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• Discount rate: make sure it is conservative (low) enough. If it's going up,
ask why.
• Expected return on plan assets: is it conservative (low) enough? If it's
significantly higher than the discount rate, be skeptical of the pension
• Rate of salary increase: is it high enough?

3. Check the target and actual allocation of the pension plan. Is the company
making sufficient use of bonds to fund the pension liability (conversely, are
they overly exposed to equities)?

Conclusion and Resources

Let's summarize the ideas discussed throughout this tutorial according to a few
major themes:

Let the Business Model Shape Your Focus Areas
The average 10-K annual report is stuffed with dozens of dense footnotes and
adjusted numbers offered as alternatives to the "recognized" numbers contained in
the body of the income statement and balance sheet. For example, companies often
disclose six or eight versions of earnings per share, such as the "as reported,"
"adjusted," and "pro forma" versions for both basic and diluted EPS. But the average
individual investor probably does not have the time to fully assimilate these

Therefore, it may be wise to first look at industry dynamics and the corresponding
company business model and let these guide your investigation. While all investors
care about generic figures, such as revenue and EPS, each industry tends to
emphasize certain metrics. And these metrics often "lead" or foreshadow the generic
performance results.

The table below illustrates this idea by showing some of the focus areas of a few
specific industries. For each industry, please keep in mind that the list of focus areas
is only a "starter set"--it is hardly exhaustive. Also, in a few cases, the table gives
key factors not found in the financial statements in order to highlight their

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Selected Industries: Nature of Business Model: Selected Focus Areas:
• •
Business Services (for People are key Revenue
example, temporary help, assets. recognition.
• •
advertising, and consulting.) Much of the Recurring sources
company value is of revenue (for
likely to be example, long-term
intangible (not on contracts).

the balance sheet). Gross margin (1 “
cost of goods as %
of revenue) since it
tells you about
"pricing power" with

• •
Computer Hardware Rapid price Revenue
deflation (decrease breakdown into no.
in price-to- of units x avg. price
performance). per unit (how many
• units are selling?).
Rapid inventory

turnover. Cash conversion
• cycle (days
Rapid innovation
inventory + days
and product
receivable “ days
• Quality of research
and development
(R&D) spending
and joint ventures.

• •
Consumer Goods Brand value is Cash conversion
critical. cycle and inventory
• turnover.
Companies require
• Gross margin.
efficient inventory

because it is often Operating margin
perishable. (for example, EBIT
• Industry sees or EBITDA margin).

relatively low Key factors not in
margins. statements: new
development and
investment in the

• •
Industrial Goods (materials, Cyclical. Long-term assets

heavy equipment) and depreciation
If commodities, then
market sets price.

• Asset turnover
Heavy investment in
(sales/assets) and
long-term assets.
• asset utilization (for
High fixed costs.
example, return on

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Investopedia.com “ the resource for investing and personal finance education.

• Key factors not in
statements: market
pricing trends and
point in business

• •
Media Economies of scale Revenue
are typically recognition,
important. especially for
• subscriptions and
Requires significant

• Free cash flow,
Convergence is
especially for cable
"blurring the line"
and publishing.
between industries.
• Pension plans as
many companies
are "old economy."
• Key factors not in
environment and

• •
Retail (for example, apparel Intense competition Revenue
or footwear) against fickle breakdown in
fashion trends. product lines and
• trends--one product
can "make or
management, which
is critical.

• Cash conversion
Low margins.
• Gross margin.
• Operating margin--
low employee
turnover will keep
this down.

• •
Software High "up front" Revenue
investment but high recognition, which is
margins and high absolutely essential
cash flow. in software industry.
• •
Complicated selling Gross margin
schemes (channels, trends.

product bundling, Stock option
license cost/dilution
arrangements). because, of all
industries, software

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grants the most

• •
Telecommunications High fixed Long-term assets
investment (capital and depreciation.

intensive). Long-term debt (for
• Changing regulatory instance, many
environment. companies are
highly leveraged).

Cash Flows Help to Determine the Quality of Earnings
While some academic theories say that cash flows set stock prices, and some
investors appear to be shifting their attention toward cash flows, can anyone deny
that earnings (and EPS) move stocks? Some have cleverly resolved the cash flow-
versus-earnings debate with the following argument: in the short run, earnings move
stocks because they modify expectations about the long-term cash flows.
Nevertheless, as long as other investors buy and sell stocks based on earnings, you
should care about earnings. To put it another way, even if they are not a
fundamental factor that determines the intrinsic value of a stock, earnings matter as
a behavioral or phenomenal factor in impacting supply and demand.

Thoughout this tutorial, we explore several examples of how current cash flows can
say something about future earnings. These examples include the following:

Cash Flows That May Impact Future Earnings Why the Cash Flows May Be
Changes in operating accounts, which are found
in the statement of cash flows, sometimes hint at
future operational deterioration:
• •
Increase in inventory as percentage of Unless company is stocking
COGS/sales (or decrease in inventory up ahead of anticipated
turnover). demand, the increase in
inventory could indicate a
slackening demand.

• •
Increase in receivables as percentage of Customers may be taking
sales (or decrease in receivables longer to pay; there may be
turnover). an increase in collection

• •
Decrease in payables as percentage of Company may be losing
COGS/sales (or decrease in payables leverage with vendors.

If "cash collected from customers" grows less Reported revenue may be getting a
than revenues, there may be future revenue temporary (current) boost by end-of-

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(Page 64 of 66)


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