Reading Financial Reports for Dummies (48 page)

Regarding Bond Rating Agencies

Bond ratings have a great impact on a company’s operations and the cost of funding its operations. The quality rating of a company’s bonds determines how much interest the firm has to offer to pay in order to sell the bonds on the public bond market. Bonds that are rated with a higher quality rating are considered less risky, so the interest rates that must be paid to attract individuals or companies to buy those bonds can be lower. Companies that issue bonds with the lowest ratings, which are also known as
junk bonds,
pay much higher interest rates to attract individuals or companies to buy those bonds.

Chapter 21: Checking Out the Analyst-Corporation Connection
275

Building bond rating’s big guns

Standard & Poor’s is one of the premiere bond-

John Moody started his rating service in 1909

rating firms. The company’s founder, Henry and was the first to rate public market securi-Varnum Poor, built his financial information ties. He adopted a letter-rating system from the company on the “investor’s right to know.” mercantile exchange and credit-rating system His first attempt at providing this type of finan-that had been used since the late 1800s. By 1924,

cial information can be found in his 1860 book,

Moody’s ratings covered nearly 100 percent

History of Railroads and Canals of the United

of the U.S. bond market. To this day, Moody’s

States,
where he included financial information prides itself on ratings based on public informa-about the railroad industry.
Today, Standard & tion and is written by independent analysts who

Poor’s is a leader in independent credit ratings,

don’t answer to the requests of bond issuers.

risk evaluation, and investment research.

Bonds are a type of debt for a company. The individual or company that buys a bond is loaning money to the company that it expects to get back. The firm must pay interest on the money that it’s borrowing from these bondholders.

You should be familiar with the three key rating agencies, where you can find out what bond analysts think:

✓

Standard & Poor’s:
Although S&P is well-known for the S&P 500, which is a collection of 500 stocks that form the basis for a
stock market index
(a portfolio of stocks for which a change in price is carefully watched), the company is also one of the primary bond raters. You can find more information at www.standardandpoors.com.

✓

Moody’s Investor Service:
Moody’s specializes in credit ratings, research, and risk analysis, tracking trillions of dollars in debt issued in the U.S. and international markets. In addition to its credit-rating services, Moody’s publishes investor-oriented credit research, which you can access at www.moodys.com.

✓

Fitch Ratings:
The youngest of the three major bond-rating services is Fitch Ratings (www.fitchratings.com). John Knowles Fitch founded Fitch Publishing Company in 1913, and the business started as a publisher of financial statistics. In 1924, Fitch introduced the credit-rating scales that are very familiar today: “AAA” to “D.” Fitch is best known for its research in the area of complex credit deals and is thought to provide more rigorous surveillance than other rating agencies on such deals.

Each bond-rating company has its own alphabetical coding for rating bonds and other types of credit issues, such as commercial paper (which are shorter-term debt issues than bonds).

276
Part V: The Many Ways Companies Answer to Others

Table 21-1 shows how the companies’ bond ratings compare.

Table 21-1

Bond Ratings

Bond Quality

Moody’s

Standard & Poor’s

Fitch

Best quality

Aaa

AAA

AAA

High quality

Aa

AA

AA

Upper medium grade

A

A

A

Medium grade

Baa

BBB

BBB

Speculative

Ba

BB

BB

Highly speculative

B

B

B

High default risk

Caa or Ca

CCC or CC

CCC, CC, or C

In default

C

D

DDD, DD, or D

Any company bonds rated in the “speculative” category or lower are considered to be junk bonds. Companies in the “best quality” category have the lowest interest rates, and interest rates go up as companies’ ratings drop. A key job of any firm’s executive team is to feed bond analysts critical financial data to keep the firm’s ratings high. Financial reports are one major component of that information.

Standard & Poor’s (S&P) makes its bond ratings publicly available with links on its Web site home page. You can search for information about any company’s debt ratings.

Whenever a change occurs in the ratings, the rating services issue a press release with an extensive explanation about why the rating has changed.

These press releases can be an excellent source of information if you’re looking for opinions on the numbers you see in the financial reports. You can find these press releases on the bond-rating companies’ Web sites, as well as in news links on financial Web sites.

Delving into Stock Rating

Stock ratings for general public consumption are primarily done by sell-side analysts, who seem to err on the side of optimism. You rarely find a stock with a
sell rating
(a recommendation to sell the stock). In fact, when analysts testified in Congress after the analyst scandals in the early 2000s (see the sidebar “Analyzing the analysts,” earlier in the chapter), one analyst was
Chapter 21: Checking Out the Analyst-Corporation Connection
277

heard saying that everybody on Wall Street knows that a
hold rating
(which is intended to mean you should hold the stock, but probably not buy more) really means to sell. Some firms use an
accumulate
rating,
which you may think means to hold onto the stock or maybe even add more shares, but really means to sell in behind-the-scenes circles on Wall Street.

Just like with bond ratings, each firm has its own vocabulary when rating stocks. A
strong buy
from one firm may be called a
buy
in another firm and may be on the
recommended
list in a third firm. You can never know which company is right, but after following a firm’s stock ratings for a while, you can understand how its systems work and how accurate it is compared with what actually happens to the price on the stock market.

Because various companies’ rankings may differ dramatically, you need to check out ratings from several different firms and research what each firm means by its ratings. A stock that’s rated as a “market outperformer” may sound pretty good, but in reality, it’s probably not a good investment, which may become clear when you compare rankings of other firms and find that they consider the stock a “neutral” or “hold” stock.

I don’t put much faith in the stock analyst rating system, and you shouldn’t, either. As you start doing independent research on a company after reading its financial reports, take everything you read with a grain of salt. Collect all the information you can and then do your own analysis. In Part III of this book, I show you how to analyze the numbers in financial reports.

Taking a Look at How Companies

Talk to Analysts

Companies not only send out financial reports to analysts but also talk with analysts regularly about the reports. Sometimes you can get access to what’s said by listening in to analyst calls or reading press releases. You can also get information from road shows, which I briefly describe later in this chapter, but you usually don’t have access to them unless you’re a major investor.

Analyst calls

Each time a company releases a new financial report, it usually schedules a call with analysts to discuss the results. Usually, these calls include the chief executive officer (CEO), president (if not the same as the CEO), and chief financial officer (CFO), as well as other top managers.

278
Part V: The Many Ways Companies Answer to Others

Individual investors can listen in on many of these calls between companies and analysts. The calls typically start with a statement from one or more of the company representatives and then are opened up to listener questions.

However, as an individual investor, you may not be able to ask any questions. In most cases, only the analysts, and sometimes the financial press, are allowed to ask questions. But even if you can’t ask questions, you can learn a lot just by listening.

The biggest advantage of listening to these calls is that analysts ask questions of the executives that help you focus on the areas of concern in the financial reports. Turn to Chapter 22 to find out more about analyst calls.

You can find out about upcoming calls or listen to calls already completed at two Web sites: VCall (www.vcall.com) and BestCalls (www.bestcalls.com).

In the past, calls between analysts and companies were a way for analysts to get insider information about a firm before the news was broadcast to individual investors. The SEC stopped that practice in 2000 with a new rule called
Fair Disclosure (Regulation FD).
This rule makes it mandatory for companies to inform everyone at the same time about major financial announcements.

Sometimes analysts find out information in a conversation with officers or employees of a corporation during a private interview. If analysts receive information that others aren’t aware of, the company must release a press release about the information within 24 hours after any company outsider gets the information. Regulation FD has certainly leveled the playing field for individual investors.

Press releases

Companies often feed information to analysts through press releases.

Luckily, individual investors can easily access these press releases on financial Web sites. But remember that press releases are always going to contain exactly what the company wants you to know. You need to read between the lines and ask questions of the company’s investor relations department if something concerns you.

Press reports, which are written after a press release is issued, are probably a more important source of information. Companies put out a lot of press releases, and not every one makes it into the newspaper as a story. In fact, most press releases end up in the garbage because a financial reporter determines the information isn’t worth a story.

Chapter 21: Checking Out the Analyst-Corporation Connection
279

You can easily track press releases online. One of my favorite spots for following not only a company’s press releases but also any stories mentioning the company is Yahoo! Finance (finance.yahoo.com). You can find out about any recent press coverage for a company by searching the Web site using the company’s stock ticker, which is a multi-letter abbreviation for the company’s stock. Links to recent press coverage and press releases are shown in a section called “Headlines.” If you want to go further back in history, most companies post at least three years’ worth of press releases in the press section of their Web sites.

Road shows

Companies use road shows (which I discuss in greater detail in Chapter 3) to introduce new securities issues, such as initial stock or bond offerings.
Road
shows
are presentations by the company and its investment bankers to the analyst community and other major investors in the hope of building interest in the new public offering. As an individual investor, you’re unlikely to be able to attend these shows; invitations are usually reserved only for those who can put up significant funding.

280
Part V: The Many Ways Companies Answer to Others

Chapter 22

How Companies Communicate

with Shareholders

In This Chapter

▶ Attending annual shareholder meetings

▶ Looking at the responsibilities of the board of directors

▶ Keeping abreast of corporate special events

▶ Listening perceptively to analyst calls

▶ Getting information from company Web sites

▶ Investing through company incentive programs

Happy shareholders don’t necessarily make for a happy company, but they’re a good start. Although a company collects most of the money generated from stock transactions when the stock is first sold to the public during an initial or secondary public offering, shareholders still hold a bit of power over management. Angry shareholders showed what their wrath could do when their lack of support for Disney CEO Michael Eisner helped oust him from the chairmanship of the board in 2004.

Sending out quarterly and annual reports aren’t the only strategies companies use to keep their shareholders informed and happy. Other activities include analyst calls, special meetings, Web site services, e-mails, stock-investment plans, and individual investor contact. In this chapter, I review the steps that companies take to inform their investors of operations and to respond to any investor concerns.

282
Part V: The Many Ways Companies Answer to Others

Making the Most of Meetings

A company must, at the very least, hold an annual meeting for its shareholders. These events are often gala affairs that are more like a carefully orchestrated pep rally than a place where you can get solid information. The company’s top officers make presentations highlighting what they want you to know and put on a show that closely resembles what you find in the glossy portion of an annual report.

The big advantage of being at the company’s annual meeting is that you can ask questions, which you can’t do if you just read the financial reports at home. Prepare yourself before the meeting by reading the recent financial reports, as well as annual reports from the past couple of years, so you’re fully armed with details about what has gone on in the past. Make a list of questions that you want answered by the company’s executives so you’re ready to ask them when the opportunity arises. Note that if shareholders are unhappy with the corporation’s board or its executives, annual meetings can turn into major shouting matches when the floor is opened to questions and comments.