quantitative analysis: basic statistics, overview, 90-98 importance of, 11, 13 problem sets, 98-99 roots of, 89 Quick ratio, 153 Quotes, on Internet sources, 261-262 R Range, 93 Rate of return: CAPM equation, 240 internal, see Internal rate of return (IRR) risk evaluation, 128 Rating agencies, 160 See also Standard & Poor's (S&P) Corporation, Corporate and Municipal Rating Definitions Ratio analysis, 149-151 Ratios, see specific types of ratios Real estate investments, 76 Red flags, in credit analysis, 158 Regression, example of, 121 Regression analysis: application of, 37 correlation, 103-104 covariance, 102-103 financial analysis and, 11 linear regression, 101 problem set, 107-108 regression, defined, 100 sample, 101-102 simple, example of, 104-106 Regulatory environment, 159, 178 Releases, economic, see Economic releases Research: economic, 36 investment, see Investment research, Internet Research and development, 7, 176-177 Reserves, 159 Restrictive covenants, 162 Retention ratio, 129 Retirement planning, 195-197 Return, equity investments and, Return on assets (ROA): credit analysis and, 154 defined, 119, 154-155 Return on equity (ROE): components of, 116-119 credit analysis, 151, 154-155 credit rating and, 173 definitions, 114-116 Page 291 Du Pont Derivation Equation, 113 equity valuation, 135 function of, 112 growth evaluation, 129-130 industry average, 118 net, 119 Revenue, income statement, 19 Revenue recognition methods, 159 Risk: active investors and, 191 in bond market, 165-166 CAPM equation and, 242 equities vs bonds, 201 equity valuation, 128-129 international investments, 41 investment policy statement, 184 investor life cycle and, 201 portfolio selection theory, 237-240 Rivalry, among existing firms, 128 Roach, Stephen, 59 Rule of 72, 194 S Sayles, Tom, 107 Scared investors, 192-193 Seasonality, 151 Securities Enforcement Remedies & Penny Stock Reform Act (SERPSRA), 254 Securities and Exchange Commission (SEC), 254, 261 Security, characteristics of, Security Market Line, 180, 236 Self-assessment, investors', 183 Self-managed portfolios, 192, 198 Senior management, 5-6, 10 Sensitive materials, 54 Shapiro, Alan, 43 Shareholders, 115 Sharpe Ratio, 236 Sherman, Peter, 224-234 Short-term money market instruments, Simple regression, 104-106 Slow-growth companies/industry, 158, 176 Small-cap holdings, 209 Social Security, 195 Solnik, Bruno, 70 Sounds-too-good-to-be-true investments, 82 Specific risk, 239 Spending phase, investor life cycle, 195 Spot rate, 61 Standard & Poor's (S&P) Corporation, 160 Corporate & Government Bond Yield Index, 170 Corporate and Municipal Rating Definitions, 167-169 International Stock Guide, 229, 232 Standard & Poor's 500 Index, 39, 198 Standard deviation, 95-97 Standard industrial classification (SIC), 50 Standards of Practice Handbook (AIMR), 3-4, 223, 225 Start-up costs, 159 Statement of Financial Accounting Concepts (SFAC) 5, ''Recognition and Measurement in Financial Statements of Business Enterprises," 114 Statistics, see Quantitative analysis central tendency measures, 90-93 confidence limits, 96-97 dispersion measures, 93-95 financial analysis and, 11 sample problems, 98-99 Stock(s): options, 16 performance, business cycle and, 57 prices, 54, 78, 167 repurchase, 29 Stockholders' equity, 18-19 Straight-line depreciation, 22, 26, 32 Substitutes, threat of, 127 Sullivan, Jack, 198 Sum-of-the-years digits (SOYD), 27 Suppliers, power of, 127 Supply sources, 177-178 Symmetrical distributions, 96 Systematic risk, 239 Page 292 T Tangible assets, 21 Taxation: dividends and, 132 double, 132 estate, 195 income, 199 investment policy statement, 184 Tax burden, 117 Tax law, corporate, 21 Technological advances: equity investments and, 7-8 impact of, 127 Telecommunications industry, 21 Third party endorsement, 162 Time horizon, investment policy statement, 184, 200 Times interest earned, 157-157 Top management, 119 See also Senior management Trade-related debt, 18 Treasury bills, 184, 201 Trend analysis, 34, 57-58 U Uncertainty, 201 See also Risk Understates theory, 59 Underwriter, 161-162 Unemployment rate, 50-51 Unique issues, investment policy statement, 185 U.S Department of Commerce, 50-51, 61 U.S dollar, 35, 40-41, 71, 74-76 U.S international trade in goods and services, 57-58 Unsystematic risk, 239 UTA Company, managerial accounting sample, 24-26 V Valuation, generally: analysis, 33 equity, see Equity valuation financial analysis and, 112 significance of, 15-16 Value investors, Value managers, 204 Variable cost, 20, 24 Variance, 94-95 Variation, 93-94 Vendors, multiple, 127 Vertical integration, 158-159 Very financially interested individuals (VFIIs), 35-39, 71, 82 Volatility: in capital markets, 203 credit ratings and, 173 growth evaluation and, 130 management, 202 W Wall Street Journal, The, 39 Watch List, 253 Waterman, Robert H., 120 Wells Fargo Bank, Working capital, 153 Workweek, average, 53 World Wide Web, 259, 264 See also Internet directory Y Yellow flag, in credit analysis, 154 Yield, in bond market, 164-165 Yield to maturity (YTM), 164-165 ... i Getting Started in Security Analysis Page ii The Getting Started In Series Getting Started in Stocks by Alvin D Hall Getting Started in Security Analysis by Peter J Klein Getting Started in. .. Lofton Getting Started in Mutual Funds by Alan Lavine Getting Started in Metals by Jeffrey A Nichols Getting Started in Rare Coins by Gregory C Roy Getting Started in Bonds by Michael C Thomsett Getting. .. Thomsett Getting Started in Options by Michael C Thomsett Getting Started in Real Estate Investing by Michael C Thomsett and Jean Freestone Thomsett Page iii Getting Started in Security Analysis