1. What Does the Company Do?

To determine what a company does means identifying which industries the company participates in and recognizing which one or ones drive a significant portion of the company's revenue stream. This requires digging into the company's financial statements, either the 10-K (annual) or 10-Q (quarterlies), which you can find at www.sec.gov. Examine the income statement, and potentially the business segment information that's found in the notes at the back of the filing to identify the different business lines the company may have. Some may only have one business segment, which can make this easier, but you should still read the company description to understand its products and services. Always read the notes in the filings, as that is often where you will find a lot more of the juicy details that investors need to know and companies may hope you overlook.

To give you an example of what we mean by understanding what the company does, let's take a look at Apple, a company almost everyone knows. While the company's history was one of personal computers, Apple today competes in the consumer electronics business with revenues coming from sales of iPhones, iPads, Mac desktop computers and laptops, Apple Watches, Apple TV, other products such as accessories, and services (Apple Care, iTunes, Apple Music, iCloud, and Apple Pay as well as the upcoming CarPlay and HomeKit). So now you know what it sells, but you don't know what brings in most of its revenue.

2. What Are Its Key Products or Services?

The answers to the first question—what does the company do?—gave you the big picture of the company. Here we're talking about those products or services that drive the bulk of the company's sales and profits. For Apple, iPhone sales were responsible for 63 percent of revenues generated in the quarter ending June 2015, which is Apple's third quarter as its year-end is September 30.¹ That's double the revenue contribution from all of Apple's other businesses (iPad, Mac, services, and other products) combined.² In fact the next-biggest product line—the Mac—accounted for only 12 percent of revenue during the quarter! The bottom line is that in 2015 Apple's business was highly dependent on the iPhone.³

If someone tried to convince you to buy Apple shares based on the Apple Watch or Apple TV, you would think twice. These new products may be sexy and may make headlines, but at least for a while, they won't be moving the revenue or profit lines in a meaningful way.

Figure 10.1 is a summary of the financials as reported by Apple for the third quarter of 2015, which ends June 30.

3. Which Business Unit or Units Make Most of the Profits?

Even after you break down the company's revenue stream, you still have to identify what really drives the company's profits. We tend to focus on operating profit generation, because it factors in things like selling, general and administration costs, as well as research and development (R&D) spending for the company.

In this case, let's step away from Apple and turn to semiconductor chip company Qualcomm (QCOM), which derived 68 percent of its 2015 revenue from chip sales and 31 percent from its licensing business.⁴ Digging into the notes found toward the back of the 2015 10-K revealed the chip business accounted for only 26.3 percent of operating profits in 2015, compared to 73.6 percent for the licensing business.⁵ This told us that at the heart of things, the real driver of Qualcomm's business and earnings was the very profitable licensing business. As such, investors in Qualcomm would need to understand the dynamics of that business and prevailing trends (vector and velocity once again) in the royalty rate.

4. Who Are the Customers, and How Are They/Will They Be Changing?

Now that you know what the company sells, what generates the majority of sales, and where it makes the most profits, you need to look at to whom it is selling. Is the company focused on a customer base that is shrinking or growing? Are preferences evolving in favor of or away from the company's products and/or services? Looking to the future, will the customer base likely have more money to spend on the company's offerings or less? Is the customer base highly concentrated (e.g., the majority of sales are to a very small number of entities)?

For example, microchip producer Cirrus Logic reported in 2015 that Apple orders accounted for 72 percent of its sales.⁶ As you can imagine, strong iPhones sales are a boon to Cirrus and weak sales a killer. An investor in this company would have to understand just how much Apple could affect it, both directly by demanding lower prices and indirectly through the success of Apple's products. Potential investors would have to recognize that shares of Cirrus Logic stock will likely react to the latest thoughts on how Apple's products (most of which are iPhones!) will fare in the future, which can make for a bumpy ride if there is a high degree of skepticism over how those Apple products will perform. Something to keep in mind as you consider your risk tolerance level for a particular company and its shares.

5. Who Are the Company's Suppliers, and What Are Its Key Inputs?

Whatever a company sells—goods, services, or both—it needs some sort of inputs, such as coffee beans for Starbucks, protein for Red Robin Gourmet Burgers, cotton for the Gap, and microchips for Apple. Investors need to understand what the key inputs are for the company and how they might be affected. Did this year's weather damage the coffee crop? Are beef and chicken prices skyrocketing, and if so, why? Have cotton prices tumbled and, if so, is that good for the Gap? (Yes it is!) Is there a trend among microchip manufacturers to merge, which might mean fewer suppliers to companies like Apple, resulting in perhaps an ability to demand higher prices for those microchips?

You also want to understand the market dynamics between the company and its suppliers. For example, Walmart has enormous purchasing power relative to many of its suppliers and has a reputation for placing significant pressure on its suppliers to cut costs.⁷ On the other end of the spectrum, iron ore is used to produce steel, and there are three iron ore suppliers that significantly dominate the industry⁸—Vale, Rio Tinto, and BHP—while the largest steel company in the world, ArcelorMittal, controls less than 10 percent of the steel market.

6. Who Are the Key Competitors, and How Are They Impacting the Market?

Looking again at Apple, the key competitors to watch out for would be those in the smartphone industry where those devices accounted for the majority of Apple's sales in 2015, rather than, say, personal computers or iPads. Samsung is the primary competitor to Apple's iPhone business, given its sizable market share,⁹ according to data from a market research firm, but an investor would still want to keep tabs on other players such as Lenovo, Huawei, LG, and HTC, as well as the once high-and-mighty BlackBerry.

Investors need to read competitor press releases and financial filings to develop a feel for how their products are doing. Watching new product introductions, feature sets, and promotional activity, as well as product pricing trends, can tell you if one of the competitors is aggressively targeting market share gains, which could reduce profit margins in the future.

7. Who Is Running the Company, and What Do They Think?

A rather well-known maxim in Silicon Valley is, “I'll take an A team with a B idea over an A idea with a B team any day.” The greatest products or services in the world still need a talented management team. Investors need to understand who is running the company, what their track record is, and what the team dynamics are.

You want to compare what you think the company does to what the management team thinks it does. Are they in sync? To get your arms around this, you can listen to the management team give their quarterly or annual earnings review. You can also read management's views in the 10-Ks and 10-Qs, as well as listen to how they talk about the company, its business, and its opportunities at investor conferences that tend to be captured in the investor relations section of the company's website. This will also give you a feel for where management is focusing their energies: Are they focused on the primary revenue and profit areas, or do they seem distracted by areas that contribute little to the company's bottom line? If so, is there a good reason for this that isn't immediately obvious?

What's the track record of the team? How long has this particular one been together? Any recent changes to the team? Any upcoming ones? If so, why? You want to try and get a good feel for the dynamics within the group. Management teams that have too much internal friction can end up wasting time and energy that ought to be put into the company. On the other hand, too much camaraderie can lead to, shall we say, lethargic leadership. You want to make sure the team is hungry and that they push each other to bring their A game every day.

Investors also need to understand who is on the board of directors and what their relationship with the management team is like. Are they working well together? Are there productive or destructive tensions? Are there any activist investors, such as Elliot Management Corporation or David Einhorn's Greenlight Capital? Just Google “Top Activist Investors” to get a current list. If so, what are they saying about the company and the management team? Do they have plans to acquire or are they already involved in the company? To what end? Are they adding value or being a distraction?

It is always a good idea to check on insider buying and selling. If members of the management team have started to sell off a material portion of their ownership, it probably isn't a good time for you to be buying. You can find information on this from the SEC, as well as from the online sites of services like Morningstar and Insider-Monitor.com. At the SEC's site you'll want to look at Form 14A, the proxy statement, which gives a list of the directors and officers and the number of shares they each own, as well as Form 4, which reports changes in ownership.¹⁰ You'll want to see if anyone has been buying or selling a material amount recently, but keep in mind that often, particularly with companies that have gone public more recently, executives set up a 10b5–1 plan that schedules to sell a specific number of shares at regular intervals regardless of the price. A very good overview on 10b5–1 plans can be found in “Rule 10b5–1 Plans: What You Need to Know” on the Harvard Law School Forum on Corporate Governance and Financial Regulation.¹¹

8. What Is Driving Growth at the Company?

Again, let's stick with Apple and its June 2015 quarterly results. iPhone revenue soared 59 percent year-over-year, which was head and shoulders ahead of the company's overall revenue growth of 33 percent for the quarter compared to what it did the prior year.¹² Generally speaking, those businesses that are growing faster than the corporate average—in this case, that 33 percent revenue growth we mentioned for the June 2015 quarter—are the ones to watch.

When it comes to growth, size does matter. We see this in Apple's Other Products business, which houses Apple TV, Apple Watch, Beats Electronics iPods, and other accessories. During the June 2015 quarter, revenue from Other Products grew 49 percent year over year—impressive!—but the business only accounted for 5 percent of Apple's overall revenues. That's still pretty small potatoes, so when you hear about high rates of growth, make sure you understand just how much of a company's revenue and profits come from that growing area.

The bottom line with Apple is that it's a smartphone company that as of this writing is still growing faster than the overall industry, which means that its products continue to take customers away from Samsung and other competitors. Despite delivering fantabulous results, the longer-term concern is: What products will overtake Apple's revenue and profit generation? Longtime investors will remember that at one point it seemed PC and mobile phone sales would never slow, let alone contract, yet we are seeing the latter happen in both of those markets today.

9. What Is Driving the Company's Profit, and, If It's Not Improving, Why Is That?

We tend to look at a company's operating margin, which is simply operating profit divided by revenue. There are several parts of the income statement that we use to calculate a company's operating profit. Here's the formula we use:

To calculate a company's Operating margin, use

And just to be sure we have things crystal clear:

Generally speaking, a company's profit picture can improve when it earns more per dollar of revenue. If Starbucks raises its prices on a cup of coffee or Apple's latest iPhone model is priced higher, then odds are that margins will be rising. If, however, Starbucks initiated that price increase to fend off the pain of higher coffee prices, the company's margins might improve, but maybe not as much because the benefit of the price increase is offset by higher costs to the company. Keep in mind, though, that any time a company raises prices, it risks losing customers. That means that while margins could be improving, which we like, total revenue could be falling, which we don't like.

Companies can also see margin improvement due to something called economies of scale, which means the more a company builds a product, the more efficient it will get and the lower its costs are per unit produced. Think of it this way: If you have a factory that can manufacture anywhere from 100 to 1,000 units in the same amount of time and with the same number of employees, the cost per unit of making 1,000 units is less than the cost per unit of making 100. Hand in hand with that robust product volume may go more favorable costs associated with key parts or ingredients that go into the product—the joys of buying in bulk. Also look for when a company initiates a new manufacturing technology or does something to reduce its production costs. There may be some short-term pain or disruptions as those new procedures are implemented, but before too long, the benefits should begin to kick in.

Another way a company can see its profitability improve is through lower costs. Take the Starbucks example above. If coffee prices drop and Starbucks doesn't lower its coffee drink prices, its operating margin would benefit from the fall in its coffee cost prices. Keep in mind though that Starbucks would run the risk of losing customers if other coffee shops, such as Peet's and Coffee Bean and Tea Leaf, lowered their prices and became more attractive to customers. In that case, while Starbucks margins would have improved, it may end up actually making less money because it has lost customers.

Of course, coffee is one input among many at Starbucks. But that's why you need to read the company's financial filings to determine which inputs are critical. The same goes for other companies and other parts and ingredients. We walk you through this with Starbucks in Chapter 11. Many companies also hedge against price increases in key inputs, such as coffee beans for Starbucks or jet fuel for airlines, so don't assume that a change in input prices will immediately have an impact. For example, airlines that didn't hedge their jet fuel costs benefited more than those that did when oil prices plummeted in 2014 and 2015.

When you look at margins for different companies in the same industry, if you find one has a much higher margin, you need to understand why and how it is going to maintain those margins. Unusually high margins attract competition and tend to get pushed down over time to be more in line with the rest of the industry, unless there is something particularly special about that company that protects those margins. In Qualcomm's case discussed in Question #3, it was the high margin licensing business that was responsible for the majority of the company's overall profits, not the semiconductor chip business.

10. Is the Company Financially Healthy?

Up until now, most of the answers to these questions can be found in and around the company's income statement. But we also want to examine its balance sheet. There are a number of line items on a balance sheet, but the ones we are immediately drawn to center on cash and debt positions. If a company doesn't have a decent amount of cash on hand to pay its bills and a cushion for emergencies, that is a big red flag for investors; after all, “Cash is king.”

How much cash does it have on its balance sheet? Is the cash position growing? Is it higher than it was in the prior quarter? Is the company's cash position larger than it was a year ago? A shrinking level of cash relative to revenue is always a cause for concern.

The same questions apply to a company's debt level, but we have to introduce some math to determine if the company's business can handle the amount of debt it has. The first thing we look at is its debt ratio. To do so, we use the following:

When confronted with formulas like the preceding one, we find it best to use a quick example to remove any math-related fear. After all, it's basically some simple addition and division.

Let's look at consumer product company Procter & Gamble (PG). Perusing the company's balance sheet for the March 2015 quarter, we find it had $15.075 billion in short-term debt, $17.364 billion in long-term debt, and shareholders' equity of $63.38 billion. Let's calculate:

Generally speaking, the lower the total debt-to-capital ratio, the better. But we have to remember that dynamics differ from industry to industry. That means acceptable total debt-to-capital ratios for a consumer products company will be very different than a defense contractor, which is very different from a young biotechnology company that barely has any revenue. We like to compare a company's total debt-to-capital ratio with those of its competitors and peers, which we identified in the first five questions. If you find one that is substantially higher than the rest, it could be a red flag.

On the other hand, don't be alarmed if you see companies without any debt on their balance sheets. Even after the explosion in debt-fueled corporate share buyback programs that resulted from the low- to no-interest rate environment post-financial crisis, there still were companies that were debt free.

Here are a few things to consider once you've looked at both the cash and debt levels: First, what is the net cash position per share, and how does it compare to the company's stock price? Let's break that down a bit, shall we?

In its March 2015 quarterly financial statements, Procter & Gamble had $13.16 billion in cash, total debt of $32.439 billion on its balance sheet, and 2.88 billion shares outstanding. Using those figures, at the end of that quarter:

It's important to point out that if a company has more debt than cash on its balance sheet, and companies like Procter & Gamble and hundreds of others fall into this category, you will see a negative net-cash-per-share figure. All that means is they have more debt than cash.

Depending on the business and its cash generation, higher debt than cash levels could be nothing major or it could be something that could cause you to strike the company from your stock shopping list.

Think of a person who has racked up so much debt—possibly from credit cards—that at the end of each month there is no money left over once the bills are paid, including the interest on all that credit card debt. If this person can't meet those minimum monthly payments—and we've all run into a person or two in our lives who has fallen into this situation—in Wall Street–speak, that person lacks proper debt coverage. That is, after all the monthly expenses (rent, utilities, car payment, and so on) and the interest payment on debt (those credit cards), there are very little funds for anything else, or insufficient funds to pay the interest. It is not a fun place to be at all.

On the other hand, most people who have a mortgage on their home have less cash in their checking accounts than they owe on their mortgage. In this instance the total debt-to-cash ratio isn't necessarily a problem. What you would be interested in is the ability to comfortably make the monthly mortgage payments on top of normal living expenses. It is the same thing with a company and is commonly referred to as the company's ability to service (make the interest payments on) its debt in investor-speak.

When we look at a company's balance sheet, we want to determine how comfortably it can pay all its obligations and how much will be left over to possibly return cash to shareholders and/or reinvest in its future growth. We look at its required interest payments (interest expense on the income statement) relative to the free cash flow from operations. We then look at what is left over from those payments to invest in its business (capital spending, research & development) so it can continue to grow (new products, new markets, geographic expansion, and so on). We like to see that management is cognizant of the need for a cash safety net as well, particularly during more challenging economic times such as the financial crisis that began near the end of 2007 and spanned until early 2010 when, for a period of time, it was almost impossible for companies to borrow any money.

The quick way to determine how easily a company's business can handle its interest payments is to examine what we call its interest coverage ratio. It means doing more math, but it's necessary to avoid a company that could fall into trouble down the line.

We determine a company's interest coverage ratio by using some information on its quarterly income statement as follows:

The higher the coverage ratio, the more easily a company can handle its interest expense payments—the company has got it covered. As you look at different companies and perform this quick calculation, a good rule of thumb is to steer clear of those companies with an interest coverage ratio of 1.5 or lower because they could be hard pressed to meet interest expense payments if things get a little difficult (economic slowdown or a recession). Should you encounter a company that has an interest coverage ratio near or below 1.0, our recommendation is to avoid it like the iceberg that hit the Titanic. In other words, steer clear as fast as possible—there simply are too many other companies out there that offer better prospects.

Let's take another look at Procter & Gamble. In that same March 2015 quarter, the company's operating profit clocked in at $3.45 billion and its interest expense for the period was $149 million, which means it will likely pay nearly $600 million in interest expense for the year (4 × $149 million = $596 million). Applying our interest coverage ratio formula:

Procter & Gamble has more than sufficient interest expense coverage alone in that particular quarter, given its $3.45 billion in operating profit, which you might have suspected given how we have to replace all of its products, which typically are consumables, every few weeks or every few months.

Another metric related to interest coverage is total receivables. This measures how much the company has sold, but for which it has not yet received payment. If this number is rising faster than revenues, it may mean that the company is having trouble collecting payments from its customers and could be headed for a cash-crunch that would require it to borrow money to plug the gap between sales and receiving payments and/or it may need to write off some of those receivables as uncollectable, which is obviously never a good thing.

As you can see, a company's balance sheet offers a fair amount of insight into the financial health of a company. Don't be scared off because of words like debt, leverage, and coverage, because at the end of the day all that's required is some pretty basic math. In the Resources section of our website, www.CocktailInvesting.com, you will find a breakdown of key metrics you can use to assess a company's balance sheet as well as its income statement. Although we all like to talk about revenue and earnings per share, the balance sheet is not to be ignored.

11. What's the Catalyst for Growth or Improved Profitability?

One of the more frustrating things we have heard during the last 20-plus years when it comes to looking at stocks is, “It's trading below X times earnings. That's cheap!” Always remember that stocks tend to be cheap for a reason; just like a deal that sounds too good to be true, there's probably a good reason that stock is trading at a price that looks so cheap. Once you know why, it may not look like such a bargain!

Flipping this around, it means you should have a reason for buying a particular stock at a certain time. If not, well, you're pretty much just throwing darts.

Wall Street lingo borrows a term you may remember from your high school chemistry days—the catalyst. A catalyst, in simple chemistry terms, is a substance that increases the rate of a chemical reaction.

The same concept holds for investing in stocks as well. In some of the earlier questions, we identified potential catalysts—new products, new product categories, and so on—that are expected to drive top- and bottom-line growth (top line means revenues and bottom line means earnings). Other catalysts include accelerating, if not favorable, economic or psychographic (the where and the how companies and consumers are spending) data. Here are several examples of catalysts:

• The introduction of Apple's iPhone 6 smartphone models in September 2014 drove big shipment volumes for Apple and boosted the shares from $99 in early September 2014 to just over $129 in late February 2015. Adoption of those newer smartphone models benefited key Apple suppliers like Skyworks Solutions (SWKS), which saw its share price climb to $102 in March 2015 from $55 in September 2014.
• Similarly, the sharp drop in coffee prices that began in 2011 and lasted into early 2014 occurred at a time when Starbucks (SBUX) was rapidly expanding internationally and overhauling, as well as improving, its food offerings. During that time, the company's earnings grew from $0.76 per share in 2011 to $1.33 in 2014, and its share price climbed to a high of $40.73 in late 2013 from $16 in early 2011. Figure 10.2 shows data from the World Bank on changes in coffee prices from October 2005 to October 2015. Keep in mind that Starbucks has a history of hedging against coffee bean prices and coffee accounts for only around 10% of Starbucks overall costs, so be wary of overestimating the impact of a catalyst. In this case, this is a catalyst of limited importance, although the chart alone could lead you to believe otherwise.

  

• Shares of the Hershey Company (HSY) benefited in 2011, 2012, and 2013 due to the sharp drop in cocoa bean prices, as is shown in Figure 10.3 using data from the International Cocoa Organization.

  

• The growing adoption of streaming video through Netflix (NFLX), Amazon (AMZN) Instant Video, Hulu, and similar services has boosted demand for Internet infrastructure equipment from the likes of Cisco Systems (CSCO).
• The continued shift toward online shopping has done wonders for Amazon shares, but the purchased items still need to get to you or the intended recipient. Beneficiaries of that pickup in shipping have included United Parcel Service (UPS) and FedEx (FDX).
• When oil prices fell in the latter half of 2014 and early 2015, so too did jet fuel prices (as is illustrated in Figure 10.4 with data from the U.S. Energy Information Administration), which are a key cost component for airlines. The Cocktail Investor would take another step deeper and would discover that the fall in prices would not affect all airlines similarly because some, such as United Airlines, Delta, and Southwest, hedge against future increases in fuel prices. Falling prices ended up actually costing these airlines dearly versus a company like American Airlines, which doesn't hedge, thus was able to benefit disproportionately from the decline. For example, hedging was expected to cost Delta Airlines approximately $1.2 billion in 2015.¹³

As you see in the previous examples, catalysts often have a ripple effect that allows for multiple investment opportunities along the supply chain—for example, Apple's impact on Skyworks, or pain points like the growth in streaming that led to Internet bottlenecks that you probably experienced as sporadic Internet speeds, which drives us all crazy. The obvious catalyst isn't always the one that will generate the greatest returns. While Apple's shares quickly climbed in response to iPhone 6 excitement, Skyworks shares offered an even better return. Why is that? Because with each new version of the iPhone, Apple needed more and more of Skyworks' radio frequency (RF) semiconductors, as did competing smartphones from Samsung, LG, HTC, and others. This meant that for each additional iPhone purchase, Skyworks sold more chips to Apple than in the prior model. This meant that Skyworks' revenue grew faster than smartphone industry shipments. To put it in Wall Street lingo, the company enjoyed rising dollar content per device, which had a multiplier effect on its revenue compared to overall smartphone shipments. Sometimes, it pays to take a step back and look at the bigger picture.

In chemistry, the opposite of a catalyst is something called an inhibitor. A formal definition reads something like this: A reaction inhibitor is a substance that decreases the rate of, or prevents, a chemical reaction. To us, an inhibitor is a lot like a headwind that slows down the speed of a plane, while a catalyst is more like a tailwind that pushes the plane along, often resulting in a shorter flight time.

One of the best examples of an inhibitor or a headwind that led to a near-death spiral for one company in particular was the evolution of the smartphone. That explosion, which only grew as Apple and Google (GOOGL) entered the race with their software platforms, transformed the landscape and laid waste to early market share leaders BlackBerry and Palm.

Sometimes a catalyst for some companies can be an inhibitor for others. Take the current bout of falling oil prices. It's good for airlines and likely good for consumers, but not good for oil-producing companies, which had already cut capital spending and announced layoffs due to the initial fall in oil prices. These price drops also were likely to curb demand for alternative energy solutions like solar and wind, which made falling oil prices an inhibitor, or headwind, for companies like First Solar (FSLR), SolarCity (SCTY), and SunPower Corp. (SPWR). The Cocktail Investor again takes a step further and would think about those secondary industries that would be affected by the fall in oil prices, such as those firms that provide equipment used in the discovery and extraction of oil, like Caterpillar, which saw its shares get pummeled as its revenues fell dramatically along with the price of oil and other natural resources.¹⁴

The bottom line is that even if shares of a company's stock are cheap, if you can't identify a catalyst—or if you uncover an inhibitor—you probably should move along and look at another stock instead.

12. Is Today's Price Right?

This last question is one of the most important and moves us from thinking about the business of the company we're thinking of investing in to the shares.

If you buy shares too late in a cycle, you may be paying too much and will have missed most, if not all, of the upside to be had. While it's a bit trite, the old Wall Street adage of “Buy low, sell high” does ring true—but how do you know what is “low”?

All of this speaks to one of the most important toolkits an investor, either individual or professional, must have. With a variety of valuation tools at your disposal, you can be prepared like Batman confronting one of his various villains: The Dark Knight has to know which tool to grab from his utility belt to thwart whatever mayhem is before him. The same goes for us (granted, we're not facing off against the Joker, Penguin, or Catwoman, but you get the idea).

There is no shortage of valuation tools, and odds are, you're rather familiar with some of the more common ones, like the price-to-earnings (P/E) ratio or dividend yield covered in Chapter 9. However, you might not be familiar with some of the variations. Just as you can exercise with variations of the standard push-up (the basic P/E ratio), we can scrutinize these P/Es on a historical basis, compare them to the industry peers that we identified with Question 6 (peer valuation), and even compare them against multiples for the S&P 500 index (better known as the relative P/E), which tells us relative to the market at large if a stock is priced more richly or at a discount. The same tweaks hold true for using dividend yields.

Of course, not all companies pay dividends, and there are more than a few that do not generate earnings. In situations like these, we turn to other valuation metrics, such as enterprise value (EV) to revenue or EV to earnings before interest, tax, depreciation, and amortization (EBITDA) and price-to-book value. As with P/E ratios and dividend yields, these metrics can be scrutinized on a historical, peer, and relative basis, as well. In the interest of preserving your sanity, we are going to stick to the primary metrics we use to value a company in the upcoming examples. For more on enterprise value (EV) and its associated metrics, please look in the Resource Guide on our website (www.CocktailInvesting.com), where we will give you a quick run through it and other valuation metrics as well as point you toward good resources for those who want to dive deeper.

While not overly difficult, it can be taxing to pull all of the various pieces of information together, but we find doing so really helps us understand the company and how it stacks up against its competitors. As you start to roll up your sleeves and do your homework on both the company and the stock, our recommendation is to build a valuation framework that includes some combination of historical, forward-looking, peer, and relative metrics mentioned above.

We prefer to triangulate the upside by using several valuation tools to home in on a price target. If three metrics zero in on the same price, or thereabouts, we have a lot of confidence in that target. If, however, those tools kick out three different and varying price targets, then we have far less confidence in any one of those figures.

Most investors, we have found, focus on the upside, while too few consider the downside, which is how low the shares can go. We look at that to assess what the net upside (upside less the downside) is likely to be. To get interested in a stock, we generally like to see at least a net upside of 20 percent. That could take the form of up 30 percent with 10 percent downside, up 25 percent with 5 percent downside, or a different permutation. In our experience, this has been a highly beneficial rule of thumb from which we waver only on the rare occasion when there are extraordinary extenuating circumstances.

Upside Potential versus Downside Risk

In order to determine the potential price range for Starbucks in the next year, we will use three metrics:

1. The range between the highest and lowest P/E ratio over the past five years
2. The range between the highest and lowest dividend yield over the past five years
3. The P/E ratio for the current price versus future EPS compared to the same metric for competitors over the past five years

Price-to-earnings (P/E) and Dividend Yield Ratio Range

Here you'll see just how useful the P/E ratio is when determining a good purchase price for a stock. From 2011 to August 25, 2015, Starbucks shares ranged from a P/E ratio (using the current market price and estimated annual EPS for 2015) of 20.7 to 37.3 as is shown in Figure 10.5. If we multiply the expected earnings per share (EPS) for 2016 of $1.87 by the low end of the minimum P/E ratio (20.7) and by the high of the average P/E ratio (34.2), we get an upside price target of $63.94 (top row under “Implied 2016 Values”) and a downside price target of $38.64 (bottom row under “Implied 2016 Values”). In the example we've marked the numbers to which we refer in a larger font.

We use the high end of the average and the low end of the minimum for the range in order to be more conservative. If we underestimate how high the price may go, the biggest risk is that we don't buy the shares and end up missing the opportunity. Not ideal, but that is a better outcome than buying because we've overestimated the potential and ended up losing money. We use the low end of the minimum so that we don't underestimate just how far the price could fall. Putting those two, average upside and maximum downside, together gives a better net upside assessment. Refer to Figure 10.5 as we walk you through the analysis.

The data in Figure 10.5 were compiled by finding the lowest and highest closing price for each year along with the actual earnings-per-share (EPS) estimated for 2015 and dividends paid each year. The P/E ratio was calculated by dividing the low and high share price for each year by each year's EPS. The dividend yield was calculated by dividing the annual dividend for each year by the low and high share price.

This information can be obtained from a variety of sources such as Yahoo! Finance, Google, Schwab, Fidelity, Bloomberg, YCharts, Value Line (available at most libraries or at ValueLine.com), Zacks Investment Research, MarketWatch, Nasdaq.com, Dividend.com, and DivData.com, as well as company annual reports.

When pulling the data together, we suggest double-checking with at least one other source to make sure there isn't an error in the data. Also be aware of the impact of stock splits or reverse stock splits and make sure they have been accounted for correctly such that all data are consistent. This means that, for example, in 2015 Starbucks had a 2-for-1 stock split, so for every one share investors owned, they were given two. To be sure to be comparing years accurately, the stock prices going backward need to have been divided by two, as will the earnings-per-share and dividends-per-share.

When you look at changes in earnings-per-share over time, keep in mind the impact of share-buyback programs, which have become particularly prevalent in recent years. When a company buys back its own shares, it reduces the number of shares outstanding, which can significantly impact earnings-per-share because it is calculated by dividing earnings (net income) by the total number of shares outstanding, as is illustrated in Figure 10.6. Here we see that for the same net income of $100, with 100 shares outstanding, EPS is $1.00 while for 90 shares outstanding EPS is $1.11, which means that a 10 percent reduction in shares outstanding created the appearance of an 11 percent increase in EPS, yet the company's net income remained the same. In other words, despite the favorable optics as a result of shrinking the number of shares outstanding, the company didn't make any more money!

Returning to the Starbucks valuation, look at the numbers under the title “Current” below the “P/E Ratio” heading. At a closing price of $51.09 there would be 25.2 percent in potential upside (using the high end of the average at $63.94) versus potential downside of –24.4 percent (using the low end of the minimum at $38.64), or 0.8 percent net upside. If we also add in the company's current dividend yield of 1.2 percent, it equates to 2 percent net upside over the coming quarters.

But that's using just one valuation metric, and we mentioned earlier you can have much more confidence in your upside and downside price targets if you triangulate them using more than one valuation metric. In this case, let's look at Starbucks' dividend yield. Over the same time frame, Starbucks' share price peaked at a dividend yield of 1.08 percent in 2015, and bottomed out at 1.9 percent in 2011.

Remember that if the stock price rises while the dividend paid remains the same, the dividend yield will fall; a $1 dividend generates a 10 percent yield when the stock price is $10, but only a 6.67 percent when the stock price is $15.

Although the Starbucks' dividend yield is rather small, at less than 1.5 percent, it has been increasing its dividends every year since it paid its first quarterly dividend of $0.05 per share in 2010, which is meaningful. For the last several years prior to September 2015, it had raised that quarterly payment to $0.16 per share. Dividends increased 27 percent from 2011 to 2012, and rose 21 percent and 20 percent in the following years with a 16 percent increase from 2014 to 2015.

Keep in mind that dividends can also be indicators of strong growth potential, which surprises many as conventional wisdom believes that companies that reinvest their earnings are more likely to experience strong growth than those that give some of their earnings back to investors through dividends. Being big fans of data over beliefs, we dug into the data and found a fantastic report¹⁷ by Robert Arnott and Cliff Asness, which we highly recommend as a quick and informative read. Their research will improve your ability to identify those companies and management teams that are most likely to generate superior shareholder value over the long run.

Could we know that Starbucks would increase its dividend in 2016? Not really, but for valuation purposes, as well as the company's shared intention to return capital to shareholders, it would be reasonable to assume a 12 percent dividend increase in 2016 to $0.72 per share. Even if we're too conservative on our 2016 dividend increase, it still looks like net upside of more than 20 percent would exist if the shares dipped closer to $45.

With the P/E ratio we used the high for the average P/E ratio and the low for the minimum to create the price range (34.2 and 20.7 in Figure 10.5). To calculate a price range using the dividend yield we use the high of the average, just like with the P/E ratio, but the low of the maximum dividend yield. This is because the higher the dividend yield for any given dividend, the lower the price. A $1 dividend represents a 1% dividend yield with a $100 stock price, but a 10% dividend with a $10 stock price. Since we want to identify the lowest price possible, we use the highest dividend yield, which in this case would be 10%.

Applying the high for the average and the low for the maximum dividend yields (1.24 percent and 1.90 percent from Figure 10.5) to our forecasted 2016 dividend yield implies potential upside to $57.82, ($1.87 divided by 1.24 percent) and potential downside to roughly $37.67 ($1.87 divided by 1.90 percent). From a percentage basis versus the August 25 closing price, that is up 13.2 percent and down –26.3 percent, which means when using this metric, the upside is less than the downside.

Let's adjust our question, shifting our perspective in the process, which we find can be rather helpful and tends to uncover items that we have overlooked previously.

Rather than determining if a particular price is a good price, how about calculating at which price we would want to buy the stock?

As we stated earlier, we like to see at least a 20 percent net upside when looking at dividend yield analysis and P/E analysis. At around $45 per share, we have a dividend yield net upside of 12.2 percent and a P/E ratio net upside of around 28 percent. We'd prefer to see a higher net upside on the dividend yield side, but we are comfortable with the P/E ratio side. Given how relatively insignificant the dividend is at less than 2%, we typically wouldn't consider that analysis to be as important. We'll give you more on why as we move through look at Starbucks' peers.

Not only should you look at pricing relative to a company's historical norms, but also relative to its peer group, which ideally consists primarily of competitors that are of similar size and product offering. However, defining a peer group is usually not all that straightforward, even in the case of a Starbucks. We looked at Starbucks against two different types of peer groups; the first was food-and-drink chains (Dunkin' Brands, McDonald's, Panera Bread, Wendy's) while the second we dubbed the “guilty pleasures” group (Altira Group, Las Vegas Sands, Mondelez International, Philip Morris International, the Hershey Company, Wynn Resorts). This investment theme refers to those little treats and would-be harmless vices that we as consumers like or need to have from time to time, even though there may be a form of guilt associated with indulging. Chocolate, beer, wine, spirits, cigarettes, junk and fast food, gambling, and more are typical products from these companies, which tend to have inelastic demand for their products, good cash flow generation, and meaningful dividend income on average. We suggest when defining peer groups for a company you think a bit creatively about just what it is that the company offers its customers, such as the guilty pleasures group.

Refer to Figure 10.7 as we walk you through this comparative valuation analysis.

There are a couple of trends we want to look at to understand how Starbucks is being priced relative to its peer group over time. The first thing we want to look at is how earnings-per-share (EPS) has evolved. In this example, we look at EPS growth over the five years from 2011 to 2016, with the latter half of 2015 and 2016 being forecasted consensus estimates. Those last three words—forecasted consensus estimates—refer to the figures (revenue, profits, earnings) published by Wall Street analysts that are averaged to form a “consensus” view of what a company (in this case Starbucks) will deliver in a particular quarter or year. We've also looked at just the later years, 2013 to 2016, which allows us to look at the long-term trend and compare it to the nearer-term trend.

If we look at the EPS growth trends for Starbucks, we see that the near-term growth is quite consistent with the longer-term growth. That gives us more confidence to predict that same level of growth going forward, based on the findings to the prior 11 questions. Out of the group, Starbucks has had the most stable, positive EPS growth with the exception of Altria, which has enjoyed an average of 8.5 percent growth for the entire period. A negative EPS growth number, as in the case of McDonald's, means that earnings-per-share are actually declining.

Comparing Starbucks EPS to its peer group, we see that not only does the company have the highest (more recent) EPS growth rate, but also it is more consistent than the peer group. We can also see that Panera's earnings have struggled in recent years, with average growth from 2011 to 2016 of 7.6 percent dropping to basically a flat 0.1 percent for the 2013 to 2016 time frame. Looking at Panera's EPS from 2013 to 2016, we confirm that it's been essentially stagnant over that time frame.

Next we will look at the P/E over the years for the peer group and see how Starbucks has been priced relative to the group. To calculate the P/E for 2014, we used the average price for the last quarter of 2013 against the EPS for 2014 and similarly calculated 2015. For 2016, we took the latest price we had, the August 25, 2015, price, against 2016 earnings. Why do that? Because investors pay for future earnings, so the price you pay today is based on what you think the company will earn per share in the future. We don't want any particularly unusual or far out P/Es from the assembled peer group to skew the data, so we averaged the P/E ratios for each peer group.

We then compared the P/E ratios for the peer group to Starbucks and found that with the exception of Wynn Resorts for 2015E, Starbucks has always priced at a premium. This is time for a bit of a gut check. Does this premium make sense? We just discussed that Starbucks' EPS growth was the highest and one of the two most stable, which makes it reasonable that investors would be willing to pay more for each dollar of earnings.

Looking at the trends in the level of premium investors have been willing to pay for Starbucks versus the peer group, we can see that the August 25, 2015, price, which is still above our target buy price of $45, is at the lower end of the historical norm for Starbucks' premium, which tells us that Starbucks is less expensive relative to its peers on this date than it has typically been in the past. This gives us additional comfort that there is decent upside potential in the stock at a price of $45.

Another way we like to look at Starbucks relative to its peers is using P/E relative to EPS growth, or the PEG ratio. This looks at what investors are willing to pay for each dollar of earnings relative to the growth of those earnings. A good rule of thumb is that a PEG ratio of less than 1 indicates stock price is low relative to its earnings growth while a PEG ratio of more than 1 indicates that the stock price may be too expensive relative to earnings. However, PEG ratios vary widely across industries. In this analysis, we used the P/E ratio for the given year, 2014, 2015E, and 2016E against the 2013 to 2016E EPS growth. We used the more current growth rates, as that is more impactful on current stock price. Investors don't pay today for the growth of the past; they pay for future growth.

Dunkin' Donuts has experienced a declining PEG ratio, which makes sense with its slowing growth. McDonald's PEG really doesn't give us much help in pricing Starbucks since it is negative, which again makes sense because its earnings keep falling and have been falling at an increasing rate—a really bad sign! Panera Bread is a major outlier that really jumps off the page. What's going on here? Remember the nearly nonexistent growth? Here it is rearing its ugly head. Dividing by 0.1 percent is going to give you a very big—really freaking big—number! This indicates a stock that you usually want to avoid like crazy, as it is wildly overpriced.

Looking across the PEG ratios for the entire peer group, we can see that there is a very wide range that runs from –7.8 to +208. What does that tell us about how Starbucks shares should trade?

Unfortunately, not a darn thing!

Sometimes the analysis doesn't give us much to go on because the companies within a peer group vary just too widely, as is the case here. But that doesn't mean that PEG ratios are pointless—far from it. It just means that in this case, we won't use this metric to assess Starbucks versus its peers. However, we do learn something from looking at Starbucks' PEG ratio. It has fallen over time, which tells us that it is less overpriced today than it has been in the past, although it is still a bit richly priced since the ratio is above 1, but keep in mind that some industries tend to remain well above a PEG of 1 for extended periods of time. Investors always need to do the research for a particular stock and industry. At $45, Starbucks' PEG would be 1.24, getting closer to 1, which is generally viewed as a “fair” price.

Finally, we look at dividend yield, which is the total dividend for the current year divided by the current share price. A quick look across the peer group shows us that here as well, there is a wide range, and, as we shared previously, Starbucks doesn't have a dividend yield that gives investors much to get excited about at 1.3 percent. At our buy target price of $45, the yield increases a bit to 1.4 percent, but is still not a serious income generator for an investor, yet investors are still paying more for Starbucks' earnings that any other company in its peer group, which tells us that investors don't buy Starbucks for its yield. This tells us that like the PEG ratio, comparing Starbucks' dividend yield to its peer group isn't very helpful in determining a good purchase price.

Not all metrics are going to give you an “Ah-ha!”

Here we've seen that while a pullback in a stock may be tempting, it may not be a large enough pullback to give you the sufficient risk-to-reward trade-off needed to warrant adding the shares to your portfolio. Keep in mind, though, that there are no guarantees in investing. We can only deal in probabilities. This analysis will help you identify a price at which you are more likely to enjoy positive returns over time, but that doesn't mean that the price couldn't drop well below our target price of $45. It doesn't guarantee that the price couldn't drop to a point where the P/E is lower than it has been since 2011, but it does tell us that is highly unlikely. In Chapter 11 we talk about keeping a list of stocks you would like to add to your portfolio, but are waiting for a more attractive price.

This is why it is important to always keep an eye on the markets as a whole. For example, during the financial crisis, stock prices and the related P/E ratios dropped to historically exceptionally low levels in late 2008 and 2009. In hindsight that was a great time to buy following a a painful ride down! That being said, stocks never stay for long at P/E ratios that are well below their historical norms, as over time they tend to reflect future growth prospects, so sit tight and know that time will be your friend.

The bottom line is that after answering all of the 12 questions, it is possible that you will not buy the shares of whichever company you've put all this work into. That's okay, because when you're done, you will have a much better understanding of the company, its business, how it trades, what will move the stock, and at what levels buying it offers a better-than-favorable risk-to-reward trade-off. Always be disciplined, and don't fall in love with a company's shares just because you happen to enjoy the company's product rather immensely. That's another big mistake we've seen investors make—becoming emotional over the shares they own.

By following these 12 questions, you will sleep better at night as you invest. But when do you sell? How far down do you go with a stock that you've purchased whose share price is falling? We will get to that in Chapter 11, where we'll discuss how to maintain your portfolio over time.

Before we move onto funds, we thought we would share some insight from an expert in her field, Emmy Sobieski. Our Cocktail Conversation focused on what she considers key data sources and the various ways she collects, views, and analyzes data.

As of the fall of 2015, Emmy Sobieski was the senior research analyst for Nicholas Investment Partners. Her prior investment experiences include serving as vice president and senior director of Oppenheimer Funds, where she provided research coverage for $6 billion in technology holdings for several of their strategies, including mid-cap and convertibles. She also served as co-manager of the Nicholas-Applegate Global Technology Fund, which was up a whopping 494 percent in 1999!

As we were finishing up our delicious steak dinner over a phenomenal bottle of red wine, Emmy commented that throughout her career she has been asked over and over how it is that she's been able to do what she does so successfully. When she tells them, essentially, what we had just discussed, they respond that there is no way that can work because it is too simple. But it has worked for her!

This fits well with our investing rules of thumb: If we can't explain it on a cocktail napkin with a crayon, we have no business being in it. Keep this in mind as we look at funds next.

Strategy and Management

Make sure you understand the fund's strategy and that it truly fits with what you are trying to accomplish. If you are looking at an actively managed fund, look at who is running it and how long they've been doing it. Make sure you are comfortable with the experience and background of those running the fund and with their track record, which may be reflected in other funds they managed previously. Understand how much of the fund's performance is attributable to the current management. You don't want to get excited about a fund with a great track record if the current management team has only been in place for three months! Look over the performance of the fund relative to the markets as a whole and within the particular sector. Understand how the fund in the past performed during particularly challenging times (downside risk) and during strongly favorable market conditions (upside potential).

For example, Lenore had a colleague come to her all excited about a fund with phenomenal annual returns, or at least phenomenal at first glance. She quickly glanced at the fund's strategy and saw it focused on biotechnology companies. She immediately pulled up the iShares Nasdaq biotechnology exchange traded fund (IBB), which tracks the investment results of an index composed of biotechnology and pharmaceutical equities listed on the NASDAQ and saw that the fund that had so excited her colleague had generated roughly the same returns as this passively managed exchange-traded fund, but charged much higher fees. We can't stress enough to always assess the performance of a fund, or a stock for that matter, on a relative basis.

Number of Fund Holdings

Most mutual funds may hold 60, 70, or more positions in different equities or bonds. Some funds may have over 100 different holdings, but here's the problem with funds that hold a lot of securities. For example, if you were to create a portfolio, made exclusively of 50 randomly chosen stocks out of the S&P 500, statistics tell us that the returns on that portfolio would, over time, track the S&P 500 within a very close range of typically 3 to 5 percent. This means that for a fund manager to outperform an index like the S&P 500, or a particular benchmark, she or he either must hold fewer positions or be radically overweight in a few particular stocks or in a sector, like the financials or technology. Investors need to look at a particular fund and then at its sector weightings. If the fund has more than 50 holdings and its sector weights are very close to those in the index it measures itself against, such as a small-cap fund compared to the Russell 2000 index, then this fund is unlikely to outperform a simple index. A fund that looks like this is basically mimicking the very index it is trying to beat. While we like funds for the diversification they provide, there can be too much of a good thing.

Top Ten Holdings

Understand just how concentrated the fund is. Do the top 10 holdings account for 40 percent or 10 percent of all assets? Does one particular holding have a relatively significant ownership position in the fund? For example, in November 2015, Amazon shares accounted for 10.8 percent of the assets in the Consumer Discretionary Select Sector SPDR Fund (XLY) even though that fund held 90 positons at the time.¹⁹ When we see situations in which individual stocks each account for more than 5 percent of a fund's assets, we tend to keep close tabs on them because more often than not, they drive the direction—good or bad—of the fund. Keep in mind that very specific funds, such as Pure Funds Cyber Security ETF (HACK), will have a much higher concentration than a fund that seeks to cover a broad spectrum. Understand the major holdings for the fund and make sure they sync with your reasons for wanting to own the fund.

Turnover

A fund's turnover rate, meaning the rate at which it buys and then sells holdings, needs to be consistent with its strategy. Many actively managed funds turn over 80 percent, 100 percent, or even more of the portfolios annually. This makes for a lot more short-term gains than occur in index funds, which increases costs and also increases costs through trading fees, all of which lower your potential returns.

Cash on Hand

Funds have to keep some portion of the fund assets in cash for normal course of business redemptions or for buying opportunities as market dips inevitably occur. The cash amount typically ranges from as low as 3 percent to as high as 7 or even 10 percent. This is dead money, earning no return. So for every $100 invested, at any given time, maybe only $95 is working for you. If a fund has a notably large level of cash, make sure you know why, and that the reason makes sense to you. For example, if the fund is actively managed, versus a passive index, and the manager thinks that it is going to have much better buying opportunities in the coming months, a higher balance would make sense. During a serious bear market (defined as a downturn of 20% or more across several broad market indices, like the S&P 500 and the Dow Jones Industrial Average, over at least a two-month period), it isn't uncommon for actively managed funds to have unusually high cash balances relative to normal market conditions, but make sure you understand what the level of cash is for the fund and why.