As I continue reading through Peter Lynch's book, "One Up on Wall Street," Lynch provides some numbers to go through when reading a company's financial statements. There was a recent article by MarketWatch that quoted Lynch as saying that his investment philosophy has never been, "Just invest in what you know." With this chapter, I believe that Lynch proves a point as he looks into the fundamentals of a company. Here are the aspects that he mentions.
Percent of sales:Â Here Lynch mentions that when a specific product catches our attention, it is worth finding out what that product represents as a percentage of total sales. While out in the store our perception might be that the product is a killer, it could turn out to be just an illusion and represent only a small fraction of the company's sales.
The PE ratio:Â "The P/E ratio of any company that's fairly priced will equal its growth rate (earnings)."Â Here Lynch presents a back-of-the-envelope calculation: "Find the long-term growth rate, add the dividend yield and divide by the P/E ratio. Less than 1 is poor, a 1.5 is okay, but what you're really looking for is a 2 or better."
The Cash position: Lynch suggests looking at the cash and cash equivalents and then deducting the long-term debt to gauge liquidity levels. He suggests caution, however, as sometimes it doesn't make a difference -- having a lot represents increased pressure to assign it.
The debt factor:Â Here the author suggests taking a look at the debt/equity ratio. "It's just the kind of thing a loan officer would want to know about you in deciding if you are a good credit risk."
Dividends:Â "One strong argument in favor of companies that pay dividends is that companies that don't pay dividends have a sorry history of blowing the money on a string of stupid diworseifications." Here, it is good to keep in mind that companies that do not pay a dividend are more likely to have more attractive prospects into which they are investing.
Does it pay? It is very important to consider not only if the company pays a dividend, but if by doing so the company does not incur solvency problems.
Book value:Â Lynch discusses the problem with investing in companies by relying solely on book value. "People invest in these on the theory that if the book value is $20 a share and the stock sells for $10, they're getting something for half price. The flaw is that the stated book value often bears little relationship to the actual worth of the company."
More hidden assets:Â "Just as often as book value overstates true worth, it can understate true worth. This is where you get the greatest asset plays." Here, Lynch mentions that it is very important to look at footnotes, especially regarding depreciation rates and how intangibles such as goodwill are calculated. In some cases, goodwill needs to be written-down, and a great asset could be hidden in plain sight.
Cash flow:Â This was a great discovery, since Lynch talks about free cash flow and not only operating cash flow. "Free cash flow is what's left over after the normal capital spending is taken out."
"Dedicated asset buyers look for this situation: a mundane company going nowhere, a lot of free cash flow, and owners who aren't trying to build up the business."
Inventories:Â "I always check to see if inventories are piling up. With a manufacturer or a retailer, an inventory buildup is usually a bad sign. When inventories grow faster than sales, it's a red flag."
Pension plans: "Even if a company goes bankrupt and ceases normal operations, it must continue to support the pension plan. Before I invest in a turnaround, I always check to make sure the company doesn't have an overwhelming pension obligation that it can't meet."
Growth rate:Â Lynch refers to the earnings growth rate over the years, and mentions that stability is the name of the game.
The bottom line:Â The author discusses how a company with smaller profit margins would benefit in a greater way whenever the industry tide goes up in terms of prices. Generally, a company that has lower margins would be able to translate these increases into double-digit growth in net profit.
So far in my reading, I have discovered that while Lynch is famous for his 10-baggers and growth investment style, he did not exclude dividend-paying stocks or steady cash flow generators such as Coca-Cola (KO, Financial), for example. I would say that while his approach may look simplistic on the surface, it has a great attachment to the fundamental values and ideas of Ben Graham. Obviously, it would be very hard to achieve such an astounding track record just by buying companies whose products we like on the streets, and this chapter has shed some light as to some of the critical aspects that we must take care of before investing.