Wednesday, August 31, 2011

Financial Evaluation of Stock

When it comes to Investment, Warren Buffett stands tall than any of his compatriots. I was reading the book by Robert G. Hagstrom called “The Warren Buffett Way” and I would like to keep a note of important things I have read in this book:

Page- 109 to 119

Warren Buffett “never takes yearly results too seriously; instead he takes four of five years averages”. True to his believes and understanding, companies finance department often are found playing with the numbers to show the performance of the company better than they actually are. Warren Buffett knows this and he always bases his decisions of few timeless financial principals.
  • Earning per equity – instead of earning per share
  • Owners earnings – to get a idea of actual earnings
  • Profit Margins – focus on companies with high profit margins
  • Above average returns on retained earnings – for every $ retained, company should create at least a dollar of market value.
Earning per share is calculated from the net profit margins of the company (net profit divided by number of outstanding shares). This gives estimation that how much profit per share the company has generated.

If say the company has generated $10 million as its net profit and number of outstanding shares is 5million, then earning per share will be $10 divided by 5, equals to $2. But generally companies never disburse complete earning per share to its share holders, “since most companies retain a portion of their previous year’s earnings to increase their equity base”.

This is the reason why Warren Buffett prefers Buffett “prefers return on equity—the ratio of operating earnings to shareholders’ equity”. Thought it is advisably to use this tip of financial investment after doing some simple manual calculation instead of taking values right as they are in the financial statements:
  1. Share holders equity shall be calculated at its face value. Number of outstanding shares multiplied by its face value.
  2. Operative earnings shall be isolated form any other gains or losses.
  3. It must be checked that that a company is not taking to much loan to finance its growth.
Owner earnings—a company’s net income plus depreciation, depletion, and amortization, less the amount of capital expenditures and any additional working capital that might be needed. The pattern of growth in owner’s earnings is generally followed by the market value of that stock.

Converting sales into profit is not a one day activity or an accounting jugglery. In order to be competitive, management shall focus on operating cont reduction per unit of production. Cost reduction shall be a habit and a discipline without which a company will be washed out of market eventually.

Often the earnings of the company is retained and reinvested within the company to fund their growth and expansion projects. Suppose the retained earnings is $10 million and number of outstanding shares in the market is 5million. Then retained earnings per share will be $2. This dollar $2 must be added in the companies market value soon in the future.
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