Wednesday, September 24, 2008

Analyzing Your Stock Market Investment Performance

How did your stock market investments perform last year? Or the year before? What about over the past 5 years? Do you ever check the performance figures. If you invest directly in the stock market (by that I mean you buy stocks directly rather than using a mutual fund or some other managed investment vehicle) one of the most important things you can do is to monitor and measure your performance.

What do I mean by that? Lets say you're looking back over the performance of your share portfolio and you notice that in 2006 you earned a return of 12% including dividends. This looks like a pretty good return doesn't it? It's better than leaving your money in the bank, right? If you then noticed that the S&P 500 returned 15.8% in the same year, would that interrupt your self-congratulation? You may be asking yourself now, what is the point I'm trying to make? Well there are several actually - let's take them one at a time.

Calculating Investment Performance:

The first thing to note is that you need to calculate your performance on a regular basis. You should know (or be able to find out fairly easily) what you average annual returns have been over the medium term (say 1 to 5 years). Make sure you're honest with yourself. Include your mistakes as well as your successes - they all count. And remember to include your costs as well. This will include brokerage of course, but you may also pay for research or other investment related services. You want to know your return after all costs.

Comparing Your Performance:

Once you have your own performance figures in hand, it's time for some comparison. At minimum, you should be comparing against an unmanaged index like the Dow Jones Industrial Average (DJIA) or the S&P 500 (or the FTSE or whatever is relevant in your region). Have you done better than the stock market average? This is critical. If you're managing your own portfolio and you haven't managed to beat an unmanaged index, it might be time to seek out a professional money manager or simply invest in an index fund.

Over What Period Should Your Comparison Be Made?

Don't be too worried if you under perform over 1 or 2 years. Likewise, don't get too cocky if you've outperformed over that same period. I think 3 years should be the minimum period of comparison with 5 years being better. If you're not beating the average over 5 years, you need to address the situation. Have a look at your investment strategy and see if it needs any adjustment. Drill down and see what individual stocks have not performed. Can you learn anything from this? If despite your best efforts you're unable to address your underperformance, there's no shame in seeking professional help to manage part or all of your portfolio.

Even from his early days investing in the stock market, Warren Buffett advocated the benchmarking of his returns against that of the average. In Buffett's letter to partners at the beginning of 1961, Buffett wrote:

"My continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average. I believe this Average, over a period of years will more or less parallel the results of leading investment companies. Unless we do achieve this superior performance there is no reason for the existence of the partnerships."
While we can't all expect to achieve the outstanding returns that Warren Buffett did, we still shouldn't accept a less than average return. Over an extended period of time, such under performance can be extremely costly. The following table shows the expected returns over 20 years for $50,000 invested at each of 8% and 10%.

As you can see, the difference by the end of 20 years is significant - over $100,000.

Choosing An Investment Benchmark:

The last thing I want to cover today is the importance of choosing an appropriate benchmark - before getting started in the stock market. If you hold a broad spread of domestic stock market investments, you could use the Dow or S&P 500 index (or whatever the equivalent is in your region). International stocks would obviously require the selection of a different index as would a concentration of stocks in a particular sector. Another benchmark to consider might be one or two mutual funds with similar investment strategies to your own and for which a reasonable performance history is available. Remember to check whether reported performance is before of after costs.

You may manage your own investments because you enjoy doing it or to save money or for some other reason. But if you're not honest with yourself about the performance you're able to achieve then it may be a costly exercise. This applies as much to the experienced investor as to the stock market beginner.

Tuesday, September 23, 2008

Quick Ratio Formula

A discussion of the formula for quick ratio calculation for the stock market beginner.

Following on from my article on debt to equity analysis, today I'd like to talk about the quick ratio, also known as the acid test ratio or just acid ratio. This measure takes into account the more immediate liquidity or cash flow requirements of a business. Investors should use this tool when conducting their financial analysis of potential stock market investments to confirm a company's ability to meet its short term obligations.

The most common representation of the formula is as follows:

QR = (Current Assets - Inventory) / Current Liabilities
There are other variations (which I'll discuss shortly) but this simple calulation does the trick in most cases. A quick explanation of the above formula is probably in order.

Since we're trying to determine an organization's ability to meet its short term funding requirements, we take cash and cash equivalents and divide them by current liabilities. The reason we subtract inventory is that it may not be easily converted into cash or if it is, it may be at less than face value (think of 50% off sales).

At this point you may be thinking "But what about other current assets which can't easily be converted to cash?". If you weren't thinking that, or if you're now wondering what current assets are, stay with me - I'll try and make this as painless as possible.

This school of thought is where one of the more common variations of the quick ratio comes from.
QR = (Cash + Cash Equivalents + Accounts Receivable) / Current Liabilities
The difference in this representation of the formula is that we are only using truly 'liquid' assets in the numerator. By only using cash, cash equivalents (short term investments and the like) and accounts receivable (short term money owed to the company) we'll be leaving behind the other potentially non-liquid current assets (things like prepayments or income tax benefits which can't really be converted to cash).

So What Is A Good Quick Ratio?

Common wisdom has it that anything over 1 is acceptable. But as with many of these financial ratios and with financial statement analysis in general, they should be compared among companies within the same industry and also for the same company over time (is the position improving or deteriorating). This should be the approach taken with all stock market formulas.

Is A High Quick Ratio Good?

This is very subjective. In general, an excessive quick ratio may mean the business is not using its assets efficiently (I'm sure shareholders would prefer to look after the cash themselves rather than having it sit on some company's balance sheet). But there maybe legitimate reasons to build up a buffer of cash. It might be in anticipation of lean times ahead for example.

The quick ratio is especially important now. As I write this, world stock markets are in turmoil after the collapse of Lehman Brothers. With consumer spending down and debt funding in short supply, businesses need to be able to survive on internal funding now more than ever.

One criticism of the quick ratio is that it doesn't take into account the timing of cash flows. For example, analysis of current liabilities may show a large proportion of short term commitments fall due within 30 days but accounts receivable may be 60 or even 90 days. This mismatch or cash flow timing could cause problems.

An Example:

What follows is the calculation of the quick ratio for Johnson & Johnson (JNJ) based on the 2008 figures from Yahoo Finance.
JNJ QR = (35,817,000 - 5,700,000) / 21,780,000
= 1.4
JNJ QR = (12,646,000 + 412,000 + 13,151,000) / 21,780,000
= 1.2
As you can see, the second version of the formula gives the more conservative result.

I know I've covered some fairly technical stuff today, but if you're serious about making money in the stock market (or perhaps more accurately - not losing money) then you'll need to do your homework. After all, even beginners' stock market investing requires thorough research and the quick ratio provides an important indicator as to the financial health of any business.