Part 5: Reader Q&A

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First off, thanks for all of the well-thought-out questions and supportive comments on our recent

series on dissecting companies' financials. Many readers, it seems, are already methodically hacking away at the tangled jungle of fundamental analysis, searching for undiscovered jewels in the form of solid, long-term investments.

Most also seem well aware of the inherent vagaries of their chosen labor yet remain undaunted by the challenge. They prove that the concept of hard work and discipline is still intact even amid the market's siren song of quick and easy money.

Your questions highlight what a tough chunk of meat we bit off to chew and why other publications rarely tackle the subject. There seem to be as many ways of analyzing a company's finances as there are investors out there to crunch the numbers. And while plenty of approaches are just plain wrong, you'll rarely find a single right way or one that magically releases a cudgel-toting genie to beat you over the head with a definitive answer. The process is just too big to fit neatly into a one-size-fits-all formula.

This Q&A will be an attempt to keep you out of the quicksand and on the firm ground of proven analytical principals. It will also be a place where

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readers can exchange ideas on fundy analysis. If you have further questions or ideas to contribute,

send them my way, with your full name.

What Is Shareholder's Equity?

In the "Balance Sheet" piece you mention that assets are recorded at book value (cost minus depreciation). Then you say book value is synonymous with shareholder's equity. I thought equity was "assets minus liabilities," so they can't be synonymous, right? Mike Davis

Mike,

You articulate a common confusion that stems from the dual use of the term "book value." In the first sense, it's an accounting term that does indeed refer to the original cost of an individual asset adjusted for any accumulated depreciation or amortization.

In the second sense, when talking about the firm as a whole, it refers to the excess of total assets over total liabilities (or the definition of shareholder's equity). The idea is that when you're trying to find the value of an entire firm, it doesn't do a lot of good to just look at what they own (assets) without subtracting what they owe (liabilities). So in an investment sense, when someone refers to the book value of a

stock

, as opposed to an individual

asset

, think "shareholder's equity."

Still Confused on Shareholder's Equity

So is shareholder's equity just the number of shares of stock outstanding times the current share price? Karen Baxter

Karen,

The answer is no. Shares outstanding times market price is what's commonly referred to as "market capitalization" (or just "market cap"). Market cap tells you the

market

value of the entire company at a given point in time. Shareholder's equity on the other hand, gives you the value of the firm in terms of "book value" (a confusing term that is described in Mike's question; here we mean the second sense described above). The difference between the market value and the book value represents how good a job management has done in increasing shareholder value. It also can give you an idea of the relative value of the stock at its current price (see price-to-book value

discussion in the series).

Good Question on Goodwill

Could you comment on how to view "goodwill" on the balance sheet when grading the quality of a company? P. Souther

P.,

In this case, "goodwill" isn't the place where sitting presidents drop off their used underwear to claim a $4-per-pair tax deduction. It's the excess amount above "fair market value" that a firm paid for another company during an acquisition. It falls under the rubric of "intangible assets." Other intangibles can include things like patents and trademarks -- but only if they're purchased from another party. Internally generated intangibles aren't generally recorded on the books at all (don't ask me why, I just work here). So you may find goodwill on the books in the wake of an acquisition.

Informally, you can think about goodwill as the value of things like positive customer relations, brand loyalty or anything else that could result in greater-than-normal earnings power. For example, you can bet that the "Golden Arches" would garner a hefty goodwill kicker if Micky Dee's ever got swallowed up by Mr. Softee.

So how does it affect your analysis? A relatively large amount of goodwill could indicate that a firm overpaid for its acquisitions in a fit of market euphoria. In addition, carrying a lot of goodwill on the balance sheet might spawn a deceptively low price-to-book ratio, leading you to think you've got a cheap stock on your hands. Some conservative analysts correct for the aberration by reducing a firm's shareholder's equity by the amount of intangible assets to get something called "tangible net worth." Not a big deal if goodwill is low, but something to consider with a firm suffering a hangover from an acquisition binge.

Interest Coverage Ratio Challenge

In your interest coverage ratio calculation, I question whether it is appropriate to add back interest expense without adjusting for interest income and other nonoperating sources of income. Chris Karlin, CFA

Chris,

A better example of a stylistic difference in fundamental analysis you'll rarely find (you say "day-tah," I say "daa-tah").

I was taught that the "earnings before interest and taxes" (EBIT) figure in your interest coverage ratio should include

all

sources of income and other expenses, regardless of where they come from. This makes sense to me since I want to find out how well a firm can cover its debt payments as a whole, not just from operating income. However, I'm open to other interpretations.

Simply using "operating income" as your EBIT figure as you seem to suggest not only makes for an easier calculation, but it also gives you a more conservative coverage ratio. However, unless these "other" income and expense categories are large (which they aren't in the case of

Anheuser-Busch

(BUD) - Get Report

), the end result should be nearly identical.

To carry the idea even further, some analysts argue that using EBIT in the first place is a bad idea. Since firms service debt out of current funds (e.g., cash), they suggest that using net cash flow in the numerator is a better method. I'm receptive to that idea too, especially if the company's standard interest coverage ratio is two or less.

Any Nuts and Bolts to Biotech?

My question is about biotech/pharmaceutical start-ups. I was wondering if there are any pointers to look at when investing in these sectors where companies are not making a profit at all and often don't until several years or more after they discover a marketable product. Michael Hailley

First off, don't confuse an investment with a crapshoot. Unless you know something definitive about a new product under development, any kind of start-up betting on a yet-to-be-invented wonder drug is usually little more than a roll of the dice. Not that you shouldn't feel free to take a flier every once in a while, just don't bet your life savings.

That said, one of the few things that a fundamental read on these firms can do for you is determine if they can survive long enough to discover their pot of gold. I'd plot their "burn rate" (sort of a negative EPS trend) to see how fast they're using up capital. Then try to assess how long they can last without an injection of fresh funds.

Other principals of the fundy view still apply. Are they financed appropriately with mostly equity and only enough debt to cover hard assets like medical equipment? Do they have enough cash flow to make their interest payments? Just running the financials through a few fundamental checks might convince you that many of these paper tigers aren't worth the risk of losing everything for the remote chance at a phenomenal windfall.

Book Selections

These titles come to us straight from the

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readership and staff. I haven't personally checked any of them out, so I'll let their comments speak for themselves.

Savvy Investing for Women by Marlene Jupiter

One of the easiest books to read and understand and has some great chapters on balance sheets and income statements. I know, you'll say men won't read it. That's a shame because it clearly explains many aspects of investing for everyone -- not just women. Submitted by Terry Kish, State College, Pa.

Security Analysis on Wall Street by Jeffrey C. Hooke

Targeted at serious investors, investment professionals, corporate managers and MBA students, the book isn't as simple to read as a "Ten Stocks to Watch" article you might find in a glossy investment magazine. But it doesn't require an expertise in calculus, either.

Submitted by George Mannes,

TheStreet.com

How to Read a Financial Report: Wringing Vital Signs Out of the Numbers by John A. Tracy, PhD, CPA

The fourth edition was published in 1994 and is written in a style similar to yours -- clear and concise. He demonstrates to the reader how to read the three financial statements and how they are interrelated.

Submitted by Francis Navarro