valuation (Ratio )Analysis

Book Value Per Common Share

How much is a company worth and is that value reflected in the stock price? There are several ways to define a company’s worth or value. One of the ways you define value is market cap or how much money would you need to buy every single share of stock at the current price. Another way to determine a company’s value is to go to the balance statement and look at the Book Value. The Book Value is simply the company’s assets minus its liabilities.

In other words, if you wanted to close the doors, how much would be left after you settled all the outstanding obligations and sold off all the assets. A company that is a viable growing business will always be worth more than its book value for its ability to generate earnings and growth. Book value appeals more to value investors who look at the relationship to the stock's price by using the Price to Book ratio. To compare companies, you should convert to book value per share, which is simply the book value divided by outstanding shares.

In simple terms it would be the amount of money that a holder of a common share would get if a company were to liquidate.

But this calculation is not as simple as it is written. Why?

Let us see…

It is true that the share is trading at price less than the book value, but the questioned to be asked here is why? Investors must know that very often companies willingly publishes wrong (higher) book value in their statements. This will confuse the investors and they will be drawn to buy its shares assuming it to be undervalued.

It is also a fact that at times market wrongly prices a share. This mainly happens if for some reason a company gets un noticed (low trading) for long time. May be other options are more lucrative and people concentrated more in those shares and because of this a particular share gets ignored.

The value of assets of company gets depreciated each year. At times companies does not deprecate the values as stated in the rule-book. This makes the value of assets to inflate and book value is quoted at higher rates than actual. In this case turn pages of some older balance sheets and compare what percentage of depreciation was deducted in say last five years. If you see any sudden drop in percentage you know that there was a trick. Let us take example of an auto industry. It takes huge capital expenditure (for buying machinery etc) to install a plant. In case of liquidation of such company, the amount that can be collected by individual machinery will be worth much less than the cost paid to buy them. Hence in accounting principles, the logic of ‘depreciation of assets’ was introduced. As an investor we must be aware that if company is depreciating its assets as required then we may end up in calculating a wrong book value. As an investors we are more concerned that at what price these equipment will be sold in the market in case of liquidation. So very often we shall not blindly believe the book value figures quoted by companies in its balance sheets.

Suppose you an individual has an earning of $1,000 per month. Now you want to by a car which costs $25,000. You will need a car loan to buy this car. When you will approach you bank, they will say that your monthly income is not sufficient to grant you a loan of $25,000. Instead they will suggest you to take a loan by giving additional guarantee of say your house, two wheeler, etc. Here what your bank is doing is, it is trying to make itself comfortable that in case you are not able to repay back the loan amount they can liquidate these assets of yours (house, two wheeler etc) to recover their amount. In this case if we calculate your book value, a financially intelligent person will not consider your house, two wheeler as your asset. As they are tied (like under dispute) with your auto loan. Similar conditions are applicable with the companies. When a company is in a bad financial condition, they tend to put a part of their asset (like land, building, cars etc) under guarantee/ security. While declaring its assets in the balance sheets, these companies are not obliged in not to include such disputed property. Instead they play safe and some where in the fine footer notes they include a statement confirming this type of transaction. But majority of investors do not read those fine prints.

The moral of the story is one must be careful in considering Book Value as their sole tool to evaluate whether the share is undervalued or overvalued. We must understand that why we are buying a share which is trading at a discount to its book value? The reason is, it open a door for fast price appreciation. As we have discussed below, if suppose a company is really under-priced as compared to its book value, then soon the market will recognize this and will start buying. With increased demand the market price will increase. In this case (you as an investor) one can sell their holding for huge profits. But if you have miscalculated the book value then instead of price appreciation, the market may fall further.

So what is the solution?

The solution lies in more in-depth research about companies financial health. Instead of considering Book Value as their only way of evaluating a share value, better to use other tools in parallel like

• PEG Ratio, Dividend Yield, Residual Income Method, frequency of dividend paid, Earning Yield Method, Earning stability, Price Earning Ratio, etc.

Cash Return On Assets

Moved to : Cash Flow Statement #TOC-Cash-Return-On-Assets

Vertical Analysis

A method of financial statement analysis in which each entry for each of the three major categories of accounts (assets, liabilities and equities) in a balance sheet is represented as a proportion of the total account. The main advantages of vertical analysis is that the balance sheets of businesses of all sizes can easily be compared. It also makes it easy to see relative annual changes within one business.

For example, suppose XYZ Corp. has three assets: cash and cash equivalents (worth $3 million), inventory (worth $8 million), and property (worth $9 million). If vertical analysis is used, the asset column will look like:

Cash and cash equivalents: 15%

Inventory: 40%

Property: 45%

This method of analysis contrasts with horizontal analysis, which uses one year's worth of entries as a baseline while every other year represents differences in terms of changes to that baseline.

Dividend Yield

A financial ratio that indicates how much a company pays out in dividends each year relative to its share price. Dividend yield is represented as a percentage and can be calculated by dividing the dollar value of dividends paid in a given year per share of stock held by the dollar value of one share of stock. The formula for calculating dividend yield may be represented as follows:

Not all of the tools of fundamental analysis work for every investor on every stock. If you are looking for high growth technology stocks, they are unlikely to turn up in any stock screens you run looking for dividend paying characteristics. However, if you are a value investor or looking for dividend income then there are a couple of measurements that are specific to you. For dividend investors, one of the telling metrics is Dividend Yield. This measurement tells you what percentage return a company pays out to shareholders in the form of dividends. Older, well-established companies tend to payout a higher percentage then do younger companies and their dividend history can be more consistent. You calculate the Dividend Yield by taking the annual dividend per share and divide by the stock’s price.

For example, if a company’s annual dividend is Rs. 1.50 and the stock trades at Rs. 25, the Dividend Yield is 6%. (Rs.1.50 / Rs.25 = 0.06)

Why Stocks that pay dividends tend to fall far less than their non-dividend paying counterparts ?

For many investors, this is a major part of the appeal as they can’t stomach huge drops or volatility. Of course, stocks are always going to be riskier than most other asset classes. On the whole, dividend paying stocks tend to display far more consistency that other enterprises

Here are the four major reasons why dividend-paying stocks tend to fall less during bear markets:

• 1. The Quality of Earnings is Higher.

It’s hard to fake cash. When shareholders get checks in the mail, there is at least some proof that the earnings aren’t just accounting magic. This makes people more comfortable holding the stocks during uncertain times because they know there is some value there.

• 2. Dividend paying stocks generate current income.

In depressions, recessions, or bear markets, many people may find themselves unemployed or earning less than they did during boom years. During times like this, you don’t want to part with something that consistently brings in funds for your family to use to buy groceries and gas unless you must. Typically, the shares of high growing, low payout stocks are the first, and hardest, to fall because you can’t use them to keep the power bill paid.

• 3. These stocks become “yield supported”.

As share price falls, dividend yield gets higher (the cash dividend divided by the share price is known as “dividend yield”). Imagine if a Rs. 200 stock paid a Rs. 10 annual cash dividend. That is a 5% return, which you would compare to all kinds of other available options such as money market accounts, bonds, etc. If the stock fell to Rs. 100 per share, the yield would suddenly be 10%. The stock would become more attractive and people or companies that did have excess funds, such as insurance groups or international corporations not damaged by domestic problems, are lured in by the relatively higher returns they can earn. If a company is healthy, in a world of 5% interest rates, it’s highly unlikely that it’s going to have a dividend yield of 15% or 20% because someone, somewhere, with a whole lot of cash is going to step into the situation.

• 4. Management doesn’t have as much capital to allocate.

Human nature being what it is, it’s often normal for executives to want to go on an empire-building spree, even if it means earning less attractive returns than their shareholders could if the money was put back into their hands. An established dividend policy solves a big part of this problem by limiting the funds that are available for stupid, overpriced acquisitions.

Hence, its always advisable to keep major allocation of your portfolio in high dividend yield companies during bear phase, you usually get better returns in terms of dividend yield.

Dividend Payout Ratio

There are some metrics used in fundamental analysis that fall into “dull” category. The Dividend Payout Ratio (DPR) is one of those numbers. It almost seems like a measurement invented because it looked like it was important, but nobody can really agree on why. The DPR (it usually doesn’t even warrant a capitalized abbreviation) measures what a company’s pays out to investors in the form of dividends.

You calculate the DPR by dividing the annual dividends per share by the Earnings Per Share.

It’s all about earnings. That is what investors want to know. How much money is the company making and how much is it going to make in the future. Earnings are profits. It may be complicated to calculate, but that’s what buying a company is about. Increasing earnings generally leads to a higher stock price and, in some cases, a regular dividend. When earnings fall short, the market may hammer the stock. Every quarter, companies report earnings. Analysts follow major companies closely and if they fall short of projected earnings, sound the alarm. While earnings are important, by themselves they don’t tell you anything about how the market values the stock. To begin building a picture of how the stock is valued you need to use some fundamental analysis tools. These ratios are easy to calculate, but you can find most of them already done on various financial websites..

One of the challenges of evaluating stocks is establishing an “apples to apples” comparison. What we mean by this is setting up a comparison that is meaningful so that the results help you make an investment decision. Comparing the price of two stocks is meaningless. Similarly, comparing the earnings of one company to another really doesn't make any sense, if you think about it. Using the raw numbers ignores the fact that the two companies undoubtedly have a different number of outstanding shares.

For example, companies A and B both earn Rs. 100, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which company’s stock do you want to own? It makes more sense to look at earnings per share (EPS) for use as a comparison tool. You calculate earnings per share by taking the net earnings and divide by the outstanding shares.

EPS = Net Earnings / Outstanding Shares

OR

Using our example above, Company A had earnings of Rs. 100 and 10 shares outstanding, which equals an EPS of 10 (Rs.100 / 10 = 10). Company B had earnings of Rs. 100 and 50 shares outstanding, which equals an EPS of 2 (Rs.100 / 50 = 2). So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some ratios.

Before we move on, you should note that there are three types of EPS numbers:

• Trailing EPS

Last year’s numbers and the only actual EPS

• Current EPS

This year’s numbers, which are still projections

• Forward EPS

future numbers, which are obviously projections

• Diluted EPS

The term "convertible instruments" refers to any financial instrument that could possibly be converted into a common shares. For reference, a few examples of convertible instruments that may be considered in the diluted earnings per share formula are stock options and convertible preferred stocks, but there are many others and anything than has the availability to be converted to a common share could be included.

Use of Diluted EPS

The diluted earnings per share is used by investors in replace of earnings per share to account for financial instruments that can be converted to shares. This conservative approach to calculating earnings per share may be used in lieu of the simple EPS formula as any convertible instrument could be converted at any time which could cause the real events to widely deviate from the simple EPS future estimates. This is especially important to consider when other financial formulas use earnings per share in its calculations. Diluted EPS is always less or equal to EPS

• Cash EPS

Cash EPS = operating cash flow (not EBITDA) / diluted shares outstanding.

Generally, cash EPS is more important than other EPS numbers, because it is a "purer" number. Cash EPS is better because operating cash flow cannot be manipulated as easily as net income and represents real cash earned, calculated by including changes in key asset categories, such as receivables and inventories. For example, a company with reported EPS of 50 cents and cash EPS of $1 is preferable to a firm with reported EPS of $1 and cash EPS of 50 cents. Although there are many factors to consider in evaluating these two hypothetical stocks, the company with cash is generally in better financial shape.

Other EPS numbers have overshadowed cash EPS, but we expect it to get more attention because of the new GAAP rule (FAS 142), which allows companies to stop amortizing goodwill. Companies may start talking about "cash EPS" in order to differentiate between pre-FAS 142 and post-FAS 142 results, however, this version of "cash EPS" is more like EBITDA per share and does not factor in changes in receivables and inventory. Consequently, it may not be as good as operating-cash-flow EPS, but is better in certain cases than other forms of EPS.

• Earning Yield

Earning yield is a great financial ratio which can be used very effectively to evaluate a stock. The process of calculating this ratio is very simple, first calculate the ‘Earning per share (EPS) and then divide EPS with current market price of stock.

How to use Earning yield to buy stock.

As a general rule, companies do not return all their earnings in a given year to shareholders. Instead they pay out a lesser amount. As a result, the earnings yield of a share and the dividend yield of a share are usually different. The formula for calculating the earnings yield in percentage terms of a stock is:

Suppose that the current price of a share is $80 and its annual earnings rate is $7. The earnings yield then is calculated like this:

So we would say here that the shares in this company are yielding an earnings rate of 8.75% at the current price.

To a great extent this is a reflection of the price/earnings ratio (P/E ratio) of a stock. If the above stock is selling at $80 and is earning $7 a share then, if you apply the P/E ratio formula, the answer is 11.42 (80/7). This means that a P/E ratio of 11.42 implies an earnings yield of 8.75 and vice versa.

Operating Profit Margin

A financial metric used to assess a firm's financial health by revealing the proportion of money left over from revenues after accounting for the cost of goods sold. Gross profit margin serves as the source for paying additional expenses and future savings.

It is also known as Operating profit Margin (OPM) , Return on Sales (ROS) or Gross Profit Margin.

A ratio widely used to evaluate a company's operational efficiency. ROS is also known as a firm's "operating profit margin" (OPM) . It is calculated using this formula

Operating Profit is the residual profit after deducting the cost of raw material, employee costs, sales & general expenses etc. from the sales revenue of any year. It shows the profitability of any company before the charges for capital structure (interest expense for debt raised) and capital-intensity (depreciation) of any business or taxes are deducted from sales revenue. OPM measures the profitability purely from core operations of any company without factoring in the non-operating income like interest income or dividend income.

Note: Some investors add interest expense back into net income when performing this calculation because they'd like to use operating returns before cost of borrowing.

Return on Equity(ROE)/ Return on Net worth (RONW)

In order to beat inflation over the long run, you need to own businesses that keep earning you 20%+ return on equity and at the same time, aren’t playing around with their balance sheets to create artificially high returns.

One important point to note here is that you must not be blind to a business that is earning a high return on equity, say in excess of 30-40% (like Infosys or TCS).

So, what should you do?

• Buy businesses that earn high return on equity consistently while keeping their borrowings low, but keep a watch on them and their competitors.
• Keep a watch on the money the company is spending on capex and/or incremental working capital, and question the logic behind such expenditure.
• If such new expenditure (on capex and/or working capital) doesn’t increase the company’s volumes and/or market share, it’s usually a warning signal of times to come.

Return on Capital Employed - ROCE

A financial ratio that measures a company's profitability and the efficiency with which its capital is employed. Return on Capital Employed (ROCE) is calculated as:

ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed

Capital Employed = Total Assets – Current Liabilities OR

Capital Employed = Shareholders Equity + Total Debt

“Capital Employed” as shown in the denominator is the sum of shareholders' equity and debt liabilities; it can be simplified as (Total Assets – Current Liabilities). Instead of using capital employed at an arbitrary point in time, analysts and investors often calculate ROCE based on “Average Capital Employed,” which takes the average of opening and closing capital employed for the time period.

A higher ROCE indicates more efficient use of capital. ROCE should be higher than the company’s capital cost; otherwise it indicates that the company is not employing its capital effectively and is not generating shareholder value.

ROCE is a useful metric for comparing profitability across companies based on the amount of capital they use. Consider two companies, Alpha and Beta, which operate in the same industry sector. Alpha has EBIT of $5 million on sales of $100 million in a given year, while Beta has EBIT of $7.5 million on sales of $100 million in the same year. On the face, it may appear that Beta should be the superior investment, since it has an EBIT margin of 7.5% compared with 5% for Alpha. But before making an investment decision, look at the capital employed by both companies. Let’s assume that Alpha has total capital of $25 million and Beta has total capital of $50 million. In this case, Alpha’s ROCE of 20% is superior to Beta’s ROCE of 15%, which means that Alpha does a better job of deploying its capital than Beta.

Compound Annual Growth Rate (CAGR)

It is the growth rate of a company expressed on an annualized basis. This also takes into consideration the effect of compounding. Let’s look at an example to understand it better.

Say the sales of a company 4 years back was 100. Today, after 4 years, it is 200. A simple conclusion is that sales has increases by 100% in 4 years. But does it mean that it has increased by 25% each year? That would not be correct, as simply dividing 100% by 4 doesn’t take into consideration the compounding effect.

So, to find out the per year growth rate of a company, we use the compound interest formula.

Where

A = Final Amount

P = Principal amount

r = Rate of interest, expressed in %

n = Number of years

In our example,

A = 200

P = 100

r = The annual growth rate (that we want to find out)

n = 4 years

From the above formula, we find out that r is around 19%.

• How to interpret?

It means that the average growth of the company over these 4 years, taking into account the impact of compounding, is 19%.

In the first year, the company grew from 100 to 119. In the second year, it grew 119 to 142. In the third year, it grew by 19% from 142 to 168.5, and in the fourth year, it grew from 168.5 to 200.

• Other Thoughts

This principle is very important to understand, because it is used at many places. For example, it is looked at while examining at returns generated by mutual funds (MFs). Whenever one sees returns for more than 1 year, they are expressed in terms of CAGR. If they are not expressed in CAGR terms, the returns are not accurate! CAGR should also be used while considering any investment. Just take the example of the Bhavishya Nirman Bonds issued by NABARD. These have been issued at around Rs. 9750. The investment is for 10 years, after which the investor gets back Rs. 20000.

Thus, the return is Rs. 20000 – Rs. 9750 = Rs. 10250, or 105% in 10 years.

Does this mean that the return is 10.5% per year? No! It has to be calculated using the CAGR formula, where:

A = 20000

P = 9250

r = Rate of return to be found out

n = 20 years,

Using the formula above, we find out that the rate is actually 7.5% per annum. Now, that’s quite far from 10.5%.

Price Ratios

Price ratios are quick and easy metrics to use when analyzing investment opportunities. They tell investors how high or how low a stock is valued relative to a business’s financial results.

Low price ratios are an important characteristic of a value stock. They provide an opportunity for investors to buy the stock at a relatively cheap price.

Price to Book (P/B)

Price to Earnings Ratio – P/E

If there is one number that people look at than more any other it is the Price to Earnings Ratio (P/E). The P/E is one of those numbers that investors throw around with great authority as if it told the whole story. Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.) The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider. You calculate the P/E by taking the share price and dividing it by the company’s EPS.

P/E = Stock Price / EPS

P/B = Share Price / Book Value Per Share

• Calculation: (P/B) = Share Price/Book Value per Share

• Definition: Book value is found on the balance sheet. It’s calculated as total assets minus total liabilities. In theory, book value is the amount of money available to shareholders if the company stopped operating. The formal name for book value is shareholder’s equity.
• How it’s used: The P/B ratio compares a stock price to the net assets of a business. Since the purpose of a business is to make money from the assets it owns, a profitable company will be priced higher than its book value. A company with a negative outlook and declining profits could be priced below its book value.
• Pros: Analyzing a company’s book value allows investors to know exactly what they are buying at a particular point in time. Net asset values are relatively stable and do not drastically change from one quarter to another.
• Cons: Assets and liabilities are accounting figures which are subject to inexact measures and can easily be manipulated by dishonest managers.

Like the P/E, the lower the P/B, the better the value. Value investors would use a low P/B in stock screens, for instance, to identify potential candidates.

Price to Sales – P/S (Market cap/Sales)

In simple words - The number of days required to clear its inventory.

Cost of sales = Expenses from Income statement

Days Receivables outstanding (DRO) (DSO)

The approximate amount of time that it takes for a business to receive payments owed, in terms of receivables, from its customers and clients. It is also known as day sales outstanding (DSO) or Average collection period or Days Receivable outstanding

A measure of the average number of days that a company takes to collect cash after a sale has been made.

• A low DSO number means that it takes a company fewer days to collect its accounts receivable.
• A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money.

Calculated as:

Where:

Days = Total amount of days in period

AR = Average amount of accounts receivables

Credit Sales = Total amount of net credit sales during period

It's an efficiency ratio or activity ratio that measures how many times a business can turn its accounts receivable into cash during a period.

Average AccountReceivables = Average cash to be collected from clients ie ((Total cash to be collected at the beginning of year+total cash to be collected at the end of the year)/2)

• A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient.
• A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm.

Inventory Turnover Ratio

A ratio showing how many times a company's inventory is sold and replaced over a period (generally in 1 year). The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand or "inventory turnover days."

Higher ratio indicates that a company is able to rotate its inventory faster and its capital is not stuck in inventory.

Ideally, Inventory turnover ratio should be stable or increase with improving performance. Declining Inventory turnover ratio should raise the flags and an investor should delve deeper to understand its cause. If the investor is not satisfied with the outcome then she should avoid investment in such company and look for other opportunities.

Fixed Asset Turnover

This ratio is often used as a measure in manufacturing industries, where major purchases are made for PP&E to help increase output. When companies make these large purchases, prudent investors watch this ratio in following years to see how effective the investment in the fixed assets was.

Fixed Assets Turnover Ratio indicates how efficiency a company is using its assets. A Fixed Assets Turnover Ratio of two indicates that every incremental investment of INR 1 in its plants and machinery would increase its sales by INR 2. A higher Fixed Assets Turnover Ratio is always preferable and indicates good use of shareholders’ funds.

Ideally, Fixed Assets Turnover Ratio should be stable or increase with improving performance. Declining Fixed Assets Turnover Ratio should raise the flags and an investor should delve deeper to understand its cause. If the investor is not satisfied with the outcome then she should avoid investment in such a company and look for other opportunities.

High fixed asset turnover in commodity chemicals space indicates that a lot of competitors can start manufacturing the same product with limited investment and in turn pose a risk to the market of the company in case it tries to increase its product prices. Therefore, it won’t come as a surprise to the investor that Bhageria Industries Limited has witnessed fluctuating profitability margins as it is not able to pass on the increases in the raw material costs to its customers on account of such competition

Asset Turnover

The amount of sales or revenues generated per dollar of assets. The Asset Turnover ratio is an indicator of the efficiency with which a company is deploying its assets.

Asset Turnover = Sales or Revenues/Total Assets

Generally speaking, the higher the ratio, the better it is, since it implies the company is generating more revenues per dollar of assets. But since this ratio varies widely from one industry to the next, comparisons are only meaningful when they are made for different companies in the same sector.

Courtesy - Investopedia