When Rupert Murdoch was quizzed about his alleged interference with the editors of his newspapers, he responded: “I read their balance sheets, not their editorials.”
Sophisticated investors contemplating an investment in a particular listed company will usually want to study its latest annual report. If their time is limited there are five key aspects that they may wish to concentrate on.
Dividends and net tangible assets were analysed in Part 1 (see below). This Part 2 discusses earnings, gearing ratios and growth rates.
Earnings
Companies report their profits (earnings) on both a “before income tax” and an “after income tax” basis. For analytical purposes non-recurring profits need to be disregarded.
The ratio of profits before tax to total shareholders’ funds is a measure of the efficiency of a company. For example, a company which consistently underperforms the Commonwealth Bond rate on this yardstick would clearly make its shareholders better off by liquidating and allowing them to make such a risk-free investment instead.
In practice this concept needs some modification, because regard also has to be had to growth expectations, but it provides a useful starting point for identifying risks and weaknesses.
The calculations are best done using weighted average shareholders’ funds for the year.
“Earnings per ordinary share” (usually referred to as “eps”) are obtained by dividing a company’s net profit (notionally adjusted where contributing shares exist) less the preference dividends (if any) by the total number of ordinary shares on issue. Such a figure is best expressed in cents per share.
Suitable adjustments will also be required if the company has made any issues or repaid any capital during the year, and also if convertible securities or options exist.
The “earnings yield” is obtained by dividing the eps figure (in cents per share) by the current market price of the share (also expressed in cents). This is another measure of the performance of the company to an investor and can be compared with interest rate levels generally.
It is really a much more useful yardstick than the “dividend yield” discussed previously, which – because it is a function of the payout ratio decided on by the directors – ignores the fact that ordinary shareholders benefit from a company’s earnings irrespective of whether these are actually distributed or not.
Other things being equal, the higher the earnings yield the better the value inherent in a transaction for a purchaser. However, things are never equal and some apparent bargains may be quite illusory. Distortions can arise from the mechanical nature of the arithmetic.
As indicated above, investors are much more interested in the future than in the past – and market prices reflect such expectations. Dividing the last published earnings figure by a current market value can sometimes produce a nonsense result, especially if losses or significantly reduced profits for subsequent years are now expected.
A more common way of looking at the above-mentioned concept is to divide the market price per share by the earnings per share figure, instead of the other way round. The result, this time expressed as a number and not as a percentage, is called the “price earnings ratio” or “PER” (sometimes shortened to just “PE”).
In effect, the PER represents the number of years’ purchase available. Other things being equal, the lower the PER the better the value is for a buyer and the worse for a seller.
Although price earnings ratios are regarded as modern and are frequently quoted in newspaper listings and in brokers’ circulars and the like, this alternative approach is for many purposes not as useful as the less popular earnings yield described above.
The latter can more readily be compared directly with other yields, such as those obtainable on fixed interest securities or property, and also with interest rates generally, including especially the cost to the investor of using borrowed money – as well as with the dividend yield on the shares being considered and on other shares.
Gearing
A company’s shareholders’ funds divided by its total assets, with the result usually expressed as a percentage, is called the “proprietary ratio”. It is a measure of the how safe the company is – the greater the proportion of the total value of the company represented by the shareholders’ equity the less the likelihood of creditors ever being able to institute receivership or liquidation proceedings.
However, in times of prosperity the use of other peoples’ money (provided the interest rate is lower than the return achieved on the funds employed) can considerably increase the yield on shareholders’ funds and, from that point of view, the lower the proprietary ratio the better.
There is obviously no “ideal” ratio – investors must (as always) do a trade off between risk and reward.
The process of using outside funds to supplement the proprietors’ money in this way is called “gearing” or “leverage”. The “gearing ratio” is obtained by dividing the total outside liabilities by the shareholders’ funds.
The fact that a company has a low gearing ratio and thus good capacity for additional borrowings and the scope for returning capital or engaging in expansion moves may make it an attractive takeover target for companies in the reverse situation.
Growth
The company’s growth rates per annum for sales, total earnings, earnings per share, NTA per share, and so on, are also worth study.
These may need adjustment for capital changes, but, subject to that, can be compared with the rate of inflation to see the extent to which the company is genuinely improving its performance and also as to how it is performing relative to its peers.
Average annual growth rates over a period such as five years are traditionally used for such an exercise.
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Story by Nick Renton AM, Commodity Warrants Australia
CompareShares.com.au
June 16 2008