balance sheet

Don't Be Fooled by an Investment's Rate of Return

Tim Lemke — Fri, 08 Dec 2017 10:00:07 +0000

When you invest, you are looking for return. You want your money to grow over time, preferably at a rate that will allow you to achieve your financial goals.

An investment's rate of return can be a deceptive thing, however. The amount of money that an investment has made in the past isn't a guarantee of future returns. Moreover, these returns by themselves don't tell you a whole lot about what you are investing in.

Learning how to analyze an investment's returns — and understanding its limitations — will help you on the path to financial freedom. Just remember these key facts about an investment's return when examining it.

Short time frames don't tell you much

"Hey, this mutual fund went up 29 percent last year! Woo hoo!" That's great, but what did it do the year before? And the year before that? How has it performed over the last decade? Looking at the rate of return for a single year is not particularly useful, as any investment can have a hot 12 months. To get a sense of how an investment may perform in the future, it helps to have a long record of performance to examine. Fortunately, most brokerages and financial websites have comprehensive information on historical returns, so you're not simply looking at the performance of the last year.

It offers no information on the type of investment

It's great if an investment has a solid rate of return, but that should not be the only consideration when looking to buy shares. If you are buying a stock, you need to ask yourself key questions aside from just looking at performance. What industry does the company operate in? How big is the company? Does it operate internationally? If you're talking about a mutual fund, what is the investment mix? Answering these questions will help you understand whether you already own similar investments, and whether it makes sense to add them to your portfolio.

It's almost useless without context

Let's say you come across a mutual fund that earned a 9 percent return last year. You might think that is pretty good, right? Well, it doesn't look so good when you consider the S&P 500 returned 11.96 percent. Information on returns is only meaningful when it is paired with information about the broader stock market, comparable investments, and specific indexes. A small cap ETF, for example, should be examined alongside the Russell 2000 index. A mutual fund focused on technology should be compared to prominent technology indexes. Fortunately, most brokerage firms and financial websites do provide this, so it's important to analyze market returns using that context.

It does not always factor in all costs

If you purchase a mutual fund or ETF, a certain portion of your investment is taken in expenses and fees. While mutual fund returns are usually reported net of expenses, not every cost is included in this calculation. Many funds have sales charges and commissions (also known as loads) that you pay when buying and selling. Your brokerage firm may also charge a commission to execute the trade. This can reduce your overall return. The good news is that there are many good no-load mutual funds out there, and many can be traded without a commission, depending on the broker.

One more caveat regarding costs. Capital gains taxes will also reduce your balance when you sell. Be sure to factor in these costs when examining an investment's rate of return.

It does not offer detail on volatility

Let's say you have a stock that rose in value from $50 to $90 in five years. The annualized return on that stock is 16 percent. But that does not tell you whether the stock's performance has been consistent or wildly up and down.

For example, during that five-year period, that stock may have risen 20 percent, then dropped 25 percent, then risen 44 percent, dropped 10 percent, and finally rose 53 percent. That's pretty volatile, and may be outside the comfort zone of many investors even though the overall return is good. To get a better picture of the investment's performance, you need to look at the returns from each individual year, but even that offers no insight into price swings within any given year.

It can't answer the question "Why?"

An investment's rate of return may be the crucial piece of information you need to know before investing, but there's a lot that it doesn't tell you. Perhaps most importantly, it does not offer any insight into why an investment's price moved up or doing during a certain period.

Investment values go up and down for a variety of reasons, not all of them related to company performance. Perhaps a retailer saw its shares fall sharply during one quarter due to a series of natural disasters. Perhaps another company saw shares rise dramatically because of hype over its Super Bowl commercial. Returns on investment are crucial to know, but if you are an investor, it's important to do your own homework to understand why a price went up or down. Doing so will help you better understand how an investment may perform in the future.

It gives you no information on fundamentals

An investment's historical rate of return can give you insight into how it might perform in the future. But the company's actual financial performance may be even more important. It's not enough to just examine an investment's return. You should also look at company balance sheets, analyze earnings reports, and look at things like cash flow, debt, and price-to-earnings ratio. This will help you understand whether an investment's price is justified. Examples abound of companies that saw share prices skyrocket based on speculation although earnings weren't there to support it.

It tells you nothing about taxes

Let's say you invested $1,000 in a company stock and it earned an annual return of 9 percent a year over five years. That means you'll end up with $1,450 when you sell, right? Well, not exactly. Remember that unless you are investing in a tax-advantaged account such as a Roth IRA, the government takes its share when you sell. Assuming that you'll be taxed at the long-term capital gains rate of 15 percent, suddenly, that 9 percent annual return became something closer to 7 percent. Keep this in mind when trying to calculate how much money you'll actually walk away with.

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

9 Ways to Tell If a Stock is Worth Buying

Tim Lemke — Fri, 12 Aug 2016 09:00:15 +0000

One of the most effective ways a person can build wealth over the long term is by investing in stocks.

When you own a share of stock, you own a portion of a public company. And when those companies do well, investors make money. In fact, stocks are considered essential for those looking to save for retirement or achieve other long-term financial goals.

It's possible to invest in groups of stocks through vehicles such as mutual funds or exchange traded funds. But you may also want to consider investing in shares of individual companies. There are more than 4,000 companies that are publicly traded on America's two largest stock exchanges.

But how do you know if a stock is worth investing in? What makes a stock good or bad? Here are nine things to consider.

1. Price

The first and most obvious thing to look at with a stock is the price. How much will it cost to buy a share of this company?

Now, it's important to note that prices should only be viewed in context. Many companies will "split" shares once they reach a certain level, thus reducing the price but increasing the number of shares available. Other companies never split, so a single share could go for several hundred dollars or more. But the price — especially when matched against historical prices — will determine how many shares you can purchase with the money you have. When you evaluate stocks, knowing the price of shares and their history will help you determine if you're getting a good value when buying.

2. Revenue Growth

Share prices generally only go up if a company is growing. And one of the few ways a company can grow is by increasing its revenue. Revenue is often referred to as the "top line," and it's a major indicator of whether a company has been successful. It's important to not look at revenue in a vacuum. Instead, look at the increase or decrease in revenue from one quarter to the next and one year to the next. A positive trendline bodes well for the stock price, but if revenue is flat or declining, it's important to find out why before investing.

3. Earnings Per Share

How much money does the company have leftover at the end of each quarter? Take that figure, divide it by the number of shares it has sold, and you get the earnings per share number, or EPS. For example, if a company made $40 million in profits last year and has 24 million shares, the EPS is $1.66.

EPS can be a driver of stock prices, as investors generally don't want to overpay for a stock. Generally, the higher the EPS, the better shape the company is in. But there is often debate about the best range for EPS, and companies can manipulate it by buying back shares, thus boosting EPS without actually increasing profits.

4. Dividend and Dividend Yield

Many companies will return a portion of their earnings to shareholders. Investors can get a small payment for every share they own, known as a dividend. Many healthy companies will issue good dividends each quarter and the revenue from this may outpace the interest you would get from a normal bank account. Thus, dividend stocks are popular among investors looking for additional income, as well as share growth.

It's easy to search for companies with the highest dividends, and you can also search for dividend yield, which is the dividend divided by the share price. If a company has maintained or raised its dividend, that's a sign that it's on strong footing. A cut to dividends is often a bad sign.

Some of the most well-regarded public companies have been designated as "Dividend Aristocrats" for distributing and increasing their dividend for at least 25 consecutive years.

It's worth noting that many good companies do not distribute dividends because they prefer to invest the cash back into the business. (Amazon is one high-profile example.) And many companies, such as utilities, offer dividends because they can't offer great growth in share value.

5. Market Capitalization

Bigger is not always best, but if you are looking to invest in a stock that will give you steady growth without a lot of volatility, the largest companies are often your best bet. A company's market cap is essentially the value of all its shares. Companies with large market caps are often large and diversified enough to avoid being affected by a single piece of bad news. Think of behemoths like Procter & Gamble, Coca-Cola, or ExxonMobil — good, solid companies that have offered decades of solid returns.

6. Historical Prices

All companies go through rough patches. But if you are investing for the long term, you need to do more than look at a single company earnings report or current price performance. Looking at five-year, 10-year, and even 15-year returns will give you a sense of whether a company can withstand tough stretches. Historical returns are not a guarantee of future performance, but can at minimum be illustrative.

7. Analyst Reports

Many brokerages and investment banks have a staff of research analysts that issue reports and recommendations about individual stocks. Often, these reports come with "buy" or "sell" ratings, based on the analysts' judgment of a company's share price and finances. It's important to note that analysts often disagree, so it's best not to rely on a single report before choosing whether to invest.

8. The Industry

It's usually important to examine not just a stock, but the industry that the company operates in. By doing this, you may get an understanding of whether a certain type of business or sector is struggling or doing well. For instance, when evaluating a company such as McDonald's, you'll want to look at the entire fast food and restaurant sector to gain an understanding of how Americans are eating out. Looking at a stock in this context will help you understand if there are positive or negative influences that may not be immediately reflected on a company's share price or balance sheet.

9. Major Economic Indicators

No matter how hard it tries, a company can't control every single thing that might impact business. The broader economy of the nation and the world can play an outsized role in the health of a company and its share performance. Things like consumer prices, the unemployment rate, or changes to interest rates can impact how a company is doing independent of its own business. While the stock market and economy are two separate things, they are very much linked. For the most part, when the economy is doing well, companies are doing well and share growth comes with that. Likewise, share prices can lag during slow economic times or times of economic uncertainty.

Anything we've overlooked? What do you look at when you evaluate a stock?

This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Another path to recovery: higher incomes

Philip Brewer — Mon, 04 May 2009 20:59:23 +0000

Preventing a collapse of the financial system is part of preventing a depression. However, the shorthand term for this--getting the banks able and willing to lend--is misleading. There are plenty of banks that can lend. The problem is the borrowers: Those that could be counted on to repay their debts are mostly uninterested in borrowing, and those who want to borrow probably can't afford to take on more debt. That's the truth about the fix we're in. There are, however, two ways to fix it.

Spend less

First there's the long slow fix: Everybody spends less than they earn and either saves or pays off debts. This can be done. In fact, it always is done--it's the way this sort of situation is always fixed. However, it takes a long time. It's painful and disruptive. It's also unfair, in the sense that the pain falls disproportionately hard on different people depending on where they live and where they are in their life.

The slow fix is slow simply because even pretty serious frugality only opens up so much room between income and expense. WIth the amount of debt that's already baked into the system, too many households simply have no daylight between their daily expenses (including debt service) and their income.

At the same time, each household that bites the bullet and puts itself on the the slow path to a sound balance sheet--expenses less than income, debt service a small fraction of their income, an emergency fund, some retirement savings--shrinks the economy a tiny bit. A smaller economy means fewer jobs, less wages, less profits--meaning that it takes even longer to dig ourselves out of the hole we're in.

There are other pieces to the long slow fix. Assets will be sold and the cash used to pay off debt. Sales of productive assets can help everybody--the seller, who gets cash to settle overwhelming debt; the buyer, who gets something valuable for less than it would normally cost; workers associated with the asset, whose jobs now depend on someone who's not so broke; and consumers, who get more stuff because the productive assets can start producing at full capacity. (Of course, it doesn't necessarily help everybody--a productive asset dismantled and shipped overseas might leave local workers less well off. But the exercise can be a positive-sum game, with everybody better off.) Another part of the same process is bankruptcies--some debts are never going to be paid back. (Short of bankruptcy, some debts can be restructured to make them affordable.)

But, put it all together and it's still long and slow.

The other, quicker fix would be to boost incomes.

Earn more

The government is trying to do a piece of that--reduce the depth of the recession by replacing some of the missing household spending with government "stimulus" spending. That may help ease the downward spiral of households cutting spending leading to businesses laying off workers leading to more households that have to cut spending. But it doesn't help with the fundamental problem that household balance sheets are so badly out of balance that even years of frugal living won't restore a proper balance--if we go that route, it's going to take decades.

If we can boost household incomes, though, the whole thing could be speeded up considerably. Of course, any particular household might just spend its extra income, but that doesn't really matter: the economy can handle some number of households that live beyond their means; it always has.

Where, though, would this extra income come from? It's not like we can just gin up some money. (Well, the government can--and, in fact, has been--but that's not real value. Money created that way just dilutes the value of the existing money.) No, the only way to boost households' real income would be to reduce someone else's real income.

To get us out of this hole faster, what would have to happen would be for a greater share of income to flow to the people whose balance sheets are most tattered--the poor, the working class, middle class home-owners, etc. What would have to happen would be to change the way profits are divided between owners and workers. (This works because the owners' balance sheets aren't so out-of-balance.)

Of course, it isn't as easy as that. The division of the receipts of the enterprise is partially a matter of markets, and tampering with markets is always problematic. On the other hand, lots of other things play into the affair. Customs and traditions matter--salesmen get commissions, executives get bonuses, etc. These traditions can change--few people get paid piece rates nowadays--but they matter.

At its core, though, the division of profits is always a matter of power.

During long swaths of time the power rests with the owners, who claim all the profits as their right, setting workers against one another in competition for bare subsistence wages. At other times the workers scrape together some power, refusing to bid down their own wages, and claiming for themselves a greater share of the profits of the enterprise.

The last couple of decades have been something of a golden age for owners and managers. Globalization has let employers put their workers in competition with poor people all over the world, giving them a huge market advantage. At the same time, some of the traditional "rules of the game" were gradually slanted in favor of owners (in the form of the decline of labor unions, growth in lower paid service jobs, and vanishing traditions of loyalty to employees and to communities).

If you're interested in this aspect, you might be interested in Robert Reich's book Supercapitalism. I wrote a review of it for Wise Bread last year.

The main point of Reich's book is that you can't really expect anyone to behave differently unless they are forced to. No owner or manager will pay more than the market rate for labor--anyone who even tries will quickly be replaced.

Generally, the workers only come out ahead when there's a genuine labor shortage--when war or plague has cut the work force so much that there simply isn't much competition for jobs. Other things factor into it, though. A huge surge in productivity can swell wages simply because owners are making money so fast it isn't worth it for them to push down the earnings of workers. Local customs and historical traditions have a strong influence. And, of course, government rules have a lot to say about the matter.

In the United States, as the graph above shows, the relationship between compensation and business output was pretty steady all through the 1950s and 1960s. In the 1970s, though, and accelerating in the 1980s and 1990s, things changed: As output (i.e. income to businesses--shown by the blue line) surged, wages (shown by the red line) quit keeping pace.

Looking at the data another way, as shown in the graph to the right, the average share of national income that went to compensation in the 1950s and 1960s was 57.1%. In the most recent quarter it was just 53.4% (and that was an increase from recent lows).

Wages and salaries in 2008 totaled $26.2 trillion (versus a total national income of $49.7 trillion). If the division of the profits of the enterprise returned to the situation that prevailed in the 1950s and 1960s, household incomes would have been $28.4 trillion--that is, households would have received an extra $2.2 trillion in wages and salaries last year. An extra couple trillion dollars a year would go a long way to recovering household balance sheets. (Data for Wages and Salaries and National Income from the Bureau of Economic Analysis via the St. Louis Fed.)

Of course, that income would have been lost to someone else. To some extent, it would have been lost to the very same people--the bus drivers and school teachers who were bringing home bigger paychecks would have seen smaller gains in their 401(k)s over the years, if more income accrued to employees and less to owners. But the bulk of the difference would have shown up in the investment accounts of the very wealthy (because that's where the bulk of the income ends up).

So, there is a path for getting to recovery quicker: higher wages and salaries for workers at the expense of smaller profits to businesses. And it would not be a radical shift--just a return to the traditional proportion of income that went to labor in my parent's generation.

Of course, getting there is another story. Owners and managers are not going to voluntarily give up any of the profits and workers lack the market power to demand a larger share. There are some moves to increase the power of workers--proposed changes in the rules that determine whether workers can form a union, for example--but they're pretty tentative.

But that's okay. There's still the long slow path to recovery.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

How To Read an Annual Report

Nora Dunn — Sat, 22 Mar 2008 00:32:57 +0000

Once a year you may receive these bulky packages in the mail for each of the stocks or mutual funds in your portfolio. You'd like to take interest in them, really. You know it would enlighten you as to the inner workings of your investments and turn you into that much more a savvy investor. You want to read them. You open them up, with the intention of scouring them for divine investment wisdom.

And after about five minutes, with eyes glazed over, your annual report finds its way to the place where oh so many annual reports find themselves: the recycle bin.

You are not alone! Here are the basics of reading an annual report, so you can get the most out of it.

And after about five minutes, with eyes glazed over, your annual report finds its way to the place where oh so many annual reports find themselves: the recycle bin.

You are not alone! Here are the basics of reading an annual report, so you can get the most out of it.

An annual report can be comprised of many different components, including the following:

Financial Statements
Chairman’s Address
Corporate Address
Listing of Board of Directors
Stockholder information
Auditor’s report
Management messages

There are many other miscellaneous pieces of information contained in an annual report, which vary from company to company. But the bulk of information of interest to investors is usually contained in the Financial Statements. This article will address these statements in detail.

There are three components to a company’s financial statements as part of their annual report:

Cash Flow Statement
Balance Sheet
Income Statement

All components compare statistics year over year, showing the past one to three years' stats, in addition to the most recent year's stats. This allows you, the investor, to relatively compare the numbers to see how the company is progressing overall.

You can detect if that company is getting its act together since a recent takeover, how an industry is reacting to certain pressures, and (most importantly) whether or not to keep your money invested (or invest more).

You can see where they are spending their cash, and how it is translating into revenue for the company, and ultimately for the investors. You can also see the source of their incoming cash: whether it takes the form of profits, sale of goods, or new investment money coming in.

The three components of an annual report marry nicely to provide a true picture of the solvency and direction of a company.

Cash Flow Statement

Just as it sounds, a cash flow statement details all the money flowing in and out of the company.

It contains three main sections:

Operations
Investing
Financing

Operations

This will detail the company's earnings, as well as depreciation of assets and inventory changes (increases in inventory use up cash, and reductions provide cash).

Investing

Expenses in this category include investing in new supplies, property, equipment, land, and anything that will generally add value to the business. Investments that have been made over the year will show as a negative number (but will ideally increase the value of the business or their ability to turn a profit).

Financing

Positive numbers in this section indicate where the company is getting its money from: selling stocks, bonds, or borrowing from the bank.

Negative numbers show the company buying back stock from holders, paying out dividends, and repaying borrowed cash.

What to look for in the Cash Flow Statement

Ideally you want to see that they can pay for their Investment activities with their Operations activities. Having to use Financing to stay afloat is a losing proposition for an established company and a bad sign.

If the financing number is negative, that’s actually a good thing. It means the company is buying back stock to keep the value high.

Income Statement (also known as Statement of Earnings or Statement of Operations)

This is the statement that shows the bottom line: profit or loss. It depicts the money coming in from sales, and the expenses associated with making those sales.

You’ll generally see a number of subsections in the Income Statement:

Sales/Operating Revenue
Sales Costs
Gross Profit
Operating Expenses
Operating Income
Net Profits (Earnings)

Sales/Operating Revenue

Just as it sounds, this section will detail how the company is making money; through sales of goods and provision of services.

Sales Costs

There is always a cost of doing business, which you’ll see outlined here. Only expenses directly related to the sales revenue will be included though; costs to turn raw materials into finished products, salaries of those workers, and overhead of the facility.

You won’t see a number of other expenses that could be construed as contributing to the sale of goods, like marketing and research.

Gross Profit

Subtract Sales Costs from Sales Revenue, and you have your gross profit (or loss).

Operating Expenses

Here come the rest of the expenses not listed in the Sales Costs section.

Operating Income

Subtract the Operating Expenses from the Gross Profit and you have Operating Income.

This is a key number in the report, because it truly gives a picture of their ability to turn a profit with their price points given the costs associated with operating the business.

Net Profits (Earnings)

There are still a few key expenses to take in to account, which are detailed in this section. The main expenses include interest payments to bondholders and taxes.

At the bottom of this section you’ll see the magic number: Net Profits/Net Income or Earnings.

What to look for in the Income Statement

This statement depicts the company’s true “bottom line” (on the bottom line!) year over year. Obviously you want the number to be positive, and ideally you want it to grow year over year.

If you take the net income and divide into it the number of outstanding shares the company has, you will get Earnings Per Share (EPS), a common valuator investors use to determine the viability of a company. Rarely is this full amount distributed to the investors though; it is often retained to be invested in future business activities (hence the term Retained Earnings).

Balance Sheet (also known as the Statement of Financial Position)

Similar to a personal balance sheet, you will see Assets and Liabilities itemized.

Assets

Within this category you will often see two main sub-categories: Current Assets and Fixed Assets.

Current assets include cash and anything that can relatively easily be converted to cash. Fixed (or non-current) Assets include less liquid assets: property, and depreciable assets like machinery.

Liabilities

Similar to assets, Liabilities can be divided into two categories; Current and Fixed/Non-Current/Long Term. Current liabilities are those that can and need to be paid within the year; long-term are beyond one year.

Among liabilities, you will see money owed to banks, money owed to investors, taxes owing, and other miscellaneous accounts payable items.

Shareholder’s Equity

This is simply expressed as Assets minus Liabilities. It is representative of what the owners (shareholders) own.

What to look for in the Balance Sheet

Obviously you would like the bottom line (Shareholder’s Equity) to be a positive number!

But beyond that, some attention should go into what exactly the assets are made up of. If a large part of the assets are in the form of retained earnings from previous years, then the company’s “bottom line” for the year really isn’t as good as it may first appear. (That’s why you cross-reference this report with the Income Statement).

Some extra references for your reading pleasure include:

IBM’S Glossary of Terms

Money Chimp’s How to Read an Annual Report

And if you're still falling asleep before you reach page three of the annual report, consider electing not to receive annual reports. It will save the company on printing and postage fees (which in turn sends more profits to you the investor!), as well as save resources that are otherwise being wasted. It doesn't make you a bad investor; rather it makes you a realistic and environmentally savvy one. Just make sure you get your investment advice from a solid and trusted source if you’re not willing or able to go the distance yourself.

This article is from Nora Dunn of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: