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Chapter 39 Investment strategies.

WHAT IS IT?

This chapter explores strategies used to select individual securities and time their purchase or sale.

Passive investment strategies implicitly assume markets are efficient, and that, therefore, reducing investment trading and research costs is more important than pursuing "market out-performance." A passive approach typically involves purchasing a basket of securities that represent a market index and holding them for the long term (perhaps with periodic rebalancing). A passive approach typically does not focus on individual security selection.

By contrast, active management strategies either assume the market is inefficient or that inefficiencies within the market can be profitably exploited. A great deal of time and effort is expended in security selection and the timing of purchases and sales.

SECURITY SELECTION

Active security selection usually involves fundamental analysis, technical analysis, or both. Fundamental analysis examines company-specific factors such as profitability, risk, relative valuation, and growth prospects. Technical analysis studies market information such as price and volume to identify important trends and opportunities.

Fundamental Analysis

Many managers use fundamental analysis techniques to identify securities they believe are mispriced. Fundamental analysis can be employed using either a top-down or a bottom-up philosophy (see Chapter 38, "Asset Allocation and Portfolio Construction").

Top-down managers begin with an overview of the entire economy and market. The idea behind such research is that one must first understand where the overall economy is headed in order to identify the asset classes, economic sectors, and, ultimately, securities that are expected to outperform. In a top down approach, the final step is typically to examine the fundamentals of a particular company whose securities are of interest.

Bottom-up analysts often call themselves stock-pickers. They attempt to identify the best securities and the price at which to buy them, regardless of sector or industry considerations. Bottom-up analysts typically begin by examining company fundamentals, often by screening large databases of securities for information the analyst finds attractive. Only after they have identified securities of interest do they consider the prospects for the industry, sector, and economy.

Some investors blend both top-down and bottom-up approaches in an attempt to add value across the spectrum.

Company Fundamentals

In order to understand some of the fundamental factors analysts look for, first some basic company financial information is presented. There are three important financial statements on which analysts focus: (1) the balance sheet; (2) the income statement; and (3) the statement of cash flows. There are other financial statements (such as a statement of owners' equity), schedules, and footnotes that are also useful in understanding the three primary statements.

The balance sheet reflects the company's financial position as of a particular date. Figure 39.1 presents a basic balance sheet for a hypothetical electronics retailer. The balance sheet presents the company's resources (assets) and the claims against those resources (liabilities and equity). The resources must always equal the claims (hence the term balance sheet).

The balance sheet heading indicates that the company has a calendar year end and that all numbers are denominated in millions. The balance sheets as of year-end 2004 and 2005 are both presented. The company's assets are classified either as current or long-term. Current assets are expected to be used up in a single operating cycle, typically one year. Non-current assets have a lifetime that spans multiple operating cycles.

U.S. accounting conventions list assets in order of how quickly they can be converted into cash. Not surprisingly, therefore, cash is normally the first asset presented. The balance sheet cash account includes cash on hand, in banks, and other short-term deposits (such as certificates of deposits).

Accounts receivable represents money the company is owed by its customers for goods or services that have been provided. For example, when a doctor provides services and bills the patient at a later date, an accounts receivable balance is created from the time the service is performed until the bill is paid.

Inventory is the unsold merchandise and materials on hand at the end of the year.

Property, plant, and equipment are long-term fixed assets of the company such as buildings, equipment, vehicles, and furniture. These assets are not used up in a single year, but rather benefit the company over time. Generally accepted accounting principles (GAAP) require that companies report the costs associated with money earned in the same period the money is earned, a concept known as the matching principle. Since a factory, for example, helps a company earn money for many years, GAAP requires that the cost of the factory be spread over many years. When the company earns money later, the relevant factory costs are recognized at the same time.

The cost a company recognizes for a fixed asset in the future period is called depreciation. Essentially, depreciation is an estimation of the economic wear and tear on the fixed assets over time.

Total assets are the sum of current and noncurrent assets. For Howard's Electronic Retailers, Inc. (HERI), there were total assets of $500 million at the end of 2004 and $595 million at the end of 2005.

Liabilities are also classified as current or noncurrent. Just as assets are listed in order of how quickly they are likely to be turned into cash or used up, liabilities are listed in the order they are expected to be paid.

Accounts payable represent the amounts owed to suppliers. Accrued expenses represent additional expenses payable to others, such as employees, the government, or landlords.

Long-term debt represents amounts due to creditors, such as banks. For example, when a company buys vehicles, it may choose to finance their purchase. In a way, financing long-lasting assets with liabilities that are paid off over time is the economic (as opposed to accounting) version of the matching principle.

Equity represents the amount owners have invested in a business, either initially or by reinvesting the company's earnings. Common stock represents the amounts paid into the company when the stock was first sold to shareholders. Retained earnings are the earnings accumulated in the company (not paid out to shareholders as dividends) since inception.

The income statement shows how profitable a company was during a particular time period. Figure 39.2 presents income statements for HERI. Typically three years of the income statement are presented in a company's annual report. For HERI, income statements for December 31, 2003, 2004, and 2005 are provided.

The top line of the income statement, revenues, is the total amount received (or due) from customers for goods and services provided during the period. Cost of goods sold represents the cost of those goods (or services), such as materials and labor used directly in delivering the goods (or services). The difference between revenues and cost of goods sold is called gross profit. Gross profit is a basic measure of how the company is doing. The higher the gross profit, the better.

Operating expenses are other expenses incurred in the operation of a business, such as overhead. Operating income is the subtotal reflecting gross profit minus operating expenses.

Interest expense is the interest paid to creditors for the use of their money during the period. Pre-tax income is the subtotal that includes operating and non-operating (financing) results. Income tax is the amount owed on the reported income. Net income, commonly termed "the bottom line," is the overall net profit during the period. When net income is divided by the number of shares of stock outstanding, the result is known as earnings per share (EPS). EPS allows each investor to determine his share of net income.

As discussed earlier, the matching principle requires that revenues be reported when earned and expenses when incurred. This does not necessarily coincide with when the cash is received or paid. As a result, the third important financial statement, the cash flow statement, presents the cash received and paid out during the period. Figure 39.3 presents the cash flow statement for HERI.

Cash flow is important because it is necessary to pay employees, suppliers, creditors, and, ultimately, owners. The cash flow statement is divided into three sections; operating cash flows, investing cash flows, and financing cash flows. Operating cash flows relate to operating the business. Investing cash flows relate to investments in long-term assets. Financing cash flows relate to financing the company, such as issuing/repaying debt, issuing/ repurchasing shares, and paying dividends.

Generally, it is preferable to have strong, positive operating cash flows that can be used to invest in long-term assets and repay capital providers (debt and equity).

Recent accounting scandals have highlighted the importance of paying attention to the cash flow statement. Some companies abuse and pervert accounting guidelines to overstate net income. If a company has rising net income but declining operating cash flow, this is a warning sign and the company should be scrutinized carefully.

Company Ratios

In order to evaluate how a company is doing over time and relative to other companies in the industry, financial performance and position must be compared. Since comparisons between companies of different sizes or growth rates can be difficult, analysts often create ratios to remove the impact of size differences. Ratios can be categorized as: liquidity and solvency, efficiency, profitability, and price multiples. Some common ratios in each of these categories are presented in Figure 39.4.

Liquidity and solvency ratios show the ability of a company to pay short- and long-term obligations, respectively. HERI has a current ratio of 2.35 (195/83) indicating that it has $2.35 of current assets for every $1.00 of current liabilities. When the current ratio is greater than one, current assets are sufficient to satisfy current liabilities. A company with a higher current ratio is less likely to default on its payments, but an extremely high current ratio may indicate the company is not using its resources efficiently.

HERI's debt ratio is 54.29% (323/595), indicating that a little more than half of its assets are financed with liabilities. In terms of solvency, a lower number would indicate lower financial risk. However, debt can be beneficial if the company can use the debt-financed assets to earn more than it pays in interest.

Times interest earned measures whether the company earns enough operating income to make its interest payments. HERI has a times interest earned ratio of 3.17 (57/18), meaning it can cover its interest slightly more than 3 times.

Efficiency ratios provide insight into how well the company is managing various activities. Accounts receivable turnover indicates how quickly the company collects money owed by its customers. A high number means the company collects its receivables quickly. HERI has an accounts receivable turnover ratio of 16.36 [900 / ((50 + 60) / 2)]. On average, this means it takes 22.31 days (365/16.36) on average to collect receivables. Similarly, inventory turnover measures how often the company turns over its inventory. HERI turned over its inventory 6.48 times per year [713 / ((100 + 120) / 2)] (equivalent to 56.33 days of inventory on hand [365 / 6.48]). Total asset turnover indicates the companies overall efficiency. HERI has a total asset turnover ratio of 1.64 times. This indicates that HERI generates $1.64 in sales for every $1.00 invested in assets.

Profitability ratios indicate the company's relative profitability. HERI's net profit margin of 3.0% (271/900) indicates that it earns $3.00 for every $100.00 in revenue. HERI has a return on assets ratio of 4.93% [27 / ((500 + 595) / 2)] indicating that it earns $4.93 of profits for every $100.00 invested in assets. Lastly, HERI's return on equity is 10.76% [27 / ((230 + 272) / 2)], indicating that it earned $10.76 in profits for every $100.00 invested by the owners.

The price multiples indicate the relative valuation of the company by the market. A low ratio indicates a low valuation relative to some fundamental measure, and could indicate that the company is a bargain or that investors expect it to do poorly. A high ratio could indicate overvaluation or high expected future growth. The price earnings (P/E) ratio is the price per share relative to earnings per share. The price to book (P/B) ratio is the price share divided by book value (stockholders' equity) per share. Price to operating cash flow is the price per share relative to operating cash flow per share. Assuming a price of $4.00 per share for HERI, its price multiples are:
P/E               15.38 [4 / .26]
P/B               1.50 [4 / (272 / 102)]
P/OCF             10.20 [4 / (40 / 102)]


The company is selling for 15.38 times earnings, 1.5 times book value (accounting basis for equity), and 10.20 times operating cash flow. These measures can be compared to peer companies and the overall market to assess the company's relative valuation.

Example

Landstar System, Inc. provides transportation services, mainly truckload transportation over medium distances. The company does not own its own vehicles, but instead uses technology to match loads sourced by commissioned agents with drivers who provide their own vehicle. As a result, Landstar's fixed asset base is relatively small.

An investor looking at Landstar in early 2006 might find the following information in the company's annual report:
Year ended December 31

(in thousands of dollars)      2005         2004         2003

Total revenue               2,520,523    2,021,282    1,597,791
Net income                    119,956       71,872       50,700
Cash flow from
  operating activities          6,529       49,744       53,396


At first glance, the investor is pleased with the company's rapid revenue growth rate (24.7% in 2005 and 26.5% in 2004). In addition, net profit margins (net income divided by total revenue) have risen from 3.2% in 2003 to 3.6% in 2004 and 4.8% in 2005. However, each year the cash flow has fallen even though the company reported higher income. The investor looks at the cash flow statement and determines that rising receivables have been the culprit.

A look at the footnotes to the financial statements provides this explanation:
   Included in revenue at the global logistics segment for the 2005
   and 2004 fiscal years was $275,929,000 and $63,790,000,
   respectively, of revenue related to disaster relief efforts for the
   storms that impacted the United States. These emergency
   transportation services were provided primarily under a contract
   between Landstar Express America, Inc. and the United States
   Department of Transportation/Federal Aviation Administration (the
   "FAA")....

   Included in accounts receivable at December 31, 2005 was trade
   accounts receivable due from various departments of the United
   States Government of $226,057,000, which includes $215,250,000 in
   trade receivables from disaster relief services provided under the
   contract with the FAA. The decrease in cash provided by operating
   activities was primarily due to an increase in trade receivables
   resulting in large part from revenue related to the emergency
   transportation services provided under the FAA contract. The
   financing of a portion of this $215,250,000 receivable from the FAA
   with borrowings under the Company's revolving credit agreement is
   the primary reason for the increase in long term debt....


The FAA contract expires December 31, 2006.

So, the investor was able to use ratios and fundamental analysis to spot a potential problem, which could then be tracked to its source using other information. If the 10K had not disclosed this information, the investor could have tried calling management to ask for an explanation.

However, as is often the case, the answer has led to more questions. The investor can feel more confident about the company's ability to collect the receivables (the US Government is a reliable customer) and can easily explain the falling cash flow in spite of rising income. In fact, the March quarter 10Q shows $97 million in cash flow against $24 million net income, as a good portion of the disaster relief receivables were collected. However, the information also reveals that a large portion of the growth depended on severe weather that may not happen again. Furthermore, with the contract expiring in 2006 it is unclear that the company would benefit even in the event that severe weather did strike again.

Fundamental Screening

Since there are more than 10,000 potential public company investments to consider, advisors are unable to examine the financial statements and ratios in detail for each company. Therefore, the process often begins by screening a large database of securities to find a small number that have desirable attributes. For example, a value manager may look for companies with relatively low price multiples but strong profitability and growing cash flows. The database could be screened to select companies that meet these criteria. The smaller sample of companies that is produced can then be analyzed in more detail.

Technical Analysis

Technical analysis assumes that fundamental information is reflected in market data such as price and trading volume and, therefore, the analyst can focus on charts of such data to make investment decisions. This does not necessarily mean that markets are perfectly efficient. For example, if markets react slowly to new information, this can be found by looking at the trend in a price chart and making an investment decision based on this trend. Technical analysis includes a study of charts depicting trends in price and volume and indicators as to when a trend is expected to continue or reverse. While many view technical analysis as the antithesis of fundamental analysis, some analysts view them as complementary tools. Technical analysts can benefit by understanding how fundamentals may be driving trends and fundamental analysts can benefit from using trend information to time buy and sell decisions.

Charting

In its simplest form, technical analysis involves preparing a chart of past price and volume data. Figure 39.5 presents a typical bar chart for Dell Computer.

[FIGURE 39.5 OMITTED]

The top portion of the chart depicts price information. Each bar on the graph summarized a day's trading activity: showing the open, high, low and closing prices.

Figure 39.6 shows one such daily bar. This bar depicts the opening price with a horizontal line to the left, the closing price with a horizontal line to the right. The vertical bar depicts the range of prices for the day from the low (bottom) to the high (top).

[FIGURE 39.6 OMITTED]

The price trend for the day appears to be up. In technical analysis, a trend is generally considered to continue until a reversal signal or pattern emerges in the chart. One such signal compares the price to a moving average of price over some period. The solid line in the price area within Figure 39.5 is a moving average of the last 50 days of prices. A reversal of the short-term trend is signaled when the price crosses the moving average line. When the price falls below the moving average it is considered a sell signal. When the price rises above the moving average it generates a buy signal.

Some technical analysts believe that certain patterns in prices signal a trend reversal. One such pattern is a head and shoulders top, depicted in Figure 39.7.

[FIGURE 39.7 OMITTED]

The jagged line in Figure 39.7 represents a summary of the price action. The line with an arrow is added to show the point at which a sell signal would be generated. This is termed the neckline. When a price chart forms a head and shoulders pattern, the analyst watches as the right shoulder is formed to see if the price falls below the neckline, which would be a sell signal.

The bottom portion of Figure 39.5 provides vertical bars depicting daily volume information. In technical analysis, trading volume is used to confirm signals generated by price data. For example, a decreasing volume pattern with each subsequent peak (left shoulder, head, right shoulder) accompanying the head and shoulders pattern confirms the strength of the sell signal. It indicates that fewer people are willing to buy as the pattern develops.

Support and resistance are two important concepts in technical analysis. Consider the price pattern in Figure 39.8. The arrow indicates a support line. Each time the price falls to this line, it rebounds indicating that buyers are coming into the security at that price.

[FIGURE 39.8 OMITTED]

Figure 39.9 presents a resistance level pattern. Resistance levels indicate a point at which sellers step in to sell at a particular price, driving the price down.

[FIGURE 39.9 OMITTED]

Support (resistance) levels may be useful in indicating target purchase (sale) prices. Care must be taken when using support and resistance levels since the support and resistance lines can be broken (for example due to new fundamental news). Breaking a support or resistance line can indicate that a new trend is forming.

Overall Market Analysis

In addition to charting individual securities, technical analysis involves the evaluation of overall security markets. Technical indicators can be used to determine the trend in the overall market and evaluate when it is desirable to make an investment in a particular asset class or alter asset allocation. Technical analysis of security markets can include the use of sentiment indicators, flow of funds indicators, and market structure indicators.

Sentiment indicators are used to evaluate the overall bullishness or bearishness of the market. Commonly used sentiment indicators include the volatility index, put/call ratio, short-interest ratio, and insider trading activity.

Volatility Index. The CBOE Volatility Index[R] (VIX[R]) is a measure of market expectations of near-term volatility derived from S&P 500 stock index option prices (www.cboe.com). According to the Chicago Board Options Exchange:
   "VIX is based on real-time option prices, which reflect
   investors' consensus view of future expected stock market
   volatility. During periods of financial stress, which are often
   accompanied by steep market declines, option prices--and VIX--tend
   to rise. The greater the fear, the higher the VIX level. As
   investor fear subsides, option prices tend to decline, which in
   turn causes VIX to decline. It is important to note, however, that
   past performance does not necessarily indicate future results."
   (www.cboe.com, Frequently Asked Questions, as of July 23,
   2006).


Figure 39.10 demonstrates the relationship of the VIX and the S&P 500 index in recent periods.

Put/Call Ratio. The CBOE also presents daily data on the ratio of put options to call options for equities, indices, and their total (equity plus indices). The ratio is the daily volume of puts options divided by the daily volume of call options. The lower the ratio the more bullish market participants are and the higher the ratio the more bearish market participants are. However,, sentiment indicators such as this are contrary indicators, bullishness of market participants gives a bearish signal for the market and bearishness of market participants gives a bullish signal for the market. This accounts for overconfidence of market participants at market tops and pessimism at market bottoms. Figure 39.11 presents CBOE Total Put/Call ratio data as of July 21, 2006.

[FIGURE 39.10 OMITTED]

[FIGURE 39.11 OMITTED]

Short Interest Ratio. The short interest ratio measures the volume of short sales for an index or security relative to average volume. This is a contrary sentiment ratio, since a high ratio indicates a high level of short activity and is considered bullish, whereas a low ratio is considered bearish.

Insider Trading. While the overall market is often wrong at market tops and bottoms, insiders have been found to be right at tops and bottoms. High insider buying relative to insider selling is therefore a bullish sentiment indicator. Low insider buying relative to selling is bearish.

Flow of funds indicators are used to assess the prospects for inflows or outflows of cash into the market or sectors. Flow of funds analysis involves examining trends of sources of cash, such as the cash positions of large investors such as mutual funds and pension funds. For example, mutual fund data can be obtained from the Investment Company Institute. Flow of funds analysis also involves examining potential demands for cash, such as new public offerings, and overall liquidity in the economy.

Market structure indicators examine charts of market indices for patterns and trends in both prices and volume (as with individual stocks discussed earlier). Market indices that are subject to analysis include the Dow Jones Industrial Average, S&P 500 Composite, Dow Jones Transportation Average, Dow Jones Utility Average, the NASDAQ, and Russell indices. Other market structure indicators include those that examine market breadth. Market breadth measures the extent to which issues underlying the indices are participating in the market trend. A market trend is stronger when more issues are participating. A popular measure of market breadth is the Advance/Decline line, which measures the number of issues advancing in excess of those declining. An increasing advance/decline line is positive for the overall market.

TIMING OF INVESTMENT PURCHASES AND SALES

In addition to selecting the right individual securities for purchase, the advisor must decide on the right price and the timing of the purchase and subsequent sale. Valuation of stocks and bonds is covered in Chapter 33, "Measuring Investment Returns," and Chapter 34, "Measuring Yield." This section explores purchase and sale strategies.

Market Timing

Market timing attempts to anticipate the market's broad direction and individual security prices, but the focus is usually on the broader market. Investors who believe stocks are too expensive will favor other asset classes. Those who believe stocks are cheap will sell other asset classes to buy more stocks.

The timing can be based on economic trends, stock prices, or valuation levels. For example, when stocks are above their normal P/E multiple range, this may be an indicator to reduce stock holdings. Similarly, when an individual security is at the high (low) end of its normal valuation range, this may be a sell (buy) indicator. Technical charts of market indices and individual securities can be useful in generating buy and sell signals in a market timing strategy.

Buy and Hold

In contrast to market timing, a buy and hold strategy does not attempt to anticipate moves in the market or even individual securities. Rather, such a strategy relies on the notion that a well-planned investment policy will result in a portfolio that best meets an investor's risk and return profile. Buy and hold strategies tend to be long-term oriented, whereas market timing strategies are short-term in nature.

One advantage of a buy and hold strategy is that it reduces transaction costs. Another is its simplicity. A disadvantage of a buy and hold strategy is that it can distort an investor's asset allocations. Consider an investor who decided in January 1996 that her appropriate asset allocation was 50% stocks and 50% bonds. She makes a single decision to buy the assets in those proportions and promptly forgets about it. By year-end 1999, stocks have vastly outperformed bonds. Because of this relative difference in performance, stocks now comprise two thirds of her portfolio. She has unintentionally changed her asset allocations to favor stocks--just before the stock market crashes and bonds enjoy several years of superior performance.

A buy and hold strategy implies that only one investment decision is made (to buy). Occasionally, however, passive market timing strategies such as rebalancing will be described as "buy and hold." It could be argued that one decision is made to "buy" the chosen allocation, and the later adjustments simply conform to the original strategy. It is important to understand which definition of "buy and hold" a particular pundit may espouse.

Passive Investing or Indexing

Passive investment strategies seek to mimic the returns on a benchmark index, such as the Standard & Poor's 500. The goal of a passive investment manager is not to beat the benchmark index, but rather to match it as closely as possible. But if no attempt is made to provide returns superior to the benchmark, why should an investor choose a passive strategy?

The main advantage of passive investing is reduced cost. Since benchmark index constituents change only occasionally, trading costs are lower than with most actively managed strategies. Also, active strategies require skilled analysts and managers. There is no need for active security selection in a passive indexing strategy.

One way to construct a passive portfolio is to simply buy and hold the securities in the index, at their appropriate weightings. This method is known as replication, and its main advantage is low tracking error with the index. However, replication can be difficult to accomplish for many reasons. For one thing, in small portfolios replication is likely to require owning partial shares. Furthermore, investment flows, such as new investment, withdrawals, or dividends, would require the proceeds to be distributed to buy or sell tiny amounts of each stock in the index. An alternative is the use of index mutual funds or exchange-traded index funds.

A second means of constructing an indexed portfolio is sampling. Under this strategy, several securities are chosen in such a way as to be representative of the overall index. Doing so reduces trading costs and the need to buy small quantities of many stocks. However, it increases specific security risk and is unlikely to track the benchmark well.

WHERE CAN I FIND OUT MORE ABOUT IT?

1. More information on financial analysis and ratios can be found on Tom Robinson's Financial Education blog at www.financial-education.com.

2. John J. Murphy, Technical Analysis of the Financial Markets (New York, NY: New York Institute of Finance, 1999).

3. Martin J. Pring, Technical Analysis Explained, 4th Edition (New York, NY: McGraw-Hill, 2002).

QUESTIONS AND ANSWERS

Question--What are the differences between fundamental and technical analysis?

Answer--Fundamental analysis involves an examination of underlying company and industry fundamentals, such as financial statements and ratios, whereas technical analysis examines only market information, such as price and volume.

Question--An investment advisor examines the overall economy and selects the industry he feels will perform best over the coming five-year period. He then screens a database of securities to find companies in this industry. Finally, he narrows down the list of companies in the industry by focusing on companies that have a low price relative to earnings, but stable and positive returns on equity. What investment strategy is being followed?

Answer--This advisor is following a top-down, fundamental strategy. Further, the fundamental screens appear to be a value (versus a growth) approach.

Question--A company's stock price has been below its 50-day moving average for some time. The price for the last few days has moved above the moving average line. Further, volume is increasing. What type of technical signal is generated?

Answer--The fact that the price has moved above the moving average from the bottom would generate a buy signal. This is reinforced by the fact that volume is increasing with the price increase.

Question--What would a high put/call ratio indicate?

Answer--A high put/call ratio indicates a high level of put option volume relative to call option volume. This signals pessimism for market participants, which is considered to be bullish for the market.
Figure 39.1
HOWARD'S ELECTRONIC RETAILERS, INC.
BALANCE SHEET
AS OF DECEMBER 31
(IN MILLIONS OF DOLLARS)

                                    2004      2005

Cash                                  $10       $15
Accounts Receivable                    50        60
Inventory                             100       120

Current Assets                        160       195

Property, Plant and Equipment         640       730
Accumulated Depreciation            (300)     (330)

Total Assets                         $500      $595

Accounts Payable                      $40       $45
Accrued Expenses                       30        38

Current Liabilities                    70        83

Long Term Debt                        200       240

Total Liabilities                     270       323

Common Stock                          100       115
Retained Earnings                     130       157

Total Equity                          230       272
Total Liabilities and Equity         $500      $595

Figure 39.2
HOWARD'S ELECTRONIC RETAILERS, INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31
(IN MILLIONS OF DOLLARS)

                         2003      2004      2005

Revenues                  $750      $800      $900
Cost of Goods Sold         560       600       713

Gross Profit               190       200       187

Operating Expenses         100       120       130

Operating Income            90        80        57
Interest Expense            18        18        18

Pre-Tax Income              72        62        39
Income Tax Expense          21        19        12

Net Income                 $51       $43       $27

Shares Outstanding
(millions)                 100       100       102

Earnings Per Share       $0.51     $0.43     $0.26

Figure 39.3
HOWARD'S ELECTRONIC RETAILERS, INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31
(IN MLLIONS OF DOLLARS)

                          2003      2004      2005

Operating
Net Income                  $51       $43       $27
Plus Depreciation            25        25        30
Change in Working
  Capital                  (20)        10      (17)

Operating Cash Flow          56        78        40

Investing
Capital Expenditures       (60)      (70)      (90)

Investing Cash Flow        (60)      (70)      (90)

Financing
  Borrowing                   0         0        40
  Issuance of Stock           0         0        15

Financing Cash Flow           0         0        55

Total Cash Flow             (4)         8         5
Beginning Cash                6         2        10

Ending Cash                  $2       $10       $15

Figure 39.4

Category          Ratio                                Formula

Liquidity &       Current Ratio                Current Assets Current
Solvency                                             Liabilities

                  Debt Ratio                   Total Liabilities Total
                                                       Assets

                  Times Interest Earned        Earning Before Interest
                                                 and Taxes Interest
                                                       Expense

Efficiency        Accounts Receivable          Sales Average Accounts
                  Turnover                           Receivable

                  Inventory Turnover             Cost of Goods Sold
                                                  Average Inventory

                  Total Asset Turnover           Sales Average Total
                                                       Assets

Profitability     Net profit margin               Net Income Sales

                  Return on assets            Net Income Average Total
                                                       Assets

                  Return on equity            Net Income Average Total
                                                       Equity

Price Multiples   Price/Earnings              Price Per Share Earnings
                                                      Per Share

                  Price/Book Value              Price Per Share Book
                                                   Value Per Share

                  Price/Operating Cash             Price Per Share
                  Flow                           Operating Cash Flow
                                                      Per Share
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Title Annotation:Techniques of Investment Planning
Publication:Tools & Techniques of Investment Planning, 2nd ed.
Geographic Code:1U2NY
Date:Jan 1, 2006
Words:5537
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