Novice Investing - Learning From Peter Lynch Part VI

Date: Monday 01st 2008f December 2008 05:37:41 PM

Learning From Peter Lynch Part VI - 10/24/2006

By: Novice Investing Staff

We have gone very deep with our book review of Peter Lynch's "One Up On Wall Street". From why we should first own a house to what kind of stocks you should avoid, it was in there in one single book. Going further into your stock analysis, Peter Lynch tells you what nifty little things you should be looking out for in stocks.

Percent of Sales. This is how much a product is affecting the whole company's sales. For example if Starbucks had just launched a tasty doughnuts menu, how much does this affect the overall sales? If most of Starbucks' sales are from its coffee and latte business, then the impact of this new product launch will be minimal, compared to say Krispy Kreme Doughnuts (KKD), which derive most of its revenue from doughnuts products.

Price Earnings Ratio. While this ratio is widely misused, do not throw this ratio into the garbage bin forever. If a stock is trading at a P/E ratio of 15 can grow its earning 15% annually, then it is fine. However, if there is another similar company that is trading at a P/E OF 39 while growing earning at the same clip, then something is wrong here. Thus, Price Earnings ratio is most useful when you compare companies of similar size and businesses with similar expectations.

The Cash Position. At Novice Investing, we refer to it as net cash. What we prefer is companies having positive net cash. That is, companies that has more cash & cash equivalents than its long-term debt. You can subtract a company's cash position with the price of the stock you bought it at. For example, if Merck & Co Inc. (MRK) spots a $ 10 Billion positive net cash while it is trading at $ 95 Billion market capitalization, in essence, you can buy the entire company with $ 85 Billion.

Dividends. Does the company pay out dividends? If so, what is the percentage of profits dedicated in giving out dividends? Do you expect the company to continue paying out its dividend? Companies that suffer a string of losses over the year are less likely to continue its dividend payment in the future. Thus, the pro case for dividend is that, only profitable companies pay them.

Book Value. This is another ratio that is commonly thrown around. Simply, because it is easy to understand. Book Value is the value left after a company add all its assets and subtract all your debts & obligations. The remaining value is your book value. Presumably, investors think that buying a stock that trade below its book value is a win-win situation. That depends. Sometimes, a company spending its money on worthless acquisition and it sits there as an asset. In reality, those acquistions are of little value. Thus, despite having a high book value, a stockholder may not get his money back if the company sold off its assets and distribute the money to shareholders.

Cash Flow. There are three types of reported cash flow on a financial statement; Cash flow from operations, cash flow from investing activities and cash flow from financing activities. In essence, investors should be interested in cash flow from operations versus cash flow from investing activities. For example, if company A is reporting a $ 100 Million cash flow from operations while cash flow from investing activities is $ 200 Million, it can mean two things. One, the company is expanding rapidly and it is in the early stage of profit growth or Two, the company needs to spend its entire profit in maintaining its long term asset (such as machinery, plant maintenance etc.).

Inventories. Inventories are listed on the balance sheet as an asset. However, in reality, not all inventories are worth that much. For example if your microprocessor are still unsold after two years, don't expect it to be sold for that same price you made it for. Same thing with out of style clothing inventories. In general, you can look at future results by observing inventories growth. If inventory growth outpaces sales growth, it is a growing sign that the company cannot sell as rapidly as the factory churning out goods. Sooner or later, that inventory will be outdated and worth much less than the stated book value.

Pension Plans. Companies are not obliged to provide pension plans to employees. But if they do, pension plans are like bond obligation where the company needs to repay it sometime in the future. A lot of companies continue to pay its pension obligations even when it is operating under bankruptcy protection.

Growth Rate. What Peter means here is not just revenue growth. What matters here is earning growth rate. A company that can increase revenue by 20% per year while its cost structure rises 22% annually, is not doing anything meaningful. On the other hand, companies that can increase revenue by 6% while experiencing a 4% rise in cost structure, will register an additional 2% net profit. If the company originally has a 10% profit margin, this 2% additional profit means that profit growth for the year is 20%!!

There are several others factors that are considered by Peter Lynch that is not explained here. We believe that the book explains it much better than us but the major point has already been discussed here.

END

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Disclaimer: The sole purpose of this article is educational. This article is merely the opinion of the writer and is not in any way a buy/sell recommendation regarding Starbucks Corp. (SBUX) or any other securities.

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