Stock Market Analysis

Stock Market Risk: Wagging The Tails

2012-02-03T00:00:00.000+06:00

by Michael Schmidt

Asset class returns are usually identified by their long-term projections, which are based on a combination of historical returns and future expectations. The historical data is usually presented in its final form of an annualized return and, while it would be helpful, is not always presented along with that return's risk history as measured by its standard deviation. Anyone who has invested assets in the stock or bond market in the span of the last 20 years has more than likely seen how volatile these markets can be. Future volatility in markets may be caused by several things, including the future sources of information and its speed, the use of leveraged, market timers and speculators, and the ease with which investors can access capital. For those with a strong stomach and deep pockets, that level of volatility may be palatable. For those who are not as comfortable with the wild ride, it is important to take a step back and re-examine risk and its real-world applications, because the tails of the bell curve will be wagged.

Bell Curve
The bell curve is a representation of a normal distribution of data and is used in many areas of research where there are sets of data to analyze. It is most commonly used in population data and is a great way to convey population information with smaller samples of the total population. It is also commonly used in the investment field to represent asset class returns and their distribution patterns.

Figure 1: A normal distribution

Bell Curve Basics
Figure 1 represents a bell curve with a normal distribution. To review the curve: the mean or arithmetic average is plotted in the middle, setting out standard deviations to either side. This particular graph has a mean value of zero and a standard deviation of 1%. This is also known as a standard normal distribution. While it may not normally occur in the real world, it is easy to use for demonstrative purposes.

Applying asset class returns to this curve, it is accepted that 68% of the returns will fall within one standard deviation of the mean, which is between -1% and 1%. It is then accepted that 95.5% of the returns will fall within two standard deviations of the mean, a range of -2% and 2%. Finally, with the tails included, 99.7% of the returns fall between -3% and 3%, or within three standard deviations of 0%.

Predictive Qualities
The goal of using historical returns is to attempt to predict future returns with a reasonable level of certainty. If you use some round numbers of an average annual return for the market of 10% with a standard deviation of 15% (this is a decent approximation of the stock market over the last 20 years) and applying a normal distribution, then 99.7% of the time the predictable range for any given future period could be -35% to 55%, which represents three standard deviations above and below the mean. Whiles it's always good to look at the longest periods available as returns tend to revert to the mean, it's also good to look at shorter time periods to see how the current market behaves.

According to Standard & Poor's, trailing five-year periods for the S&P 500 averaged 5.2% with a standard deviation of 10.4% between 1928 and 2007 (on average).

Shorter time periods, like five-year spans, typically exhibit notably higher risk levels. Using the five-year data, the tails start at around -25 and +35%. There have been annual periods that approach and dip into those tails. These events might be considered statistical anomalies as the probability is rare, but this proves that anything is possible. It also lends additional credibility to the bell curve and shows that the stock market may not be following a normal distribution and carrying considerable amount of unpredictable risk.

Lessons Learned About Risk
What has history taught investors? For one thing, we know that stocks are inherently risky and difficult to forecast using normal probability predictive tools over shorter time periods. Over five years, it has not mattered how stocks were packaged, whether in mutual funds, exchange traded funds (ETFs) or even index funds, they are risky and the numbers prove it. The chart below represents the number of days in which the S&P 500 was up or down by at least 2% between January 1928 and October 2007. In the past, this has been a prelude to some type of event as the stock market tends to be a leading economic indicator. Unfortunately, it is difficult to tell what events the volatility may precede.

Figure 2: Number of trading days in which the S&P 500's volatility was over 2% from January 1928 to October 2007.

Source: S&P 500, Charles Schwab

Why Invest in Stocks?
Now that stocks have been presented as a scary and risky asset class, it's important to point out that as an asset class, they have outperformed other asset classes over long time periods. If you have a strong stomach and have survived the temptation to panic sell during violent downturns, then a long-term commitment to stocks is a sound strategy.

What does the Zigzag Indicator Measure?

2012-02-01T23:36:00.000+06:00

The Zigzag indicator is not really an indicator per se. Instead, it defines price swings that meet a minimum percentage change. Chartists can use this indicator to identify significant price swings and filter out insignificant price swings. The definition of significant is, of course, subjective.

A Zigzag set at 10% would only shows swings that were at least 10%. Price swings less than 10% would be ignored. The example below shows a 15-minute chart for the Gold SPDR (GLD) with the 10% Zigzag overlaid. There have been three 10% swings in the last two months. Chartists should ignore that last Zigzag line. It simply connects the last peak or trough with the current close. It may or may not be a 10% swing.

The Zigzag can also help with Elliott Wave counts. The chart below shows the Gold SPDR (GLD) with a 5% Zigzag using daily bars. Elliotticians could count only the pink zigzag waves and ignore price action that does not fit the Zigzag. Note that the Zigzag on a bar or candle chart uses intraday highs and lows. The Zigzag on a close-only line chart uses closing prices only. The Zigzag on a close-only chart will look different and have fewer zigzags.

by Arthur Hill

Return On Equity

2012-01-31T02:27:00.000+06:00

This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net income of $732.5 (income statement), and average shareholders' equity of $4,312.7 (balance sheet). By dividing, the equation gives us an ROE of 17% for FY 2005.

Variations:If the company has issued preferred stock, investors wishing to see the return on just common equity may modify the formula by subtracting the preferred dividends, which are not paid to common shareholders, from net income and reducing shareholders' equity by the outstanding amount of preferred equity.

Commentary:Widely used by investors, the ROE ratio is an important measure of a company's earnings performance. The ROE tells common shareholders how effectively their money is being employed. Peer company, industry and overall market comparisons are appropriate; however, it should be recognized that there are variations in ROEs among some types of businesses. In general, financial analysts consider return on equity ratios in the 15-20% range as representing attractive levels of investment quality.

While highly regarded as a profitability indicator, the ROE metric does have a recognized weakness. Investors need to be aware that a disproportionate amount of debt in a company's capital structure would translate into a smaller equity base. Thus, a small amount of net income (the numerator) could still produce a high ROE off a modest equity base (the denominator).

By Richard Loth

Operating Cash Flow/Sales Ratio

2012-01-30T17:21:00.000+06:00

This ratio, which is expressed as a percentage, compares a company's operating cash flow to its net sales or revenues, which gives investors an idea of the company's ability to turn sales into cash.

It would be worrisome to see a company's sales grow without a parallel growth in operating cash flow. Positive and negative changes in a company's terms of sale and/or the collection experience of its accounts receivable will show up in this indicator.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net cash provided by operating activities of $878.2 (cash flow statement), and net sales of $3,286.1 (income statement). By dividing, the equation gives us an operating cash flow/sales ratio of 26.7%, or approximately 27 cents of operating cash flow in every sales dollar.

Variations:None

Commentary:The statement of cash flows has three distinct sections, each of which relates to an aspect of a company's cash flow activities - operations, investing and financing. In this ratio, we use the figure for operating cash flow, which is also variously described in financial reporting as simply "cash flow", "cash flow provided by operations", "cash flow from operating activities" and "net cash provided (used) by operating activities".

In the operating section of the cash flow statement, the net income figure is adjusted for non-cash charges and increases/decreases in the working capital items in a company's current assets and liabilities. This reconciliation results in an operating cash flow figure, the foremost source of a company's cash generation (which is internally generated by its operating activities).

The greater the amount of operating cash flow, the better. There is no standard guideline for the operating cash flow/sales ratio, but obviously, the ability to generate consistent and/or improving percentage comparisons are positive investment qualities. In the case of Zimmer Holdings, the past three years reflect a healthy consistency in this ratio of 26.0%, 28.9% and 26.7% for FY 2003, 2004 and 2005, respectively.

By Richard Loth

Return On Assets

2012-01-28T02:21:00.000+06:00

This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company's total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. The ROA ratio is calculated by comparing net income to average total assets, and is expressed as a percentage.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net income of $732.50 (income statement), and average total assets of $5,708.70 (balance sheet). By dividing, the equation gives us an ROA of 12.8% for FY 2005.

Variations:Some investment analysts use the operating-income figure instead of the net-income figure when calculating the ROA ratio.

Commentary: The need for investment in current and non-current assets varies greatly among companies. Capital-intensive businesses (with a large investment in fixed assets) are going to be more asset heavy than technology or service businesses.

In the case of capital-intensive businesses, which have to carry a relatively large asset base, will calculate their ROA based on a large number in the denominator of this ratio. Conversely, non-capital-intensive businesses (with a small investment in fixed assets) will be generally favored with a relatively high ROA because of a low denominator number.

It is precisely because businesses require different-sized asset bases that investors need to think about how they use the ROA ratio. For the most part, the ROA measurement should be used historically for the company being analyzed. If peer company comparisons are made, it is imperative that the companies being reviewed are similar in product line and business type. Simply being categorized in the same industry will not automatically make a company comparable. Illustrations (as of FY 2005) of the variability of the ROA ratio can be found in such companies as General Electric, 2.3%; Proctor & Gamble, 8.8%; and Microsoft, 18.0%.

As a rule of thumb, investment professionals like to see a company's ROA come in at no less than 5%. Of course, there are exceptions to this rule. An important one would apply to banks, which strive to record an ROA of 1.5% or above.

By Richard Loth

Return On Capital Employed

2012-01-25T13:46:00.000+06:00

The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company's debt liabilities, or funded debt, to equity to reflect a company's total "capital employed". This measure narrows the focus to gain a better understanding of a company's ability to generate returns from its available capital base.

By comparing net income to the sum of a company's debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company's profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management's ability to generate earnings from a company's total pool of capital.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net income of $732.50 (income statement). The company's average short-term and long-term borrowings were $366.60 and the average shareholders' equity was $4,312.70 (all the necessary figures are in the 2004 and 2005 balance sheets), the sum of which, $4,479.30 is the capital employed. By dividing, the equation gives us an ROCE of 16.4% for FY 2005.

Variations:Often, financial analysts will use operating income (earnings before interest and taxes or EBIT) as the numerator. There are various takes on what should constitute the debt element in the ROCE equation, which can be quite confusing. Our suggestion is to stick with debt liabilities that represent interest-bearing, documented credit obligations (short-term borrowings, current portion of long-term debt, and long-term debt) as the debt capital in the formula.

Commentary:The return on capital employed is an important measure of a company's profitability. Many investment analysts think that factoring debt into a company's total capital provides a more comprehensive evaluation of how well management is using the debt and equity it has at its disposal. Investors would be well served by focusing on ROCE as a key, if not the key, factor to gauge a company's profitability. An ROCE ratio, as a very general rule of thumb, should be at or above a company's average borrowing rate.

Unfortunately, there are a number of similar ratios to ROCE, as defined herein, that are similar in nature but calculated differently, resulting in dissimilar results. First, the acronym ROCE is sometimes used to identify return on common equity, which can be confusing because that relationship is best known as the return on equity or ROE. Second, the concept behind the terms return on invested capital (ROIC) and return on investment (ROI) portends to represent "invested capital" as the source for supporting a company's assets. However, there is no consistency to what components are included in the formula for invested capital, and it is a measurement that is not commonly used in investment research reporting.

By Richard Loth

Effective Tax Rate

2012-01-23T02:17:00.000+06:00

This ratio is a measurement of a company's tax rate, which is calculated by comparing its income tax expense to its pretax income. This amount will often differ from the company's stated jurisdictional rate due to many accounting factors, including foreign exchange provisions. This effective tax rate gives a good understanding of the tax rate the company faces.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had a provision for income taxes in its income statement of $307.30 (income statement), and pretax income of $1,040.70 (income statement). By dividing, the equation gives us an effective tax rate of 29.5% for FY 2005.

Variations:None

Commentary:The variances in this percentage can have a material effect on the net-income figure.

Peer company comparisons of net profit margins can be problematic as a result of the impact of the effective tax rate on net profit margins. The same can be said of year-over-year comparisons for the same company. This circumstance is one of the reasons some financial analysts prefer to use the operating or pretax profit figures instead of the net profit number for profitability ratio calculation purposes.

One could argue that any event that improves a company's net profit margin is a good one. However, from a quality of earnings perspective, tax management maneuverings (while certainly legitimate) are less desirable than straight-forward positive operational results.

For example, Zimmer Holdings' effective tax rates have been erratic over the three years reported in their 2005 income statement. From 33.6% in 2003, down to 25.9% in 2004 and back up to 29.5% in 2005. Obviously, this tax provision volatility makes an objective judgment of its true, or operational, net profit performance difficult to determine.

Tax management techniques to lessen the tax burden are practiced, to one degree or another, by many companies. Nevertheless, a relatively stable effective tax rate percentage, and resulting net profit margin, would seem to indicate that the company's operational managers are more responsible for a company's profitability than the company's tax accountants.

By Richard Loth

Operating Cycle

2012-01-20T16:57:00.000+06:00

Expressed as an indicator (days) of management performance efficiency, the operating cycle is a "twin" of the cash conversion cycle. While the parts are the same - receivables, inventory and payables - in the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets, as opposed to their impact on cash.

Formula:

Components:
DIO is computed by:

Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
Calculating the average inventory figure by adding the year's beginning (previous yearend amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of inventory for any given year; and
Dividing the average inventory figure by the cost of sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DIO would be computed with these figures:

(1) cost of sales per day	739.4 ÷ 365 = 2.0
(2) average inventory 2005	536.0 + 583.7 = 1,119.7 ÷ 2 = 559.9
(3) days inventory outstanding	559.9 ÷ 2.0 = 279.9

DSO is computed by:

Dividing net sales (income statement) by 365 to get net sales per day figure;
Calculating the average accounts receivable figure by adding the year's beginning (previous yearend amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable for any given year; and
Dividing the average accounts receivable figure by the net sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DSO would be computed with these figures:

(1) net sales per day	3,286.1 ÷ 365 = 9.0
(2) average accounts receivable	524.8 + 524.2 = 1,049 ÷ 2 = 524.5
(3) days sales outstanding	524.5 ÷ 9.0 = 58.3

DPO is computed by:

Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
Calculating the average accounts payable figure by adding the year's beginning (previous yearend amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and
Dividing the average accounts payable figure by the cost of sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DPO would be computed with these figures:

(1) cost of sales per day	739.4 ÷ 365 =2.0
(2) average accounts payable	131.6 + 123.6 = 255.2 ÷ 125.6
(3) days payable outstanding	125.6 ÷ 2.0 = 63

Computing OC
Zimmer Holdings' operating cycle (OC) for FY 2005 would be computed with these numbers (rounded):

DIO	280
DSO	+58
DPO	-63
OC	275

Variations:Often the components of the operating cycle - DIO, DSO and DPO - are expressed in terms of turnover as a times (x) factor. For example, in the case of Zimmer Holdings, its days inventory outstanding of 280 days would be expressed as turning over 1.3x annually (365 days ÷ 280 days = 1.3 times). However, it appears that the use of actually counting days is more literal and easier to understand.

Commentary:As we mentioned in its definition, the operating cycle has the same makeup as the cash conversion cycle. Management efficiency is the focus of the operating cycle, while cash flow is the focus of the cash conversion cycle.

To illustrate this difference in perspective, let's use a narrow, simplistic comparison of Zimmer Holdings' operating cycle to that of a competitive peer company, Biomet. Obviously, we would want more background information and a longer review period, but for the sake of this discussion, we'll assume the FY 2005 numbers we have to work with are representative for both companies and their industry.

Days Sales Outstanding (DSO):
Zimmer	58 Days
Biomet	105 Days

Days Inventory Outstanding (DIO):
Zimmer	280 Days
Biomet	294 Days

Days Payable Outstanding (DPO):
Zimmer	63 Days
Biomet	145 Days

Operating Cycle:
Zimmer	275 Days
Biomet	254 Days

When it comes to collecting on its receivables, it appears from the DSO numbers, that Zimmer Holdings is much more operationally efficient than Biomet. Common sense tells us that the longer a company has money out there on the street (uncollected), the more risk it is taking. Is Biomet remiss in not having tighter control of its collection of receivables? Or could it be trying to pick up market share through easier payment terms to its customers? This would please the sales manager, but the CFO would certainly be happier with a faster collection time.

Zimmer Holdings and Biomet have almost identical days inventory outstanding. For most companies, their DIO periods are, typically, considerably shorter than the almost 10-month periods evidenced here. Our assumption is that this circumstance does not imply poor inventory management but rather reflects product line and industry characteristics. Both companies may be obliged to carry large, high-value inventories in order to satisfy customer requirements.

Biomet has a huge advantage in the DPO category. It is stretching out its payments to suppliers way beyond what Zimmer is able to do. The reasons for this highly beneficial circumstance (being able to use other people's money) would be interesting to know. Questions you should be asking include: Does this indicate that the credit reputation of Biomet is that much better than that of Zimmer? Why doesn't Zimmer enjoy similar terms?

Shorter Is Better?
In summary, one would assume that "shorter is better" when analyzing a company's cash conversion cycle or its operating cycle. While this is certainly true in the case of the former, it isn't necessarily true for the latter. There are numerous variables attached to the management of receivables, inventory and payables that require a variety of decisions as to what's best for the business.

For example, strict (short) payment terms might restrict sales. Minimal inventory levels might mean that a company cannot fulfill orders on a timely basis, resulting in lost sales. Thus, it would appear that if a company is experiencing solid sales growth and reasonable profits, its operating cycle components should reflect a high degree of historical consistency.

By Richard Loth

Cash Conversion Cycle

2012-01-18T02:06:00.000+06:00

This liquidity metric expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable. The cash conversion cycle (CCC) measures the number of days a company's cash is tied up in the the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter this cycle, the more liquid the company's working capital position is. The CCC is also known as the "cash" or "operating" cycle.

Formula:

Components:
DIO is computed by:

Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
Calculating the average inventory figure by adding the year's beginning (previous yearend amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of inventory for any given year; and
Dividing the average inventory figure by the cost of sales per day figure.

For Zimmer's FY 2005 (in $ millions), its DIO would be computed with these figures:

(1) cost of sales per day	739.4 ÷ 365 = 2.0
(2) average inventory 2005	536.0 + 583.7 = 1,119.7 ÷ 2 = 559.9
(3) days inventory outstanding	559.9 ÷ 2.0 = 279.9

DIO gives a measure of the number of days it takes for the company's inventory to turn over, i.e., to be converted to sales, either as cash or accounts receivable.

DSO is computed by:

Dividing net sales (income statement) by 365 to get a net sales per day figure;
Calculating the average accounts receivable figure by adding the year's beginning (previous yearend amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable for any given year; and
Dividing the average accounts receivable figure by the net sales per day figure.

For Zimmer's FY 2005 (in $ millions), its DSO would be computed with these figures:

(1) net sales per day	3,286.1 ÷ 365 = 9.0
(2) average accounts receivable	524.8 + 524.2 = 1,049 ÷ 2 = 524.5
(3) days sales outstanding	524.5 ÷ 9.0 = 58.3

DSO gives a measure of the number of days it takes a company to collect on sales that go into accounts receivables (credit purchases).

DPO is computed by:

Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
Calculating the average accounts payable figure by adding the year's beginning (previous yearend amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and
Dividing the average accounts payable figure by the cost of sales per day figure.

For Zimmer's FY 2005 (in $ millions), its DPO would be computed with these figures:

(1) cost of sales per day	739.4 ÷ 365 = 2.0
(2) average accounts payable	131.6 + 123.6 = 255.2 ÷ 125.6
(3) days payable outstanding	125.6 ÷ 2.0 = 63

DPO gives a measure of how long it takes the company to pay its obligations to suppliers.

CCC computed:
Zimmer's cash conversion cycle for FY 2005 would be computed with these numbers (rounded):

DIO	280 days
DSO	+58 days
DPO	-63 days
CCC	275 days

Variations:Often the components of the cash conversion cycle - DIO, DSO and DPO - are expressed in terms of turnover as a times (x) factor. For example, in the case of Zimmer, its days inventory outstanding of 280 days would be expressed as turning over 1.3x annually (365 days ÷ 280 days = 1.3 times). However, actually counting days is more literal and easier to understand when considering how fast assets turn into cash.

Commentary:An often-overlooked metric, the cash conversion cycle is vital for two reasons. First, it's an indicator of the company's efficiency in managing its important working capital assets; second, it provides a clear view of a company's ability to pay off its current liabilities.

It does this by looking at how quickly the company turns its inventory into sales, and its sales into cash, which is then used to pay its suppliers for goods and services. Again, while the quick and current ratios are more often mentioned in financial reporting, investors would be well advised to measure true liquidity by paying attention to a company's cash conversion cycle.

The longer the duration of inventory on hand and of the collection of receivables, coupled with a shorter duration for payments to a company's suppliers, means that cash is being tied up in inventory and receivables and used more quickly in paying off trade payables. If this circumstance becomes a trend, it will reduce, or squeeze, a company's cash availabilities. Conversely, a positive trend in the cash conversion cycle will add to a company's liquidity.

By tracking the individual components of the CCC (as well as the CCC as a whole), an investor is able to discern positive and negative trends in a company's all-important working capital assets and liabilities.

For example, an increasing trend in DIO could mean decreasing demand for a company's products. Decreasing DSO could indicate an increasingly competitive product, which allows a company to tighten its buyers' payment terms.

As a whole, a shorter CCC means greater liquidity, which translates into less of a need to borrow, more opportunity to realize price discounts with cash purchases for raw materials, and an increased capacity to fund the expansion of the business into new product lines and markets. Conversely, a longer CCC increases a company's cash needs and negates all the positive liquidity qualities just mentioned.

Note: In the realm of free or low-cost investment research websites, the only one we've found that provides complete CCC data for stocks is Morningstar, which also requires a paid premier membership subscription.

Current Ratio Vs. The CCCThe obvious limitations of the current ratio as an indicator of true liquidity clearly establish a strong case for greater recognition, and use, of the cash conversion cycle in any analysis of a company's working capital position.

Nevertheless, corporate financial reporting, investment literature and investment research services seem to be stuck on using the current ratio as an indicator of liquidity. This circumstance is similar to the financial media's and the general public's attachment to the Dow Jones Industrial Average. Most investment professionals see this index as unrepresentative of the stock market or the national economy. And yet, the popular Dow marches on as the market indicator of choice.

The current ratio seems to occupy a similar position with the investment community regarding financial ratios that measure liquidity. However, it will probably work better for investors to pay more attention to the cash-cycle concept as a more accurate and meaningful measurement of a company's liquidity.

By Richard Loth

Cash Flow Coverage Ratios

2012-01-17T17:40:00.000+06:00

This ratio measures the ability of the company's operating cash flow to meet its obligations - including its liabilities or ongoing concern costs.

The operating cash flow is simply the amount of cash generated by the company from its main operations, which are used to keep the business funded.

The larger the operating cash flow coverage for these items, the greater the company's ability to meet its obligations, along with giving the company more cash flow to expand its business, withstand hard times, and not be burdened by debt servicing and the restrictions typically included in credit agreements.

Formulas:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had no short-term debt and did not pay any cash dividends. The only cash outlay the company had to cover was for capital expenditures, which amounted to $255.3 (all numbers for the cash flow coverage ratios are found in the cash flow statement), which is the denominator. Operating cash is always the numerator. By dividing, the operative equations give us a coverage of 3.4. Obviously, Zimmer is a cash cow. It has ample free cash flow which, if the FY 2003-2005 period is indicative, has steadily built up the cash it carries in its balance sheet.

Variations:None

Commentary:The short-term debt coverage ratio compares the sum of a company's short-term borrowings and the current portion of its long-term debt to operating cash flow. Zimmer Holdings has the good fortune of having none of the former and only a nominal amount of the latter in its FY 2005 balance sheet. So, in this instance, the ratio is not meaningful in the conventional sense but clearly indicates that the company need not worry about short-term debt servicing in 2006.

The capital expenditure coverage ratio compares a company's outlays for its property, plant and equipment (PP&E) to operating cash flow. In the case of Zimmer Holdings, as mentioned above, it has ample margin to fund the acquisition of needed capital assets. For most analysts and investors, a positive difference between operating cash flow and capital expenditures defines free cash flow. Therefore, the larger this ratio is, the more cash assets a company has to work with.

The dividend coverage ratio provides dividend investors with a narrow look at the safety of the company's dividend payment. Zimmer is not paying a dividend, although with its cash buildup and cash generation capacity, it certainly looks like it could easily become a dividend payer.

For conservative investors focused on cash flow coverage, comparing the sum of a company's capital expenditures and cash dividends to its operating cash flow is a stringent measurement that puts cash flow to the ultimate test. If a company is able to cover both of these outlays of funds from internal sources and still have cash left over, it is producing what might be called "free cash flow on steroids". This circumstance is a highly favorable investment quality.
By Richard Loth

Sales/Revenue Per Employee

2012-01-15T16:53:00.000+06:00

As a gauge of personnel productivity, this indicator simply measures the amount of dollar sales, or revenue, generated per employee. The higher the dollar figure the better. Here again, labor-intensive businesses (ex. mass market retailers) will be less productive in this metric than a high-tech, high product-value manufacturer.

Formula:

Components:

As of December 31, 2005, Zimmer Holdings generated almost $3.3 billion in sales with an average personnel complement for the year of approximately 6,600 employees. The sales, or revenue, figure is the numerator (income statement), and the average number of employees for the year is the denominator.

Variations:An earnings per employee ratio could also be calculated using net income (as opposed to net sales) in the numerator.

Commentary:Industry and product-line characteristics will influence this indicator of employee productivity. Tracking this dollar figure historically and comparing it to peer-group companies will make this quantitative dollar amount more meaningful in an analytical sense.

For example, Zimmer Holdings' sales per employee figure of $497,878 for its 2005 fiscal year compares very favorably to the figure for two of its direct competitors - Biomet, Inc. (NYSE:BMET) and Stryker Corp. (NYSE:SYK). For their 2005 fiscal years, these companies had sales per employee figures of only $320,215 and $293,883, respectively.

The comparison of Microsoft (Nasdaq:MSFT) and Wal-Mart (WMT), two businesses in very different industries, illustrates how the sales per employee ratio can differ because of this circumstance. Microsoft relies on technology and brain power to drive its revenues, and needs a relatively small personnel complement to accomplish this. On the other hand, a mega-retailer like Wal-Mart is a very labor-intensive operation requiring a large number of employees. These companies' respective sales per employee ratios in 2005 were $670,939 and $172,470, which clearly reflect their industry differences when it comes to personnel requirements.

The sales per employee metric can be a good measure of personnel productivity, with its greatest use being the comparison of industry competitors and the historical performance of the company.

By Richard Loth

Profit Margin Analysis

2012-01-13T02:13:00.000+06:00

In the income statement, there are four levels of profit or profit margins - gross profit, operating profit, pretax profit and net profit. The term "margin" can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues. Profit margin analysis uses the percentage calculation to provide a comprehensive measure of a company's profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks.

Basically, it is the amount of profit (at the gross, operating, pretax or net income level) generated by the company as a percent of the sales generated. The objective of margin analysis is to detect consistency or positive/negative trends in a company's earnings. Positive profit margin analysis translates into positive investment quality. To a large degree, it is the quality, and growth, of a company's earnings that drive its stock price.

Formulas:

Components:

All the dollar amounts in these ratios are found in the income statement. As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net sales, or revenue, of $3,286.10, which is the denominator in all of the profit margin ratios. The numerators for Zimmer Holdings' ratios are captioned as "gross profit", "operating profit", "earnings before income taxes, minority interest and cumulative effect of change in accounting principle", and "net earnings", respectively. By simply dividing, the equations give us the percentage profit margins indicated.

Variations:None

Commentary:First, a few remarks about the mechanics of these ratios are in order. When it comes to finding the relevant numbers for margin analysis, we remind readers that the terms: "income", "profits" and "earnings" are used interchangeably in financial reporting. Also, the account captions for the various profit levels can vary, but generally are self-evident no matter what terminology is used. For example, Zimmer Holdings' pretax (our shorthand for profit before the provision for the payment of taxes) is a literal, but rather lengthy, description of the account.

Second, income statements in the multi-step format clearly identify the four profit levels. However, with the single-step format the investor must calculate the gross profit and operating profit margin numbers.

To obtain the gross profit amount, simply subtract the cost of sales (cost of goods sold) from net sales/revenues. The operating profit amount is obtained by subtracting the sum of the company's operating expenses from the gross profit amount. Generally, operating expenses would include such account captions as selling, marketing and administrative, research and development, depreciation and amortization, rental properties, etc.

Third, investors need to understand that the absolute numbers in the income statement don't tell us very much, which is why we must look to margin analysis to discern a company's true profitability. These ratios help us to keep score, as measured over time, of management's ability to manage costs and expenses and generate profits. The success, or lack thereof, of this important management function is what determines a company's profitability. A large growth in sales will do little for a company's earnings if costs and expenses grow disproportionately.

Lastly, the profit margin percentage for all the levels of income can easily be translated into a handy metric used frequently by analysts and often mentioned in investment literature. The ratio's percentage represents the number of pennies there are in each dollar of sales. For example, using Zimmer Holdings' numbers, in every sales dollar for the company in 2005, there's roughly 78¢, 32¢, 32¢, and 22¢ cents of gross, operating, pretax, and net income, respectively.

Let's look at each of the profit margin ratios individually:

Gross Profit Margin - A company's cost of sales, or cost of goods sold, represents the expense related to labor, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company's net sales/revenue, which results in a company's first level of profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator.

Industry characteristics of raw material costs, particularly as these relate to the stability or lack thereof, have a major effect on a company's gross margin. Generally, management cannot exercise complete control over such costs. Companies without a production process (ex., retailers and service businesses) don't have a cost of sales exactly. In these instances, the expense is recorded as a "cost of merchandise" and a "cost of services", respectively. With this type of company, the gross profit margin does not carry the same weight as a producer-type company.

Operating Profit Margin - By subtracting selling, general and administrative (SG&A), or operating, expenses from a company's gross profit number, we get operating income. Management has much more control over operating expenses than its cost of sales outlays. Thus, investors need to scrutinize the operating profit margin carefully. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.

A company's operating income figure is often the preferred metric (deemed to be more reliable) of investment analysts, versus its net income figure, for making inter-company comparisons and financial projections.

Pretax Profit Margin - Again many investment analysts prefer to use a pretax income number for reasons similar to those mentioned for operating income. In this case a company has access to a variety of tax-management techniques, which allow it to manipulate the timing and magnitude of its taxable income.

Net Profit Margin - Often referred to simply as a company's profit margin, the so-called bottom line is the most often mentioned when discussing a company's profitability. While undeniably an important number, investors can easily see from a complete profit margin analysis that there are several income and expense operating elements in an income statement that determine a net profit margin. It behooves investors to take a comprehensive look at a company's profit margins on a systematic basis.

By Richard Loth

Fixed-Asset Turnover

2012-01-10T14:08:00.000+06:00

This ratio is a rough measure of the productivity of a company's fixed assets (property, plant and equipment or PP&E) with respect to generating sales. For most companies, their investment in fixed assets represents the single largest component of their total assets. This annual turnover ratio is designed to reflect a company's efficiency in managing these significant assets. Simply put, the higher the yearly turnover rate, the better.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net sales, or revenue, of $3,286.10 (income statement) and average fixed assets, or PP&E, of $668.70 (balance sheet - the average of yearend 2004 and 2005 PP&E). By dividing, the equation gives us a fixed-asset turnover rate for FY 2005 of 4.9.

Variations:Instead of using fixed assets, some asset-turnover ratios would use total assets. We prefer to focus on the former because, as a significant component in the balance sheet, it represents a multiplicity of management decisions on capital expenditures. Thus, this capital investment, and more importantly, its results, is a better performance indicator than that evidenced in total asset turnover.

Commentary:There is no exact number that determines whether a company is doing a good job of generating revenue from its investment in fixed assets. This makes it important to compare the most recent ratio to both the historical levels of the company along with peer company and/or industry averages.

Before putting too much weight into this ratio, it's important to determine the type of company that you are using the ratio on because a company's investment in fixed assets is very much linked to the requirements of the industry in which it conducts its business. Fixed assets vary greatly among companies. For example, an internet company, like Google, has less of a fixed-asset base than a heavy manufacturer like Caterpillar. Obviously, the fixed-asset ratio for Google will have less relevance than that for Caterpillar.

As is the case with Zimmer Holdings, a high fixed-asset turnover ratio is more the product of a relatively low investment in PP&E, rather than a high level of sales. Companies like Zimmer Holdings are fortunate not to be capital intensive, thereby allowing them to generate a high level of sales on a relatively low base of capital investment. Manufacturers of heavy equipment and other capital goods, and natural resource companies do not enjoy this luxury.

By Richard Loth

Cash Ratio

2012-01-08T01:52:00.000+06:00

The cash ratio is an indicator of a company's liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' cash assets amounted to $233.20 (balance sheet); while current liabilities amounted to $606.90 (balance sheet). By dividing, the equation gives us a cash ratio of 0.4

Commentary:The cash ratio is the most stringent and conservative of the three short-term liquidity ratios (current, quick and cash). It only looks at the most liquid short-term assets of the company, which are those that can be most easily used to pay off current obligations. It also ignores inventory and receivables, as there are no assurances that these two accounts can be converted to cash in a timely matter to meet current liabilities.

Very few companies will have enough cash and cash equivalents to fully cover current liabilities, which isn't necessarily a bad thing, so don't focus on this ratio being above 1:1.

The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company. It is not realistic for a company to purposefully maintain high levels of cash assets to cover current liabilities. The reason being that it's often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this money could be returned to shareholders or used elsewhere to generate higher returns. While providing an interesting liquidity perspective, the usefulness of this ratio is limited.

By Richard Loth

Dividend Payout Ratio

2012-01-07T17:44:00.000+06:00

This ratio identifies the percentage of earnings (net income) per common share allocated to paying cash dividends to shareholders. The dividend payout ratio is an indicator of how well earnings support the dividend payment.

Here's how dividends "start" and "end." During a fiscal year quarter, a company's board of directors declares a dividend. This event triggers the posting of a current liability for "dividends payable." At the end of the quarter, net income is credited to a company's retained earnings, and assuming there's sufficient cash on hand and/or from current operating cash flow, the dividend is paid out. This reduces cash, and the dividends payable liability is eliminated.

The payment of a cash dividend is recorded in the statement of cash flows under the "financing activities" section.

Formula:

Components:
Note: Zimmer Holdings does not pay a dividend. An assumed dividend amount, as of December 31, 2005, is provided to illustrate the ratio's calculation:

0.80 ÷ 2.96 = 27%

The numerator (annual report or Form 10-K) represents the annual dividend per share paid in cash and the denominator (income statement) represents the net income per share for FY 2005.

Variations:At the bottom of the income statement, after the stated amount for net income (net earnings), the per share amounts for "basic" net income per common share and "diluted" net income per common share are provided. The basic per share amount does not take into consideration the possible effects of stock options, which would increase the number of shares outstanding. The diluted per share amount does take into account precisely this possible dilution. Conservative analysis would use the diluted net income per share figure in the denominator.

In another version of the dividend payout ratio, total amounts are used rather than per share amounts. Nevertheless, an investor should arrive at the same ratio percentage.

Note: In the U.K. there is a similar dividend payout ratio, which is known as "dividend cover". It's calculated using earnings per share divided by dividends per share.

Commentary:Our first observation states the obvious - you only use this ratio with dividend-paying companies. Investors in dividend-paying stocks like to see consistent and/or gradually increasing dividend payout ratios. It should also be noted that exaggerated (i.e. very high) dividend ratios should be looked at skeptically.

The question to ask is: Can the level of dividends be sustained? Many investors are initially attracted to high dividend-paying stocks, only to be disappointed down the road by a substantial dividend reduction (see remarks below). If this circumstance happens, the stock's price most likely will take a hit.

Secondly, dividend payout ratios vary widely among companies. Stable, large, mature companies (i.e. public utilities and "blue chips") tend to have larger dividend payouts. Growth-oriented companies tend to keep their cash for expansion purposes, have modest payout ratios or choose not to pay dividends.

Lastly, investors need to remember that dividends actually get paid with cash - not earnings. From the definition of this ratio, some investors may assume that dividend payouts imply that earnings represent cash, however, with accrual accounting, they do not. A company will not be able to pay a cash dividend, even with an adequate unrestricted balance in retained earnings, unless it has adequate cash.

In view of this accounting treatment of dividends, it is incumbent upon investors to check a company's dividend payout ratio against an adequate margin of free cash flow to ensure that the payout percentage (ratio) is sustainable.

By Richard Loth

Free Cash Flow/Operating Cash Flow Ratio

2012-01-05T17:28:00.000+06:00

The free cash flow/operating cash flow ratio measures the relationship between free cash flow and operating cash flow.

Free cash flow is most often defined as operating cash flow minus capital expenditures, which, in analytical terms, are considered to be an essential outflow of funds to maintain a company's competitiveness and efficiency.

The cash flow remaining after this deduction is considered "free" cash flow, which becomes available to a company to use for expansion, acquisitions, and/or financial stability to weather difficult market conditions. The higher the percentage of free cash flow embedded in a company's operating cash flow, the greater the financial strength of the company.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had free cash flow of $622.9. We calculated this figure by classifying "additions to instruments" and "additions to property, plant and equipment (PP&E)" as capital expenditures (numerator). Operating cash flow, or "net cash provided by operating activities" (denominator), is recorded at $878.2. All the numbers used in the formula are in the cash flow statement. By dividing, the equation gives us a free cash flow/operating cash flow ratio of 70.9%, which is a very high, beneficial relationship for the company.

Variations:A more stringent, but realistic, alternative calculation of free cash flow would add the payment of cash dividends to the amount for capital expenditures to be deducted from operating cash flow. This added figure would provide a more conservative free cash flow number. Many analysts consider the outlay for a company's cash dividends just as critical as that for capital expenditures. While a company's board of directors can reduce and/or suspend paying a dividend, the investment community would, most likely, severely punish a company's stock price as a result of such an event.

Commentary:Numerous studies have confirmed that institutional investment firms rank free cash flow ahead of earnings as the single most important financial metric used to measure the investment quality of a company. In simple terms, the larger the number the better.

By Richard Loth

Quick Ratio

2012-01-03T01:44:00.000+06:00

The quick ratio - aka the quick assets ratio or the acid-test ratio - is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' quick assets amounted to $756.40 (balance sheet); while current liabilities amounted to $606.90 (balance sheet). By dividing, the equation gives us a quick ratio of 1.3.

Variations:Some presentations of the quick ratio calculate quick assets (the formula's numerator) by simply subtracting the inventory figure from the total current assets figure. The assumption is that by excluding relatively less-liquid (harder to turn into cash) inventory, the remaining current assets are all of the more-liquid variety. Generally, this is close to the truth, but not always.

Zimmer Holdings is a good example of what can happen if you take the aforementioned "inventory shortcut" to calculating the quick ratio:

Standard Approach: $233.2 plus $524.2 = $756 ÷ $606.9 =1.3

Shortcut Approach: $1,575.6 minus $583.7 = $991.9 ÷ $606.9 = 1.6

Restricted cash, prepaid expenses and deferred income taxes do not pass the test of truly liquid assets. Thus, using the shortcut approach artificially overstates Zimmer Holdings' more liquid assets and inflates its quick ratio.

Commentary:As previously mentioned, the quick ratio is a more conservative measure of liquidity than the current ratio as it removes inventory from the current assets used in the ratio's formula. By excluding inventory, the quick ratio focuses on the more-liquid assets of a company.

The basics and use of this ratio are similar to the current ratio in that it gives users an idea of the ability of a company to meet its short-term liabilities with its short-term assets. Another beneficial use is to compare the quick ratio with the current ratio. If the current ratio is significantly higher, it is a clear indication that the company's current assets are dependent on inventory.

While considered more stringent than the current ratio, the quick ratio, because of its accounts receivable component, suffers from the same deficiencies as the current ratio - albeit somewhat less. To understand these "deficiencies", readers should refer to the commentary section of the Current Ratio chapter. In brief, both the quick and the current ratios assume a liquidation of accounts receivable and inventory as the basis for measuring liquidity.

While theoretically feasible, as a going concern a company must focus on the time it takes to convert its working capital assets to cash - that is the true measure of liquidity. Thus, if accounts receivable, as a component of the quick ratio, have, let's say, a conversion time of several months rather than several days, the "quickness" attribute of this ratio is questionable.

Investors need to be aware that the conventional wisdom regarding both the current and quick ratios as indicators of a company's liquidity can be misleading.

By Richard Loth

Current Ratio

2011-12-31T01:41:00.000+06:00

The current ratio is a popular financial ratio used to test a company's liquidity (also referred to as its current or working capital position) by deriving the proportion of current assets available to cover current liabilities.

The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' current assets amounted to $1,575.60 (balance sheet), which is the numerator; while current liabilities amounted to $606.90 (balance sheet), which is the denominator. By dividing, the equation gives us a current ratio of 2.6.

Commentary:The current ratio is used extensively in financial reporting. However, while easy to understand, it can be misleading in both a positive and negative sense - i.e., a high current ratio is not necessarily good, and a low current ratio is not necessarily bad (see chart below).

Here's why: Contrary to popular perception, the ubiquitous current ratio, as an indicator of liquidity, is flawed because it's conceptually based on the liquidation of all of a company's current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going concern. It's the time it takes to convert a company's working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio can be "misleading."

A simplistic, but accurate, comparison of two companies' current position will illustrate the weakness of relying on the current ratio or a working capital number (current assets minus current liabilities) as a sole indicator of liquidity:

--	Company ABC	Company XYZ
Current Assets	$600	$300
Current Liabilities	$300	$300
Working Capital	$300	$0
Current Ratio	2.0	1.0

Company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over current liabilities, a seemingly good current ratio, and working capital of $300. Company XYZ has no current asset/liability margin of safety, a weak current ratio, and no working capital.

However, to prove the point, what if: (1) both companies' current liabilities have an average payment period of 30 days; (2) Company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days); and (3) Company XYZ is paid cash by its customers, and its inventory turns over 24 times a year (every 15 days).

In this contrived example, Company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can't pay bills with working capital; you pay bills with cash! Company's XYZ's seemingly tight current position is, in effect, much more liquid because of its quicker cash conversion.

When looking at the current ratio, it is important that a company's current assets can cover its current liabilities; however, investors should be aware that this is not the whole story on company liquidity. Try to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities. This important perspective can be seen through the cash conversion cycle. By digging deeper into the current assets, you will gain a greater understanding of a company's true liquidity.

By Richard Loth

Cash Flow To Debt Ratio

2011-12-28T01:14:00.000+06:00

This coverage ratio compares a company's operating cash flow to its total debt, which, for purposes of this ratio, is defined as the sum of short-term borrowings, the current portion of long-term debt and long-term debt. This ratio provides an indication of a company's ability to cover total debt with its yearly cash flow from operations. The higher the percentage ratio, the better the company's ability to carry its total debt.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net cash provided by operating activities (operating cash flow as recorded in the statement of cash flows) of $878.20 (cash flow statement), and total debt of only $1,036.80 (balance sheet). By dividing, the equation provides the company, in the Zimmer example, with a cash flow to debt ratio of about 85%.

Variations:A more conservative cash flow figure calculation in the numerator would use a company's free cash flow (operating cash flow minus the amount of cash used for capital expenditures).

A more conservative total debt figure would include, in addition to short-term borrowings, current portion of long-term debt, long-term debt, redeemable preferred stock and two-thirds of the principal of non-cancel-able operating leases.

Commentary:In the case of Zimmer Holdings, their debt load is higher than their operating cash flows, giving it a ratio of less than one, however the percentage (being above 80%) is considered high. In this instance, this circumstance would indicate that the company has ample capacity to cover it's debt expenses with its operating cash flow.

Under more typical circumstances, a high double-digit percentage ratio would be a sign of financial strength, while a low percentage ratio could be a negative sign that indicates too much debt or weak cash flow generation. It is important to investigate the larger factor behind a low ratio. To do this, compare the company's current cash flow to debt ratio to its historic level in order to parse out trends or warning signs.

More cash flow to debt relationships are evidenced in the financial positions of IBM and Merck, which we'll use to illustrate this point. In the case of IBM, its FY 2005 operating cash amounted to $14.9 billion and its total debt, consisting of short/current long-term debt and long-term debt was $22.6 billion. Thus, IBM had a cash flow to debt ratio of 66%. Merck's numbers for FY 2005 were $7.6 billion for operating cash flow and $8.1 billion for total debt, resulting in a cash flow to debt ratio of 94%.

By Richard Loth

Interest Coverage Ratio

2011-12-23T01:08:00.000+06:00

The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had earnings before interest and taxes (operating income) of $1,055.00 (income statement), and total interest expense of $14.30 (income statement). This equation provides the company with an extremely high margin of safety as measured by the interest coverage ratio.

Commentary:The ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. While the non-payment of debt principal is a seriously negative condition, a company finding itself in financial/operational difficulties can stay alive for quite some time as long as it is able to service its interest expenses.

In a more positive sense, prudent borrowing makes sense for most companies, but the operative word here is "prudent." Interest expenses affect a company's profitability, so the cost-benefit analysis dictates that borrowing money to fund a company's assets has to have a positive effect. An ample interest coverage ratio would be an indicator of this circumstance, as well as indicating substantial additional debt capacity. Obviously, in this category of investment quality, Zimmer Holdings would go to the head of the class.

Let's see how the interest coverage ratio works out for IBM, Merck, Eagle Materials and Lincoln Electric: 57, 20, 39 and 20, respectively. By any standard, all of these companies, as measured by their latest FY earnings performances, have very high interest coverage ratios. It is worthwhile noting that this is one of the reasons why companies like IBM and Merck have such large borrowings - because in a word, they can. Creditors have a high comfort level with companies that can easily service debt interest payments. Here again, Zimmer Holdings, in this regard, is in an enviable position.

By Richard Loth

Profit With The Power Of Price-To-Earnings

2011-12-20T02:51:00.000+06:00

Perhaps one of the most widely-used stock analysis tools is the price-to-earnings ratio, or P/E. This perpetual prophesier of profit has been used for ages by analysts and still remains one of the most relevant pieces of stock valuation. A simple P/E ratio can reveal the stock's real market value and how the valuation compares to its industry group or a benchmark like the S&P 500 Index. Investors will find that an understanding of this financial term is priceless in properly communicating to other investing professionals.

Comparing Doughnut ShopsOne way to tell if a stock is over or undervalued is to compare it to its sector or industry group. Sectors are made up of industry groups and industry groups are made up of stocks with similar businesses. Industry groups tend to come into favor, which means the price for one doughnut shop rises then most other doughnut shop prices rise. For instance, if some anti-Atkins doctor was to release the "Doughnut Diet" and it caused a new sensation of demand for doughnuts, then every doughnut shop would likely benefit.

In most cases, an industry group will benefit during a particular phase of the business cycle and therefore many professional investors will concentrate on an industry group when their turn in the cycle is up. Remember that the P/E is a measure of expected earnings. Near the end of a period of economic expansion, inflation will usually become a problem; however, basic materials and energy companies will have higher earnings because of the better price they'll get for the commodities they harvest. Toward the end of an economic recession, interest rates will usually be low and consumer cyclical stocks will usually expect higher earnings, because consumers may be more willing to purchase on credit because rates is low.

There are numerous examples of when P/Es will be expected to rise on a particular industry group. An investor could look for stocks within an industry group that is coming into favor and find those with the lowest P/Es as a way to determine which are the most undervalued.
Relative P/EWhen a company is in its growth phase, it will usually trade with a much higher P/E than a more mature company would. However, by comparing the current P/E to a company's historical P/E, investors could determine if the stock is trading higher or lower compared to the past.
If the stock is at the higher end of its range, the likelihood of the stock being overvalued is much greater, whereas, if the stock has a P/E at the lower end of its range, then there is a greater likelihood of it being undervalued. Because of the way companies grow, this isn't always as reliable as one may hope. Therefore, investors may choose to only use approximately 10 years of P/E to keep the range in better perspective.
Fundamental and technical analysts have been looking at historical P/Es for over 100 hundred years. Charles Dow noted in his observations, that later became known as Dow Theory, that the bottom of a bear market commonly coincided with P/E ratios on the Dow Jones Industrial Average below 10. Financial bubbles have expanded P/E ratios over time to higher highs (see Figure 1). A quick observation of P/E ratios of the S&P 500 since the late 1800s shows that the average P/E ratio for the S&P 500 is approximately 15 and a P/E above 20 may be considered overvalued for the benchmark index.

Figure 1: S&P 500 PE Ratio

Source: Investools.com

The Rising Demand of DoughnutsIn the end, P/E ratios matter most depending on a person's expectation of earnings. Referring back to the doughnut shop example, if our doughnut shop was located in the less-than-thriving metropolis of Neola, Utah and the customers are mostly farmers and ranchers, you would likely view the P/E of 20 to be too expensive because future growth is limited. However, if the doughnut shop is in downtown Chicago where a new high school and police station are being built right next door, than you would likely feel that the future earnings growth is excellent and the doughnut shop is a bargain.
Looking at P/E in terms of future earnings growth can be done with a PEG ratio. The PEG ratio is the earnings divided by the five-year earnings growth rate (there can be variations of the growth rate estimate). For example, a company that has a P/E ratio of 10 and a five-year growth rate of 40%, would have a PEG ratio of 0.25. A PEG ratio of one or lower is considered to be an undervalued stock and likely a good buy.

Value investors who like to purchase stock with dividends may choose to use the PEGY ratio to determine if a stock is undervalued. The PEGY ratio is similar to the PEG ratio, but factors in the dividend yield. Investors will also look for stocks with a PEGY of one or lower.
PEGY Ratio = (P/E Ratio / Growth Rate + Dividend Yield)These two ratios will help investors utilize P/E ratios to find excellent investing opportunities.

by Ryan Campbell

Capitalization Ratio

2011-12-18T00:48:00.000+06:00

The capitalization ratio measures the debt component of a company's capital structure, or capitalization (i.e., the sum of long-term debt liabilities and shareholders' equity) to support a company's operations and growth.

Long-term debt is divided by the sum of long-term debt and shareholders' equity. This ratio is considered to be one of the more meaningful of the "debt" ratios - it delivers the key insight into a company's use of leverage.

There is no right amount of debt. Leverage varies according to industries, a company's line of business and its stage of development. Nevertheless, common sense tells us that low debt and high equity levels in the capitalization ratio indicate investment quality.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had total long-term debt of $81.60 (balance sheet), and total long-term debt and shareholders' equity (i.e., its capitalization) of $4,764.40 (balance sheet). By dividing, the equation provides the company with a negligible percentage of leverage as measured by the capitalization ratio.

Commentary:A company's capitalization (not to be confused with its market capitalization) is the term used to describe the makeup of a company's permanent or long-term capital, which consists of both long-term debt and shareholders' equity. A low level of debt and a healthy proportion of equity in a company's capital structure is an indication of financial fitness.

Prudent use of leverage (debt) increases the financial resources available to a company for growth and expansion. It assumes that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However successful this formula may seem, it does require a company to maintain a solid record of complying with its various borrowing commitments.

A company considered too highly leveraged (too much debt) may find its freedom of action restricted by its creditors and/or have its profitability hurt by high interest costs. Of course, the worst of all scenarios is having trouble meeting operating and debt liabilities on time and surviving adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, will find its competitors taking advantage of its problems to grab more market share.

As mentioned previously, the capitalization ratio is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company's total capital base, which is the capital raised by shareholders and lenders.

The examples of IBM and Merck will illustrate this important perspective for investors. As of FY 2005, IBM had a capitalization ratio of 32%, and Merck's was 22%. It is difficult to generalize on what a proper capitalization ratio should be, but, on average, it appears that an indicator on either side of 35% is fairly typical for larger companies. Obviously, Merck's low leverage is a significant balance sheet strength considering its ongoing struggle with product liability claims. Eagle Materials and Lincoln Electric have capitalization ratios (FY 2006 and FY 2005) of 30% and 20%, which most likely fall into the average and low ratio range, respectively. Zimmer Holdings' 2% capitalization ratio needs no further comment.

By Richard Loth

How To Use Price-To-Sales Ratios To Value Stocks

2011-12-15T02:38:00.000+06:00

Investors are always seeking ways to compare the value of stocks. The price-to-sales ratio (Price/Sales or P/S) provides a simple approach: take the company's market capitalization (the number of shares multiplied by the share price) and divide it by the company's total sales over the past 12 months. The lower the ratio, the more attractive the investment. As easy as it sounds, price-to-sales provides a useful measure for sizing up stocks. But investors need to be mindful of the ratio's potential pitfalls and possible unreliability.

How P/S Is Useful
In a nutshell, this ratio shows how much Wall Street values every dollar of the company's sales. Coupled with high relative strength in the previous twelve months, a low price-to-sales ratio is one of the most potent combinations of investment criteria. A low price-to-sales ratio can also be effective in valuing growth stocks that have suffered a temporary setback.

In a highly cyclical industry such as semiconductors, there are years when only few companies produce any earnings. This does not mean semiconductor stocks are worthless. In this case, investors can use price-to-sales instead of the price-earnings ratio (P/E Ratio or PE) to determine how much they are paying for a dollar of the company's sales rather than a dollar of its earnings. Price-to-sales is used for spotting recovery situations or for double checking that a company's growth has not become overvalued. It comes in handy when a company begins to suffer losses and, as a result, has no earnings (and no PE) with which investors can assess the shares.

Let's consider how we evaluate a firm that has not made any money in the past year. Unless the firm is going out of business, the price-to-sales ratio will show whether the firm's shares are valued at a discount against others in its sector. Say the company has a price-to-sales ratio of 0.7 while its peers have higher ratios of, say, 2. If the company can turn things around, its shares will enjoy substantial upside as the price-to-sales ratio becomes more closely matched with those of its peers. Meanwhile, a company that goes into a loss (negative earnings) may lose also its dividend yield. In this case, price-to-sales represents one of the last remaining measures for valuing the business. All things being equal, a low price-to-sales ratio is good news for investors, while a very high price-to-sales ratio can be a warning sign.

Where P/S Fall ShortThat being said, turnover is valuable only if, at some point, it can be translated into earnings. Consider construction companies. They report very high sales turnover, but, with the exception of building booms, they rarely make much in the way of profit. By contrast, a software company can easily generate $4 in net profit for every $10 in sales revenue. What this discrepancy means is that sales dollars cannot always be treated the same way for every company.

Many people look at sales revenue as a more reliable indicator of a company's growth. Granted, earnings are a complicated bottom-line number, whose reliability is not always assured. But, thanks to somewhat hazy accounting rules, the quality of sales revenue figures can be unreliable too.

Comparing companies' sales on an apples-to-apples basis hardly ever works. Examination of sales must be coupled with a careful look at profit margins and their trends, as well as with sector-specific margin idiosyncrasies.

Debt Is a Critical Factor
A firm with no debt and a low price-to-sales metric is a more attractive investment than a firm with high debt and the same price-to-sales ratio. At some point, the debt will need to be paid off, so there is always the possibility that the company will issue additional equity. These new shares expand market capitalization and drive up the price-to-sales ratio.

Debt-laden companies on the verge of bankruptcy, however, can emerge with low price-to-sales ratios. This is because their sales have not suffered a drop while their share price and capitalization collapses.

So how can investors tell the difference? There is an approach that helps to distinguish between "cheap" sales and less healthy, debt-burdened ones: use enterprise value/sales rather than market capitalization/sales. By adding the company's long-term debt to the company's market capitalization and subtracting any cash, one arrives at the company's enterprise value (EV).

Think of EV as the total cost of buying the company, including its debt and leftover cash, which would offset the cost. EV shows how much more investors pay for the debt. This approach also helps eliminate the problem of comparing two very different types of companies:

1) the kind that relies on debt to enhance sales and
2) the kind that has lower sales but does not shoulder debt.

by Ben McClure

Debt-Equity Ratio

2011-12-13T00:19:00.000+06:00

The debt-equity ratio is another leverage ratio that compares a company's total liabilities to its total shareholders' equity. This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed.

To a large degree, the debt-equity ratio provides another vantage point on a company's leverage position, in this case, comparing total liabilities to shareholders' equity, as opposed to total assets in the debt ratio. Similar to the debt ratio, a lower the percentage means that a company is using less leverage and has a stronger equity position.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had total liabilities of $1,036.80 (balance sheet) and total shareholders' equity of $4,682.80 (balance sheet). By dividing, the equation provides the company with a relatively low percentage of leverage as measured by the debt-equity ratio.

Variations:A conservative variation of this ratio, which is seldom seen, involves reducing a company's equity position by its intangible assets to arrive at a tangible equity, or tangible net worth, figure. Companies with a large amount of purchased goodwill form heavy acquisition activity can end up with a negative equity position.

Commentary:The debt-equity ratio appears frequently in investment literature. However, like the debt ratio, this ratio is not a pure measurement of a company's debt because it includes operational liabilities in total liabilities.

Nevertheless, this easy-to-calculate ratio provides a general indication of a company's equity-liability relationship and is helpful to investors looking for a quick take on a company's leverage. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble.

The debt-equity ratio percentage provides a much more dramatic perspective on a company's leverage position than the debt ratio percentage. For example, IBM's debt ratio of 69% seems less onerous than its debt-equity ratio of 220%, which means that creditors have more than twice as much money in the company than equity holders (both ratios are for FY 2005).

Merck comes off a little better at 150%. These indicators are not atypical for large companies with prime credit credentials. Relatively small companies, such as Eagle Materials and Lincoln Electric, cannot command these high leverage positions, which is reflected in their debt-equity ratio percentages (FY 2006 and FY 2005) of 91% and 78%, respectively.

By Richard Loth

How To Use The P/E Ratio And PEG To Tell A Stock's Future

2011-12-10T02:33:00.000+06:00

It is common practice for investorsto use the price-to-earnings ratio (P/E ratio or pricemultiple) to determine if a company's stock price is over or undervalued.Companies with a high P/E ratio are typically growth stocks. However, theirrelatively high multiples do not necessarily mean their stocks are overpricedand not good buys for the long term.

Let's take a closer look at what the P/E ratio tells us:

P/E Ratio

There are two primary components here, the market value (price) of the stock and the earnings of the company. Earnings are very important to consider. After all, earnings represent profits, and that's what every business strives for. Earnings are calculated by taking the hard figures into account: revenue, cost of goods sold (COGS), salaries, rent, etc. These are all important to the livelihood of a company. If the company isn't using its resources effectively it will not have positive earnings, and problems will eventually arise. Learn more about how to use the price-to-earnings ratio to reveal a stocks real market value.

Besides earnings, there are other factors that affect the value of a stock. For example:

Brand - The name of a product or company has value. Established brands such as Proctor & Gamble are worth billions.
Human Capital - Now more than ever, a company's employees and their expertise are thought to add value to the company.
Expectations - The stock market is forward looking. You buy a stock because of high expectations for strong profits, not because of past achievements.
Barriers to Entry - For a company to be successful in the long run, it must have strategies to keep competitors from entering the industry. For example, most anyone can make a soda, but marketing and distributing that beverage on the same level as Coca-Cola is very costly.

All these factors will affect a company's earnings growth rate. Because the P/E ratio uses past earnings (trailing 12 months), it gives a less accurate reflection of these growth potentials.

The relationship between the price/earnings ratio and earnings growth tells a more complete story than the P/E on its own. This is called the PEG ratio and is formulated as:

*_{The number used for annual growth rate can vary. It can be forward (predicted growth) or trailing, and either a one- to five-year time span. Check with the source providing the PEG ratio to see what kind of number they use.}

Looking at the value of PEG of companies is similar to looking at the P/E ratio: A lower PEG means the stock is more undervalued.

Comparative Value
Let's demonstrate the PEG ratio with an example. Say you are interested in buying stock in one of two companies. The first is a networking company with 20% annual growth in net income and a P/E ratio of 50. The second company is in the beer brewing business. It has lower earnings growth at 10% and its P/E ratio is also relatively low at 15.

Many investors justify the stock valuations of tech companies by relying on the assumption that these companies have enormous growth potential. Can we do the same in our example?

Networking Company:

P/E ratio (50) divided by the annual earnings growth rate (20) = PEG ratio of 2.5

Beer Company:

P/E ratio (15) divided by the annual earnings growth rate (10) = PEG ratio of 1.5

The PEG ratio shows us that, when compare to the beer company, the always-popular tech company doesn't have the growth rate to justify its higher P/E, and its stock price appears overvalued.

investopedia.com

Overview Of Debt

2011-12-08T00:08:00.000+06:00

Before discussing the various financial debt ratios, we need to clear up the terminology used with "debt" as this concept relates to financial statement presentations. In addition, the debt-related topics of "funded debt" and credit ratings are discussed below.

There are two types of liabilities - operational and debt. The former includes balance sheet accounts, such as accounts payable, accrued expenses, taxes payable, pension obligations, etc. The latter includes notes payable and other short-term borrowings, the current portion of long-term borrowings, and long-term borrowings. Often times, in investment literature, "debt" is used synonymously with total liabilities. In other instances, it only refers to a company's indebtedness.

The debt ratios that are explained herein are those that are most commonly used. However, what companies, financial analysts and investment research services use as components to calculate these ratios is far from standardized. In the definition paragraph for each ratio, no matter how the ratio is titled, we will clearly indicate what type of debt is being used in our measurements.

Getting the Terms Straight
In general, debt analysis can be broken down into three categories, or interpretations: liberal, moderate and conservative. Since we will use this language in our commentary paragraphs, it's worthwhile explaining how these interpretations of debt apply.

Liberal - This approach tends to minimize the amount of debt. It includes only long-term debt as it is recorded in the balance sheet under non-current liabilities.
Moderate - This approach includes current borrowings (notes payable) and the current portion of long-term debt, which appear in the balance sheet's current liabilities; and, of course, the long-term debt recorded in non-current liabilities previously mentioned. In addition, redeemable preferred stock, because of its debt-like quality, is considered to be debt. Lastly, as general rule, two-thirds (roughly one-third goes to interest expense) of the outstanding balance of operating leases, which do not appear in the balance sheet, are considered debt principal. The relevant figure will be found in the notes to financial statements and identified as "future minimum lease payments required under operating leases that have initial or remaining non-cancel-able lease terms in excess of one year."
Conservative - This approach includes all the items used in the moderate interpretation of debt, as well as such non-current operational liabilities such as deferred taxes, pension liabilities and other post-retirement employee benefits.

Note: New accounting standards, which are currently under active consideration in the U.S. by the Financial Accounting Standards Board (FASB) and internationally by the International Accounting Standards Board (IASB), will eventually put the debt principal of operating leases and unfunded pension liabilities in the balance sheet as debt liabilities. Formal "Discussion Papers" on these issues are planned by FASB and IASB in 2008, with adoption of the changes following the discussion phase expected in 2009.
Investors may want to look to the middle ground when deciding what to include in a company's debt position. With the exception of unfunded pension liabilities, a company's non-current operational liabilities represent obligations that will be around, at one level or another, forever - at least until the company ceases to be a going concern and is liquidated.

Also, unlike debt, there are no fixed payments or interest expenses associated with non-current operational liabilities. In other words, it is more meaningful for investors to view a company's indebtedness and obligations through the company as a going concern, and therefore, to use the moderate approach to defining debt in their leverage calculations.

So-called "funded debt" is a term that is seldom used in financial reporting. Technically, funded debt refers to that portion of a company's debt comprised, generally, of long-term, fixed maturity, contractual borrowings. No matter how problematic a company's financial condition, holders of these obligations, typically bonds, cannot demand payment as long as the company pays the interest on its funded debt. In contrast, long-term bank debt is usually subject to acceleration clauses and/or restrictive covenants that allow a lender to call its loan, i.e., demand its immediate payment. From an investor's perspective, the greater the percentage of funded debt in the company's total debt, the better.

Lastly, credit ratings are formal risk evaluations by credit agencies - Moody's, Standard & Poor's, Duff & Phelps, and Fitch - of a company's ability to repay principal and interest on its debt obligations, principally bonds and commercial paper. Obviously, investors in both bonds and stocks follow these ratings rather closely as indicators of a company's investment quality. If the company's credit ratings are not mentioned in their financial reporting, it's easy to obtain them from the company's investor relations department.

By Richard Loth

What is P/E Ratio?

2011-12-05T02:16:00.000+06:00

P/E is short for the ratio of a company's share price to itsper-share earnings. As the name implies, to calculate the P/E, you simply takethe current stock price of a company and divide by its earnings per share(EPS):

P/E Ratio =	Market Value per Share

	Earnings per Share (EPS)

Most of the time, the P/E is calculated using EPS from the last fourquarters. This is also known as the trailing P/E. However, occasionally the EPSfigure comes from estimated earnings expected over the next four quarters. Thisis known as the leading or projected P/E. A third variation that is alsosometimes seen uses the EPS of the past two quarters and estimates of the nexttwo quarters.

There isn't a huge difference between these variations. But it isimportant to realize that in the first calculation, you are using actualhistorical data. The other two calculations are based on analyst estimates thatare not always perfect or precise.

Companies that aren't profitable, and consequently have a negative EPS,pose a challenge when it comes to calculating their P/E. Opinions vary on howto deal with this. Some say there is a negative P/E, others give a P/E of 0,while most just say the P/E doesn't exist.

Historically, the average P/E ratio in the market has been around15-25. This fluctuates significantly depending on economic conditions. The P/Ecan also vary widely between different companies and industries.

Using The P/E Ratio

Theoretically, a stock's P/E tells us how much investors are willing to pay per dollar of earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay $20 for every $1 of earnings that the company generates. However, this is a far too simplistic way of viewing the P/E because it fails to take into account the company's growth prospects.

Growth of Earnings
Although the EPS figure in the P/E is usually based on earnings from the last four quarters, the P/E is more than a measure of a company's past performance. It also takes into account market expectations for a company's growth. Remember, stock prices reflect what investors think a company will be worth. Future growth is already accounted for in the stock price. As a result, a better way of interpreting the P/E ratio is as a reflection of the market's optimism concerning a company's growth prospects.

If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop.

A good example is Microsoft. Several years ago, when it was growing by leaps and bounds, and its P/E ratio was over 100. Today, Microsoft is one of the largest companies in the world, so its revenues and earnings can't maintain the same growth as before. As a result, its P/E had dropped to 43 by June 2002. This reduction in the P/E ratio is a common occurrence as high-growth startups solidify their reputations and turn into blue chips.

Cheap or Expensive?
The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things being equal, a $10 stock with a P/E of 75 is much more "expensive" than a $100 stock with a P/E of 20. That being said, there are limits to this form of analysis - you can't just compare the P/Es of two different companies to determine which is a better value.

It's difficult to determine whether a particular P/E is high or low without taking into account two main factors:

1. Company growth rates - How fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? Something isn't right if a company has only grown at 5% in the past and still has a stratospheric P/E. If projected growth rates don't justify the P/E, then a stock might be overpriced. In this situation, all you have to do is calculate the P/E using projected EPS.

2. Industry - It is only useful to compare companies if they are in the same industry. For example, utilities typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterized by phenomenal growth rates and constant change. Comparing a tech company to a utility is useless. You should only compare high-growth companies to others in the same industry, or to the industry average.

Problems With The P/E

So far we've learned that in the right circumstances, the P/E ratio can help us determine whether a company is over- or under-valued. But P/E analysis is only valid in certain circumstances and it has its pitfalls. Some factors that can undermine the usefulness of the P/E ratio include:

Accounting
Earnings is an accounting figure that includes non-cash items. Furthermore, the guidelines for determining earnings are governed by accounting rules (Generally Accepted Accounting Principles (GAAP)) that change over time and are different in each country. To complicate matters, EPS can be twisted, prodded and squeezed into various numbers depending on how you do the books. The result is that we often don't know whether we are comparing the same figures, or apples to oranges.

Inflation
In times of high inflation, inventory and depreciation costs tend to be understated because the replacement costs of goods and equipment rise with the general level of prices. Thus, P/E ratios tend to be lower during times of high inflation because the market sees earnings as artificially distorted upwards. As with all ratios, it's more valuable to look at the P/E over time in order to determine the trend. Inflation makes this difficult, as past information is less useful today.

Many Interpretations
A low P/E ratio does not necessarily mean that a company is undervalued. Rather, it could mean that the market believes the company is headed for trouble in the near future. Stocks that go down usually do so for a reason. It may be that a company has warned that earnings will come in lower than expected. This wouldn't be reflected in a trailing P/E ratio until earnings are actually released, during which time the company might look undervalued.

investopedia.com

What is The Debt Ratio?

2011-12-03T00:01:00.000+06:00

Debt Ratio
The debt ratio compares a company's total debt to its total assets, which is used to gain a general idea as to the amount of leverage being used by a company. A low percentage means that the company is less dependent on leverage, i.e., money borrowed from and/or owed to others. The lower the percentage, the less leverage a company is using and the stronger its equity position. In general, the higher the ratio, the more risk that company is considered to have taken on.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had total liabilities of $1,036.80 (balance sheet) and total assets of $5,721.90 (balance sheet). By dividing, the equation provides the company with a relatively low percentage of leverage as measured by the debt ratio.

Commentary:The easy-to-calculate debt ratio is helpful to investors looking for a quick take on a company's leverage. The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheets compared to its assets. The more debt compared to assets a company has, which is signaled by a high debt ratio, the more leveraged it is and the riskier it is considered to be. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble.

However, one thing to note with this ratio: it isn't a pure measure of a company's debt (or indebtedness), as it also includes operational liabilities, such as accounts payable and taxes payable. Companies use these operational liabilities as going concerns to fund the day-to-day operations of the business and aren't really "debts" in the leverage sense of this ratio. Basically, even if you took the same company and had one version with zero financial debt and another version with substantial financial debt, these operational liabilities would still be there, which in some sense can muddle this ratio.

For example, IBM and Merck, both large, blue-chip companies, which are components of the Dow Jones Index, have debt ratios (FY 2005) of 69% and 60%, respectively. In contrast, Eagle Materials, a small construction supply company, has a debt ratio (FY 2006) of 48%; Lincoln Electric, a small supplier of welding equipment and products, runs a debt ratio (FY 2005) in the range of 44%. Obviously, Zimmer Holdings' debt ratio of 18% is very much on the low side.

The use of leverage, as displayed by the debt ratio, can be a double-edged sword for companies. If the company manages to generate returns above their cost of capital, investors will benefit. However, with the added risk of the debt on its books, a company can be easily hurt by this leverage if it is unable to generate returns above the cost of capital. Basically, any gains or losses are magnified by the use of leverage in the company's capital structure.

By Richard Loth

The 4 Basic Elements Of Stock Value

2011-12-01T21:08:00.003+06:00

by Andrew Beattie

The ancient Greeks proposed earth, fire, water and air as the main building blocks of all matter, and classified all things as a mixture of these elements. Investing has a similar set of four basic elements that investors use to break down a stock's value. In this article, we will look at the four ratios and what they can tell you about a stock.

Earth: The Price-to-Book Ratio (P/B)Made for glass-half-empty people, the price-to-book (P/B) ratio represents the value of the company if it is torn up and sold today. This is useful to know because many companies in mature industries falter in terms of growth but can still be a good value based on their assets. The book value usually includes equipment, buildings, land, and anything else that can be sold, including stock holdings and bonds. With purely financial firms, the book value can fluctuate with the market as these stocks tend to have a portfolio of assets that goes up and down in value. Industrial companies tend to have a book value based more in physical assets, which depreciate year after year according to accounting rules. In either case, a low P/B ratio can protect you - but only if it's accurate. This means an investor has to look deeper into the actual assets making up the ratio.

Fire: Price-to-Earnings Ratio (P/E)The price to earnings (P/E) ratio is possibly the most scrutinized of all the ratios. If sudden increases in a stock's price are the sizzle, then the P/E ratio is the steak. A stock can go up in value without significant earnings increases - this happened most recently in the tech bubble - but the P/E ratio is what decides if it can stay up. Without earnings to back up the price, a stock will eventually fall back down.

The reason for this is simple: a P/E ratio can be thought of as how long a stock will take to pay back your investment if there is no change in the business. A stock trading at $20 per share with earning of $2 per share has a P/E ratio of 10, which is sometimes seen as meaning that you'll make your money back in 10 years if nothing changes. The reason stocks tend to have high P/E ratios is that investors try to predict which stocks will enjoy progressively larger earnings. An investor may buy a stock with a P/E ratio of 30 if he or she thinks it will double its earnings every year (shortening the payoff period significantly). If this fails to happen, then the stock will fall back down to a more reasonable P/E ratio. If the stock does manage to double earnings, then it will likely continue to trade at a high P/E ratio. You should only compare P/E ratios between companies in similar industries and markets.

Air: The PEG RatioBecause the P/E ratio isn't enough in and of itself, many investors use the price to earnings growth (PEG) ratio. Instead of merely looking at the price and earnings, the PEG ratio incorporates the historical growth rate of the company's earnings. This ratio also tells you how your stock stacks up against another stock. The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year-over-year growth rate of its earnings. The lower the value of your PEG ratio, the better the deal you're getting for the stock's future estimated earnings.

By comparing two stocks using the PEG, you can see how much you're paying for growth in each case. A PEG of 1 means you're breaking even if growth continues as it has in the past. A PEG of 2 means you're paying twice as much for projected growth when compared to a stock with a PEG of 1. This is speculative because there is no guarantee that growth will continue as it has in the past. The P/E ratio is a snap shot of where a company is and the PEG ratio is a graph plotting where it has been. Armed with this information, an investor has to decide whether it is likely to continue in that direction.

Water: Dividend Yield It's always nice to have a back-up when a stock's growth falters. This is why dividend-paying stocks are attractive to many investors - even when prices drop you get a paycheck. The dividend yield shows how much of a payday you're getting for your money. By dividing the stock's annual dividend by the stock's price, you get a percentage. You can think of that percentage as the interest on your money, with the additional chance at growth through the appreciation of the stock.

Although simple on paper, there are some things to watch for with the dividend yield. Inconsistent dividends or suspended payments in the past mean that the dividend yield can't be counted on. Like the water element, dividends can ebb and flow, so knowing which way the tide is going - like whether dividend payments have increased year over year - is essential to making the decision to buy. Dividends also vary by industry, with utilities and some banks paying a lot whereas tech firms invest almost all their earnings back into the company to fuel growth.

No Element Stands AloneP/E, P/B, PEG, and dividend yields are too narrowly focused to stand alone as a single measure of a stock. By combining these methods of valuation, you can get a better view of a stock's worth. Any one of these can be influenced by creative accounting - as can more complex ratios like cash flow. As you add more tools to your valuation methods though, discrepancies get easier to spot. From the Greeks' four basic elements, we now have more than 100, some of which exist so briefly that we wonder if they count, and none of them are named water, earth, air, or fire. In investing, however, these four main ratios may be overshadowed by thousands of customized metrics, but they will always be useful stepping stones for finding out whether a stock's worth buying.

Confirm Forex Momentum With Heikin Ashi

2011-11-30T16:39:00.000+06:00

Investors and speculators are always looking for an edge in determining the strength and direction of trends. The Heikin Ashi application is one tool that may be able to provide this edge. Similar to the Ichimoku charts, the Heikin Ashi has been a relatively unknown tool that has recently seen a rise in popularity, even though it has been accessible since its introduction almost two decades ago.

In addition to showing the relative strength of a trend, the application also notes key turning points in price action and reacts much like a moving average. Incorporating the overall session activity in a single candlestick (open, close, high and low), the charting tool also "smooths" over erratic fluctuations in the currency markets and omits spikes that may be sparked by volatility or jumps in price. This allows chartists to obtain a clearer picture of what's going on in the market and to make a more informed trading decision. Let's take a look at how the Heikin Ashi is calculated and how it can be applied to forex trading.

Defining the Heikin Ashi
Before we get into the actual application of the Heikin Ashi, let's dive into some logistics involving the real meaning behind it. Usually a type of candlestick chart, the Heikin Ashi is available on some charting packages as a separate indicator. This allows investors or speculators to make a side-to-side comparison between the standard candlestick and the Heikin Ashi, allowing for a more cohesive interpretation. In Figure 1, the chartist can see that the two are very similar but offer different perspectives, as the Heikin Ashi indicator disregards market noise and concentrates on the smoother trend of the underlying price action in the euro/U.S. dollar.

Source: FX Trek Intellicharts

Figure 1: A nearly identical interpretation (top: price action, bottom: Heikin Ashi)

The reason the Heikin Ashi tends to be smoother is because instead of using a simple low and high of the session to calculate individual candles, the Heikin Ashi takes the prices per bar and averages them to create a "smoother" session. This is key because the currency markets tend to offer traders more volatility and market noise in the price than other markets. Here is how each candle is constructed:
Close = (Open Price + High + Low +Close) / 4
Open = (Open Price of the previous bar + Close Price of the previous bar) / 2
High = [Maximum value of the (High, Open, Close)]
Low = [Minimum value of the (Low, Open, Close)]

By plugging formulas into each individual session to construct consecutive candles, the chart continues to be reflective of the underlying price action, isolating the price and excluding currency market volatility and noise. The resulting picture gives the trader a more visually appealing perspective, and one that can help in identifying the overall trend.

Now that we've established how the candles are calculated, here is how to interpret them:
Positive candles (blue) containing no wicks: There is strong uptrend momentum in the session and it will likely continue. Here, the trader will have a hands-off approach to profits while strongly considering adding on to the position.
Positive candles (blue) containing shadows or wicks: Strength continues to support the price action higher. At this point, with upside potential still present, the investor will likely consider the notion of adding to the overall position.
A smaller candle body with longer wicks: Similar to the doji candlestick formation, this candle suggests a near-term turnaround in the overall trend. Signaling indecision, market participants are likely to wait for further directional bias before pushing the market one way or the other. Traders following on the signal will likely prefer confirmation before initiating any positions.
Negative candles (red) containing shadows or wicks: Weakness or negative momentum is supporting the price action lower in the market. As a result, traders will want to begin exiting initial long positions or selling positions at this point.
Negative candles (red) containing no shadows or wicks: Selling momentum is strong and will likely support a move lower in the overall decline. As a result, the trader would do well to add to existing short holdings.

The Heikin Ashi will still take some time to master; however, once this is accomplished, the Heikin Ashi will act to confirm the overall trend of the price action. Now let's see how it is used in market opportunities.

Improve on Opportunities
With a smoother picture, sometimes a more simplified one, a speculator can improve on trading the overall trend by combining the Heikin Ashi with multiple indicators. As with any other chart application, it's better to find an indicator that works well with your individual trading style when adding on the Heikin application. This will not only help traders to establish a directional bias, but it will also clear up entries, support and resistance and offer further confirmation of the trade becoming profitable. In Figure 2, the chartist is looking at a prime example using the Australian dollar/Canadian dollar currency pair.

Source: FX Trek Intellicharts
Figure 2: A pivotal turn confirmed by Heikin Ashi

Taking a look at the price action, the Australian dollar weakened enormously against a rising Canadian dollar, hence the downtrending channel. Reaching the psychological 0.8300 support, the cross pair presents an opportunity to the speculator. Not only is the AUD/CAD pair testing the support trendline at the 0.8300 level, the potential bottom coincides with the lower channel trendline. Confirming the strength of such a barrier, we overlay the Heikin Ashi and focus on the two dojis that have formed on the chart. The presented signal gives us the best confirmation in this example, as the trade is calling out a long position in Figure 3.

Source: FX Trek Intellicharts

Figure 3: Two dojis scream out a probably long

Signaling a potential turn in the price action, the dojis set the trade up nicely. Next, an entry point must be established. At this point, the best entry afforded, according to industry theory, is a break above the high of the session at Point A in Figure 3. This will set the long buy order at 0.8400 with a corresponding stop 2 points, for example, below the low of the session, at 0.8328. Theoretically, the trade is looking to profit, not only on a retracement test of the upper trendline, but a potential break. That's where the profits lie as the break above would create a longer term advance. The idea coincides with what is being viewed on the Heikin Ashi. Over the course of the next month, with the stop fully intact and untriggered as the price never trades back, the long position remains profitable until the creation of another doji near mid month's time. Taking into account the close of the session - including the doji, which is precisely set at 0.8554 - the trade has already profited by 154 points. Looking back, this is more than sufficient, as the risk/reward ratio is well above the 2:1 minimum prescribed. Subsequently, a trailing stop would be perfect at keeping profits close while letting potential unfold in the coming weeks.

Breaking It Down
Let's take it down a notch and look into the steps of another example. Here, we'll reference a textbook example in the New Zealand dollar/Japanese yen currency pair. Taking a look at the overall price action, we see consolidation in the month of July on the longer term daily chart. Applying the stochastic oscillator, we see a golden cross form (Point B), suggesting a near-term uptick in Figure 4.

Source: FX Trek Intellicharts

Figure 4: Point B shows trigger on golden cross

Identify support or resistance: Although not a full requirement, this helps to establish a viewpoint where a directional bias can be established. This will likely help in isolating points of entry, assisting with stop placement and risk assessment. In the example, there is ample support that is coming in at the 69.25 figure, offering a great opportunity for a long trade.
Overlay the technical indicator: The stochastic oscillator assists in suggesting bidding support as both indicators begin to form a golden cross. The cross at Point B confirms the trade bias and isolates the point of entry.
Confirm with Heikin Ashi: Obtaining the entry point off of support and the technically bullish crossover in the stochastic, the trader can confirm the strength of the nascent trend by using the smoother based candles. In the visual example at Point C, the chartist can see that the doji is indicative of the shift in momentum as sellers begin to exit the market. Simultaneously, the following longer bodied candle signifies a stronger uptrend in buying.
Place Entry Order: Now, with the directional bias confirmed, the trader will do well to place the entry five to 10 points above the doji session high. Although the order can actually be placed at the high or any other position in the session, the placement in this case is in order to capitalize on a breakout of price action (Point D). As a result, the entry is placed at 69.90. Placing the corresponding stop five points below the support will ensure a viable test. Should the level be broken to the downside, the previous trade is negated on overriding selling momentum. However, in this case, our indicators confirmed the directional bias, profiting 360 points before topping out for the first time two weeks.

Source: FX Trek Intellicharts

Figure 5: Point B shows trigger on golden cross

Richard Lee

Tips For Controlling Investment Losses

2011-11-25T16:04:00.000+06:00

Who needs a profit/loss plan? Isn't investing only about buying low and selling high? It would be nice to always buy at the bottom and sell at the top, but it is nearly impossible to do so consistently. Furthermore, investors are only human: emotions sway our judgment and it is in our nature to hate losing. Taking a loss on a stock, therefore, is not only detrimental to our pocketbooks, but it also hurts our egos. Time and time again investors take profits by selling an investment that has appreciated, but hold onto declining stocks in the hope of a rebound; oftentimes these investments shrivels to a fraction of their previous worth.

So how can an investor avoid this type of outcome? One solution is to learn to be a disciplined investor and to adopt a profit/loss plan. In this article, we'll go over this strategy and show you how to use it to stay in the black.

What Is a Profit/Loss Plan?
This plan is a step that many retail investors (and professionals) often overlook. The profit/loss plan is a set of limits that determines the maximum loss or gain an investor will take on a stock. Containing losses is a very important part of investing, so the profit/loss plan is crucial to a sound strategy.

We all make stock-picking mistakes and most of us have lost money in the stock market - what sets the great investors apart is their ability to recognize their bad choices and use what they've learned to make up for them later. A profit/loss plan helps you recognize your mistakes by allowing you to separate your emotions from investing. If you aren't too zealous about your gains and you see them purely as a means of increasing your cash flows (rather than your ego), you will have a much easier time letting go of your losses and, therefore, controlling them.

Devising Your Plan
Devising a plan may be more difficult than you'd expect. First, you'll need to set the maximum gain you will accept and the maximum loss you will tolerate for your investments, but these maximums and minimums shouldn't necessarily be the same for every stock. For example, a blue chip stock is more unlikely to rise or fall by 10% within any given year as compared to a small-cap growth stock, which will exhibit more volatility. In other words, you must analyze each stock individually to estimate how much it is likely to move in either direction.

Some investors use technical or fundamental analysis or a combination of both to determine appropriate limits for gains and losses. Another way to devise your limits is by modeling your plan on the performance of a designated benchmark such as an index or even on the past performance of your own portfolio.

Another factor you must consider when devising your profit/loss plan is your risk tolerance, which depends on many factors such as your personality, your time frame and your available capital. Typically, people who are risk averse will have tighter boundaries than those who don't mind risk. Risk lovers will try to profit as much as possible from a rising stock, but a more conservative investor may sell the stock early on in its rise to eliminate the risk of losses, which would occur if the stock took a quick downward dive. If you prefer to shy away from risks, a profit/loss plan of 10% each way may not be suitable or even realistic for you. On the other hand, if you are willing to take on the added risks associated with potential profits, then a 10% profit/loss might be more appropriate.

Carrying Out Your Plan
Once you've decided on your numbers, whether conservative or aggressive, you have to put the plan into action with as few hitches as possible. Remember, this plan has a double requirement: you have to sell your stocks (1) if they fall to a certain level and (2) if they rise to a certain level.

Now, brokers will not let you enter two different sell orders for the same security so you need to figure out which one you'd rather enter first. It may be wisest to enter orders that first protect your downside: many wise investors use the stop-loss order, which instructs your broker to buy or sell a stock once it has reached a certain price. The stop loss ensures that you won't get burned on a down market, especially if you aren't able to watch your stocks every second. When you enter in your order with your broker, set the stop price at your maximum loss percentage and then sit and wait. If the price ends up appreciating to your upper boundary, just change the price of your stop loss order, which will then activate the immediate sale of your stock.

Staying Disciplined
Once you have your profit/loss strategy in place, you will have to remember that the whole idea of the plan is to establish strict guidelines for when to sell. Sure, it hurts to see a stock continue to rise once you have sold it, but it is often better to sell on the way up than to wait until you have to dump the stock while the price is collapsing after its peak. Joseph P. Kennedy, Sr. once said, "Only a fool holds out for the top dollar."

investopedia.com

The Stop-Loss Order - Make Sure You Use It

2011-11-20T15:58:00.000+06:00

What Is a Stop-loss Order?
It is an order placed with a broker to buy or sell once the stock reaches a certain price. A stop-loss is designed to limit an investor's loss on a security position. Setting a stop-loss order for 10% below the price at which you bought the stock will limit your loss to 10%. For example, let's say you just purchased Microsoft (Nasdaq:MSFT) at $20 per share. Right after buying the stock you enter a stop-loss order for $18. This means that if the stock falls below $18, your shares will then be sold at the prevailing market price.

Positives and Negatives
The advantage of a stop order is you don't have to monitor on a daily basis how a stock is performing. This is especially handy when you are on vacation or in a situation that prevents you from watching your stocks for an extended period of time.

The disadvantage is that the stop price could be activated by a short-term fluctuation in a stock's price. The key is picking a stop-loss percentage that allows a stock to fluctuate day to day while preventing as much downside risk as possible. Setting a 5% stop loss on a stock that has a history of fluctuating 10% or more in a week is not the best strategy. You'll most likely just lose money on the commissions generated from the execution of your stop-loss orders.

There are no hard and fast rules for the level at which stops should be placed. This totally depends on your individual investing style: an active trader might use 5% while a long-term investor might choose 15% or more.

Another thing to keep in mind is that once your stop price is reached, your stop order becomes a market order and the price at which you sell may be much different from the stop price. This is especially true in a fast-moving market where stock prices can change rapidly.

A last restriction with the stop-loss order is that many brokers do not allow you to place a stop order on certain securities like OTC Bulletin Board stocks or penny stocks.


Watch: Stop Loss Order

Not Just for Preventing Losses
Stop-loss orders are traditionally thought of as a way to prevent losses thus it's namesake. Another use of this tool, though, is to lock in profits, in which case it is sometimes referred to as a "trailing stop". Here, the stop-loss order is set at a percentage level below, not the price at which you bought it, but the current market price. The price of the stop loss adjusts as the stock price fluctuates. Remember, if a stock goes up, what you have is an unrealized gain, which means you don't have the cash in hand until you sell. Using a trailing stop allows you to let profits run while at the same time guaranteeing at least some realized capital gain.

Continuing with our Microsoft example from above, say you set a trailing stop order for 10% below the current price, and the stock skyrockets to $30 within a month. Your trailing-stop order would then lock in at $27 per share ($30 - (10% x $30) = $27). This is the worst price you would receive, so even if the stock takes an unexpected dip, you won't be in the red. Of course, keep in mind the stop-loss order is still a market order - it's simply stays dormant and is activated only when the trigger price is reached -- so the price your sale actually trades at may be slightly different than the specified trigger price.

Advantages of the Stop-Loss Order
First of all, the beauty of the stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. You can think of it as a free insurance policy.

Most importantly, a stop loss allows decision making to be free from any emotional influences. People tend to fall in love with stocks, believing that if they give a stock another chance, it will come around. This causes procrastination and delay, giving the stock yet another chance. In the meantime, the losses mount....

No matter what type of investor you are, you should know why you own a stock. A value investor's criteria will be different from that of a growth investor, which will be different still from an active trader. Any one strategy may work, but only if you stick to the strategy. This also means that if you are a hardcore buy-and-hold investor, your stop-loss orders are next to useless.

The point here is to be confident in your strategy and carry through with your plan. Stop-loss orders can help you stay on track without clouding your judgment with emotion.

Finally, it's important to realize that stop-loss orders do not guarantee you'll make money in the stock market; you still have to make intelligent investment decisions. If you don't, you'll lose just as much money as you would without a stop loss, only at a much slower rate.

Investopedia.com

Triangles: A Short Study In Continuation Patterns

2011-11-15T15:50:00.000+06:00

In the study of technical analysis, triangles fall under the category of continuation patterns. There are three different looks of triangles, and each should be closely studied. These formations are, in no particular order, the ascending triangle, the descending triangle and the symmetrical triangle.

Triangles can be best described as horizontal trading patterns. At the start of its formation, the triangle is at its widest point. As the market continues to trade in a sideways pattern, the range of trading narrows, and the point of the triangle is formed. In its simplest form, the triangle shows losing interest in an issue, both from the buy side as well as the sell side: the supply line diminishes to meet the demand.

Think of the lower line of the triangle, or lower trendline, as the demand line, which represents support on the chart. At this point, the buyers of the issue outpace the sellers, and the stock's price begins to rise. The supply line is the top line of the triangle and represents the overbought side of the market, when investors are going out taking profits with them.

Ascending Triangle Pattern

Figure 1

Often a bullish chart pattern, the ascending triangle pattern in an uptrend is not only easy to recognize but is also a slam-dunk as a entry or exit signal. It should be noted that a recognized trend should be in place for the triangle to be considered a continuation pattern. In figure 1, you can see an uptrend is in place and the demand line, or lower trendline is drawn to touch the base of the rising lows. The two highs have formed at the top line. These highs do not have to have reach the same price point but should be close to each other.

The buyers may not be able to break through the supply line at first and they may take a few runs at it before establishing new ground and new highs. The chartist will look for an increase in the trading volume as the key indication that new highs will form. An ascending triangle pattern will take about four weeks or so to form and will not likely last more than 90 days.

How do the longs (the buyers) know when to jump into the issue? Most analysts will take a position once the price action breaks through the top line of the triangle with increased volume, which is when the stock price should rise an amount equivalent to the widest section of the triangle.

Descending Triangle Pattern

Figure 2

The descending triangle is recognized primarily in downtrends and is often thought of as a bearish signal. As you can see in figure 2, the descending triangle pattern is the upside-down image of the ascending triangle pattern. The two lows on the above chart form the lower flat line of the triangle and, again, have to be only close in price action rather than exactly the same. The development of the descending triangle takes the same amount of time as the ascending triangle, and volume again plays an important role in the breakout to the downside.

Symmetrical Patterns
So far we have seen two triangle patterns. One, from an uptrend and bullish market move and one from a downtrend with a decidedly bearish look. Symmetrical triangles, on the other hand, are thought of as continuation patterns developed in markets that are, for the most part, aimless in direction. The market seems listless in its direction. The supply and demand therefore seem to be one and the same.

During this period of indecision, the highs and the lows seem to come together in the point of the triangle with virtually no significant volume. Investors just don't know what position to take. However, when the investors do figure out which way to take the issue, it heads north or south with big volume in comparison to that of the indecisive days and or weeks leading up to the breakout. Nine times out of ten, the breakout will occur in the direction of the existing trend. But, if you are looking for an entry point following a symmetrical triangle, jump into the fray at the breakout point.

Figure 3

These patterns, both the symmetrical triangles on the bullish as well as the bearish side are known to experience early breakouts that give investors a "head fake". Hold off for a day or two after the breakout and determine whether or not the breakout is for real. Experts tend to look for a one-day closing price above the trendline in a bullish pattern and below the trendline in bearish chart pattern.

Remember, look for volume at the breakout and confirm your entry signal with a closing price outside the trendline.

Investopedia.com

Short-, Intermediate- and Long-Term Trends

2011-11-10T15:45:00.000+06:00

Simply put, short, intermediate and long-term trends are the three kinds of trends that we see each day in our study of technical analysis. "A trend is your friend", is just one of the sayings that have come out of the study of primary as well as secular trends. Given the understanding that the psychology of the markets actually moves the markets, we can acknowledge that psychology develops and ends the trends we are going to look at today.

Learning how to identify the trend should be the first order of business for any student of technical analysis. Most investors, once invested in an uptrend, will stay there looking for any weakness in the ride up, which is the indicator needed to jump off and take the profit.

The bull and bear markets are also known as primary markets, and history has shown us that the length of these markets generally last from one to three years in duration. If we consider recent history, the current markets are showing the early signs of making the turn from a three-year bear market to the makings of an early bull market.

Chart Created with Tradestation

You can see in the chart that the bull market preceding the most recent three-year slide lasted much longer than the average trend duration of which I spoke above, and if certain economic factors don't soon resolve themselves, the bear market may be somewhat longer than most would like to see.

A secular trend, one that can last for one to three decades holds within its parameters many primary trends, and, for the most part, is easy to recognize because of the time frame. The price-action chart, for a period of 25 years or so would appear to be nothing more than a number of straight lines moving gradually up or down. Have a look for a moment at the chart of the S&P 500 below. I have taken the chart back to early the 1980s to show you the rise of the market leading up to the turn of the century.

Chart Created with Tradestation

Within all primary trends are intermediate trends, which keep the business journalists and market analysts constantly searching for the answers for why an issue or a market suddenly turns and heads in the direction opposite to that of yesterday or last week. Sudden rallies and directional turnarounds make up the intermediate trends and, for the most part, are the results of some kind of economic or political action and its subsequent reaction.

History tells us that the rallies in bull markets are strong and that the reactions are somewhat weak. The flip side of the coin shows us that bear-market reactions are strong and that the rallies are short. Twenty/twenty hindsight also shows us that each bull and bear market will have at least three intermediate cycles. Each intermediate cycle could last as little as two weeks or as long as six to eight weeks.

To determine the long-term trends that appear on the charts of their favorite stocks, veteran analysts will use a stochastics indicator. My favorite, however, is the momentum indicator called the rate of change (ROC):

The normal time frame for ROC measurement is 10 days. The ratio to build the ROC indicator is as follows:

Rate of Change = 100 (Y/Yx)

"Y" represents the most recent closing price, and Yx represents the closing price a specific number of days ago. So, if the price of a stock closes higher today than it did 10 days ago, the ROC value point will be above the equilibrium, thus indicating to chartists that prices are rising in that particular issue. Conversely, if the price in today's session closes lower than it did 10 trading days ago, the value point will be below the equilibrium, indicating that prices are falling off. It is safe to say that if the ROC is rising, it gives a short-term bullish signal, and a bearish sign would have the ROC falling. Chartists pay great attention to the time period in the calculation of ROC. Long-term views of the market or a specific sector or stock, will use perhaps a 26- to 52-week time period for Yx and a shorter view would use 10 days to six months or so.

Markets are made up of several different kinds of trends, and it is the recognition of these trends that will largely determine the success or failure of your long and short-term investing.

Investopedia.com

Volume Oscillator Confirms Price Movements

2011-11-05T14:43:00.001+06:00

When volume is low but gains and loss are big, the professionals are most likely getting overly excited about a possible turn in market direction. That's because many have been taught that without strong volume, a market move is not valid. Here we look at how to interpret volume and the principles behind this doing so.

Simple but Powerful
Volume, volume, volume – it is the indicator at which chartists constantly look to determine whether or not a move in the markets, a sector or a single issue has conviction. It may also be the easiest of all indicators to understand. Add the number of shares traded in a given period, and you have the answer. It requires no weightings or exotic mathematical formulas. It simply indicates enthusiasm or lack thereof for an issue, and it has nothing to do with the price of the.

To confirm a market turnaround or trend reversal, the technical analyst must determine whether or not the measurements of price and volume momentum agree with each other. If they do not, it is a sure indicator of weakness in the trend, and thus a trend reversal may be well on the horizon. If we have a look at volume from the standpoint of momentum, we see a recognizable level of buying and selling activity.

The Oscillator
A volume oscillator measures volume by measuring the relationship between two moving averages. The volume oscillator indicator calculates a fast and slow volume moving average. The difference between the two (fast volume moving average minus slow volume moving average) is then plotted as a histogram. The fast volume moving average is usually over a period of 14 either days or weeks. The slow volume moving average is usually 28 either days or weeks. On a regular basis, analysts argue over whether or not the lengths of these time periods are appropriate. Some say that 14 and 28 are too conservative while others argue these numbers are not conservative enough.

Here we use use 5/20 like a short-term trader. The histogram, like an oscillator, fluctuates above and below a zero line. Volume can provide insight into the strength or weakness of a price trend. This indicator plots positive values above the zero line and negative values below the line. A positive value suggests there is enough market support to continue driving price activity in the direction of the current trend. A negative value suggests there is a lack of support, that prices may begin to become stagnant or reverse.

Interpretation
If a market is rallying, the volume oscillator should rise. When the issue becomes overbought, the oscillator will reverse its direction. If the market is declining or moving in a horizontal direction, the volume should contract. Always keep in mind that we are measuring changes in volume, and volume expands during a sell-off. It is important to note that an increasing price together with declining volume is always, without exception, bearish. When the market is at the top, one would therefore see an oversold volume chart. Another important fact is that rising volume together with declining prices is also bearish.

Chart Created with Tradestation

A look at the chart of the Dow Jones Industrial Average from Aug 2001 to Aug 2002 shows two significant run-ups in the volume oscillator after equally significant slides. The first is a result of the activity after Sept 11 and the subsequent market turnaround on Sept 21. The second is the result of the most recent fall-off this summer and the turnaround of over 1,500 points over the past three weeks or so.

For the first case, you can see that the volume increased dramatically when the market collapsed on the re-open of the exchanges on Sept 17, 2001. The Dow then witnessed very low volumes with the rising market after the bounce on Sept 21. Volumes were low mostly because investors were still in shock; only the most steely-nerved investors got back in. The second case occurs in line with annual summer market conditions where, for the most part, the institutional players are gone for the month of August; furthermore, the pundits find little excitement, because of a lack of volume, when the market moves daily 100 points in either direction.

Remember, it's your money - invest it wisely.

Investopedia,com

8 Basic Forex Market Concepts

2011-10-30T16:25:00.000+06:00

Eight Majors
Unlike the stock market where investors have thousands of stocks to choose from, in the currency market, you only need to follow eight major economies and then determine which will provide the best undervalued or overvalued opportunities. These following eight countries make up the majority of trade in the currency market:

United States
Eurozone (the ones to watch are Germany, France, Italy and Spain)
Japan
United Kingdom
Switzerland
Canada
Australia
New Zealand

These economies have the largest and most sophisticated financial markets in the world. By strictly focusing on these eight countries, we can take advantage of earning interest income on the most credit-worthy and liquid instruments in the financial markets.

Economic data is released from these countries on an almost daily basis, allowing investors to stay on top of the game when it comes to assessing the health of each country and its economy.

Yield and Return
When it comes to trading currencies, the key to remember is that yield drives return.

When you trade in the foreign exchange spot market, you are actually buying and selling two underlying currencies. All currencies are quoted in pairs, because each currency is valued in relation to another. For example, if the EUR/USD pair is quoted as 1.3500 that means it takes $1.35 to purchase one euro.

In every foreign exchange transaction, you are simultaneously buying one currency and selling another. In effect, you are using the proceeds from the currency you sold to purchase the currency you are buying. Furthermore, every currency in the world comes attached with an interest rate set by thecentral bank of that currency's country. You are obligated to pay the interest on the currency that you have sold, but you also have the privilege of earning interest on the currency that you have bought.

For example, let's look at the New Zealand dollar/Japanese yen pair (NZD/JPY). Let's assume that New Zealand has an interest rate of 8% and that

Japan

has an interest rate of 0.5% In the currency market, interest rates are calculated in basis points. A basis point is simply 1/100^th of 1%. So, New Zealand rates are 800 basis points and Japanese rates are 50 basis points. If you decide to go long NZD/JPY you will earn 8% in annualized interest, but have to pay 0.5% for a net return of 7.5%, or 750 basis points.

Leveraging Returns
The forex market also offers tremendous leverage - often as high as 100:1 - which means that you can control $10,000 worth of assets with as little as $100 of capital. However, leverage can be a double-edged sword; it can create massive profits when you are correct, but may also generate huge losses when you are wrong.

Clearly, leverage should be used judiciously, but even with relatively conservative 10:1 leverage, the 7.5% yield on NZD/JPY pair would translate into a 75% return on an annual basis. So, if you were to hold a 100,000 unit position in NZD/JPY using $5,000 worth of equity, you would earn $9.40 in interest every day. That's $94 dollars in interest after only 10 days, $940 worth of interest after three months, or $3,760 annually. Not too shabby given the fact that the same amount of money would only earn you $250 in a bank savings account (with a rate of 5% interest) after a whole year. The only real edge the bank account provides is that the $250 return would be risk-free.

The use of leverage basically exacerbates any sort of market movements. As easily as it increases profits, it can just as quickly cause large losses. However, these losses can be capped through the use of stops. Furthermore, almost all forex brokers offer the protection of a margin watcher - a piece of software that watches your position 24 hours a day, five days per week and automatically liquidates it once margin requirements are breached. This process insures that your account will never post a negative balance and your risk will be limited to the amount of money in your account. Management Matters.)

Carry Trades
Currency values never remain stationary and it is this dynamic that gave birth to one of the most popular trading strategies of all time, the carry trade. Carry traders hope to earn not only the interest rate differential between the two currencies, but also look for their positions to appreciate in value. There have been plenty of opportunities for big profits in the past. Let's take a look at some historical examples.

Between 2003 and the end of 2004, the AUD/USD currency pair offered a positive yield spread of 2.5%. Although this may seem very small, the return would become 25% with the use of 10:1 leverage. During that same time, the Australian dollar also rallied from 56 cents to close at 80 cents against the U.S. dollar, which represented a 42% appreciation in the currency pair. This means that if you were in this trade - and many hedge funds at the time were - you would have not only earned the positive yield, but you would have also seen tremendous capital gains in your underlying investment.

Figure 1: Australian Dollar Composite, 2003-2005

Source: eSignal

The carry trade opportunity was also seen in USD/JPY in 2005. Between January and December of that year, the currency rallied from 102 to a high of 121.40 before ending at 117.80. This is equal to an appreciation from low to high of 19%, which was far more attractive than the 2.9% return in theS&P 500 during that same year. In addition, at the time, the interest rate spread between the U.S. dollar and the Japanese yen averaged around 3.25%. Unleveraged, this means that a trader could have earned as much as 22.25% over the course of the year. Introduce 10:1 leverage, and that could be as much as 220% gain.

Figure 2: Japan Yen Composite, 2005

Source: eSignal

Carry Trade Success
The key to creating a successful carry trade strategy is not simply to pair up the currency with the highest interest rate against a currency with the lowest rate. Rather, far more important than the absolute spread itself is the direction of the spread. In order for carry trades to work best, you need to be long a currency with an interest rate that is in the processes of expanding against a currency with a stationary or contracting interest rate. This dynamic can be true if the central bank of the country that you are long in is looking to raise interest rates or if the central bank of the country that you are short in is looking to lower interest rates.

In the previous USD/JPY example, between 2005 and 2006 the U.S. Federal Reserve was aggressively raising interest rates from 2.25% in January to 4.25%, an increase of 200 basis points. During that same time, the Bank of Japan sat on its hands and left interest rates at zero. Therefore, the spread between

U.S.

and Japanese interest rates grew from 2.25% (2.25% - 0%) to 4.25% (4.25% - 0%). This is what we call an expanding interest rate spread.

The bottom line is that you want to pick carry trades that benefit not only from a positive and growing yield, but that also have the potential to appreciate in value. This is important because just as currency appreciation can increase the value of your carry trade earnings, currency depreciation can erase all of your carry trade gains - and then some.

Getting to Know Interest Rates
Knowing where interest rates are headed is important in forex trading and requires a good understanding of the underlying economics of the country in question. Generally speaking, countries that are performing very well, with strong growth rates and increasing inflation will probably raise interest rates to tame inflation and control growth. On the flip side, countries that are facing difficult economic conditions ranging from a broad slowdown in demand to a full recession will consider the possibility of reducing interest rates.

The Bottom Line
Thanks to the widespread availability of electronic trading networks, forex trading is now more accessible than ever. The largest financial market in the world offers a world of opportunity for investors who take the time to get to understand it and learn how to mitigate the risk of trading here.

by Kathy Lien and Boris Schlossberg

Mastering Short-Term Trading

2011-10-28T14:19:00.000+06:00

Short-term trading can be very lucrative, but also risky. It can last for as little as a few minutes to as long as several days. To succeed at this strategy, traders must understand the risks and the rewards of each trade. They must not only know how to spot good short-term opportunities, but also must be able to protect themselves from unforeseen events. In this article, we'll examine the basics of spotting good short-term trades and show you how to profit from them.

The Fundamentals of Short-Term Trading
Several basic concepts must be understood and mastered for successful short-term trading. These fundamentals can mean the difference between a loss and a profitable trade. Let's take a look at these vital principles.

Recognizing Potential Candidates
Recognizing the right possible trade will mean that you know the difference between a good potential situation and the ones to avoid. Too often, investors get caught up in the moment and believe that if they watch the evening news and read the financial pages they will be on top of what's happening in the markets. The truth is, by the time we hear about it, the markets are already reacting. So, some basic steps must be followed to find the right trades at the right times.

Step 1: Watch the Moving Averages
A moving average is the average price of a stock over a specific period of time. The most common time frames are 15, 20, 30, 50, 100 and 200 days. The overall idea is to show whether a stock is trending upward or downward. Generally, a good candidate will have an increasing moving average that is sloping upward. If you are looking for a good short, you want to find an area where the moving average is flattening out or declining.

Step 2: Understand Overall Cycles or Patterns
Generally, the markets trade in cycles, which makes it important to watch the calendar at particular times. Since 1950, most of the stock markets gains have occurred in the November to April time frame, while during the May to October period, the averages have been relatively static. Cycles can be used to traders' advantage to determine good times to enter into long or short positions.

Step 3: Get a Sense of Market Trends
If the trend is negative, you might consider shorting and do very little buying. If the trend is positive, you may want to consider buying with very little shorting. The reason for this is that when the overall market trend is against you, the odds of having a successful trade drop even more.

Following some of these basic steps will give you an understanding of how and when to spot some of the right potential trades.

Controlling Risk
Controlling risk is one of the most important aspects of trading successfully. Short-term trading involves risk, so it is essential to minimize risk and maximize return. This requires the use of sell stops or buy stops as protection from market reversals.

A sell stop is a sell order to sell a stock once it reaches a predetermined price. Once this price is reached, it becomes an order to sell at the market price. A buy stop is the opposite. It is used in a short when the stock rises to a particular price and it becomes a buy order.

Both of these are designed to limit your downside. As a general rule in short term trading, you want to set your sell stop or buy stop within 10-15% of where you bought the stock or initiated the short. The basic idea here is to keep the losses manageable so that the gains can always be considerably more than any losses you may incur.

Technical Analysis
There is an old saying on Wall Street: "never fight the tape". Whether most admit it or not, the markets are always looking forward and pricing in what is happening. This means that everything we know about earnings, the management and other factors is already priced into the stock. Staying ahead of everyone else requires that you use technical analysis to understand what is going on.

Technical analysis is a process of evaluating and studying the stock or markets using previous prices and patterns to predict what will happen in the future. In short-term trading, this is an important tool to help you understand how to make profits while others are unsure. Below we will uncover some of the various tools and techniques of technical analysis.

Buy and Sell Indicators
Several indicators are used to determine the right time to buy and sell. Two of the more popular ones include the relative strength index (RSI) and the stochastic oscillator.

The RSI compares the inside strength or weakness of a stock. Generally, a reading of 70 indicates a topping pattern, while a reading below 30 shows that the stock has been oversold.

The stochastic oscillator is used to decide whether a stock is expensive or cheap based on the stock's closing price range over a period of time. You will see a reading of 80 if the stock is overbought (expensive); when the stock is oversold (inexpensive), you will see a reading of 20.

RSI and stochastics can be used as stock-picking tools, but you must use them in conjunction with other tools to spot the best opportunities.

Patterns
Another tool that can help you find good short-term trading opportunities are patterns. A pattern is a change in direction up or down in the price of stock and reflects changing expectations. Patterns can develop over several days, months or years. While no two patterns are the same, they are very close and can be used to predict price movements.

Several important patterns to watch for include:

Head-and-Shoulders Patterns: The head and shoulders is considered one of the most reliable patterns. This is considered to be a reversal pattern when a stock is topping out.
Triangles: A triangle is when the range between the highs and lows narrows. These occur when prices are bottoming or topping out. As the prices narrow, this will signify that the stock could break out to the up- or downside in a violent fashion.
Double Tops: A double top occurs when prices rise to a certain point on heavy volume and then retreat. You will then see a retest of that point on decreased volume. At this point, a decline will take place and the stock will head lower.
Double Bottoms: A double bottom is when prices will fall to a certain point on heavy volume. They will then rise and fall back to the original level on lower volume. Unable to break the low point, prices will then start to rise.

Conclusion
Short-term trading uses many methods and tools to make money, however, you must know how to apply the tools to achieve success using this type of strategy. If you can do this, you will be able to make money in both bull and bear markets while keeping your losses at a minimum and your profits at a maximum. This is the key to mastering short-term trading.

by Chris Seabury

How does leverage work in the forex market?

2011-10-25T14:15:00.000+06:00

The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments that include options, futures and margin accounts. Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.

In forex, investors use leverage to profit from the fluctuations in exchange rates between two different countries. The leverage that is achievable in the forex market is one of the highest that investors can obtain. Leverage is a loan that is provided to an investor by the broker that is handling his or her forex account. When an investor decides to invest in the forex market, he or she must first open up a margin account with a broker. Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position the investor is trading. Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of $50,000 or less.

To trade $100,000 of currency, with a margin of 1%, an investor will only have to deposit $1,000 into his or her margin account. The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided by the futures market. Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading. If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.

Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses. To avoid such a catastrophe, forex traders usually implement a strict trading style that includes the use of stop and limit orders.

investopedia.com

Forex Leverage: A Double-Edged Sword

2011-10-23T13:36:00.000+06:00

One of the reasons why so many people are attracted to trading forex compared to other financial instruments is that with forex, you can usually get much higher leverage than you would with stocks. While many traders have heard of the word leverage, few have a clue about what leverage is, how leverage works, and how leverage can directly impact their bottom line

What is leverage?
Leverage involves borrowing a certain amount of the money needed to invest in something. In the case of forex, that money is usually borrowed from a broker. Forex trading does offer high leverage in the sense that for an initial margin requirement, a trader can build up - and control - a huge amount of money.

To calculate margin-based leverage, divide the total transaction value by the amount of margin you are required to put up.

Margin-Based Leverage =	Total Value of Transaction
	Margin Required

For example, if you are required to deposit 1% of the total transaction value as margin and you intend to trade one standard lot of USD/CHF which is equivalent to US$100,000, the margin required would be US$1,000. Thus, your margin-based leverage will be 100:1 (100,000/1,000). For a margin requirement of just 0.25%, the margin-based leverage will be 400:1, using the same formula.

Margin-Based Leverage Expressed as Ratio	Margin Required of Total Transaction Value
400:1	0.25%
200:1	0.50%
100:1	1.00%
50:1	2.00%

However, margin-based leverage does not necessarily affect one's risks. Whether a trader is required to put up 1% or 2% of the transaction value as margin may not influence his or her profits or losses. This is because investor can always attribute more than the required margin for any position. What you need to look at is the real leverage, not margin-based leverage.

To calculate the real leverage you are currently using, simply divide the total face value of your open positions by your trading capital.

Real Leverage =	Total Value of Transaction
	Total Trading Capital

For example, if you have $10,000 in your account, and you open a $100,000 position (which is equivalent to one standard lot), you will be trading with a 10 times leverage on your account (100,000/10,000). If you trade two standard lots, which is worth $200,000 in face value with $10,000 in your account, then your leverage on the account is 20 times (200,000/10,000).

This also means that the margin-based leverage is equal to the maximum real leverage a trader can use. And since most traders do not use their entire accounts as margin for each of their trades, their real leverage tends to differ from their margin-based leverage.

Leverage in Forex Trading
In trading, we monitor the currency movements in pips, which is the smallest change in currency price, and that could be in the second or fourth decimal place of a price, depending on the currency pair. However, these movements are really just fractions of a cent. For example, when a currency pair like the GBP/USD moves 100 pips from 1.9500 to 1.9600, that is just a $0.01 move of the exchange rate.

This is why currency transactions must be carried out in big amounts, allowing these minute price movements to be translated into decent profits when magnified through the use of leverage. When you deal with a large amount like $100,000, small changes in the price of the currency can result in significant profits or losses.

When trading forex, you are given the freedom and the flexibility to select your real leverage amount based on your trading style, personality and money management preferences.

Risk of Excessive Real Leverage
Real leverage has the potential to enlarge your profits or losses by the same magnitude. The greater the amount of leverage on capital you apply, the higher the risk that you will assume. Note that this risk is not necessarily related to margin-based leverage although it can influence if a trader is not careful.

Let's illustrate this point with an example (See Figure 1).

Both Trader A and Trader B have a trading capital of US$10,000, and they trade with a broker that requires a 1% margin deposit. After doing some analysis, both of them agree that USD/JPY is hitting a top and should fall in value. Therefore, both of them short the USD/JPY at 120.

Trader A chooses to apply 50 times real leverage on this trade by shorting US$500,000 worth of USD/JPY (50 x $10,000) based on his $10,000 trading capital. Because USD/JPY stands at 120, one pip of USD/JPY for one standard lot is worth approximately US$8.30, so one pip of USD/JPY for five standard lots is worth approximately US$41.50. If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which is equivalent to a loss of US$4,150. This single loss will represent a whopping 41.5% of his total trading capital.

Trader B is a more careful trader and decides to apply five times real leverage on this trade by shorting US$50,000 worth of USD/JPY (5 x $10,000) based on his $10,000 trading capital. That $50,000 worth of USD/JPY equals to just one-half of 1 standard lot. If USD/JPY rises to 121, Trader B will lose 100 pips on this trade, which is equivalent to a loss of $415. This single loss represents 4.15% of his total trading capital.

Refer to the chart below to see how the trading accounts of these two traders compare after the 100-pip loss.

-	Trader A	Trader B
Trading Capital	$10,000	$10,000
Real Leverage Used	50 times	5 times
Total Value of Transaction	$500,000	$50,000
In the Case of a 100-Pip Loss	-$4,150	-$415
% Loss of Trading Capital	41.5%	4.15%
% of Trading Capital Remaining	58.5%	95.8%
Figure 1: All figures in U.S. dollars

Excessive Leverage Can Kill

With a smaller amount of real leverage applied on each trade, you can afford to give your trade more breathing space by setting a wider but reasonable stop and avoiding risking too much of your money. A highly leveraged trade can quickly deplete your trading account if it goes against you as you will rack up greater losses due to bigger lot sizes. Keep in mind that leverage is totally flexible and customizable to each trader's needs. Having an aim of trading profitably is not about making your millions by the end of this month or this year.

by Grace Cheng

Blending Technical And Fundamental Analysis

2011-10-20T14:43:00.000+06:00

People often ask if technical analysis can be used as an effective substitute for fundamental analysis. Although there is no definitive answer whether technical analysis can be used as a whole substitution for fundamental analysis, there is little doubt that combining the strengths of both strategies can help investors better understand the markets and gauge the direction in which their investments might be headed. In this article, we'll look at the pros and cons of technical analysis and the factors that investors should consider when incorporating both strategies into one market outlook.

The Best Of Both Worlds
Some technical analysis methods combine well with fundamental analysis to provide additional information to investors. These include:

1) Volume Trends
When an analyst or an investor is researching a stock, it's good to know what other investors think about it. After all, they might have some additional insight into the company or they might be creating a trend.

One of the most popular methods for gauging market sentiment is to take a look at the recently traded volume. Large spikes suggest that the stock has garnered much attention from the trading community and that the shares are under either accumulation or distribution.

Volume indicators are popular tools among traders because they can help confirm whether other investors agree with your perspective on a security. Traders generally watch for the volume to increase as an identified trend gains momentum. A sudden decrease in volume can suggest that traders are losing interest and that a reversal may be on its way.

Intraday charting is growing in popularity because it enables traders to watch for spikes in volume, which often correspond with block trades and can be extremely helpful in deciphering exactly when large institutions are trading.

2) Tracking Short-Term Movements
While many fundamental investors tend to focus on the long haul, the odds are that they still want to obtain a favorable buy-in price and/or a favorable selling price upon liquidating a position. Technical analysis can be handy in these situations as well.

More specifically, when a stock punches through its 15- and/or 21-day moving average (either to the upside or the downside), it usually continues along that trend for a short period of time. In other words, it is largely an indicator of what to expect in the coming term. Incidentally, 50- and 200-day moving averages are often used by chartists and some fundamental investors to determine longer term breakout patterns

For those looking to time a trade or to solidify a favorable entry or exit price in a given stock, these types of charts and analyses are invaluable.

3) Tracking Reactions Over Time
Many fundamental analysts will look at a chart of a specific stock, industry, index or market to determine how that entity has performed over time when certain types of news (such as positive earnings or economic data) has been released.

Patterns have a tendency to repeat themselves, and the investors who were lured (or put off by) the news in question tend to react in a similar manner over time.

For example, if you take a look at the charts of various housing stocks, you'll often see that they react negatively when the Federal Reserve chooses to forgo a cut in interest rates. Or check out how home improvement stores tend to react when reports of new and existing home sales decline. The reactive move lower is pretty consistent each time.

In short, by analyzing historical trends, investors can ballpark the possible reaction to a future event.

The Downside to Blending
Technical analysis may also provide an inaccurate or incomplete perspective on a stock because:

1) It's History!
While it is possible to decipher and anticipate certain movements based on patterns or when a particular stock crosses a major moving average, charts cannot usually predict future positive and/or negative fundamental data - instead they are heavily focused on the past.

However, if news leaks out that a company is about to release a good quarter (for example), investors might be able to take advantage of it and this good news will be apparent in the chart. A simple chart cannot provide the investor with crucial long-term fundamental information such as the future direction of cash flow or earnings per share.

2) The Crowd is Sometimes Wrong
As mentioned above, it's nice to buy into a stock that has upside momentum. However, it is important to note and understand that the crowd is sometimes wrong. In other words, it is possible that a stock that's being accumulated en masse this week may be under heavy distribution the next. Conversely, stocks that are being heavily sold this week may be under accumulation in the weeks to come.

A terrific example of the "crowd is wrong" mentality can be found in the large amount of money that went into technology shares at the turn of the millennium. In fact, money kept flowing into shares of companies such as CMGI or JDS Uniphase, as well as a number of other high-tech issues. When the bottom dropped out, the money flow into these stocks and the stock markets on which they traded dried up almost overnight. The charts did not indicate that such a harsh correction was coming.

3) Charts Don't Typically or Consistently Forecast Macro Trends
Charts also are generally unable to accurately forecast macroeconomic trends. For example, it is nearly impossible to look at a major player in the oil and gas sector and decipher definitively whether OPEC intends to increase the amount of oil it pumps, or whether a fire that just started at a shipping facility in Venezuela will affect near-term supplies.

4) There is Subjectivity
When it comes to reading a chart, a certain amount of subjectivity comes into play. Some may see a chart and feel that a stock is basing, while another person might see it and conclude that there is still more downside to be had.

Who is right?

Again, there's no calculation that can be done to solve the argument, as might be the case with fundamental analysis. When it comes to charting, only time will tell which way the markets will actually go.

by Glenn Curtis

Leverage's "Double-Edged Sword" Need Not Cut Deep

2011-10-18T02:46:00.001+06:00

In some fields of business, such as real estate, you'll frequently hear that the way to make money is by "using other people's money". This is true in the case of every real estate transaction that involves a mortgage; when you use a mortgage to buy a house, you are using other people's money, in this case, the bank's. The concept of using other people's money to enter a transaction can also be applied to the financial markets through a tool known as leverage. In this article, we'll explore the benefits of using borrowed capital for trading and will examine the common misconceptions about this tool's excessive risk.

Leverage in Other Markets

Borrowing money from a bank is the most common method that allows the average person to buy a bigger house than he or she could otherwise expect for the amount of money readily available. When this concept is applied to commercial properties, it provides a greater return on equity than if the buyer had paid for the entire property using only his or her own funds.

For example, suppose that you own a leased property that you bought for $1 million and the property returns a net 15% each year; your return on investment is 15% per year. However, suppose that instead of paying $1 million in cash, you mortgage the property and borrow $800,000, and therefore only invest $200,000 of your own money. After paying the interest on the loan, you may only achieve an 8% return, rather than 15%. However, 8%, or $80,000, divided by your equity investment of $200,000 is actually equivalent to a 40% return on your investment. In real estate, this type of leverage is considered perfectly acceptable and is actually encouraged.

Risk From a Different Perspective

Now when it comes to the markets, especially the forex markets, the pundits tend to look at leverage as a dirty word. Many go as far as to suggest that it's a strategy that we should be afraid of, and resisted at all costs. They tell us that leveraging in the markets is a double-edged sword that will cut both ways. If we make a profit on leveraged investments, the returns can be huge; if we make losses, those losses can devastate an account. Of course, there is truth to this statement, but the double-edged sword analogy can give an incomplete account of how forex actually works.

If you understand how leverage works and learn to handle it correctly, you can use its power to build wealth. Returning to the sword analogy, the way to do this is to use the blade to cut out losses quickly, leaving the profits room to grow.

Similarly, some people liken trading with leverage to a journey in a car. You could walk to your destination, but driving is a much more efficient solution, especially if the destination is far away. Driving a car is probably much riskier than walking, and statistically more people die in road accidents. But how many people listen to those statistics and never drive in a car? Investors' fear of leverage is often similarly absurd.

Leverage In the Forex Market

In the foreign exchange markets, leverage is commonly as high as 100:1. This means that for every $1,000 in your account, you can trade up to $100,000 in value. Many traders believe that the reason that forex market makers are prepared to offer such high leverage is because leverage is a function of risk. They know that if the account is properly managed, the risk will also be very manageable. Otherwise they would not offer the leverage, simple as that. Also, because the spot cash forex markets are so large and liquid, the ability to enter and exit a trade at the desired level is much easier than in other less liquid markets.

Let us look at an example of a leveraged position in the forex market and how such a position should be managed. Assume, for this example, that you are interested in trading the U.S. dollar against the Canadian dollar (USD/CAD). Let us also suppose that you have $10,000 of trading capital in your account. One of the first rules in trading your account is to define a risk profile. For example, you may decide to never risk more than 2% of your trading capital in any one trade. This means that you will not be prepared to lose more than $200 in any trade as long as your available capital remains at $10,000. As you can imagine, the 2% rule means that you have a good chance of staying in the game. The odds are stacked against a string of losses, but, by sticking to the 2% rule, a leveraged account can still be reasonably safe.

Factors To Consider

There is more to managing leverage than just setting up a 2% rule - you also have to take the personality of the market into account.

For example, suppose the USD/CAD had a daily range of 70 pips. If each pip is worth approximately $10, then you can only risk 20 pips in order to stick to the 2% rule. (2% of $10,000 = $200 and if 1 pip = $10 then $200 = 20 pips.) Therefore, when you enter into a trade, it is important to place a stop loss no farther away than 20 pips. If the stop of 20 pips is in such a place that the normal back and forth movement of the market is likely to hit the stop, you will be stopped out every time, and will incur a string of losses. As such, it is crucial that your stop be placed in a position that it is unlikely to be hit. If you are trading on a daily chart and that position is farther away than 20 pips, you might have to trade in a shorter time frame where the natural stop is not farther than 20 pips.

So, once you have determined the maximum amount of loss you can sustain, which is a percentage of your trading capital, (the 2% rule), and you understand the best place to position a stop loss so that the 2% rule is automatically enforced, but is unlikely to be hit, then you can use leverage to build profits quickly and efficiently. Whenever you think of leverage, you must think of risk management tools such as the stop order as the safety mechanism that controls its power.

by Selwyn Gishen