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
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.
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
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