Exercising Stock Opions: When Should You Do It?

In the most recent issue of CFO (September 2007), one reader made a very good point about exercising of stock options. Apparently, people often assume that if they hold company's shares for a year after exercising the options, they'll qualify for 15% long-term capital gains rate. Even though a portion of that statement is correct, it is misleading nevertheless. Here is what that CFO reader had to say in the response to magazine's article about stock options:

"When one exercises an non-qualified stock option (NSO), he is taxed on the spread between the option price and the market value of the shares at the date of exercise. He pays income tax at ordinary rates on this spread whether he sells the shares or holds them. This is considered compensation and is also subject to payroll taxes. Future appreciation istaxed at capital gain rates (generally 15%) if the shares are held for more than one year from date of exercise.

"This incorrect tax perspective is frequently offered in conjunction with advice to exercise options at vesting and hold the shares until expiration rather than holding the options until expiration. While this approach will cause a portion of the profits to be taxed as capital gains instead of ordinary income, it requires a cash infusion at the time of exercise. Rather than paying the taxman at vesting, this cash could be invested in shares, which when appreciated, by any amount small or large, will more than cover the difference in taxes."

Now, if you're as "knowledgeable" about stock options as I am, you might wonder what is the difference between the "non-qualified" and "qualified" stock options. Well, as it turns out, there is no such thing as "qualified" stock options, they are called "incentive" stock options (ISOs). So, here are their respective Investopedia definitions to clarify this matter:

Non-Qualified Stock Option (NSO):

• A type of employee stock option where you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.
• NSOs are simpler and more common than incentive stock options (ISOs).
  
• They're called non-qualified stock options because they don't meet all of the requirements of the Internal Revenue Code to be qualified as ISOs.
  

Incentive Stock Option (ISO):

• A type of employee stock option with a tax benefit, when you exercise, of not having to pay ordinary income tax. Instead, the options are taxed at a capital gains rate.
  
• Although ISOs have more favorable tax treatment than non-qualified stock options (NSOs), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.
• Also, numerous requirements must be met in order to qualify as an ISO.

Additional resources:

• Original CFO article ("Lessons in Sitting Pretty") this reader responded to: click here
  
• Full version of the reader's response ("Incorrect Tax Perspective") that I've quoted in this post: click here
  
• IRS explanation of the tax-treatment you can expect when you exercise your stock options: click here
  
• SmartMoney's take on this in "Options: Should I Exercise?": click here
  
• CNNMoney.com - Money101: Employee Stock Options: click here
  

Stock Analysis: Paychex (PAYX)

Company description:

Paychex is primarily a payroll processor, but is rapidly expanding its slate of human
resource capabilities to include retirement and health benefit administration, among other services. Substantially all of Paychex's revenue originates in the U.S. from small businesses with 17 employees on average, though it has a small presence in Germany. The firm operates about 100 branches to service its clients and is headquartered in New York.

Click here for a full description of company operations.

Financial highlights:

Revenue Growth (1-yr): 12.7%
Revenue Growth (4-yr average): 14.5%

Net Income Growth (1-yr): 11.0%
Net Income Growth (4-yr average): 15.5%

Free Cash Flow Growth (1-yr): 13.1%
Free Cash Flow Growth (4-yr average): 15.3%

Net Profit Margin (current): 27.3%
Net Profit Margin (5-yr average): 26.1%

Return On Equity (current): 28.6%
Return On Equity (5-yr average): 33.8%

Debt Ratio (current): 0.68
* The company has no long-term debt; it’s all current liabilities that company pays every year and is capable of paying them year-to-year as you can see from the Current Ratio below.

Current Ratio (current): 1.15

Discounted Cash Flow (DCF) Analysis:

I’ve used discounted cash flow analysis to arrive at the intrinsic value of the company. I estimated that free cash flow would grow at an average rate of 11% per year for the next 10 years and at 3% (trailing GDP growth) perpetually after that.

I used a discount rate of 10%, which is slightly below the default rate of 10.5% for an average company. At this time I’m using some of the defaults that Morningstar uses in their analysis (namely, a 3% perpetuity rate and 10.5% as the default discount rate) since I don’t have enough of investing experience to have meaningful rates of my own.

Using the assumptions listed above my intrinsic value of the stock is $38.37. My intrinsic value of Paychex is lower than what Morningstar has listed as a “fair value” for this company on its web site. The difference is mostly due to the fact that they judge this company as a “below average” risk and use 9% as the discount rate (I used 10%) while I think that this company is riskier than that (I think it has an “average risk”) due to uncertainty in the job market which would affect its revenue and earnings growth if unemployment rates were to increase.

Pros:

• A solid company with a long history of profitability and earnings growth
  
• Excellent financials: plenty of cash, no long term debt
  
• Expanding into other human resource offerings, which should fuel long-term growth
  
• High customer satisfaction (most of the marketing is done through word-of-mouth referrals)
  
• Paychex is more profitable than any of its competitors
  

Cons:

• Revenue and earnings growth have been slowing as can be seen in the last four quarters (and the last five years)
  
• Uncertainty in the job market could have adverse affect on the earnings
  
• Stock is currently overpriced according to my DCF analysis
  

Final decision:

At this time I will pass on this stock as being too expensive at $42 vs. $38 intrinsic value. Also, taking into account margin safety (this is a built-in padding in case my calculations are significantly off or stock market behaves even more irrationally than usually), my buying price range for this company would be between $27 and $19, which is 30% and 50% off the intrinsic value, respectively.

Cashing Out Into An Early Retirement

Just finished reading the SmartMoney article on how a handful of couples have successfully retired early and found a balance and control of their lives. For some, who had seven-figure incomes, it was easier than for others, but even those with more modest middle-class incomes have managed to retire in their 40s and 50s. I would certainly like to do that as well. Of course, I always imagined myself not worrying about retirement since I will be a multimillionaire for some reason by then. But then again, it never hurts to have a backup plan.

So, here are some of the highlights:

• Set a goal and make a plan for your future
• If you want to retire in, say, your 40s instead of 50s, then save more rigorously and let stock market pick up the slack
• Find a source of additional income to either supplement your paycheck so you can save more money now and/or to supplement your retirement money once you do retire
  
• Live in the area with a lower cost of living if you can help it. You can save between 10% and 30% a year in living expenses by doing that.
• Make good investment choices with your set-aside money, don't let it sit in CDs or saving accounts. Stock market may be volatile, but over long term it delivers significantly higher returns than CDs, saving accounts, or bonds.
• Make a plan! If you want to retire 10, 20, or 30 years earlier, you have to plan for it, it will not just happen by itself!

Investing: Phase II - Stock Weeding - Maxim Integrated Products

So, one of the companies that came up in my screening process is Maxim Integrated Products (MXIM 29.71). Here is what the company does:

Maxim Integrated Products makes high-performance analog and mixed-signal integrated circuits. The company offers a wide range of products serving a host of analog-intensive applications, including power management and data conversion. Maxim supplies its diverse array of about 5,000 circuits to a broad base of customers in end markets, including communications, computing, industrial, and consumers. Roughly 70% of the firm's sales are based outside the United States.

Yeah, exactly. That didn't make much sense to me, so there was no reason to continue with the analysis. Sometimes you can tell that no matter how much more you will (reasonably) read about the company's operations, it probably will still be too vague to be able to confidently invest in it. The stock, has also been underperforming for the past 5 years. Even though that may mean that now will be the time that it soars, I don't feel like taking that chance.

Investing: Phase II - Stock Weeding

Alright, after I ran my stock screen I've come up with about two dozen companies that met my criteria. Out of them I removed companies the following sectors and industries: Financials, Drugs, Biotech. Financials require a more unique way of analysis than for other stocks and I'm not familiar with that - there is already enough risk in my investment process, I don't need to add anymore. Plus, you don't know which companies will be affected by the subprime mortgage crisis and subsequent private equity downturn. As for Drugs and Biotechs, first of all, I really don't understand them and second of all, they seem to be cyclical. I'm trying to avoid cyclical companies, as that is another form of risk, and yes, I don't need anymore of that.

Even though I might seem very "risk-averse", fact of the matter is that I'm trying to eliminate as much risk as possible where I can control it because once I make the picks the only thing that will be controlling the performance will be Mr. Market and the underlying economics of the companies I'll choose. So, I want to make my choices count.

Investing: Phase I - Stock Screening

So, I feel fairly confident now about the investment process after reading a book about Warren Buffett, reading various literature, and what I found especially useful - a free online course from Morningstar.com.

I'm definitely not an expert, but I think I at least know my limitations. Now I'm should be ready to start looking for companies to analyze and make my picks for the virtual mutual fund that I will run on Marketocracy.com.

First things first - I need to select a pool of stocks from the whole stock universe (6000+ U.S. listings) to play with. Since I know that my knowledge and experience are very limited, I will be very conservative with my choices, but conservative shouldn't mean minimal returns. I think it's reasonable to expect 10-15% annual return if the task at hand is approached carefully.

On the more basic level, I intend to look at companies whose basic business I can reasonably understand since if I don't understand I cannot make any sort of realistic valuations of the business or forecast its future growth, both of which are essential when evaluating a stock. Then, I will look at companies with consistent sales/earnings growth as well as steady free cash flow margins. The company I will consider must have a long track record of consistent returns and a history of innovation (be it in marketing, their products, etc.), which would be a strong indicator of how a company might perform in the future. Yes, I know that they say "Past performance doesnt't guarantee future results," and yet a company that was profitable for decades is unlikely to turn the corner without any hints of business going bad.

Another reason why large-cap stocks would be a good choice right now is because they have underperformed for the past 6-7 years while small-caps soared. Currently, the market seems to be turning the other way - when there is a lot of uncertainty the markets people tend to prefer to invest in the more stable, blue-chip companies. Besides, many small-caps are already bid-up so high, there is not much room left for stock growth since they're overpriced now.

Bonds or CDs?

Those looking to invest their savings into something other than, well, savings accounts, probably encounter bonds being mentioned as the more stable and safe alternative to stocks. But I think CDs should be the main competitor for bonds, not stocks.

Bonds' annual returns vary from 3% to 6% and their risks vary from Treasury-backed to junk bonds. So even though they're arguable safer than stocks, there is still risk involved and you'd have to dig into bonds or mutual funds invested in bonds and do some research before investing. Or, you could just invest into a CD for the time period from 1-month to 5-years with an annual return hovering around 5%. Oh yeah, and all CDs under $100,000 are backed by FDIC.

So, why bother with all the bond-related hassle when you can just put your money into a CD (or even several of them, for different time periods) and get virtually the same return with zero risk involved?

Moats: How to Find One

Following a brief description of the economic moats in the previous post, here is how to determine whether the company has a moat or not:

• Strong free cash flow (operating cash flow minus capital expenditures)
• for ex., free cash flow greater than 5% of sales is a good start
• More profitable than competitiors
• for ex., net margins consistently exceeding 15%
• High efficiency
• for ex., companies with higher asset turnover (total sales/average assets) than competition are more efficient
• Consistently higher Return On Equity (ROE) and Return On Assets (ROA)
• for ex., ROE greater than 15% and ROA greater than 10%, if delivered on a regular basis are good indicators of a company with an economic moat

Additional notes about ROE and ROA:

• ROEs (net income/average equity) can be boosted by extensive leverage since the more debt there is the less equity there is relatively speaking (remember: assets=liabilities (or debt) + equity)
• since more debt means paying out more interest, it's better to avoid companies who boost ROE through overleveraging the company


• ROA (asset turnover x net profit) can be boosted through either the efficient use of company's assets or by having higher margins of on the products it sells

To invest in CDs or bank stocks?

Let's say you have some money sitting in your savings account and the current rate is barely keeping up with the inflation, where should you put it? The safest and most liquidate bet would be to put the money into CDs for up to 5 years. You can get your money back for a relatively low penalty anytime before the CD expires and your principal is backed by the government since all CDs under $100,000 are guaranteed by FDIC.

Or, you can invest into one of the bank's stock and 1) Receive a dividend that is likely to have a higher yield than a CD, plus bank dividends have a good chance of growing while CD rates are fixed; 2) Receive a lower tax bill since dividends are taxed at a preferred rate of 15% instead of the CD's interest being taxed at the ordinary rate of up to 35%; 3) By carefully choosing the bank to invest in, your total return would be even higher with a growing stock price for that bank.

Of course there are a few caveats that come with investing into a stock. It is not as liquid as a CD, it may decrease in value, and dividends can be suspended. Well, dividends are very unlikely to be suspended by a large bank that has a history of paying dividends for decades. Currently, many bank stocks are considered a bargain (partly due to the subprime mortgage crisis) and stocks will most likely rise in value over the next several years.

So, if you have a long-term outlook of 3-5 years, the stock is likely to outperform the CD investment and possibly by a large margin. If you don't feel comfortable committing your funds for that long, then you should probably stick with the safety and certainty that CDs offer.

There is more information on this topic in this article: Is Your Money Smarter 'In' or 'On' the Bank?

Global Trade vs. Protectionism

Now, I'm not an economist and I don't pretend to be one, but the case for protectionism makes no sense to me. Let's look at Pros for both protectionism and global trade:

Protectionism

• Protect domestic jobs from unfair foreign competition
  
• Reduce dependence on foreign products for "strategic" reasons
• Is that...it?

Global Trade

• A growing GDP: currently 1.4% of the U.S. GDP growth is attributed to the global trade
• More jobs as U.S. companies are more stable and growing thanks to the global trade: U.S. firms derive 29% of their profits from overseas operations/sales
• A stable economy: stagnation in U.S. industries is offset by growth overseas which is reflected in the financial markets
• Increased innovation: with additional competition from abroad U.S. companies are under pressure to innovate and deliver new, better products for less

If a simpleton like myself can see more good coming from the global trade than bad, then why can't those smart gentlemen and ladies on the Capitol Hill see that, with all their advisers and what not? Ohhh, right, right, I forgot. I forgot about the lobbyists of the failing industries that have been complacent for decades and instead of investing into R&D and becoming more efficient and innovative were just pocketing the profits. Now that they have competition and can't compete, they decided that paying lobbyists to get rid of the said competition will be a better investment than becoming formidable competitors in the global marketplace.

Or maybe I'm just oversimplifying a very complicated subject that is way over my head. Maybe.

Schedule DEF14a: A Wealth of Information About Management

Schedule DEF14a, or annual proxy filing, contains a significant amount of information about management. It provides information about the firm's compensation structure and numbers for management and the board of directors, so you can judge for yourself how well the management's and directors' interests are aligned with those of investors'. The proxy also contains biographies and background information about c-level executives and directors.

It's probably a good idea to familiarize yourself with the most recent proxy filing for a company that you're interested in. After all, you'd better know who is running the business you're investing into.

Moats... What are they?

You maybe thinking medieval defenses now. Well, you're not that far off - moats are defenses, but rather economic defenses. The term "economic moat" refers to the competitive advantage a company might have in the market. The more sustainable and long-lasting the moat is the "wider" it's considered to be. Analysts usually classify companies as having a moat that is "wide", "narrow", or "none."

Competitive advantages that can be considered moats vary widely between industries. Some examples of economic moats are: patents (Pfizer); copyrighted materials and intellectual property (Microsoft); economies of scale unmatched in the industry (Wal-Mart); high-cost of switching to a competitor (think 2-year AT&T wireless contract with free calls to all your friends who are on the same network); powerful brand (Coca-Cola).

It is through wide moats, or sustainable competitive advantages, that companies are able to outperform the overall market and post great return over long periods of time.

401(k), Traditional IRA, and Roth IRA

Came upon this brief description of the three tax-advantaged retirement accounts on Morningstar.com and thought it would be a good idea to paste that info here. I would have just linked to their web site, but it's from their pop-up window that doesn't show an address. Anywho, here it is:

401(k)s
401(k) plans, so named after a section of the Internal Revenue Code, are set up by employers as a retirement-savings vehicle. The primary advantage of a 401(k) is tax deferral. First, employees can contribute a percentage of their income from each paycheck to their own 401(k) accounts on a pretax basis. This means the amount you contribute to your 401(k) is exempt from current federal income tax. For example, if you are in the 25% income tax bracket, a $100 contribution will reduce your current tax burden by $25. Second, dividends and capital gains earned inside a 401(k) are not subject to current taxation. In short, 401(k) plans allow you to defer taxation on dividends, capital gains, and a portion of your wages until you begin withdrawing from the plan, presumably during retirement, when you may be in a lower tax bracket. (All withdrawals are taxed at ordinary income rates.)

The amount you can contribute to your 401(k) plan is limited to $14,000 in 2005 and $15,000 in 2006. Thereafter, the annual contribution limit can be adjusted in $500 increments to account for inflation. You also must begin mandatory withdrawals from your 401(k) when you reach age 70 1/2. Withdrawals made before you turn 59 1/2 are taxed as ordinary income, and you may be subject to an additional 10% penalty.

Traditional IRAs
Individual retirement accounts are another vehicle for tax deferral. When you contribute to a traditional IRA, the IRS allows you to take an income tax deduction up to the amount of the contribution, subject to income limitations. In addition, dividends and capital gains earned inside a traditional IRA are not subject to tax until withdrawal.

However, there are some important limitations to remember. First, you must be age 70 1/2 or under with earned income to contribute to a traditional IRA. Second, the annual contribution limit is $4,000 from 2005 to 2007. The limit rises to $5,000 in 2008, and thereafter can be adjusted in $500 increments to account for inflation. If you are age 50 or older, you can make additional "catch-up" contributions of $500 in 2005 and $1,000 from 2006 onward. Finally, like 401(k) plans, you must begin mandatory withdrawals when you reach age 70 1/2. Withdrawals made before you turn 59 1/2 are taxed and may be subject to an additional 10% penalty.

Roth IRAs
These are typically the best retirement account option for many taxpayers. As with traditional IRAs, interest income, dividends, and capital gains accumulate tax-free. However, the main feature of Roth IRAs is that they are funded with aftertax dollars (contributions are not tax deductible). The upside of this is that qualified distributions from a Roth IRA are exempt from federal taxation.

The Roth IRA has the same annual contribution limits and "catch-up" provisions as a traditional IRA, but you must meet certain income requirements to contribute to a Roth IRA. Generally, single filers with income up to $95,000 and joint filers with income up to $150,000 are eligible to make the full annual contribution to a Roth IRA. Contributions to a Roth IRA can be withdrawn at any time without paying taxes or penalties, but withdrawal of earnings may be subject to income taxation and a 10% early withdrawal penalty if made before you turn 59 1/2.

In addition, the distribution must also be made after a five-tax-year period from the time a conversion or contribution is first made into any Roth IRA. So, if you open your first Roth IRA and make your first contribution on April 15, 2005, for the 2004 tax year, your five-year period starts on Jan. 1, 2004. Assuming you meet the other requirements, distributions made in this case after Dec. 31, 2008, from any Roth IRA will receive tax-free treatment.

Price/Book Ratio

Price/Book (P/B) ratio shows a relationship between the stock market value of the company and the book value. Book value of a company is its net worth (or net equity), it's what a company would fetch if it was liquidated today.

Book Value Per Share = Total Shareholders Equity / Shares Outstanding

P/B = Stock Price / Book Value Per Share = Market Capitalization / Total Shareholder Equity

P/B ratio is very important when evaluating companies, but like any other ratio it must be approached carefully and keep in perspective other factors such as: industry average P/B, ROE of the company, etc. Lowest P/B ratios can be expected in capital-intensive industries such as utilities and retail, while higher P/B ratios will be found at companies that have significant intangible assets that book value doesn't take into account such as pharmaceuticals, biotech, technological and consumer products companies. Also, if a company consistently earns a high ROE (Return on Equity = Net Income / Total Equity), it can commend a higher P/B ratio.

About PEG Ratio

The PEG ratio can help you determine whether a stock's P/E is too high and will give you an idea of how much investors are paying for a company's growth. A stock's PEG ratio is its forward P/E divided by its expected earnings growth over the next five years as predicted by a consensus of Wall Street estimates. For example, if a company has a forward P/E of 30 with annual earnings estimated to grow 15% per year on average, its PEG ratio is 2.0. The higher the PEG ratio, the more relatively expensive a stock is.

PEG = Forward P/E Ratio / 5-Year EPS Growth Rate

Of course, the PEG ratio should be used with caution. PEG relies on two different estimates - next year's earnings and five-year earnings growth - which makes twice as susceptible to the possibility of overly optimistic or pessimistic analysts. If anything, I would rather make my own rough estimates about the earnings instead of relying on the "consensus" estimates by Wall Street analysts. Those "consensus" estimates are often wrong as the analysts often look at same thing and think the same way. Consider this, if the analysts were always right there would be barely any volatility on the stock market, especially when yearly and quarterly earnings are announced. I am not saying I am smarter or more knowledgeable than they are, but since they are not all that reliable either, I might as well trust myself.

Three Kinds of Profits

Everytime I see some sort of a "profit" mentioned, I need to think for a second exactly what that particular "profit" means. So, hopefully once I'll actually type them out I will be able to keep them straight (yeah, I know, wishful thinking).

So, here we go, I will list them in the ascending order (first one is going to be the largest):

• Gross Profit: calculated as Revenues - Cost of Sales (or Cost of Goods Sold). It basically shows how much money is left over to pay for operating expenses after a sale is made.


• Operating Profit: calculated as Revenues - Cost of Sales - SG&A expenses (Selling, General, and Administrative). This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations.


• Net Profit (Net Income): generally represents the company's profit after all expenses, including financial expenses, have been paid. This number is often called the "bottom line" and is generally the figure people refer to when they use the word "profit" or "earnings."

There are also related financial ratios, which are the three profit margins:
Gross Margin = Gross Profits / Revenues
Operating Margin = Operating Profits / Revenues
Net Margin = Net Profits / Revenues

Earnings Per Share (EPS): Why bother?

In most business publications and investment educational materials "earnings per share" (EPS) is regarded to as a key metric in evaluating a company's profitability and one of the key ratios in evaluating a stock. Personally, I don't understand why. Not at all. Earnings per share are expressed in dollar figures, $1 per share, $2 per share, etc., but how is that supposed to assist you on evaluating a stock when it doesn't really provide you with any kind of a perspective in evaluating a company's profitability? Even though $2 per share in earnings might seem better than $1 per share, whether it really is better or not will also depend on the share price. $1 per share in earnings for Company A would actually end up being better if the share price is $20 than $2 per share earnings of a $50 share of Company B. What I am saying is that dollar figures that EPS provides don't provide the big picture or an objective basis to evaluate companies on. If anything, EPS expressed in percentage terms would make more sense - let's say 10% earnings per share. This way you could see that a company improved earnings per share from 9% to 10%, or company A is performing better than Company B which has earnings per share at only 5%. On the other hand if EPS increased from $1 to $1.15, that may not necessarily be great since the stock price could have skyrocketed during that period, so your earnings per share percentage-wise would have plummeted, or the company could have just bought back a significant amount of outstanding common stock and there would be less shares to divide earnings upon.

All I'm saying is that EPS doesn't seem to be an objective measure and in my opinion should be used in percentage not dollar figures. The result of this switch would actually make it a reverse P/E, or an earnings yield. For ex., a company with a P/E of 20 would have a yield of 5% (100/20) .

Determining Fair Value (per Morningstar)

I'm a big fan of Morningstar as it adheres to the value-investing approach (or as I like to call it, "The Warren Buffett Way"). Of course, it's not without faults and I wouldn't base my investing decisions purely on their star rating of stocks (the less risky and the more undervalued the deem a stock to be, the higher the rating they give to a particular stock). I don't believe that if you just pick their 5-star rated stocks you will gain superior returns, you still have to do your own research even among their top-rated picks. As they themselves say:

In the end, our fair value estimates are more of a guide than automatic buy or sell prices. As long as you have a good idea of what a stock is worth, you'll be in a better position to determine whether it's a bargain or is overvalued.

But their long-term oriented core values and in-depth analysis of 1900+ stocks are definitely valuable. So, here is how Morningstar evaluates equities (as quoted from their web site):

This philosophy of fundamental research is the foundation for our valuation model. We believe that:

• How much capital a company invests and what it earns on that capital drive shareholder value.
• Free cash flow--not reported earnings--is what counts.
• As Warren Buffett has said, “Growth is always a component in the calculation of value--sometimes a positive, often a negative.” If a company can’t earn its cost of capital, growth destroys value instead of creating it.
• Competitive advantages disappear over time.
• It’s dangerous to assume that the future will be better than the past.

These core beliefs guide our stock analysts as they estimate future cash flow, using their in-depth knowledge of each company and its competitive position within its industry. Our analysts forecast revenue growth, profit margins, and capital investment (and all of the numbers that go into them) for each firm they cover.

Their forecasts for each company populate our discounted cash flow model, which calculates the present value of the company’s future discretionary cash flow based on its cost of capital, as determined by our analysts.

Value Investing: To Each His Own?

As soon as you hear the words "value investing," the names Warren Buffett and Ben Graham come to mind. Yes, those are basically the forefathers of value investing, Ben Graham taught Warren Buffett, and Mr. Buffett has been the flagbearer ever since.

So, you'd think that value investing is a fairly universal concept and that everyone understands it in the same way. Wrong. That's what I thought too, but apparently to each his own. All the great value investors have their own techniques, methods, and valuation models for companies. The only common theme among them is that they don't invest into stocks, rather, they invest into companies and think of themselves more as business owners and less as stock speculators. They all buy good companies for cheap, but they all have different ways of determining which ones are "good" companies and what "cheap" is exactly.

There is a good article on Morningstar (Take-Home Lessons on Value Investing) highlighting some of those differences and a common ground among value investors. The takeaway lesson, in my opinion, is that don't take any advice at face value, even from Mr. Buffett: research companies you consider investing into and don't invest until you're absolutely comfortable with the decision to invest in it, because if you're not, you should simply move on and find the company (and stock) that you're comfortable with. As Warren Buffett himself has said on numerous occasions: Rule #1 in investing is "Don't lose money!". So, take your time, learn as much as you can, do read the advice and listen to investors with a great track record, but don't let anyone dictate you what to do, its YOUR money!

Looking into FactSet (FDS) - a great company, but inflated P/E?

I've ventured to analyze this company and go through their most recent 10-K filing (which is basically their annual statement). I have to warn you, this is not the most comprehensive or coherent analysis of a stock or company that you'll ever read, just some of my thoughts on the subject as I'm learning more.

Here is a very brief description of what the company does:

"FactSet® offers instant access to accurate financial data and analytics to thousands of investment professionals around the world. Our company combines hundreds of databases from industry-leading suppliers and clients' own proprietary data into a single, powerful information system, making FactSet a one-stop source for financial information."

10-K for 2006 Fiscal Year

- Revenue went up 24% from the previous year while cost increased by 32% and net income increased by only 15%. In the previous year changes between income statements items were much more consistent. The only thing that I could attribute this to is acquisition activity during this period.

- I’ve found that going through this filing is very time-consuming and much of the data is repeated a number of times throughout the document.

- All the financial information listed here can be found dissected and sprinkled with a variety of valuation/financial ratios on many financial web sites such Yahoo! Finance to mention one.

- It is rather tiring to look through these statements unless there is something specific that you want to find out about the company: what they do, the risks the take, how they obtain their revenue and where, who their competitors are, and how they explain various line items on the balance sheet or income statements.

- Although I’m most definitely not an expert by any means, but I have found nothing alarming, unusual, or strange in their financial statements. Everything seemed to be very in order and straightforward, which only further cemented my interest in this company.

What I am uneasy about is the fact that analysts are predicting a significantly lower P/E ratio for the stock, which means that the company would have to significantly increase its earnings just to stay at the same price level. What that means to me is that as a stockholder, you will make no money for at least a year if the P/E will go down.

But then again, maybe there is something that I’m missing with all these forecasts and estimates by analysts, I’ll show you what I’m talking about. I took this information from Yahoo! Finance (http://finance.yahoo.com/q/ks?s=FDS). Current P/E is 30 and forward P/E a year from now they expect to be at 24.5. Average estimate for earnings per share for next year is $2.44. Doesn’t that mean if both, the forward EPS and the forward P/E are correct then we should expect the price to be around $60/share ($2.44 x 24.5)? Well, apparently not. These same analysts have a mean price target of $69/share. Now, if the P/E does go down to 24.5, then earnings must increase from $2.04 to $2.82 to get share prices to the $69 price target those analysts expect. Only a 38% jump in earnings at a company that has generated growth in earnings between 15% and 25% in the past 5 years.

What am I missing?

Stock Indexes

DJIA

The DJIA is a measure of the relative price of 30 widely held stocks traded on the New York Stock Exchange. The value of the DJIA is determined by dividing the sum of the per share prices of the 30 stocks in the index by an adjusted denominator that accommodates for splits and changes in stock composition. Therefore the index values represent equal weighted calculations.

Though it is called an average, it is actually a price-weighted index, which means the gains and losses of the highest priced stocks are counted more heavily than gains and losses of lower priced stocks.

The best known US index of stocks. A price-weighted average of 30 actively traded, well-established companies' shares. The Dow, as it is called, is a barometer of how shares of the largest US companies are performing. There are hundreds of investment indexes around the world for stocks, bonds, currencies and commodities. Even though the Dow is composed of only 30 stocks, its performance has tracked that of the broader market indexes, such as the S&P 500, remarkably closely over long periods.

Nasdaq Composite

An index that covers the price movements of stocks traded on the NASDAQ stock market.

Russell 2000

An equity index comprising 2000 mid-capitalization US listed stocks.

Everything is Interconnected

In order to be a successful investor in the stock market, mutual funds, and Forex, you really have to understand the relationships between such things as gold, inflation, overall economic situation in the world, in the country you live in, and what affects each one of them. It's really overwhelming, but if you take one step at a time and actually start using your brain cells, you will gain understanding of what is going on in the world (and why) and how you can profit or at least protect your investment from various economic events happening throughout the globe. Make no mistake about it, an economic crisis in Chile or Korea can set off a chain of events affecting your own checking account. It's not enough to read business magazines and take in the information that they give you, you have to think about factors that affect economic situation around the world, look for them yourself and stay up-to-date on what's going on around you and in the global financial markets.