Fisher begins his research by studying a company’s reports. Reading the CEO’s letter and management’s discussion in annual reports, he analyzes performance numbers, research and development (R&D) activities, goals, and business risks. By evaluating the assets and lia- bilities shown on the firm’s balance sheet, he looks for firms with low debt and good financial strength. He studies the income statement,
comparing current sales and earnings as well as costs and expenses with those of previous years. Fisher pays attention to the notes of the firm’s financial statements and evaluates information about extraordinary earnings or expenses, changes in accounting, or other disclosures.
He reads the proxy statement, which lists salaries, stock owner- ship, and stock options held by the top executives and directors. If the top executives own a substantial amount of shares, their interests tend to be more aligned with shareholders. The proxy statement includes a graph comparing a company’s stock performance with a stock market index, such as the S&P 500 Index, and with a sector or subgroup(s) of industry peers within the index. The term sector refers to companies that are in similar businesses. Performance numbers can also be illustrated in dollar amounts. The 1999 proxy statement of Texas Instruments, for example, showed that an initial investment of $100 in Texas Instruments stock from 1993 to 1998 grew to $565 (with all dividends reinvested). During the same period, $100 invested in the S&P 500 Index would have grown to $294 and, in the S&P Technology Sector Index, $514.
The S&P technology sector consists of companies in the fields of computers, electronics, communications equipment, and photography/ imaging, such as Lucent Technologies, Motorola, Microsoft, Novell, International Business Machines (IBM), Intel, Oracle, Cisco Systems, and National Semiconductor.
Fisher evaluates some financial numbers and ratios, such as R&D expenditures and profit margins, but his emphasis is on how the num- bers were created and he wants to know what the company is doing to produce substantial future profits.
Learn What the Company Is Doing to Maintain Profit Margins
It’s not enough for Fisher to know that a company has favorable profit margins—he also questions how management plans to maintain profit margins. The profit margin, an indicator of how efficiently manage- ment is running a company, shows the amount of sales being turned into earnings. In order to achieve strong profit margins, a firm should be increasing sales while keeping costs and expenses low, resulting in higher profits.
Fisher evaluates the operating profit margin: operating earnings (earnings from the main business as opposed to earnings from other sources such as income from investments) before interest, depreci- ation, and taxes, divided by sales, and expressed as a percentage (as discussed in Chapter 3). The operating profit margin is compared with previous years’ margins to determine the trend, and with competitors’ profit margins.
There are various reasons profit margins may be higher or lower. One of Fisher’s holdings, Motorola, in the semiconductor and cellu- lar communications business, had a low profit margin in 1998, in part due to the global economic problems. Subsequently, the economic recovery of foreign countries where Motorola sells products as well as restructuring and other internal changes within the business helped increase profit margins. Motorola’s operating profit margin for 1999 was 14.5 percent, compared to its 1998 operating margin of 10.3 percent.
A method that Motorola developed in the late 1980s, which helped create higher profit margins, was to reduce cycle time. This is the time from receipt of orders to delivery and from development of products to shipment. Reducing cycle time by establishing a faster, more efficient process creates faster inventory turnover, lowers costs, and helps increase profit margins. In the 1990s, the effective use of computer software programs has increased efficiency of scheduling, billing, and inventory control for businesses. Restructuring, successful joint ventures, and intelligent use of the Internet to do business have helped increase profit margins. Information about policies or tech- nologies used to create profit margins may be found by reading com- pany reports. Investors also may question executives or representatives of investor relations departments to determine what a company is doing to improve or maintain profit margins.
Profit margins change from year to year and can vary among industries and within sectors.
Operating Profit Margins (Year-to-Year Comparisons for the Technology Sector)
1995 1996 1997 1998
Electronics 11.1 10.3 10.4 9.5
Semiconductors 25.9 25.7 28.0 24.1
Computer and Peripheral 16.2 13.7 14.6 12.7 Computer Software and Services 27.3 27.2 29.3 31.5 Source: Value Line Investment Survey
Paying Dividends or Reinvesting Earnings
Growth companies typically pay low or no cash dividends. Texas Instruments and Motorola, for example, paid about 20 percent of earnings in dividends on average for the five years ending 1998. Microsoft paid no dividend, and Intel paid a dividend of about 4 per- cent of earnings.
Dividends are not important to Fisher. He is primarily concerned with whether retained earnings are being invested wisely to produce future earnings growth. Growing companies can use money otherwise paid out in dividends more effectively to pay for R&D, new tech- nologies, and advertising and marketing in anticipation of creating higher earnings.
Evaluating the P/E and P/S
Although he may look at the price-to-earnings (P/E) ratio of a stock, Fisher believes investors put too much emphasis on this ratio. When he buys a stock he wants to feel reasonably confident the firm will have much higher earnings growth over the long term, resulting in much higher stock prices. To Fisher, what’s important is the current stock price in relation to the company’s long-term future potential earnings. Fisher also may look at the price-to-sales ratio (P/S), but like the P/E, this ratio would not have a great deal of significance for him. Nevertheless, many investors use the P/S and it is helpful to understand how it can be applied. Fisher’s son Ken was a pioneer in bringing the P/S to the investment world.
Even well-established companies have problems from time to time, especially in the technology field, and some firms may report very low
earnings or losses. In this case, because the company has a high P/E or no P/E, investors may evaluate the stock based on the P/S instead of the P/E (the P/S may also be used as an additional measure in other circumstances). To calculate the P/S ratio, divide the stock’s price by the company’s sales per share.
Motorola, for instance, was selling at a low of about $38 in 1998, down from its high of $66 and its 1997 high of $90. Motorola sells products worldwide and its earnings suffered because of the severe eco- nomic problems in Asia and other parts of the world. Additionally, man- agement was slow in changing from analog to digital cellular equipment, already accomplished by competitors. Motorola reported earnings per share of $.58 (a P/E of 66) and sales per share of $48 (a P/S of under 1). A P/S ratio of 3 is considered reasonable, 1 or less very attractive, but this varies from industry to industry, and like other ratios, should be compared to industry competitors. Motorola refocused, restructured, cut costs, produced new products, and at the end of 1999 the stock was $147 (as of June 1, 2000, Motorola had a three-for-one stock split).