Fred Schobert, Jr.
The home computer is ideally suited for the task of investment analysis and can quickly perform calculations that would take hours to do by hand, even with a calculator. This program provides you with some of the same powerful tools used by professional financial analysts in evaluating stocks and bonds and the companies that issue them. Versions are included for the 64 and VIC with 3K or more expansion, Atari, and IBM PC and PCjr.
In today's financial environment, even the most modest investor can participate in a wide variety of investment opportunities through discount brokers or stock accumulation plans like Merrill Lynch's Sharebuilder account.
If you're interested in the stock market but don't know anything about investing, you should know that most brokers will be happy to assist you. Also, there are many excellent sources of investment information available. Some of the best are: the PBS television program Wall Street Week, The Wall Street Journal, Barron's, Forbes, Fortune, Business Week, Moody's Investors Service, the Value Line Investment Survey, and Standard and Poor's Outlook and Stock Guide. These sources are available in most libraries and brokerage houses.
You must clearly understand, however, that the market is risky and that usually the higher the profit potential, the higher the accompanying risk. This program is not a get-rich-quick scheme. It merely gives you a set of fundamental analytical tools that you can use to make informed, intelligent investment decisions.
The program is written for the average person. However, if you are completely unfamiliar with fundamental analysis, it would be helpful if you first read two free pamphlets distributed by the nation's largest stockbroker, Merrill Lynch. They are How to Read a Financial Report and The Bond Book. Familiarity with these and the notes in this article should allow you to use this program correctly and evaluate its output even though you've never been exposed to investments or financial matters before.
The program is divided into five main subroutines. Two are used for stock valuation, one for fundamental analysis, one for bond valuation, and the final one for printing to the screen.
The Gordon Valuation Model
The Gordon stock valuation model is located in lines 205–580. Although limited in its usefulness, it is academically sound and is the basis for the more complex models used by professional securities analysts. It is based on the premise that stock prices are determined as the present value of a stream of cash flows (dividends). The major drawback of the model is that it assumes that the growth rate and dividend policy of the company are perpetual and unchanged.
The subroutine asks you to estimate the company's annual growth rate in earnings. Due to the importance of accurately estimating earnings growth, it is best to use the estimates of professional analysts who have the most up-to-date objective and subjective information at their fingertips. These estimates can often be found in the sources listed earlier. However, if no growth estimates are available, the program will request more data from you and estimate a growth rate itself.
In line 230 the model also defines what is known as the market risk premium as 5.5 percent over the long term Treasury rate, adjusted for risk. This is an estimate and differs slightly from year to year and from stock to stock. The figure was derived, however, from a study which calculated the average market risk premium for Standard and Poor's 400 Industrials over the past 20 years. Another study, based on figures from 1926–1978 found the market risk premium to average 6.2 percent over the U.S. T-bill rate. If you feel more comfortable dealing with the T-bill rate, you can make the appropriate changes in lines 220–230. A quick comparison of the two figures shows that they are approximately equivalent.
Another, more general, model is located in lines 750–940. This is a revision of the famous Graham valuation model and was designed to yield a value closely approximating the values obtained from much more complex models. An earnings multiple is obtained and then multiplied by normalized earnings to obtain the price of the stock.
Although this method leaves something to be desired, namely subjective input, you can normalize earnings by fitting a least squares linear trend line to the last five years' earnings per share in lines 790–820 and then pick off the current year's normalized earnings per share (EPS).
To obtain a growth rate, calculate a mean growth rate and add one standard deviation to obtain a high value and subtract one standard deviation to obtain a low value in lines 830–860. The program prints out the last four years' growth rates to allow you to determine if growth is accelerating, declining, or remaining stable.
The program allows you to make your own growth and normalized earnings estimates, but since it is difficult to find seven- to ten-year growth estimates, it might be best to allow the program to calculate these for you.
Before leaving stock valuation, one word of caution. These models only approximate the theoretical value of stock. Although useful in arriving at a "buy, sell or hold" recommendation, it is important to bear in mind that something is worth only as much as people are willing to pay for it.
The subroutine located in lines 600–720 will give you an abbreviated fundamental analysis of the corporation. The data input stage requires a large amount of data to be entered which can be obtained from a variety of easily accessible sources. The company's yearly or quarterly financial reports are the best sources of information here, and these are readily available from the company itself. Even if it takes a week or two for the information to arrive, it will be well worth the wait. Other sources of this information are brokers' Standard and Poor's sheets and Moody's Investors Service.
You can get printouts of both the entered data and the calculated ratios. Enter the requested data carefully and check it. If the data is incorrect, your ratios will also be incorrect. Be sure to keep your units equivalent. For example, if you start out in millions, stay with millions. If you switch from millions to hundreds of thousands, the affected ratios will be meaningless, unless you entered all of the significant digits throughout. And that's both unnecessary and time-consuming. For example, 327,700,000 would be entered 327.7.
A Few Definitions
The prompts should be self-explanatory, but a few notes are in order.
- Interest expense and income tax are normally entered as positive numbers, even though they are negative numbers on the income statement. If the company receives a net tax benefit, however, income tax should be entered as a negative number. Naturally, if the company loses money, then net income and income before tax would show up and be entered as negative numbers.
- COGS means cost of goods sold, but may also be cost of sales if it is a service industry where inventory turnover is of less importance.
- Sinking fund is the principal repayment of long-term debt. It is usually found in the "notes to the financial statements" section of the company's annual report. But if no figure is available, the program calculates it as 5 percent of the long-term debt, which is usually not far from the truth.
- Stockholder's equity is sometimes referred to as net worth or shareholder's equity.
- Retained earnings means accumulated retained earnings.
- The burden coverage ratio is a measure of risk and represents how well the company is able to service its total debt burden.
- If you don't know the beta of a stock, use 1, which is the beta of the market as a whole.
It is important to remember that the ratios themselves are of little value unless they are compared to something, such as the industry averages or the firm's leading competitors. Also, historical trends can be identified if the ratios for the same firm are calculated over a period of years using historical data.
Finally, this subroutine calculates a bankruptcy score in lines 625–630 based on the Altman bankruptcy model. It's very accurate in forecasting impending financial troubles for companies with total assets of between $l–$25 million. Its applicability for firms outside that range is disputed, but it ought to be a good indicator of trouble for firms of any size.
In the bond valuation subroutine located in lines 1000–1130, the user is asked to enter the appropriate interest rate for the bond. This rate is your required rate of return for the bond, and you should consider these factors before determining this crucial figure: interest rate risk, inflation risk, maturity risk, default risk, callability risk, and liquidity risk. These are obviously subjective evaluations, but are no less important than the equation itself.
To help you with this, you can quickly and easily determine a proxy for this figure by looking on the credit page of The Wall Street Journal to see what the coupon rate (or current yield) is for newly issued bonds of equivalent rating. This figure is what professional analysts, investment bankers, and individual investors are currently using for an appropriate rate for newer, but similar, bonds. Also, when the appropriate rate you enter yields a bond value closely approximating that day's selling price of the bond, that rate is the bond's yield to maturity and is your yearly rate of return should you buy the bond at that price and hold it to maturity.
Finally, there is no substitute for common sense in interpreting the results of the program. Remember that the program was designed to be a set of investment tools and cannot guarantee financial success.