The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market

by Pat Dorsey

Remember that buying a stock means becoming part owner in a business. By treating your stocks as businesses, you’ll find yourself focusing more on the things that matter—such as free cash flow—and less on the things that don’t—such as whether the stock went up or down on a given day.

Your goal as an investor should be to find wonderful businesses and purchase them at reasonable prices. Great companies create wealth, and as the value of the business grows, so should the stock price in time.

The key to identifying wide economic moats can be found in the answer to a deceptively simple question: How does a company manage to keep competitors at bay and earn consistently fat profits? If you can answer this, you’ve found the source of the firm’s economic moat.

One simple way to get a feel for a stock’s valuation is to look at its historical price/earnings ratio—a measure of how much you’re paying for every dollar of the firm’s earnings—over the past 10 years or more.

If a stock is currently selling at a price/earnings ratio of 30 and its range over the past 10 years has been between 15 and 33, you’re obviously buying in at the high end of historical norms.

To justify paying today’s price, you have to be plenty confident that the company’s outlook is better today than it was over the past 10 years. Occasionally, this is the case, but most of the time when a company’s valuation is significantly higher now than in the past, watch out. The market is probably overestimating growth prospects, and you’ll likely be left with a stock that underperforms the market over the coming years.

This is the best reason of all to sell because it means you did something right and picked a winner. The key is to not let greed get in the way of smart portfolio management. If an investment is more than 10 percent to 15 percent of your portfolio, it’s time to think long and hard about trimming it down no matter how solid the company’s prospects may be. (These percentages are a rough guide—you might be comfortable with more money in a single stock, or you might want to be more diversified.)

So, before we dive into the company analysis process, I want to introduce you to seven easily avoidable mistakes that many investors frequently make. Resisting these temptations is the first step to reaching your financial goals: 1. Swinging for the fences 2. Believing that it’s different this time 3. Falling in love with products 4. Panicking when the market is down 5. Trying to time the market 6. Ignoring valuation 7. Relying on earnings for the whole story

Falling in Love with Products This is one of the easiest investment traps to fall into. Who wouldn’t have thought that Palm was a great investment after buying a Palm Pilot when they were first introduced a few years ago? It seems entirely logical, but the reality is that great products do not necessarily translate into great profits.

For example, Palm was the first company to invent a handheld organizer that was relatively easy to use and affordable, but consumer electronics is simply not an attractive business. Margins are thin, competition is intense, and it’s very tough to make a consistent profit. Although great products and innovative technologies do matter when you’re assessing companies, neither matters nearly as much as economics.

At the end of the day, cash flow is what matters, not earnings. For a host of reasons, accounting-based earnings per share can be made to say just about whatever a company’s management wants them to, but cash flow is much harder to fiddle with.

The statement of cash flows can yield a ton of insight into the true health of a business, and you can spot a lot of blowups before they happen by simply watching the trend of operating cash flow relative to earnings. One hint: If operating cash flows stagnate or shrink even as earnings grow, it’s likely that something is rotten.

Evaluate the firm’s historical profitability. Has the firm been able to generate a solid return on its assets and on shareholders’ equity? This is the true litmus test of whether a firm has built an economic moat around itself.

Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

Next, divide free cash flow by sales (or revenues), which tells you what proportion of each dollar in revenue the firm is able to convert into excess profits. If a firm’s free cash flow as a percentage of sales is around 5 percent or better, you’ve found a cash machine—as of mid-2003, only one-half of the S&P 500 pass this test. Strong free cash flow is an excellent sign that a firm has an economic moat.

Just as free cash flow measures excess profitability from one perspective, net margins look at profitability from another angle. Net margin is simply net income as a percentage of sales, and it tells you how much profit the firm generates per dollar of sales.

In general, firms that can post net margins above 15 percent are doing something right.

As a rule of thumb, firms that are able to consistently post ROEs above 15 percent are generating solid returns on shareholders’ money, which means they’re likely to have economic moats.

When you’re looking at all four of these metrics, look at more than just one year. A firm that has consistently cranked out solid ROEs, good free cash flow, and decent margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results. Consistency is important when evaluating companies, because it’s the ability to keep competitors at bay for an extended period of time—not just for a year or two—that really makes a firm valuable. Five years is the absolute minimum time period for evaluation, and I’d strongly encourage you to go back 10 years if you can.

When you’re examining the sources of a firm’s economic moat, the key thing is to never stop asking, “Why?” Why aren’t competitors stealing the firm’s customers? Why can’t a competitor charge a lower price for a similar product or service? Why do customers accept annual price increases?

When possible, look at the situation from the customer’s perspective. What value does the product or service bring to the customer? How does it help them run their own business better? Why do they use one firm’s product or service instead of a competitor’s? If you can answer these questions, odds are good that you’ll have found the source of the company’s economic moat.

When you’re looking for evidence of high customer switching costs, these questions should help: • Does the firm’s product require a significant amount of client training? If so, customers will be reluctant to switch and incur lost productivity during the training period. • Is the firm’s product or service tightly integrated into customers’ businesses? Firms don’t change vendors of mission-critical products often because the costs of a botched switch may far outweigh the benefits of using the new product or service. • Is the firm’s product or service an industry standard? Customers may feel pressure from their own clients—or their peers—to continue using a well-known and well-respected product or service. • Is the benefit to be gained from switching small relative to the cost of switching? Bank customers, for example, often endure slightly higher fees because the lower fees they might get from moving to a competing bank are of less value than the potential hassle of moving their account. • Does the firm tend to sign long-term contracts with clients? This is often a sign that the client does not want to frequently switch vendors.

Think of the three statements like this: The balance sheet is like a company’s credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities) at a specific point in time. It tells you how strong the framework and foundation of the business is. The income statement, meanwhile, tells how much the company made or lost in accounting profits during a year or a quarter. Unlike the balance sheet, which is a snapshot of the company’s financial health at a precise moment, the income statement records revenues and expenses over a set period, such as a fiscal year. Finally, there’s the statement of cash flows, which records all the cash that comes into a company and all of the cash that goes out. The statement of cash flows ties the income statement and balance sheet together.

Right now, you’re probably wondering why we need an income statement and a cash flow statement—after all, if a company makes money, it makes money, right? The difference lies in a confusing concept called accrual accounting. Here’s how it works. Companies record sales (or revenue) when a service or a good is provided to the buyer, regardless of when the buyer pays. As long as the company is reasonably certain that the buyer will eventually pay the bill, the company can post the sale to its income statement. The cash flow statement, on the other hand, is concerned only with when cash is received and when it goes out the door.

Let’s say that Colgate sells a few cases of toothpaste to Joe’s Corner Store for $1,000 on February 15 but gives Joe 60 days to pay because he’s a regular customer and has a good track record of paying his bills on time. March 31 rolls around, Joe hasn’t paid yet, and Colgate closes its books for the quarter. Colgate shows $1,000 in sales on its income statement because it shipped the toothpaste to Joe—according to the income statement, the sale is complete, regardless of whether Colgate has received payment. But because Joe hasn’t ponied up the grand yet, Colgate will post an entry on its balance sheet to show that Joe owes Colgate $1,000. (The entry goes into the accounts receivable line—more on this later in the chapter.)

As you can see, a company can show rip-roaring sales growth without receiving a cent of cash. In fact, if Colgate produces and sells toothpaste faster than its customers pay for the toothpaste, sales growth would look fantastic even though cash is flowing out the door—which is why we need a statement of cash flows.

This is the critical difference between accounting profits and cash profits—accounting profits match revenues (hot dogs sold) with expenses (a worn-out set of grilling tongs) as closely as possible, whereas cash profits measure only the actual dollar bills flowing into and out of a business.

The key takeaway here is that the income statement and cash flow statement can tell different stories about a business because they’re constructed using different sets of rules. The income statement strives to match revenues and expenses as closely as possible—that’s why we had to deduct the $1 in depreciation from Mike’s profits, and that’s why Mike gets to record the $7 in sales that he made on credit. But the cash flow statement cares only about the dollar bills that go in and out the door, regardless of the timing of the actions that generated those dollar bills.

If you look only at the income statement without checking to see how much cash a company is creating, you won’t be getting the whole story by a long shot. This simple concept—the difference between accounting profits and cash profits—is the key to understanding almost everything there is to know about how a business works, as well as how to separate great businesses from poor ones.

Watch how this account changes relative to the company’s sales—if accounts receivable are rising much faster than sales, the firm is booking a large amount of revenue for which it has not yet received payment. This can be a sign of trouble because it may mean that the firm is offering looser credit terms to increase sales—remember, a firm can record a sale as soon as it has shipped the product—but has less likelihood of ever receiving the cash it’s owed.

(Remember, comparing the growth rate of accounts receivable with the growth rate of sales is a good way to judge whether a company is doing a good job collecting the money that it’s owed by customers.)

The speed at which a company turns over its inventory can have a huge impact on profitability because the less time cash is tied up in inventory, the more time it’s available for use elsewhere. You can calculate a metric called inventory turnover by dividing a company’s cost of goods sold by its inventory level.

If we compare these numbers to the firms’ total assets (see Figures 5.6 and 5.7, we can get a feel for how capital-intensive the firms are—Dell’s PP&E makes up about 6 percent of its total assets, whereas almost 10 percent of H-P’s assets are in PP&E. Therefore, H-P is more capital-intensive than Dell.

Be sure to check the “revenue recognition policies” buried in the financial statements so you know what you’re looking at—companies can record revenue at different times depending on the business that they’re in. A software firm, for example, might record a big chunk of revenue when a product is shipped to a customer, whereas a service firm might record revenue smoothly over the life of the service contract.

This doesn’t appear on all income statements, but it’s simply revenue minus cost of sales. Once you have gross profit, you can calculate a gross margin, which is gross profit as a percentage of revenue. Essentially, this tells you how much a company is able to mark up its goods.

You’ll often see a relationship between SG&A and gross margin—firms that are able to charge more for their goods (e.g., H-P) have to spend more on salespeople and marketing. You can get a feel for how efficient a firm is by looking at SG&A as a percentage of revenues—a lower percentage of operating expenses relative to sales generally means a tighter, more cost-effective firm.

Unfortunately, it’s tough to give any hard-and-fast rules as to just how much a company should be spending on SG&A. Your best bet is to compare a company with its closest competitors to see which is able to do more with less and to look at SG&A as a percentage of sales over time. (If it’s rising fast, watch out—the firm is spending more on overhead without reaping the benefit of higher sales.)

This number is equal to revenues minus cost of sales and all operating expenses. Theoretically, it represents the profit the company made from its actual operations, as opposed to interest income, one-time gains, and so forth. In practice, companies often include nonrecurring expenses (such as write-offs) in figuring operating income, and you have to add back one-time charges (or subtract one-time gains) yourself.

Operating income is as close to a solid bottom-line number as you’re going to get for most firms. Because it excludes most one-time items, as well as income from nonoperational sources such as investments, you can use it to calculate an operating margin, which is fairly comparable across firms and across industries.

In addition, look at the tax rate of the firm you’re analyzing over time. If it bounces around from year to year, the firm may be generating earnings by playing with tax loopholes rather than selling more goods or services. Tax advantages are nice to have, but politicians have a bad habit of taking them away at inopportune times, so it’s not money you want to necessarily count on.

Net Income This number represents (at least theoretically) the company’s profit after all expenses have been paid, and it’s the number most companies highlight in their quarterly earnings releases. As we saw in the Mike’s hot dog example, net income may or may not be a good representation of the amount of cash the company has generated. For that, we’ll need to look at the statement of cash flows. Although net income is the number you’ll most often see companies tout in their press releases, don’t forget that it can be wildly distorted by one-time charges and/or investment income.

Diluted shares, however, include securities that could potentially be converted into shares of stock, such as stock options and convertible bonds. Given the amount of egregious granting of stock options that has occurred over the past several years, it’s the diluted number that you’ll want to look at, because you want to know the degree to which your stake in the firm could potentially be shrunk (or diluted) if all those option-holders convert their options into shares.

Earnings per Share (Basic and Diluted) This number, which represents net income divided by number of shares, usually gets the most attention when a company reports its quarterly or annual results. It’s not the end-all, be-all of corporate financial performance, though—in fact, without looking at cash flow and many other factors, it’s mostly meaningless.

The Statement of Cash Flows This statement is the true touchstone for corporate value creation because it shows how much cash a company is generating from year to year—and cash is what counts

In fact, I would almost recommend that you look at the statement of cash flows first when evaluating a company to see how much cash it’s throwing off, then look at the balance sheet to test the firmness of its financial foundation, and only then look at the income statement to check out margins and such.

The cash flow statement strips away all the abstract, noncash items such as depreciation that you see on the income statement and tells you how much actual cash the company has generated. Many of the items on this statement are also found on either the income statement or the balance sheet, but here they’re rearranged to highlight the cash generated and how it relates to reported earnings.

The “cash flows from operating activities” section comes first and it tells you how much cash the company generated from its business. This is the area to focus most of your attention on because it’s the cash-generating power of the business that we’re most interested in.

Tax Benefit from Employee Stock Plans When an employee exercises stock options, the employer gets to deduct the gain received by the employee against its corporate income. (Employee compensation is generally tax deductible.) Because the result is a lower tax bill, we need to add back the tax benefit to the already-taxed net income. Be wary of this line item—if it’s large relative to total operating cash flow and the company’s stock has been zooming upwards, you shouldn’t count on this cash being around in the future. When the shares sink, fewer employees will exercise their options, and the company will receive a smaller cash tax benefit.

You don’t need to go through all of this every time you look at a statement of cash flows because everything gets neatly netted out for you in the “net cash provided by operating activities” line. But because the “changes in working capital” entry is often the biggest cause of differences between net income and operating cash flow, this is an area that you’ll want to pay attention to—hence our detailed analysis.

This is your holy grail for figuring out whether a company is generating cash. Also known as operating cash flow, it’s the result of adding or subtracting the previous items from net income. It doesn’t replace net income, but if you don’t look at it in addition to net income, you’re not getting the full picture because the two can often tell very different stories.