The 10-Minute Stock Test in Action
Focusing on the essentials can help you avoid mistakes.
The beginning of January is a time of unbridled optimism and simple fixes--a time when you believe it's possible to get in shape with eight minutes of daily exercise, become a better parent by carving out a few minutes of quality time with the kids, and build a million-dollar portfolio by skipping your daily latte. While skeptics might grumble that it takes far more time and effort to achieve these important goals, there's nothing particularly wrong with starting small. In fact, following these simple, streamlined ideas can help you get over the inertia that might otherwise prevent you from making progress.
The same idea applies to investing in stocks. It's true that making well-informed investment decisions takes time; in fact, we regularly recommend that stock investors read the entire 10-K annual report on a company as a first step to understanding the business model and operations. But even if you don't have several hours to plow through the 10-K, there are some key metrics you can focus on to help sort the wheat from the chaff. My colleague, Pat Dorsey, came up with a helpful and insightful "10-minute test" for stock investors, which he details in The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market. In this column, I'll highlight each of the items included in the 10-minute test and explain where to find it on Morningstar.com. I'll use packaging and bubble wrap maker Sealed Air (SEE), which currently earns a 4-star rating from Morningstar, as an example throughout.
Does the Firm Pass a Minimum Quality Hurdle?
Most investors are better off avoiding micro-cap stocks, issues that don't trade on one of the major exchanges, and non-U.S. firms that don't file regular financial statements with the U.S. Securities and Exchange Commission. To see how Sealed Air looks, first enter the company's ticker "SEE" in the quote box at the top of any page on Morningstar.com. You'll go to the Quote & News page of our stock report on this company. Near the top of this page, you'll see some basic stats about the stock, including its market capitalization (about $4.3 billion) and average daily trading volume (about 450,000 shares). Sealed Air isn't a huge company, but it has enough shares outstanding to give it ample liquidity. To check the company's SEC filings, click on the SEC Filings tab on the left side of the page. The company is based in the United States and files regularly with the SEC, so no worries here.
Has the Company Ever Made an Operating Profit?
Here, we're looking at operating income--the company's profits after paying basic costs for making its products, employing people to sell products and run the operations, and pay other operating costs. To find this, first go to the Financial Statements tab on the left side of the page, and then click on 10-Year Income near the top of the page to see up to 10 years of financial data as originally reported by the company. Sealed Air has consistently generated positive operating profits, so it easily passes this test.
Does the Company Generate Consistent Cash Flow from Operations?
Because the accounting rules for the income statement are different than those that apply to the statement of cash flows, it's possible for some companies to report positive income without actually generating cash. But eventually, any company will have to generate some of the green stuff or seek additional financing. To find cash flow from operations, click on 10-Year Cash Flows at the top of the Financial Statements page, and scan down to the bold line titled Cash from Operations. Again, Sealed Air has shown positive cash flows from operations for each of the past eight years.
Are Returns on Equity Consistently above 10%, with Reasonable Leverage?
To see how profitable the company has been in percentage terms, click on the Key Ratios tab on the left side of the page and then go to Profitability near the top of the page. Scroll down to the bottom of this page to see return on equity. Sealed Air has generally produced strong returns on equity, except for 2002 (when it paid about $500 million to settle asbestos claims) and 1998 (when it also incurred other charges that dampened profitability). To check the company's financial leverage, go to the Financial Health tab at the top of the same page. Scroll down to the bottom of the page to see the annual debt/equity ratio. Sealed Air's debt/equity ratio has jumped around a bit, but stood at about 2.0 at the end of 2003. That's a bit on the high side; for comparison, the average debt/equity ratio for the companies in the S&P 500 is currently about 1.4.
Is Earnings Growth Consistent or Erratic?
Depending on industry fundamentals and the company's competitive position, some companies enjoy more stable earnings growth than others. All else being equal, consistent growth is preferable because it makes the company's results more predictable. To check on this metric, click on the Growth Rates tab in the Key Ratios section. Because Sealed Air is leveraged to economic growth (better economic growth means more demand for packaging material) its earnings growth has been quite volatile. Even though the firm has consistently operated in the black, investors shouldn't expect it to be a steady Eddie.
How Clean Is the Balance Sheet?
As we saw earlier, the company's debt/equity ratio is higher than average. For another look at the balance sheet, go back to the 10-Year Balance Sheet tab in the Financial Statements section. Here, you can see a complete breakdown of where the company's debt comes from--for Sealed Air, most of its debt consists of long-term debt, which increased substantially in 2002. To see how the company's financial health has changed over time, go back to the Financial Health tab in Key Ratios. Near the bottom of the page, you can see financial leverage and debt/equity as of the end of each year. A bit higher on the same page, you can see total liabilities as a percentage of assets. While Sealed Air has a fair amount of debt, the trend is at least going in the right direction, as total liabilities have declined from about 87% of assets in 1996 to 76% at the end of 2003.
Does the Firm Generate Free Cash Flow?
Free cash flow is the summum bonum for stock investors, because this is what ultimately drives the value of the company. At Morningstar, we like to look at this metric both in absolute dollars and as a percentage of the company's sales, and we generally look for companies that generate free cash flows equivalent to at least 5% of sales. Sealed Air scores well on this metric, which you can see by going to the Cash Flow tab under Key Ratios. The firm had negative free cash flows in 1996 and 1997, but since then, free cash flows have consistently cleared our 5% hurdle.
How Much "Other" Is There?
The accounting scandals of the past few years have cast a harsh light on potential abuses in financial reporting, many of which are buried in "one-time" charges on the income statement. To check out this category, go to the 10-Year Income Statement under Financial Statements for complete details on the historical income statements. For this test, we're primarily looking for items near the bottom of the page--accounting changes, discontinued operations, and extraordinary items. Sealed Air doesn't have much showing up here, so there aren't any immediate red flags.
Has the Number of Shares Outstanding Increased Markedly over the Past Several Years?
Most investors focus their attention on the daily stock price, but the size of your slice of the pie is equally important. If the company is issuing more and more shares, that means the value of your ownership stake is being diluted. To check this item, check out the line labeled Shares at the bottom of the 10-Year Income Statement page, which shows the average shares outstanding for each of the previous calendar years. Sealed Air's number of shares outstanding has increased from about 74 million in 1997 to 84 million at the end of 2003, but it doesn't appear that the company has made a habit of egregiously diluting shareholder value.
So, there you go. Based on our 10-minute test, Sealed Air has a few blemishes that are worth investigating further, but it scores well on most of the key metrics. There are plenty of other items worth checking out before making an investment decision, but this initial check should give you a clear picture of a company's strengths and weaknesses.
Amy C. Arnott does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.