5 Torpedo Watch™ Dimensions

In our research we have identified indicators that suggest the existence of fundamental problems -- the causes of torpedoes -- that we call "Torpedo Warnings." They are: Investment Quality, Cash flow Quality, Earnings Quality, Balance Sheet Quality and Valuation, our five dimensions.

Each of these five warnings focuses on important characteristics of a company and how those characteristics are changing over time. Each of them is a composite of a series of measurements, which is then combined into the dimension. These warnings are summarized below:

1) Investment Quality

A company is nothing more than a collection of assets, and the company's ability to earn a profit is a function of how fast it can convert those assets into revenues, and how much money it actually makes, which is its profit margin. We determine Investment Quality by looking at a combination of various factors that measure operating efficiency and profitability, by looking at measures such as Turnover, Margins and Returns.

2) Cash Flow Quality

Many investors focus on cash flow from operations as an indicator of the quality of the company. Cash is real and it is difficult to manufacture (although Enron taught us it is not impossible) which is the reason investors look at it. Unfortunately, cash flow from operations, as reported can be somewhat deceptive due to the kind of items that can be included, which are not necessarily the result of the ongoing operations of the company. These are generally permissible under current accounting rules, but we prefer to eliminate the items that are not part of recurring cash flow or the result of actual operations of the company.

3) Earnings Quality

Earnings quality has long been analyzed as an indicator of the quality of the company and its future prospects. The first author of note to discuss this subject was Ben Graham, Warren Buffet's college professor, who was obsessed with cash flow as a determinant of earnings quality. Determining earnings quality requires several adjustments to the reported earnings that eliminate the non- recurring components and penalize the company for balance sheet deterioration.

4) Balance Sheet Quality

The balance sheet is important because it is the receptacle capturing any difference between company-reported performance and actual performance including evidence of aggressive accounting. Reported earnings that do not generate cash flow generally end up on the balance sheet. Of particular note are the following: Accounts Receivable, Inventory, Accruals, and Liquidity. Accounts receivable tell us how the company's products are selling and inventory tells us how able the customers are to pay for it.

When a company reports a dollar of earnings one of two things underlies it: cash flow or a change in a balance sheet item, which is called an accrual. Excessive accruals suggest poorer quality balance sheet (and earnings as discussed above).

Liquidity is simply the measurement of how liquid a company's assets are and answers the question: How capable is it of paying its bills? When a company gets into liquidity problems it can go out of business or go bankrupt.

5) Valuation

High valuation means a bigger potential price fall for a torpedo stock. Our valuation warning is done on an absolute and relative basis. On the basis of price, we compare a company to its peers within its sector based on earnings, sales and expected earnings growth rates.

Copyright ©2008 Torpedo Watch, LLC. All rights reserved.
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