by Andy Tanner
In the United States fiscal policy is set by Congress, and monetary policy is set by the Federal Reserve Bank. The history and ownership of the Federal Reserve—and its relationship to our government—is a long and interesting one that we will explore in another book. But please remember that learning about the Federal Reserve and other central banks is a vital part of your financial education.
To help your understanding for this discussion, here is a short rundown of the Federal Reserve:
•It is not federal, because it is not technically a United States government agency.
•It does not hold reserves in the sense that we often think of reserves.
•It is most certainly not a bank as we understand the term.
From its own publication, this is how the Federal Reserve describes itself:
“The Federal Reserve System is considered to be an independent central bank...The Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government; therefore, the description of the System as ‘independent within the government’ is more accurate.”
By stating that it is independent, the Federal Reserve admits it is not a government entity. It is responsible for its own decisions, and not even the President of the United States can tell it what to do. It gets to decide whether or not it’s going to buy Treasury bonds, and it gets to decide whether or not to raise or lower the interest rate. While the U.S. Congress claims to have oversight, there is very little the citizens, or Congress, or even the President can do to affect the actions of the Federal Reserve.
The Federal Reserve has powers to decide the monetary policies of the United States. The two powers that we will concentrate on for the purposes of this book are:
1)The power to change the discount rate (aka interest rate)
2)The power to buy bonds and other securities
By lowering interest rates, the Federal Reserve can incentivize borrowing. That in turn can boost the GDP as people make purchases with the borrowed money. The Fed can also buy Treasury bonds. (And although it seems counterintuitive, the Fed has been given the power to do this with money they print out of thin air!) These two powers cause changes to the currency supply.
Analyzing Monetary Policies
Virtually all the economies of the world are intertwined. From sovereign nations to corporations to individuals, nearly every financial statement exists under the umbrella of the United States and its fundamental numbers. The sheer size of the massive U.S. economy has something to do with it, of course. But this intertwining is also the result of something you may never have heard of: the Bretton Woods System.
The Bretton Woods Agreement dates back to 1944 when the industrial nations of the world agreed that since the United States backed its currency with gold at the time, the dollar would become the world’s reserve currency. This means that all the commodities we consume—wheat, barley, oats, frozen concentrated orange juice, gold, silver, and even oil—are measured in U.S. dollars.
Why should you care about Bretton Woods? Because if you are investing in stocks, you will be mindful of sovereign fundamental analysis. You need to know what’s happening with the different nations of the world. And most importantly, you need to know about the strength or weakness of the dollar at any given time. Due to the Bretton Woods Agreement, the U.S. dollar affects virtually everything on the planet.
The next chapter in the history of U.S. currency began in 1971 when U.S. President Richard Nixon took the U.S. dollar off the gold standard. But even today, the U.S. dollar represents more than 60 percent of the world reserve currency. That’s why stock investors worldwide always want to know how the U.S. dollar is currently performing.
Your Future Can Be Bright
With U.S. policies of deficit spending, pressure for higher taxes, printing money (which devalues the dollar), and the policies of Europe, Japan, and China sending similar messages, many people are afraid of what will happen to the global economy in the future and how they will weather the financial storms that will surely come our way. Never fear! Remember that fundamental analysis is a stepping stone that brings you closer to your goal of stock market cash flow.
Remember that cash flow is all about how you position yourself. It has less to do with good or bad news as the world sees things. With the right education, financial storms can quickly become some of the greatest opportunities. This is why your context is so important
A few years ago my wife and I were vacationing in Orlando, Florida with our kids. I got a phone call early in the morning from Robert asking me if I had seen the news. There had been a huge accident on an oil rig in the Gulf of Mexico. As a result, massive amounts of oil were spewing into the water. It created an environmental nightmare, and it was unclear how the problem would be fixed or how long repairs would take. This was terrible news from almost every angle. But it did not have to be bad financial news as well. When you receive bad news, you have two choices: 1) You can cry about it and hope it changes, or 2) You can position yourself to avoid the problems and possibly even profit from them.
Robert and I discussed the different ways an investor could reposition himself during such an event. The company responsible for the accident was British Petroleum. The first step was to evaluate the financial strength of that company to see how well they could deal with this crisis.
Are you beginning to see how valuable fundamental analysis can be in deciding how to position yourself? There is no question that the sovereign fundamentals in Europe, Asia, and the United States help determine how investors position themselves. And when it comes to individual stocks, fundamentals are there to help you position yourself more intelligently.
Corporate Financial Statements
With that important insight, let’s begin looking at how to evaluate stocks that we might want to invest in. To do so, we will show some ways to perform fundamental analysis of the corporations that issue stock to the public. Specifically, we will look at corporate financial statements to calculate value and determine risk that will help us make intelligent decisions on the purchase of stocks.
Here are two corporate financial statements. On the left is Apple Computer, developer of the iMac, iPod, iPhone, iTunes, and other popular products. And on the right we have Blockbuster, the company that provided their customers with movie rentals. As you may know, Blockbuster was a video rental company that declared bankruptcy and was then acquired for pennies on the dollar by a satellite broadcasting company. It was a victim of technologic obsolescence. The advent of new technology made Blockbuster’s business model obsolete. Who wants to drive over to a video rental place when they can just download the same video at home?
Take a look at the Apple statement first. At the end of 2010, Apple had about $86 billion in assets. Now, it also cost the company some money to make that $86 billion, but generating that income from the assets, Apple made about $26 billion the last quarter of that year. That’s a lot of revenue, by any standard. Of course Apple also had expenses. It had to pay employees, rent, fuel, raw materials…all kinds of minuses on the balance sheet. It had assets that produced money, but it spent $20 billion to make those assets possible. Still, it had reported $6 billion profit within a quarter.
Now, another thing Apple did was to take on some debt because it wanted to grow really, really fast. And sure, $6 billion in profit isn’t bad, but you could grow a lot faster if you borrowed $32 billion, and Apple did just that. So it had $32 billion in liabilities.
As we learned in the previous chapter, it’s always good to look at the relationship between debt and assets. For Apple, the assets were far greater than the liabilities, which put it in a very strong position as compared to what we saw on the U.S. financial statement. In my opinion, the United States is abusing its debt; Apple, on the other hand, is using its debt wisely.
Using debt for growth was a good decision for Apple—and its profits prove it. It was more powerful to leverage the money out of debt than
to pay out of earnings. As investors, we need to realize this principle and use it in our evaluations. I don’t care if a company like Apple has some debt, as long as it’s using the debt to grow and not to pay for liabilities. If it is solvent, then debt is not a problem. In the case of Apple, it was certainly solvent with $6 billion of profits each quarter.
Looking again at the balance sheet, one might wonder why Apple didn’t just pay off its debt from its huge asset base. If it did, its asset base would drop to $54 billion. It’s much harder to generate $26 billion from that smaller amount of assets. Apple was using some leverage with debt. And it was doing it very well.
The financial statement of Blockbuster tells a different story. It had $1.12 billion in assets, which it used to produce an income of $736 million. But it was very expensive to generate that revenue. From the income statement we can see that its expenses were $786 million, leaving it with a $53 million loss for the quarter. At that time, Blockbuster was not solvent.
The first step toward bankruptcy is insolvency, meaning the income is less than expenses. The second step is default, which is when an entity can’t pay its bills. In the case of Blockbuster, it had debts of $1.16 billion. When we subtract its liabilities from its assets to calculate the equity, we can see that it had a negative equity of $400 million. And with negative cash flow, the situation looked bleak. Blockbuster was in a very difficult situation.
Stock Prices Don’t Indicate Investment Quality
It’s pretty likely that you’ve heard the old adage, “You get what you pay for.” Well, it’s often true when it comes to buying stock.
Some naïve investors focus all their efforts on finding what they think are “affordable” stocks. But the price of a stock is only part of the story. As an investor, you need to always be considering value. Price is what you pay…and value is what you receive.
Let’s look at Apple and Blockbuster again. At the end of 2010, Apple shares were trading at more than $300. Some people would say that such prices were far too expensive. They might think that a stock such as Blockbuster was far better because it was available for just six cents per share. They’d be right if they were just looking at price. But fundamental analysis lets us consider value instead.
Looking closely at Apple’s financial statement, we see that it had strong cash flow and an excellent debt/assets ratio. Its fundamentals were sound and the stock offered an investor real value, even though the actual stock price appeared to be high. Smart investors responded by buying Apple stock.
Blockbuster’s fundamentals were very poor. Despite this, there were uneducated investors who were willing to buy Blockbuster’s stock at six cents per share. I can imagine them thinking, “Hey, it’s Blockbuster, it’s been around for a long time. I can’t believe its stock price is so cheap, I need to grab some while it’s so low. This thing has got to go up. What have I got to lose?”
Investing is about making smart decisions to grow your money and create positive cash flow. When you make a poor decision, you are undermining that goal. It doesn’t matter if the price of a stock is really low or really high—we need to focus on buying value that will help us achieve our investing goals.
Blockbuster has since gone bankrupt, providing us with another valuable investing lesson. People who fish for these penny stocks in hopes of netting a big winner often go home empty-handed. When you buy something with almost zero value, you are hoping against reason that it will pay off. However, this approach isn’t investing—it’s gambling. And smart investors rarely gamble.
Valuation
With fundamental analysis we have gained some valuable tools to examine an entity and determine its strengths and weaknesses. This leads us to the next logical step: Determining the real value of a stock based on the fundamental numbers. This is a key point called valuation.
As you may have noticed, stock prices don’t just have a price tag on them like a package of paper towels in the grocery store. They tend to fluctuate all day while the stock market is open. These fluctuations occur because of supply and demand. When investors think the price of a stock makes it a good value, they rapidly buy the stock forcing the price to go up. When the price gets to a point where investors think it is overvalued, they start selling and force the price down.
As investors, we need to be aware of what we think a stock is worth and what the price of that stock is in the market. To develop this valuation, we consider the company’s earnings and growth.
Price/Earnings Ratio—the PE
Earnings represent how much money the company makes. The price investors are willing to pay for a stock is largely based on how much money the company generates. The more money a company earns, the more valuable it is to investors, which means they are generally willing to pay a higher price to own that stock.
As we learn to determine the value of a stock, we’ll be in a much better position to make good investment decisions that will help us achieve those goals of growing our money and creating cash flow. To do this, let’s look again at the income statement, the balance sheet, and some new relationships between price and the earnings.
One of my goals since becoming a parent has been to provide my sons with experiential learning. I don’t worry about home schooling versus public schooling; I do both. When I want to teach my sons about volcanoes, we fly to Hawaii and see a real volcano. When we study space travel, we go to Kennedy Space Center in Florida. They go to public school, and they learn a lot there, but I don’t rely on that system alone to teach them everything I want them to learn. (Of course, all this takes money, and we have invested a lot of money tied to these life goals. There’s nothing that moves me more deeply than watching my kids learn).
So when I wanted to start teaching my kids about money, I helped them start a business. I didn’t want their first income to come from shoveling snow from somebody’s walkway or washing windows. I wanted them to experience what it was like to start a business and offer value through that business to as many people as possible. I want them to grow up with running a business being second nature.
My boys started Tanner Brothers Ice Cold Lemonade when they were just little kids—not yet even in first grade. They learned very quickly that people would show up because they were cute. But they would come back if they delivered value. So we spent some time and built a nice wooden lemonade stand that they could take pride in. They spent some time experimenting with different recipes until they found a truly superior lemonade. They found a venture capitalist (me) and an intern for cheap labor (named Mom). They were set.
Let’s take a look at their initial financials. They started with an investment of $30. With this capital they went to the store and spent $20 on ice, lemons, and sugar. This represents their expenses. On a hot Saturday morning they opened up the stand and immediately made $50. So here’s how their business looked in numbers:
Revenue = $50
Expenses = $20
Earnings = $30
They now easily make more than that $30 every time they set up the stand. They post a schedule on Facebook (https://www.facebook.com/tannerbroslemonade#) so people know when they’re open for business and they find a line waiting for them when they open. They have built a reputation for value that exceeds their cuteness (and let me tell you, they’re pretty cute) and that has increased the value of their business.
With a little taste of business success, let’s say my boys decide they want to grow it even more. They might make the decision to raise more capital by selling one hundred shares in the company to investors.
Based on their experience, they believe they can generate a minimum of $30 of income every Saturday. Divided into 100 shares, we can see that each share represents 30 cents. This is what we call earnings per share.
At this point, let’s suppose you walk past this lemonade stand and you reckon you would like a share of the business. How much should you pay for that share? You look at the earnings and see that if you buy one share you will make 30 cents every Satur
day. Think of the lemonade stand as simply a machine that can generate 30 cents for you each Saturday without having to do any of the work! When you go to buy the shares you will be competing against other investors, and there are only 100 shares of stock being offered to the public. Thus the price of the shares will be determined by supply and demand.
When the shares become available to the public, you see the share price settles in at $3 per share.
So how can you know if $3 per share is a good deal for you?
One place to start is comparing this opportunity to others that are being offered in the neighborhood. If you can see what other investors are willing to pay for the earnings of other companies, you can get an idea of the relative value of this lemonade stand. Let’s say you know that there are two other businesses in the neighborhood with shares available where you could invest your money.
The Smith brothers have a lawn mowing business, and the Jones brothers wash windows.
The Smith Brothers shares have a share price of $2.50.
The Jones Brothers have a share price of $2.00.
Most people would think that the Jones brothers have a better value because their stock is less expensive per share. But you should not look at shares of a stock the same way you shop for things at a store. In the stock market, price simply tells us what we have to pay to own the stock. Price does not tell us anything about what we receive. To better gauge the value, we need to look at the earnings.
You can see the Smith Brothers have a higher share price, but they also deliver greater earnings per share. The Jones bothers have the cheaper stock, but their company produces a smaller amount of earnings for each share.
If you look closely you will discover that investors in both companies are actually receiving the same amount of value when it comes to earnings.
