The Ursinus College

Student Managed Investment Fund

Handbook

Last updated: July 30, 2018

The logo of the fund’s founding organization, the Ursinus College Investment Club.
 Table of Contents
1. Preface
2. Portfolios and Governance
3. Investment Strategies
4. Basic Terminology
5. How to Get Information on Investments
6. Financial Statements
a. The Balance Sheet
b. The Income Statement
7. Key Ratios
a. Price-to-earnings (P/E)
b. Quick
c. Debt-to-equity
d. Interest coverage
8. Qualitative Analysis
a. Porter’s Five Forces
b. SWOT Analysis
9. Net Income and Free Cash Flow
10. Further Reading on Investing
1. Preface
This handbook is designed to help students who work on the Ursinus College student-
managed investment fund yet have little background in finance or investments. We hope to give
readers a condensed yet informative overview of strategies, key terms, research resources, and
some quantitative methods. The end goal of the listed equities group is to help manage the
Endowment portfolio, which requires a year of experience with the Pursley fund.

2. Portfolios and Governance

The student-managed investment fund encompasses two portfolios, one geared towards
beginning investors and one geared towards students with experience and coursework in
finance and investments.

The portfolio for beginning investors (the Pursley Fund) was established through the
generosity of Joseph Pursley (Ursinus class of 2003), who donated $5,000 in the summer of
2018 to create the portfolio. Students working on the portfolio learn the basics of investing by
researching and buying individual stocks. At the time of purchase, each stock will carry equal
weight within the portfolio. The portfolio may suffer from relatively high volatility of returns, but
the investigation of individual stocks will provide the foundation for understanding of the
advanced portfolio as well as investment decisions in a variety of other situations.

The portfolio for more-advanced students (the Smith Fund) was established through the
generosity of several donors who made contributions of $22,000 between Nov. 2016 and
February 2018. They include the founding donor, the late Rev. Dr. Harold C. Smith (Ursinus
Class of 1955); Daniel Myers (parent of a student-managed investment fund leader); Hirtle
Callaghan and Company (the firm that advises the college on its endowment management);
Michael Fleming (Ursinus Class of 1997); and the above-mentioned Joseph Pursley. The
remaining portion of the fund’s value come from capital gains and dividends earned from the
portfolio’s investments.

The student-managed investment fund began as an activity of the Ursinus College

Investment Club, but effective with the Fall 2018 semester, it is a program managed by the
college’s Department of Business and Economics. To take part in fund management, students
must register for a one-credit course. Students in the class conduct research in the first half of
each semester and reach a consensus on the make-up of each portfolio by the semester’s mid-
point. The portfolio for beginning students will be liquidated at the end of each semester. The
portfolio for advanced students will generally be maintained between semesters.

The student-managed investment fund is part of Ursinus College’s endowment. For this
reason, final authority over the fund rests with the Ursinus College Board of Trustees. Students
manage the fund thanks to the cooperation and support of the Trustees’ endowment committee,
which is generally represented by the college’s Vice-President of Finance and Administration,
Annette Parker, and the college’s Associate Controller, Christopher Guy. A faculty adviser, Prof.
Scott Deacle, guides and supports students managing the fund. Prof. Deacle sends buy and sell
orders for the two portfolios to Christopher Guy, who has access to the club’s brokerage
accounts.

3. Investment Strategies
The Pursley Portfolio

As noted above, the Pursley Portfolio is intended to be managed by beginners who will
select several individual stocks to be held by the fund for part of each semester. Student
managers of this portfolio pursue a “value” investing strategy in which they examine financial
statement and qualitative data on U.S. firms with publicly traded common stock. The goal is to
identify stocks that the rest of the market currently under-values.

To do this, Pursley Portfolio managers follow a simplified version of the investing

strategy that value investor Edgar Wachenheim III describes in his book Common Stocks and
Common Sense (2016). Our modification of this strategy can be summarized in the following
three steps:

1. Identify stocks with low price-to-earnings (P/E) ratios relative to similar stocks.
2. Among the stocks identified in step 1, identify those issued by firms with low risk of
bankruptcy.
3. Among the stocks identified in step 2, identify those that could generate rapid earnings
growth if one or two factors change.

Our process involves a combination of data gathering, number crunching, and reading.
In step 1, we employ the price to earnings ratio (P/E). In step two, we examine three financial
statement ratios: the quick, debt-to-equity, and interest coverage ratios. In step 3, we read about
our firms to identify opportunities and challenges with respect to their earnings growth.

The Smith Fund

Students will manage The Smith Fund in line with commonly accepted principles for non-
profit endowment management. Students will strive to increase the value of the portfolio while
minimizing the chance of losses, both large and small. The goal is to maintain the portfolio in
perpetuity (forever) for the advancement of the college and future generations of students.
In its first semester, fall of 2018, student fund managers will use mean-variance portfolio
optimization techniques at the beginning of the semester to identify ranges of weights to place
on various categories of investments. Students will then conduct research on exchange-traded
funds (ETFs) to identify the most suitable investments within within each category. After making
the initial round of investments in fall of 2018, students will periodically rebalance the portfolio
and make relatively small modifications within this overarching strategy in future semesters.
 By purchasing ETFs, which consists of multiple investments, students will minimize risk
through diversification. Students will further minimize the chance of loss by allocating a portion
of the investments to the lowest risk securities, such as U.S. government bonds or U.S.
government-insured deposit accounts.

4. Basic Terminology
Like most investment professionals, the student-managed investment fund makes use of
a variety of accounting and financial terms that may not be familiar to newcomers, at least in this
context. Here is a brief dictionary of some of those commonly-used terms. (Slashes between
bold-faced terms indicate the terms are used interchangeably.)

❏ Asset: Something that has the potential to earn money. From a firm’s perspective,
assets include (but are not limited to) stocks, bonds, commodities, real estate, factories,
unpaid bills from customers (accounts payable), and cash sitting in bank accounts.
❏ Blue Chip: A company that has a history of solid earnings, regular and increasing
dividends, and an impeccable balance sheet.
❏ Book Value/Total Equity: The value of a company if total liabilities are subtracted from
total assets.
❏ Broker: A firm or person that buys or sells an investment for you in exchange for a fee
called a commission. TD Ameritrade is our broker. It charges a commission of $6.95 on
each transaction we make.
❏ Capital Gain: The percentage change in the market value of a security. For example, if
stock in ABC Corporation increases in value from $10 to $11, it has enjoyed a capital
gain of 10%. The total return on a stock is the sum of its capital gain and dividend yield.
❏ Current: An adjective that in financial statements means “short-term.” Current assets
are assets that mature in one year or less, for example.
❏ Dividends: A portion of a company’s profits that is paid out to shareholders on a
quarterly or annual basis. It is not mandatory to declare dividends on common stock
even if the company is making good profits.
❏ Diversification: A portfolio characteristic that shows investments in different sectors,
industries, or geographic locations.
❏ Earnings / Net Income / Profit: The portion of income left over after meeting all costs,
overhead and taxes during a reporting period. Also called “the bottom line.”
❏ ETF (Exchange-Traded Fund): An investment fund that issues shares that can be
traded on the same exchanges as common stocks. ETFs typically manage diversified
portfolios of securities within a sector, industry, or national market. ETFs dramatically
reduce transaction costs for investors who want to invest in a large number of securities.
❏ Index: A tool used to measure the performance of a group of stocks that share common
characteristics. The Dow Jones, S&P500, and NASDAQ are examples of indexes.
❏ Liability: Something for which the firm must pay cash in the future. From a firm’s
perspective, liabilities include (but are not limited to) bonds, loans, unpaid bills to
suppliers (accounts payable), unpaid wages, and unpaid taxes. (Unpaid wages and
taxes are sometimes called “accruals.”)
❏ Market Capitalization/Market Cap: For a given firm, the current price per share times
the number of shares outstanding.
❏ Revenue / Sales: What a company earns for the goods it produces or the services it
provides. This is not profit.
 ❏ Stock / Equities: If you own a stock, you own part, or a share, of the company.
Companies divide their ownership stakes into shares, and the number of shares you
purchase determines your level of ownership of the company. The price of that share
can fluctuate given what people think the company is worth and what they are willing to
pay for a share.
❏ Yield: The cash an investor can expect to receive each year, expressed as a percentage
a securities market value. When a company pays a dividend to its stockholders, the
dividend yield is the dividend expressed as a percentage of the stock price. In other
words, if a stock is trading for $10 and pays a dividend of $0.50, the yield is 5%. The
total return on a stock is the sum of its capital gain and dividend yield.
It’s okay if you don’t understand 100% of the material here. You will pick it up as you go
along.

5. How to Get Information on Investments

Student-investment fund managers use a variety of resources, most of them freely available on
the Internet, to conduct research on investments. Each resource has strengths and
weaknesses. Some provide a lot of information on many firms

Seeking Alpha
Seeking Alpha (www.seekingalpha.com) provides a variety of “dashboard” data and
news on U.S. stocks as well commentary on those stocks. Seeking Alpha is useful for both
tracking stocks, obtaining key ratios and performance data, and finding ideas to explore and test
while conducting qualitative research on a stock. It is recommended that you read Seeking
Alpha on your computer’s Web browser and not the smart phone app, because the app does
not provide much of the financial data that we use.
The commentary is written by both amateur investors and professionals. Seeking
Alpha’s editors screen the commentary before it is published. Seeking Alpha writers receive
financial rewards for attracting clicks and followers, do they have incentive to write clearly and to
provide accurate forecasts. The quality of analysis on Seeking Alpha varies, and it rarely rises to
the level of equity reports written by professionals at large investment banks such as JP Morgan
or Goldman Sachs. That said, reports from the large investment banks, cost hundreds or
thousands of dollars, while much of Seeking Alpha’s commentary is free to registered users.
To gain access to most of Seeking Alpha’s information, you must create a free account.
Seeking Alpha also sells premium accounts which give users access to some more commentary
than free account users receive.
Yahoo! Finance
Yahoo! Finance (finance.yahoo.com) is a popular, easy-to-use tool to get “dashboard”
information on U.S. stocks and ETFs as well as a variety of other investments. It provides
charting tools, news, downloadable historical data on stock prices and volumes.
Jason Strimpel’s Bulk Stock-Price Download
 One can download historical price data on stocks from Yahoo!, one at a time. To
download historical price data on many stocks at once, use this free web site.
http://finance.jasonstrimpel.com/bulk-stock-download/
Koyfin
Koyfin (www.koyfin.com) provides data on most stocks and ETFs on the U.S. market as
well as macroeconomic data and a number of easy-to-use charting tools. It’s great for
comparing stocks to their peers along a variety of dimensions. Koyfin allows users to download
much of the data it provides into CSV files. Johnny swears by it.
Sharadar via Quandl
We use a service called Quandl (www.quandl.com) to access a database of information
from publicly-released financial statements from U.S. firms with exchange-traded stocks. This
database is called the “Core Fundamental Database,” and it is built and maintained by a firm
called Sharadar.
Quandl distributes Sharadar (and other firms’) data through an application programming
interface API. Rather than try to explain what APIs are, let’s just say that this means you can
obtain Sharadar Core Fundamental data by entering the appropriate code into your Web
browser’s address bar. (We will cover the code in class.) The data you receive by submitting
this code comes in comma separated value (CSV) files that can then be opened in widely
available spreadsheet software such as Microsoft Excel and Google Sheets.
The downside of obtaining Sharadar data from Quandl: you must write code and use
spreadsheets to look at it. The upside: Once you understand how to write and submit the code,
you can, in seconds, get financial statement data on many firms for many quarters or years. You
can then use spreadsheet software to quickly make calculations to help identify potential
investments. None of the services described above make it possible to get financial statement
data on many firms at once.
We enjoy the use of Sharadar in 2018 thanks to a donation from Prof. Deacle and a
discount from Quandl. Whether we continue to use it in 2019 will depend on an assessment of
its value at the end of Fall 2018.
Other sources
There is no consensus on what the best free or low-cost source of investing information
is. Other widely-used, credible, low-cost sources include The Wall Street Journal (wsj.com),
Bloomberg.com, Morningstar.com, Marketwatch.com and Fidelity.com. Ursinus students also
have access to the Mergent database, available on the library’s website
(www.ursinus.edu/library, then click “Databases & Online Resources,” then click “Databases A-
Z,” then click “M” and find Mergent.)

6. Financial Statements
 We learn much of what we know about publicly-traded firms by reading their financial
statements. U.S. firms that issue publicly traded stocks must release financial statements four
times per year. Accounting firms audit those statements, and CEOs pledge that they are
accurate. Thus, the information in them is fairly reliable, though you should expect it to be spun
in a way that serves the interests of the firm’s management.

The two most important financial statements are the balance sheet and the income
statement. We describe these statements and how to interpret them below.

The Balance Sheet

Examining balance sheets gives readers a sense of a firms’ size, the composition of its
assets and liabilities, and its risk of going bankrupt.

Every balance sheet includes a table describing the firms’ assets and a table describing
its liabilities and equity. As the name “balance sheet” implies the reported value of the firms
assets must equal the reported value of its liabilities and equity. Assets are anything of value
that belongs to the firm. They include cash, securities, investments in other companies,
buildings, equipment, and automobiles. The asset section of a balance sheet lists the values of
multiple categories of assets.

On the other side of the balance sheet are liabilities and equity. Liabilities are what the
firm owes to other people, firms, and government. They can include bonds, loans, wages not yet
paid to workers, taxes not yet paid to the government, and much more.

On the balance sheet, equity is the “book value” of the owner’s shares in the firm. It
reflects the amount the firms’ owners invested in the company at the time their ownership
stakes were created. The value of equity on a balance sheet is usually different from the stock
market value of a firm’s equity. The market value of equity, which is reflected by the firm’s stock
price, depends on outside investors’ expectations for the firm’s profitability. Since firm’s owners
may get a share of the firm’s profits, the market value of equity tends to increase when investors
believe profits will increase.

Every firm’s assets must be equal, or balanced with, its liabilities plus equity. The
balance sheet shows readers what kind of assets, liabilities, and equity the firm has. Balance
sheets must balance, causing the following relationship to hold:

Total Assets = Total Liabilities + Total Equity

Consider this analogy: you need money to start your own company and buy assets. You
can categorize the sources of that money as others and yourself, the owner. The money that
others lend you are your liabilities. The money you put up yourself is equity in the company. The
value of the two combined should equal the amount you pay for your assets. The same holds
true for firms of all sizes.
 Balance sheets typically classify assets and liabilities as short-term (current) or long-
term. They list short-term (current) assets or liabilities above long-term assets and liabilities.
Below is a sample balance sheet that illustrates these concepts. Note that real-life balance
sheets don’t tell you when line-items are sums of the items above them. The authors expect you
to know from accounting class.

Sample Balance Sheet

Assets Liabilities and Equity

Cash $50 Short-term notes (short-term loans) $25

Accounts payable $75 Accruals (unpaid wages and taxes) $15

Current assets (cash, short-term $125 Current liabilities $40

securities, inventories, accounts
payable)

Plant, Property, and Equipment $300 Bonds $200

Other long-term assets $50 Long-term loans $75

Long-term assets $350 Long-term liabilities $275

Total Assets (sum of all current assets $475 Total Liabilities $315
and all long-term assets)

Total Equity $160

Total Liabilities and Equity $475

Real-life balance sheets are much more complicated. Part of the art of stock valuation is
understanding those complexities and developing ways to interpret them. Ratios, described in
section 7 help with those interpretations.

The Income Statement

Income statements outline how firms earn their profits (or suffer their losses). They list
revenues and expenses, each of which are broken down into several categories. Understanding
the categories of expenses and earnings on income statements helps financial analysts assess
firms’ past and future performance.

Financial analysts use operating expenses to assess the “physical” costs of making the
firm’s profits -- the costs of raw materials, equipment, wages, and so on. Operating expenses
are cash expenses, meaning they reflect money the firm has paid to other entities.
 Not all expenses are cash expenses. Firms must report on their income statements
some costs that require no transfers of funds. For example, a firm may buy a truck for $30,000
in 2016. By 2017, that truck could sell for only $25,000. The firm must report that $5,000 loss of
value as a depreciation expense.1 When tangible, physical property loses value, we call it
depreciation. When intangible property, such as a patent, loses value, we call it amortization.
Amortization must also be reported on income statements. Generally, firms add depreciation
and amortization expenses and report them on one line.

The cash/non-cash distinction becomes important in assessing the value of firms in

some contexts. A firm that has a large, one-time depreciation and amortization expense will
appear to have low profits on its income statement. That firm would, however, report higher
levels of profits on future income statements. More importantly, the depreciation and
amortization expense may not permanently affect the firm’s ability to pay cash to its lenders and
shareholders, and that is what lenders and shareholders tend to care about the most.

In addition to reporting operating expenses, firms report the interest they must pay for
their borrowed funds on their income statements. In the Ursinus student-managed investment
fund’s approach to investment analysis, we are interested in the level of a firm’s interest relative
to its earnings before interest and taxes. We use the interest coverage ratio (described in
Section 7) to get a sense of a firm’s interest burden.

A final cost that appears on income statements are taxes. It is common for firms to
report a negative number for taxes. If firms suffer a loss in a given year, U.S. tax law allows
them to claw back income taxes paid in previous years, resulting in negative income taxes.

The terms “net income,” “earnings,” and “profit” are interchangeable. So are the terms
“earnings before interest and taxes” and “operating income.”

Note that there are separate lines on income statements for “earnings before interest,
depreciation, and amortization (EBITDA),” “earnings before interest and taxes (EBIT),” “earnings
before taxes,” and “net income.” Each of those lines allows readers to analyze the firm’s
performance and draw preliminary conclusions about the future. For example, a firm with high
EBITDA but low net income is probably selling its product well above the cost of producing it. It’s
net income, however, is being reduced by a factor unrelated to operations - either depreciation
and amortization, interest, or taxes. If the firm can address the unrelated factor, it could quickly
increase its net income.

Sample Income Statement

Revenues $1,000,000

Operating expenses $250,000

1
In reality, the classification of depreciation is more complicated, due to incentives provided by tax laws.
 Earnings before interest, depreciation, and amortization (EBITDA) $750,000

Depreciation and amortization $10,000

Earnings before interest and taxes (EBIT, or operating income) $740,000

Interest expenses $15,000

Earnings before taxes $725,000

Taxes $253,750

Net income $471,250

A few things to note:

❏ Most income statements assume readers know which numbers are added and which
numbers are subtracted.
❏ Most income statements are more complicated than the sample. They break figures into
smaller categories, or sometimes have additional categories as management and
auditors see fit.

7. Key Ratios
Examining financial statements gives analysts a sketch of firms’ financial health, but they
are easy to misinterpret because financial statement line items (such as net income, current
assets, and so on) vary according to the size of a company. A company with $1 million in net
income may be a better investment than a company with $1 billion in net income -- if its scale of
operations is disproportionately smaller than the company with $1 billion in earnings.

The Ursinus student-managed investment fund uses the below ratios to screen stocks
for the Pursley Portfolio. No single ratio gives us the entire picture. There are many more
balance sheet and valuation ratios that could show us more about the company, but these allow
us to conduct steps one and two of the investment strategy described in Section 3. We will be
using these ratios often, and fund managers should be familiar with them.

The P/E Ratio

The P/E ratio is calculated by dividing the current market price of a stock by its earnings
per share (earnings per share is the net earnings of the company divided by the number of
shares outstanding). Step one of the Pursley Portfolio strategy calls for using this ratio to identify
stocks that may be under-valued by other investors. A stock with a relatively high P/E ratio is
likely to already enjoy a high price generated by investor optimism. A stock with a relatively low
P/E ratio is more likely to be an undervalued “diamond in the rough.”
 The average P/E ratio varies from industry to industry and sector to sector. We like to
buy stocks that are trading below the industry average P/E and sell them when they are above
industry average. Some margin above sector and industry averages may be acceptable as long
as the thesis for increased valuation is reasonable. Note that P/E constantly fluctuates, as the
price per share changes second-to-second during trading hours while the earnings per share
stays fixed between the release of quarterly statements.

The Quick Ratio

The quick ratio is calculated by taking a company’s total current assets, subtracting out
inventories, and then dividing by the company’s total current liabilities. This ratio gives you an
idea of the company’s ability to meet all of its current obligations. Current assets includes all
cash, short-term liquid securities, accounts receivable, and inventories. Of those four types of
assets, inventories are most often mis-valued and most difficult to collect cash from. Thus, the
quick ratio tells analysts how many dollars of easy-to-raise cash the firm has per dollar of short-
term liabilities. Step 2 of the Pursley Portfolio strategy involves an assessment of firms’ risk of
bankruptcy. Firms with high quick ratios will be able to cover their short-term obligations, a
characteristic associated with low risk of bankruptcy.

When we say we look for “high” quick ratios, we generally mean high quick ratios
compared to firms in the same industry or sector. In absolute terms, some analysts view a very
high quick ratio (greater than 2) as a sign of financial mismanagement. The firm may be holding
too much cash or other short-term assets. It could be using those assets for investment in profit-
generating projects, paying dividends, or buying stock back from shareholders (and thus
increasing the price of the stock).

The Debt-to-Equity Ratio

The debt-to-equity ratio is calculated by dividing the company’s total liabilities by the
book value its total equity (the value that appears on the balance sheet). A company with a high
debt-to-equity ratio is using a significant amount of debt instruments, such as bonds, to finance
its operations and is more likely to go bankrupt. (As with the quick ratio, this ratio is used to in
step to of the Pursley Portfolio strategy.) We like companies with a relatively low debt-equity
ratio- ideally below 1. Again, an individual firm’s debt-to-equity ratio should also be compared to
those of firms in the same industry or sector before judging it “low” or “high.”

The Interest Coverage Ratio

The interest coverage ratio is calculated by dividing operating income (EBIT) by interest
expenses. As with the quick and debt-to-equity ratios, interest coverage is used to assess firms’
likelihood of bankruptcy. Firms with low interest coverage ratios have little income available from
operations to pay off interest on loans. If a surprise occurs, the firm may not be able to make its
loan payments, at which point it would go bankrupt and its stock would become worthless.
 As with other ratios, a firm’s interest coverage ratio should be compared to those of firms
in the same industry or sector. In absolute terms, a company with a low interest coverage ratio
(below 1.5, according to Investopedia) is unable to cover the interest owed on its debt and
remain profitable at the same time.

8. Qualitative Analysis
Not everything we do in the Investment Club comes from numbers and ratios. A lot of
our work is discussion around what qualitative factors a company must face. How an industry
behaves, what the company competes against, and how buyers react to a change in price all
affect a company’s Bottom Line. Below, we will discuss SWOT Analysis and Porter’s Five
Forces.

SWOT Analysis
SWOT stands for: Strengths, Weaknesses, Opportunities, and Threats. If you answer
these four questions about a firm, the answers can help you support your prediction for its
earnings growth.
❏ Strengths: What gives the business an advantage?
❏ Possibilities: Low input prices; a product of superior quality to those of
competitors; a patent for a desirable product; few competitors; exclusive
contracts with large buyers
❏ Weaknesses: What puts it at a disadvantage?
❏ Possibilities: Increasing input prices, inferior product quality; many competitors;
shrinking market for the firm’s product.
❏ Opportunities: What can cause earnings to grow?
❏ Possibilities: Groups of buyers who would be willing and able to purchase the
firm’s products but haven’t yet; cost-cutting; successful implementation of a new
strategy
❏ Threats: What can cause trouble for the business?
❏ Possibilities: Competitors; regulation; poor product quality; shrinking demand for
the product due to demographics, shifts in preferences, or substitutes.

We can also apply SWOT analysis to the assessment of asset classes and ETFs that
represent segments of an asset class.

Porter’s Five Forces

SWOT analysis is not the only way to assess a firm’s prospects. Harvard Business
Professor also identified five “forces” that can be used to analyze what adversities companies
face when they enter the market.
 1. Threat of New Entrants

Profitable businesses will attract new firms to enter the market. This results in many new
entrants, which eventually will decrease profitability for all firms in the industry.
❏ Product differentiation
❏ Customer loyalty to established brands
❏ Industry profitability (the more profitable the industry the more attractive it will be to
new competitors)

2. Threat of Substitutes

The existence of products outside of the realm of the common product boundaries
increases the propensity of customers to switch to alternatives. For example, tap water might be
considered a substitute for Coke, whereas Pepsi is a competitor's similar product. Increased
marketing for drinking tap water might "shrink the pie" for both Coke and Pepsi, whereas
increased Pepsi advertising would likely "grow the pie" (increase consumption of all soft drinks),
albeit while giving Pepsi a larger slice at Coke's expense.
❏ Relative price performance of substitute
❏ Perceived level of product differentiation
❏ Number of easily substitutable goods available in the market

3. Bargaining Power of Customers

The bargaining power of customers is the ability of customers to put the firm under
pressure. Firms can attempt to reduce buyer power, such as implementing a loyalty program.
The buyer power is high if the buyer has many alternatives.
❏ Buyer concentration to firm concentration ratio
❏ Degree of dependency upon existing channels of distribution
❏ Buyer information availability

4. Bargaining Power of Suppliers

Suppliers of raw materials, components, labor, and services to the firm can be a source
of power over the firm when there are few substitutes. If you are making biscuits and there is
only one person who sells flour, you have no alternative but to buy it from them.

❏ Supplier switching costs relative to firm switching costs

❏ Presence of substitute inputs
❏ Supplier competition: the ability to forward vertically integrate and cut out the buyer

5. Industry rivalry
 For most industries, the intensity of competitive rivalry is the major determinant of the
competitiveness of the industry.
❏ Sustainable competitive advantage through innovation
❏ Competition between online and offline companies
❏ Powerful competitive strategy

9. Net income and free cash flow

The “bottom line” on income statements is net income. Many people view net income as
the most important measure of a firm’s performance. The Ursinus student-managed investment
fund itself uses price-to-earnings (P/E) ratios to assess stocks. That said, net income
sometimes conceals important information about a corporation. For this reason, you will often
come across coverage of stocks that mentions or focuses on the firms’ free cash flow. You are
welcome to use this in your analysis, though given our limited time, student-managed
investment fund analysts don’t typically do this.

To calculate net income, one must subtract depreciation and amortization. Those
expenses, however, do not require a cash payment. Thus net income doesn’t show how much
cash is available to the firm’s stockholders and debt holders. This is an important point, because
a firm’s ability to pay cash to stockholders in theory should affect its value more than its net
income.

This is why many stock analysts estimate corporations’ free cash flow. Firms are not
required to report free cash flow in their financial statements. It can, however, be estimated in
several ways, all of which involve 1) adding depreciation and amortization back to earnings in
some way and 2) require an estimate of how much cash the firm must divert to plant, property,
equipment, and working capital to maintain production over the next quarter or year.

In the introductory finance textbook Ursinus uses, free cash flow is calculated as follows:

First, use the following abbreviations:

❏ FCF is free cash flow

❏ EBIT is earnings before interest and taxes, also known as operating income.
❏ T stands for taxes
❏ D&A is depreciation and amortization.
❏ Cap. Ex. is capital expenditures. This is how much money the company spent on
buildings, machinery, equipment, and other physical assets that will last for a year or
longer. If a company needs to build a large new plant, it will have a large capital
expenditure and a low free cash flow. You can get an estimate of a company’s capital
expenditure by calculating the change in its net fixed assets from one year to the next.
❏ NOWC is net operating working capital, the excess of operating current assets over
operating current liabilities. In plainer terms, this is like the money individuals keep in
their wallets. If a company puts more money in its “wallet,” it will reduce its free cash
 flow. NOWC = (Current Assets - Current Liabilities - Short term debt), and 𝞓NOWC is
the change in NOWC from one year to the next (i.e. how much cash the firm puts in its
wallet).

Free cash flow can be calculated as follows:

𝐹𝐶𝐹 = [𝐸𝐵𝐼𝑇(1 − 𝑇) + 𝐷&𝐴] − [𝐶𝑎𝑝. 𝐸𝑥. +𝛥𝑁𝑂𝑊𝐶]

This formula essentially takes the firm’s operating income and removes taxes (EBIT(1-T)) adds
depreciation and amortization (D&A) and then subtracts out the funds it must spend on plant,
property, equipment, and its “wallet” (Cap. Ex + 𝞓NOWC) to continue operating as it has.

10. Further Reading on Investing

As the Rev. Dr. Harold C Smith, who gave the student-managed investment fund its initial
$5,000 donation, put it: “You can never learn too much.” Below is a list of books, articles, and
other sources to begin your personal education. This list of books is not complete, and it is
recommended that future analysts add to the list.

Damodaran, Aswath, Damodaran on Valuation

Ellis, Charles D. Winning the Loser’s Game
Graham, Benjamin. The Intelligent Investor
Klarman, Seth. Margin of Safety http://aforetheherd.com/wp-content/uploads/2015/02/Margin-of-
Safety-Klarman.pdf
Lo, Andrew 15.401 Finance Theory I. Fall 2008. Massachusetts Institute of Technology: MIT
OpenCourseWare, https://ocw.mit.edu. License: Creative Commons BY-NC-SA. (Not a
book, but notes for an introductory finance course at MIT).
Lowenstein, Roger When Genius Failed: The Rise and Fall of Long-Term Capital Management
Malkiel, Burton. A Random Walk Down Wall Street. New York, New York. Norton, 1999.
ISBN: 978-0393352245
Moe, Michael. Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks
of Tomorrow. Portfolio; Reprint edition, 2007. ISBN: 978-1591841890.
Peters, Josh. The Ultimate Dividend Playbook. Hoboken, New Jersey. Morningstar,
2008. ISBN: 978-0470125120.
Tetlock, Phillip and Gardner, Dan. Super Forecasting: The Art and Science of Prediction.
Broadway Books, New York. ISBN: 978-0804136709.
Swensen, David F. Pioneering Portfolio Management: An Unconventional Approach to
Institutional Investment. New York. Free Press, 2009. ISBN: 978-146544692
Vigna, Paul & Casey, Michael J. Cryptocurrency: The Future of Money?. London,
England. Vintage, 2016. ISBN: 978-1784700737.
Wachenheim, Edgar. Common Stocks and Common Sense: the Strategies, Analyses,
Decisions, and Emotions of a Particularly Successful Value Investor. Wiley, 2016. ISBN:
978-1119259602.
Wheelan, Charles. Naked Economics: Undressing the Dismal Science. W. W. Norton &
Company; Fully Revised and Updated edition. ISBN: 978-0393337648