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

by Pat Dorsey

When inventories rise faster than sales, there’s likely to be trouble on the horizon. Sometimes the buildup is just temporary as a company prepares for a new product launch, but that’s usually more the exception than the rule. When a company produces more than it’s selling, either demand has dried up or the company has been overly ambitious in forecasting demand. In any case, the unsold goods will have to get sold eventually—probably at a discount—or written off, which would result in a big charge to earnings.

One item that can be altered is a firm’s depreciation expense. If a firm is assuming that an asset—such as a building or factory—will wear out in 10 years, it subtracts (or depreciates) one-tenth of the building’s value from its earnings each year. As you can imagine, the longer the depreciation period, the smaller the annual hit to earnings. Therefore, if a firm suddenly decides that an asset has a longer useful life and stretches out the depreciation period, it’s essentially pushing costs out into the future and inflating current earnings.

Firms can also change things as basic as how expenses are recorded and when revenue is recognized (one of those gray accounting areas). You’ll generally find this kind of information in the “summary of significant accounting policies” section of the 10-K—and if a firm chooses to make changes that materially reduce expenses or increase revenue, watch out. Unless these moves were required by the accounting rule makers, the firm is probably trying to cover up deteriorating results.

The simplest way to detect aggressive accounting is to compare the trend of net income with the trend in cash flow from operations. If net income is growing quickly while cash flow is flat or declining, there’s a good chance of trouble lurking.

Pension income and gains from investments can boost reported net income, but don’t confuse them with solid results from the company’s core operations.

Over time, the stock market’s returns come from two key components: investment return and speculative return. As Vanguard founder John Bogle has pointed out, the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio.

If you find great companies, value them carefully, and purchase them only at a discount to a reasonable valuation estimate, you’ll be fairly well insulated against the vicissitudes of market emotion.

For example, let’s take a stock that trades for $30 per share, earns $1.50 per share, and pays a $1.00 annual dividend. Assume that earnings and dividends grow at 6 percent per year, and the initial P/E ratio of 20 doesn’t change. After five years, earnings will be $2.01, so our shares would theoretically trade for $2.01 × 20 = $40.20. We’ve also received $6.59 in dividends, which means we have $46.79 after five years. That works out to an annualized return of 9.3 percent, which is our investment return. Because the P/E remained at 20, we didn’t receive any speculative return.

However, if earnings and dividends grow at the same rate, but the P/E ratio decreases from its starting point of 20 to 15, our returns change dramatically. Although we still have $2.01 in earnings after five years, our shares are worth only $2.01 × 15 = $30.15. Add in $6.79 in dividends, and annualized return shrinks to just 4.1 percent—our 9.3 percent investment return was damaged by a −5.2 percent speculative return. Conversely, a rise in the P/E ratio fr...

Thus, a change in the market’s mood can reduce our solid 9.3 percent return to a paltry 4.1 percent or boost it to a wonderful 13.6 percent. You can buy an excellent company that kicks out earnings and dividends like clockwork, but the negative effects of a sharp decline in the stock’s valuation can wipe out even the most rob...

This relative smoothness of sales makes the P/S ratio useful for quickly valuing companies with highly variable earnings, by comparing the current P/S ratio with historical P/S ratios.

However, the P/S ratio has one big flaw: Sales may be worth a little or a lot, depending on a company’s profitability. If a company is posting billions in sales, but it’s losing money on every transaction, we’d have a hard time pinning an appropriate P/S ratio on the shares because we have no idea what level (if any) profits the company will generate.

Therefore, although the P/S ratio might be useful if you’re looking at a firm with highly variable earnings—because you can compare today’s P/S with a historical P/S ratio—it’s not something you want to rely on very much. In particular, don’t compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.

Now we come to the most popular valuation ratio, which can take you pretty far as long as you’re aware of its limitations. The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales, and they’re more up-to-date than book value. Moreover, earnings per share results and estimates are easily available from just about any financial data source imaginable, so it’s an easy ratio to calculate.

However, comparing a stock’s current P/E with its historical P/E ratios can be useful, especially for stable firms that haven’t undergone major shifts in their business. If you see a solid company that’s growing at roughly the same rate with roughly the same business prospects as in the past, but it’s trading at a lower P/E than its long-term average, you should start getting interested. It’s entirely possible that the company’s risk level or business outlook has changed, in which case a lower P/E is warranted, but it’s also possible that the market is simply pricing the shares at an irrationally low level.

Because most companies are increasing earnings from year to year, the forward P/E is almost always lower than the trailing P/E, sometimes markedly so for firms that are increasing earnings at a very rapid clip. Unfortunately, estimates of future earnings by Wall Street analysts—the consensus numbers that you often read about—are consistently too optimistic. As a result, buying a stock because its forward P/E is low means counting on that future E to materialize in its entirety, and that’s usually not the case.

The best yield-based valuation measure is a relatively little-known metric called cash return. In many ways, it’s actually a more useful tool than the P/E. To calculate a cash return, divide free cash flow by enterprise value. (Enterprise value is simply a stock’s market capitalization plus its long-term debt minus its cash.) The goal of the cash return is to measure how efficiently the business is using its capital—both equity and debt—to generate free cash flow.

Essentially, cash return tells you how much free cash flow a company generates as a percentage of how much it would cost an investor to buy the whole shebang, including the debt burden. An investor buying the whole company would not only need to buy all the shares at market value, but also would be taking on the burden of any debt (net of cash) the company has.

At Morningstar, we use 10.5 percent as the discount rate for an average company based on the factors in the preceding list, and we create a distribution of discount rates based on whether firms are riskier or less risky than the average. As of mid-2003, firms such as Johnson & Johnson, Colgate, and Wal-Mart fall at the bottom of the range, at around 9 percent, whereas riskier firms—such as Micron Technology, JetBlue Airways, and E*Trade—top out at 13 percent to 15 percent.

The orthopedic device industry is pretty attractive. Developed-country populations are aging, and better health care means that people are staying active longer—which increases the demand for artificial joints. Moreover, artificial joints became a mass-market product only during the 1980s and 1990s. Because joints typically have a 10- to 12-year life span, the number of revision procedures, which replace or repair a worn-out artificial joint, is just now starting to climb. Add these revisions to the demand for first-time procedures, and the market is growing at 7 percent to 10 percent. And because annual price hikes of 3 percent to 4 percent are pretty usual in the orthopedic industry, sales growth of 10 percent to 14 percent looks pretty doable for the average orthopedic device company.

These are the kinds of consistently excellent financial results that serious stock investors dream about—consistent and constantly increasing free cash flow, a free cash-to-sales ratio well above 5 percent (and usually above 10 percent), and very consistent operating and net margins. There’s little to quibble with here—any company that can convert more than 10 percent of sales into free cash flow for a decade is doing something right.

It’s tough to increase the bottom line at 15 percent annually for a decade, but that’s what Biomet has done. In addition, it looks as though long-term earnings growth of 15.7 percent is right in line with long-term sales growth of 15.8 percent, which means Biomet probably hasn’t had to play any accounting games to generate such solid results. The firm increased earnings the way a great company should—by selling more products, year in and year out.

These are some very solid, steady results. Gross margins of 70 percent are high, and it looks as if they’ve been very gradually increasing over time, which means the firm has been able to maintain pricing power of the goods it sells and control costs of the materials used to make its products.

Overhead (SG&A) costs have been very steady as a percentage of sales, which means Biomet isn’t becoming more efficient as it grows. This is all right, though, because a big chunk of those SG&A costs are Biomet’s payments to its salesforce—when salespeople sell more, they get paid more, which is as it should be.

Finally, it looks as though research and development has been declining as a percentage of sales. Although this could be positive, because it means higher overall margins as Biomet spreads R&D costs over a larger sales base, we need to be sure that Biomet hasn’t pared back too far on research. Innovation is the lifeblood of a company such as Biomet, so we want to do some digging to make sure the company has plenty of new products in the pipeline. We can probably determine this by going through the company’s recent press rel...

Biomet’s free cash flow has increased pretty steadily over the past several years, so let’s use $180 million as our estimated amount for 2004. (Biomet’s historical free cash flows are shown in Figure 11.8.) If we increase free cash flow at 15 percent over the next five years and conservatively assume that Biomet starts to lose market share and grow more slowly after five years, we see that the present value of the free cash that Biomet will generate over the next 10 years is about $2 billion. (I used a relatively low discount rate of 9 percent—versus a market average of 10.5 percent—because Biomet is a very financially stable company.) Add in our perpetuity value of about $3.5 billion, and Biomet is worth $5.5 billion, or about $21 per share

With the stock trading at about $28 as of this writing, Biomet doesn’t look like much of a value under this set of assumptions. However, maybe we’re being too conservative by forecasting that a competitor will start eating Biomet’s lunch in just five years. Moreover, it might not be reasonable to assume that a firm in an industry as young and robust as orthopedic devices will be growing at just 3 percent after a decade. That’s a really low growth rate—in line with the overall economy—and it’s entirely possible that Biomet will still be growing at an above-average rate in 10 years’ time. Therefore, let’s try another scenario. We’ll assume Biomet can grow faster starting in year six, and we’ll push our forecast horizon out to 15 years, at which time we assume that Biomet’s growth rate declines to a steady state of 3 percent

This set of assumptions results in an estimated intrinsic value per share of about $30, which is right around where the shares are trading as of this writing. Assuming this is a reasonable scenario, I’d start getting interested in the stock at around $24, which would be a 20 percent discount to my estimated intrinsic value. I’m not looking for much of a margin of safety because Biomet’s strong balance sheet, excellent industry prospects, and solid profitability all make it less likely that something will go horribly wrong with my assumptions.

However, this process has taught us something very important: For us to believe that Biomet’s shares are worth $30, rather than $20, we have to believe that the firm can hold off its competition and grow at an above-average rate for a long period of time. Companies that can increase free cash flow at an average annual rate of 12 percent for a lengthy period of time—which is what our second scenario assumes—are few and far between, after all.

This is the key benefit of a discounted cash flow approach to valuation. Having thought through a couple of possible scenarios for Biomet, we now know exactly what assumptions are incorporated in our estimated intrinsic value of $30 per share. Armed with that knowledge, we can make a more informed investment decision—we wouldn’t know as much about the assumptions needed to believe that the st...

WITH LITERALLY THOUSANDS of companies available to invest in, one of the toughest challenges for any investor is figuring out which ones are worth detailed examination and which ones aren’t. Now that you know the tools of in-depth fundamental analysis, I want to give you some tips on narrowing down the field. Apply the following tests to any stock that you think might be a worthwhile investment, and you should be able to decide in 10 minutes whether it warrants much of your time.

Has the Company Ever Made an Operating Profit?

Does the Company Generate Consistent Cash Flow from Operations?

Fast-growing firms can sometimes report profits before they generate cash—but every company has to generate cash eventually. Companies with negative cash flow from operations will eventually have to seek additional financing by selling bonds or issuing more shares. The former will likely increase the riskiness of the firm, whereas the latter will dilute your ownership stake as a shareholder.

Are Returns on Equity Consistently above 10 Percent, with Reasonable Leverage?

Is Earnings Growth Consistent or Erratic?

How Clean Is the Balance Sheet?

Does the Firm Generate Free Cash Flow?

As we know, free cash flow is the holy grail—cash generated after capital expenditures that truly increases the value of the firm. Generally, you should prefer firms that create free cash to ones that don’t and firms that create more free cash to ones that create less. As I discussed in Chapter 6, divide free cash flow by sales, and use 5 percent as a rough benchmark.

The one exception—and it’s a big one—is that it’s fine for a firm to be generating negative free cash flow if it’s investing that cash wisely in projects that are likely to pay off well in the future. For example, neither Starbucks nor Home Depot generated meaningful free cash flow until 2001—yet there’s no question that they had been creating economic value (and shareholder wealth) for many years before 2001. That’s because they were plowing every cent they earned right back into their businesses becau...

So don’t automatically write off firms with negative free cash flow if they have solid ROEs and pass the other tests in this chapter. Just be sure you believe that t...

Has the Number of Shares Outstanding Increased Markedly over the Past Several Years?

If shares outstanding are consistently increasing by more than around 2 percent per year—assuming no big acquisitions—think long and hard before investing in the firm.

If the firm does pass these tests and it looks as though it’s worth a detailed examination, here’s how to proceed. This research process will take much longer than 10 minutes, but it’s worth the effort for an idea that passes the initial hurdles:

• Look over the 10-year summary balance sheet, income statement, and statement of cash flows on Morningstar.com or another Web site. Look for trends, and make notes of anything that raises an eyebrow and deserves further investigation. This process should give you an initial road map for investigation. • Read the most recent 10-K filing front to back. Pay special attention to the sections that describe the company and its industry, the sections about risks and competition, any mention of legal issues (sometimes labeled “commitments and contingencies”), and the “management’s discussion and analysis” section.

• Read the two most recent proxies (form DEF-14A, in the SEC’s jargon). Look for reasonable compensation that varies with corporate financial performance and a reasonable options-granting policy. Check to make sure the board of directors isn’t packed with individuals with close ties to management.

• Look at the two most recent quarterly earnings reports and 10-Q filings to see whether anything has changed recently. Look for signs that business is getting better—or worse—as well as for anything major that has changed since the last 10-K. If it’s still available, listen to the most recent quarterly conference call. (Companies often archive these on their Web sites for some time after the quarter is over.) Does management get defensive or evasive when analysts ask tough questions, or does it respond with straightforward answers?

• Start valuing the stock. Look at the stock’s valuation multiples relative to the market, the industry, and the stock’s historical valuation ranges. If the firm has low reinvestment needs, low risk, high returns on capital, or a high growth rate, be prepared to accept a higher price-to-earnings ratio.

Although it’s recorded as a liability on the balance sheet, deferred revenue is a good liability to have—it represents cash the company has received before some services have been performed. It’s common for software companies to get paid for consulting and maintenance work up front, so tracking deferred revenue can give you a good estimate of the potential trend in future revenues. Rising deferred revenue indicates a healthy backlog of business, whereas declining deferred revenue may suggest business has started to slow because fewer sales will be recognized in the future.

Refer to the balance sheet and income statement and calculate this formula: accounts receivable/(revenues/number of days in the reporting period). The absolute DSO number is less important than the trend in DSOs. Falling DSOs indicate a company is collecting its outstanding accounts faster than before, whereas rising DSOs may indicate that the company has extended easier credit terms to customers to close deals and boost revenues. However, this practice merely steals revenue from future periods and may lead to revenue shortfalls. In an industry where demand can change quickly, rising DSOs are often the first signal that a firm’s products are no longer as hot as they once were.