Financial Topics Newsletter Archive
SBT Investment Services, Inc. through its relationship with Infinex Investments, Inc., member SIPC/FINRA, offers a range of educational resources to help customers achieve their life goals. These include the personal attention of our Advisors, registered representatives of Infinex Investments, Inc., periodic educational forums, and topical articles in our Financial Newsletter.
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October 2007
In This Issue:
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Evaluating Stock Investments
You should thoroughly analyze a stock before purchase. But pick up a company’s annual report, and you can quickly become overwhelmed by all the numbers. What figures should you concentrate on when evaluating a stock? At a minimum, look for answers to these questions:
- What are the company’s earnings? Earnings per share (EPS) is the company’s net income after taxes and preferred stock dividends divided by the average number of shares outstanding. Look for steadily increasing EPS, which shows a pattern of consistent growth.
- How does the company’s price relate to earnings? The price/earnings (P/E) ratio is calculated by dividing the company’s stock price by EPS. It basically indicates how much investors are willing to pay for a dollar of the company’s earnings. P/E ratios can be calculated using different earnings numbers. Trailing P/E ratios use earnings per share for the most recent four quarters, while forward P/E ratios use forecasts of future earnings per share. To get a feel for the reasonableness of a company’s P/E ratio, review its historical P/E ratio, the P/E ratio of other companies in similar industries, and the P/E ratio of the market as a whole.
- How does the company’s book value relate to its price? A company’s book value equals its assets less its liabilities, commonly referred to as stockholders’ equity. Dividing the stock’s price by its book value per share will give you the price-to-book value. Companies with low price-to-book values are often considered value stocks.
- What is the company’s return on equity? Return on equity (ROE) is calculated by dividing the company’s income by its shareholders’ equity. It is used to measure how well a company is utilizing capital retained in the company.
- What is the stock’s total return? Total return equals dividends plus or minus changes in stock price divided by your purchase price. This is the overall measure of the stock’s performance and is useful when comparing one investment with other investments.
- What is the company’s debt level? The debt ratio is the company’s outstanding debt divided by shareholders’ equity, which measures how leveraged a company is. High levels of debt can make a company more vulnerable during economic downturns. Also take a look at the current ratio, which is calculated by dividing current assets by current liabilities. It is a measure of a company’s ability to pay its current obligations.
- What is the company’s growth rate? A company’s growth prospects can be evaluated using the price/earnings growth, or PEG, ratio, which is calculated by dividing the P/E ratio by the company’s projected earnings growth rate. A PEG ratio of one is considered standard, meaning the growth rate is incorporated in the stock’s price. A PEG ratio higher than one means the stock is trading at a premium to its growth rate, while a ratio of less than one may mean the stock is undervalued.
- How volatile is the stock? Beta is a statistical measure of how stock market movements have historically impacted a stock’s price. By comparing the movements of the Standard & Poor’s 500 (S&P 500) to the movements of a particular stock, a pattern develops that gauges the stock’s exposure to stock market risk. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market and has a beta of one. A stock with a beta of one means that on average it moves parallel with the S&P 500. A beta greater than one means the stock should rise or fall to a greater extent than movements in the S&P 500, while a beta less than one means it should rise or fall to a lesser extent than the S&P 500. Since beta measures movements on average, you cannot expect an exact correlation with each market movement.
The decision to purchase a stock can’t be made solely from a review of financial ratios. You’ll also need to evaluate subjective factors, such as the quality of management, prospects for the company’s industry, and where the company stands in relation to its competitors.
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Assessing Stock Returns
When designing an investment program, your expected rate of return is a critical element in determining how much to periodically invest to help reach a future goal. Since no one can predict future returns, the expected rate of return is typically estimated based on an analysis of past returns for various investments. So what return can you expect in the future for stock investments? The average annual return for the Standard & Poor’s 500 (S&P 500) for the period from 1926 to 2006 was 10.4%, but you don’t want to simply use this return without determining whether it is reasonable for the future.*
A starting point for making that assessment is to review the equity risk premium. Since stocks are generally considered more volatile than bonds, investors typically expect a higher return. This excess return is called the equity risk premium. Although there are many complicated methods to calculate this premium, a simplified approach calculates the difference between total returns for large-company stocks and long-term government bonds.
For the period from 1926 to 2006, that difference was 4.5%.* However, the annual equity risk premium fluctuated significantly during this period. For the near future, is this a reasonable expectation? It may not be for a couple of reasons. First, even though price/earnings (P/E) ratios have declined, they still remain at high levels. Since corporate profits are not expected to increase as rapidly in the future, P/E ratios may not return to previous levels. Second, a significant portion of the equity risk premium results from dividends, which are at low levels. Third, investors can develop a preference for one asset class over another, which can drastically change the premium.
If the equity risk premium does decrease in the future, total returns will be lower than historical averages. Only time will tell if this will happen. However, it may be prudent to consider a lower return for investment programs than historical returns would suggest. To compensate for potentially lower returns, consider the following strategies:
- Take a fresh look at your financial goals. Reevaluate your goals, how much you need to reach them, and how much you should be saving annually considering lower expected returns.
- Save more of your income. If you can’t count on returns to provide growth in your portfolio, you should compensate by saving more of your income.
- Invest in a tax-efficient manner. Taxes are often a significant investment expense, so using strategies to defer the payment of taxes can make a substantial difference in your portfolio’s ultimate size. Utilize tax-deferred investment vehicles, such as 401(k) plans and individual retirement accounts. Or emphasize investments generating capital gains rather than ordinary income.
- Don’t concentrate your investment portfolio in one category. Diversify so when one asset class declines, other assets will hopefully be increasing or not decreasing as much.
- Evaluate your portfolio’s performance annually. That way, if returns are lower than you targeted, you can make adjustments to your strategy to compensate for these variations in return.
* Source: Stocks, Bonds, Bills, and Inflation 2007 Yearbook. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future performance.
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Age for “Kiddie Tax” Raised Again
The Small Business and Work Opportunity Tax Act of 2007, signed into law on May 25, 2007, raised the age limit for application of the “kiddie tax” to all children under age 19 (previously age 18) and to students under age 24, effective for tax years beginning after May 25, 2007. Just last year, the “kiddie tax” age limit was raised from under age 14 to under age 18. There is an exception to these new age limits. If the earned income of an individual over age 17 exceeds half of his/her support, the “kiddie tax” does not apply. Scholarships are not considered in this test.
The “kiddie tax” refers to the manner in which unearned income is taxed for children. In 2007, the first $850 of unearned income is tax free, the second $850 is taxed at the child’s marginal tax rate, and any remaining unearned income is taxed at the parents’ marginal tax rate. Once the individual exceeds the age limits, all unearned income is taxed as his/her marginal tax rate.
This change effectively eliminates a common college funding technique of gifting investments to the child as he/she approaches college age and then having the child sell the assets to take advantage of lower capital gains tax rates (5% if the child is in the 10% or 15% tax bracket, instead of 15%). Some families were planning to postpone asset sales until 2008 to 2010, when the long-term capital gains tax rate would be 0% for taxpayers in the 10% or 15% tax bracket.
Since the provision will typically not apply until 2008 for most taxpayers, individuals under age 24 may want to sell assets in 2007 to take advantage of the 5% capital gains tax rate. Another alternative would be to wait until a student turns age 24 to sell the assets. However, there is the possibility that the individual would immediately start working at a job that would put him/her in a higher tax bracket, so the 15% capital gains tax rate would have to be paid anyway. The capital gains tax rate is scheduled to increase from 15% to 20% after 2010, unless further legislation is passed.
To minimize the effects of this new provision, taxpayers with children under age 18 should reevaluate their investments, looking into investments that generate little or no taxable income. Another alternative, if you are saving for a child’s college education, is to invest the child’s assets in section 529 plans or Coverdell education savings accounts, which provide tax-free distributions as long as the funds are used for qualified education expenses. If the child has earned income, he/she can also set up a traditional or Roth individual retirement account.
Taxpayers who own a business may want to employ their children, especially those in the 14 to 24 age group, since earned income is not subject to the “kiddie tax” rules and is taxed at the child’s marginal tax rate. There is added incentive to do so for students over age 17, because the “kiddie tax” rules won’t apply for that year if the individual’s earned income is more than half of his/her support.
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Don’t Underestimate the Value of Social Security
For years, we’ve heard that Social Security benefits are at best modest and should not be counted on as our only source of retirement income. Sometimes, it’s even suggested to completely forget about Social Security benefits when planning for retirement, because changes in the system will probably be necessary when the huge number of baby boomers start retiring. But the fact is that Social Security benefits are a very valuable benefit, especially since benefits are adjusted for inflation annually.
For instance, the maximum Social Security benefit in 2007 for workers retiring at full retirement age is $2,116 monthly. While that might not seem like that much money, consider how much you’d need to accumulate to generate that monthly income. A 66-year-old male would have to pay approximately $420,000 for an annuity that would pay $2,116 monthly for life with annual inflation adjustments, while a 66-year-old woman would pay approximately $468,000 (Source: Vanguard, 2006). Suppose you want to invest the assets yourself. A common rule of thumb is you should withdraw no more than 4% annually. Thus, to generate a monthly income of $2,116, you would need assets of $635,000.
While it’s easy to dismiss the value of Social Security benefits, that value becomes apparent when you realize how much is needed to generate that income. Although no one knows how the Social Security system may change in the future, benefits currently paid are very valuable to retirees.
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Is Economic Inequality Increasing?
For the past two decades, the economy has experienced moderate inflation and fewer, less severe recessions. Technological advancements have helped raise productivity. Yet, these advances have mostly helped upper income workers.
For instance, from 1973 to 2005, real hourly wages for individuals in the 90th percentile of income, typically those with college or advanced degrees, rose by 30% or more. For individuals in the 50th percentile or below, typically those with at most a high school diploma, real wages increased by only 5% to 10% (Source: FRBSF Economic Letter, December 1, 2006).
In large part, this increasing wage inequality is caused by a widening gap in wages between college graduates and those with a high school education or less. In spite of increased college enrollment, it appears that the demand for college graduates has been stronger than the supply. This increased demand is a result of increasing usage of technology, such as computers, which has changed the nature of work and the skills needed for that work. There is greater demand and higher wages for workers who have the skills to use these technologies effectively.
Another major factor in this inequality is increasing globalization of labor markets. The United States tends to export goods that use skilled labor and import goods that use less skilled labor. That places more demand in the United States for skilled labor and less demand for less skilled labor.
Job instability has also increased, which can affect a family’s income. Approximately one in three workers change jobs every year, with approximately half doing so on a voluntary basis. Involuntary job loss results in unemployment for approximately four months, and new jobs typically pay 17% less than the former job (Source: FRBSF Economic Letter, December 1, 2006).
Due to all these factors, it is now increasingly likely for a family to experience a decline in annual income. The odds that a family will experience a 50% drop in yearly income has more than doubled since the early 1970s, rising to approximately one in six families (Source: FRBSF Economic Letter, December 1, 2006).
Copyright © 2008. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.
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Copyright © 2008. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.
FR2007-0420-0124
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