Business revenue growth is a very important fundamental analysis indicator used by investors for picking good value stocks.  To start with lets go over the difference between business revenue and total revenue.  Business revenue is income, or sales, that comes from the primary activities for a given company, whether it is organized as a corporation, partnership, sole-proprietorship, etc., doesn’t matter, business revenue is the same across all types of companies. 

Business revenue does not include other types of revenue that may be included on a given comany’s balance sheet like incidental or non-operating revenue.  Some examples of the types of revenue streams will help you see the difference between non-operating revenue and business revenue.  One example would be incidental revenue earned on a deposit in a demand bank account – this type of revenue is not associated with business revenue generated by the primary activity of the company.  Another type of non-operating revenue that needs to be filtered out of the total revenue number might be from a manufacturing company owning or leasing a building, and sub-leasing a portion of the building that it is not using to another company – again, this is not business revenue, but would show up in the top line number on an income statement.

The focus of your value stock picking should be on business revenue growth, also known as net sales growth.  Examples of business revenue would include a manufacturing company or a bakery selling goods, or an accounting firm or a consulting firm selling services.

Business revenue growth is calculated by dividing this periods (typically quarterly or annual) net sales by last periods net sales and subtracting 1.  This gives you the percent growth, or reduction, in business revenue.  Above average business revenue growth combined with the company efficiency you can find by learning how to calculate ROIC, is a great way to filter stock candidates down to a manageable list.

Good value stocks have business revenue growth that is greater than the company’s peers in it’s industry.  It should have consistent multi-year growth, if there is an anomally in the annual growth rate, make sure you understand why – it could be anything from a recession that took out all company’s growth, to the introduction of a game changing technology that the stock will have a hard time recovering from.

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What is Return On Equity?

Return on equity is a popular fundamental analysis technique to measure how efficiently a company uses it’s shareholders’ investment to produce eanings.  The formula to calculate Return On Equity (ROE) is straightforward:

Return on Equity (ROE) = Net Income / Shareholder equity

Obviously this is a much simpler formula than how to calculate ROIC (return on invested capital).  Some investors would answer the “What is Return On Equity?” question by stating that return on equity is an easy and readily available way to compare different companies profitability.  A company with a high return on equity is more likely to be capable of generating cash organically (internally). For the most part, the higher a company’s return on equity compared to its industry, the better.  You need to look at ROE relative to the industry the company your evaluating is in, because not all high ROE companies make good investments.  For example, companies that require little very little assets, like consultants, will have high ROE’s relative to capital intensive companies.

So, hopefully this helped you understand what is return on equity.

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Lets look at how to calculate ROIC (Return on Invested Capital).  I make no secret that ROIC is one of my favorite value stock investing tools.   Learning how to calculate ROIC is relatively easy, and will require you to look at a company’s financial reports to get the numbers you need to calculate ROIC.

The formula for how to calculate ROIC is:

ROIC = ((Net Operating Profit – Income Tax) / (long term debt + equity))

 ROIC calculations look like they have a lot going on, but I’ll now show you how easy it is to get everything so you can calculate ROIC.

Lets use Walgreens in 2007 as an example of how to calculate ROIC, click here for the data you’ll need to follow along with this ROIC example.

From the Income statement, the numerator in the ROIC calculation (Net Operating Profit - Taxes) is 2041.3, you can find this about half way down the page.

The next step to learn how to calculate ROIC is to determine the denominator, so we’ll look at the Balance Sheet tab on the above Walgreens data, and find equity is 11,104.3, and long term debt (+ other liabilities) is 1284.8, which means the ROIC denominator is 12389.1.

So ROIC is 2041.3/12389.1 = 15.5%

Now you know how to calculate ROIC.

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Value stock investing is an investment strategy that looks for stocks which are undervalued when compared to a value you calculate with various fundamental analysis indicators.  While the description may sound a little complicated, you will see that with a little practice, fundamental analysis for value stock investing is not as difficult as it sounds, in fact, with readily available online tools, finding good value stocks is easy.

First a little history – value stock investing was popularized by Benjamin Graham and David Dodd, and their 1934 book, Security Analysis, remains popular to this day – many bookstores still stock this one on their shelves.  Famous investors like Warren Buffet and Mario Gabelli have made fortunes using the value stock investing strategy to find under priced stocks to buy.

Value stock investors look for stocks with strong fundamental characteristics, such as business revenue growth, cash flow, earnings growth, book value, and cash flow.  All of these items, and more, are found on company’s quarterly and annual reports.  The key is finding stocks that sell at a bargain price vs. their underlying quality based on these fundamental metrics.  Value stock investors constantly seek out companies that are currently incorrectly valued (i.e. undervalued) by the stock market and therefore have the potential to increase in share price when the market corrects its error in valuation.  Some good value stocks pay higher dividend yields due to their lower price relative to the dividend that they pay (there are even monthly dividend stocks that fall inot this category).

Since value stocks are under priced, this means that they are out of favor with the market, which makes value stock investors contrarians by definition.  Buying value stocks can, at times, be tough psychologically, because in many cases, you are buying companies or industries that are receiving a lot of negative press.  Right now there are companies and industries that you can read about in the news, where nearly every article you read in the business press, or every story about them you watch on television, is very negative.  As I write this article in Spring, 2009, there is a recession in full swing, with banks, housing stocks, and REITs all being whacked the most by the business media.  These are the types of areas where value stock investors are prospecting for good companies with good fundamantal characteristics, that are having their stock prices dragged down with the rest of the companies in their industry.  A good tool for determining if a stock is undervalued is to look at it’s earnings yield.

With the tools, resources, and articles posted on this website, value stock investing will become another tool for you to use in your successful online investing activities.

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ROIC, or  Return On Invested Capital, is one of my favorite value investing indicators for trying to forecast the financial performance of a company’s stock.  If you think about earnings growth at a high level, most companies have to pay a price to achieve earnings growth – by issuing stock, selling long term bonds (debt), investing in assets, and/or investing in working capital.  ROIC is a superior way to measure this cost to achieve growth, and to compare one company’s financial performance to another company’s, or for that matter, to the performance of an industry group as a whole.  In a nutshell, ROIC is a way of determining the amount of cash earnings a company produces for every dollar invested, and is a primary tool for value investing, along with equity growth rate, earnings yield, and free cash flow growth.

You may already be familiar with one of the cousins of ROIC – Return on Equity (ROE).  ROE, which divides net income by the average shareholder equity over the time period being examined, is also a good measure of a company’s financial performance, and a favorite stock value indicator among value investors.  Click here if you want to learn more about what is Return On Equity.  The downside of ROE is that it does not take into account certain balance sheet liabilities that are being used to power a company’s growth, thus ROE may overstate the company’s economic efficiency.  ROIC corrects this issue, which is why I like it better than ROE.

ROIC is a good way to measure the quality of earnings growth, and is calculated with Net Operating Profit After Taxes (NOPAT) to focus on that earnings quality.  Lets use an example:  Company ABC sells a popular line of widgets, and earned $20 million last year.  This year, they decide to expand, and take on $20 billion in debt to finance that growth.  They are successful, and their earning double to $40 million.  Investors focusing on earnings growth are ecstatic – the company doubled it’s yearly earnings.  ROIC investors, however, are probably running for the exits, because they see that while the company doubled it’s earnings, the debt the company took on to finance that earnings growth only yielded a 1% return ($20 million divided by $20 billion), which is a very inefficient use of dollars invested in the company.  ROIC, unlike ROE or earnings growth, will highlight that inefficient use of dollars.  Investors looking for value stocks should look for high returns on invested dollars, as represented by ROIC, in addition to other key fundamental measures like business revenue growth.

Next up we will look at how to calculate ROIC.

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Value Stock Investing

Picking good value stocks will cause you to rely on a fundamental analysis of the company’s operating condition, as represented in its quarterly and annual reports.  Fundamental analysis is concerned with values found on balance sheets, income statements, and statements of cash flows.  Don’t let fundamental analysis scare you, the numbers needed for choosing good value stocks are freely available on the internet.  One really good website for getting fundamental data, including pertinent ratios for value investors, is msn.com.

Good value stock picking uses some of the important and popular fundamental analysis ratios shown below:

Return on Equity

Return on Equity is one of the most powerful value stock measures available – it compares a company’s profit to the total shareholder equity as represented on the company’s balance sheet.  This ratio shows how efficiently the company’s management is using the shareholders equity.  Always look for companies with above industry average return on equity.

Book Value per Share

Book value per share is calculated the ratio, which is calculated by subtracting a company’s total liabilities from its total assets and then dividing this book value by the total number of outstanding shares of stock. Deep value stocks trade at or below their book value.  One thing to keep in mind when looking at book value on major money websites is that book value can count intangible assets like goodwill, it’s usually best to remove intangible assets from the book value equation before calculating book value (also known as Tangible Book Value). Use equity growth rate calculated with BVPS to find good stocks to invest in.

Earnings per Share (EPS)

Earnings per share are calculated by dividing total profit after tax by total number of shares outstanding. EPS can be found on most major financial websites.  For value investors looking for deep value stocks, you would ideally like to find a stock that has a consistent historical earnings growth rate.  A value stock may have a currently low price not because of an earnings miss, but maybe just an analyst downgrade, unfavorable news report, etc.  The important things to look for are consistently growing earnings both from quarter to quarter, as well as compared to the year ago quarter.  Read our article on Net Operating Profit After Taxes (NOPAT) for an alternate way to calculate earnings.

Price to Earning (P/E) ratio

Price to Earnings ratio is just what it looks like – divide a stocks price per share by it’s earnings per share, and you have the P/E ratio.  This number is also known as the earnings multiple of a stock.  When looking for a good value stock, we need the price (P) to be relatively low compared to the earnings per share (E).  “Relatively low” means you need to compare the stock you are considering relative to other stocks in the same industry, with similar earnings and sales growth rates.

Dividend Yield

A stocks dividend yield is important to value investors.  There are many studies that show at least half of the long term return you can expect from the stock market comes from dividends.  Calculate the dividend yield by dividing the annual dividend payout by the price of the stock.  Since value stocks are out of favor and low priced, you would expect a higher percentage dividend yield on a value stock. One thing to watch for on high dividend yield stocks is the percentage of quarterly earnings it takes to cover the dividend payout.  Value stocks as a group have generally hit a rough patch, so their earnings may be temporarily low, however, you really want to make sure that if/when your stock returns to a more favorable earnings climate, it will need no more than half of its quarterly earnings to cover dividend payouts.

Good value stock picking relies on a host of other fundamental indicators, and we will explore more of those in upcoming articles.  Additionally, using stock market breadth to help determine when the market is right to invest in is also critical in making the right investment decisions.  It is a compination of finding the right stock, and buying it at the right price, that tilts the odds of a successful investment in your favor.

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