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Chapter 14 Company analysis - Coggle Diagram

- - - - the reasons for increase in revenue
        
        “It increased the prices or volumes of its products.
        
        • It introduced new products.
        
        • It expanded into a new geographic market.
        
        • It consolidated with another company acquired in a takeover.
        
        • It received an initial contribution from a new plant or diversification program.
        
        • It gained market share at the expense of competitors.
        
        • It launched an aggressive advertising and promotional campaign.
        
        • It benefited from new industry legislation.
        
        • Sales temporarily increased when a strike occurred at a major competitor.
        
        • An upswing in the business cycle occurred.”
    - - A rising trend: a company is having difficulty keeping overall costs under control; losing potential profits
      - A falling trend: operating cost effectively and more profitable in the future
      - “ the main reasons for any changes in a company’s ability to pay its operating costs”
        
        -measure using the gross profit margin ratio; 1. Raw materials has a major impact on company's gross profit margin; 2. the introduction of new products or services with wider profit margins
    - - “The company may have an unusually high dividend payout rate (more than 65%, for example) for any of several reasons”
        
        “Stable earnings that allow a high payout
        
        • Declining earnings, which may indicate a future cut in the dividend
        
        • Earnings based on resources that are being depleted, as in the case of some mining companies”
      - A low payout reflect any of the following factors
        
        “Earnings reinvested back into a growth company’s operations
        
        • Growing earnings, which may indicate a future increase in the dividend
        
        • Cyclical earnings at their peak, along with a company policy to maintain the same dividend in good and bad times
        
        • A company policy of buying back shares, rather than distributing earnings through higher dividend payouts”
  - - - “The capital structure of a company refers to the distribution of debt and equity that comprise the company’s finances. ”
        “reveals the amount of debt used in its operations. Analysis may indicate the need for future financing. As well as the type of security that might be used. ”
    - - “A large debt issue approaching maturity may have to be refinanced by a new securities issue or by other means.
      - • Retractable securities may also have to be refinanced if investors choose to retract. A similar possibility exists for extendible bonds.
      - • Convertible securities represent a potential decrease in earnings per common share (EPS) through dilution.
      - • Any outstanding warrants or stock options represent a potential increase in common shares outstanding.
    - - “The earnings of a company are said to be leveraged if the capital structure contains debt or preferred shares”
      - “In comparison to companies without leverage, earnings increase faster during an upswing in the business cycle and collapse more quickly as economic conditions deteriorate”
      - “a relatively small increase in revenue can produce a magnified increase in EPS. ”
        “ The market action of shares in leveraged companies shows considerable volatility.”
  - - - “assess management effectiveness and other intangibles that cannot be measured with concrete data. ”
      - “contact with industry and company executives, experience, judgment, and even intuition.”
    - - “how easy it is to sell or buy a security on a stock exchange without causing significant movement in its price. Trading should be sufficient to absorb transactions without undue distortion in the market price.
        
        “Information on trading volume is readily available from most financial newspapers and stock exchange publications.”
        
        “Institutional investors dealing in large blocks of shares require a high degree of liquidity. ”
    - - “monitoring the operations of the company for changes that might affect the price of its shares and the dividends it pays. ”
      - “Quarterly financial reports to shareholders are an especially important source of information, which you should scrutinize in detail
      - “glean useful material from prospectuses, trade journals, and financial publications.”
- - - - calculation: current assets/ current liabilities
      - current ratio: 2/1 means company has $2 cash and equivalents to pay for each $1 of its debt
    - - Definition : “Current assets are cash and other company possessions that can be readily turned into cash (and normally would be) within one year. Current liabilities are liabilities of the company that must be paid within the year.”
      - “How you interpret the ratio depends on the type of business, composition of current assets, inventory turnover rate, and credit terms. ”
      - “The current ratio does not easily translate into multiples.”
        e.g. “A company that consistently maintains a current ratio that exceeds 5 to 1 may have an unnecessary accumulation of funds :“ too much inventory or from financial mismanagement”
      - “Different businesses have different working capital requirements”
      - A current ratio that exceeds 5 may signify that the company has an unnecessary accumulation of funds which could indicate sales problems or financial mismanagement.
    - - “The second of the two most common corporate liquidity ratios—the quick ratio (also called the acid test)”
      - calculation : (current assets- inventories)/ current liabilities
      - “offers a more conservative test of a company’s ability to meet its current obligations. It shows how well current liabilities are covered by cash and by items with a ready cash value.”
      - more stringent than the current ratio
      - “There is no absolute standard for the quick ratio, but 1 to 1 or better suggests a good liquid position. ”
      - “However, companies with a quick ratio of less than 1 to 1 may be in equally good shape if they have a high rate of inventory turnover. Inventory that is turned over quickly is the equivalent of cash. ”
        e.g. retail store chain with large inventories and a high turnover rate
  - - - “The asset coverage ratio shows a company’s ability to cover its debt obligations with its assets after all non-debt liabilities have been satisfied.”
      - “This ratio typically shows the net tangible assets (NTA) of the company for each $1,000 of total debt outstanding.”
      - Tangible assets - (current liabilities- short term debt) / total debt outstanding
      - “tangible assets are the company’s total assets less goodwill and other intangible assets.”
      - “Current liabilities do not include short-term debt such as short-term borrowings and the current portion of long-term debt when calculating asset coverage.”
      - “Industry standards for this ratio vary, due in part to the stability of income provided by the company.”
        e.g. utilities company has a fair return on its investment
    - - “ shows the proportion of borrowed funds used relative to the investments made by shareholders in the company”
      - calculation: total debt outstanding / equity (equity = share capital + retained earning + non-control interest)
      - “If the ratio is too high, it may indicate that the company has borrowed excessively, it may increase its financial risk”
        “If the debt burden is too large, it reduces the margin of safety protecting the debtholder’s capital, increases the company’s fixed charges, and reduces earnings available for dividends. In times of recession or high interest rates, a high debt burden could cause a financial crisis for the company”
      - “We have excluded other liabilities to focus the ratio on the company’s financial risk, based on leverage through the use of debt”
    - - “Cash flow from operating activities is a measure of a company’s ability to generate funds internally”
      - “The cash flow-to-total debt outstanding ratio gauges a company’s ability to repay the funds it has borrowed.
      - “Because of the substantial size of non-cash items on a statement of comprehensive income, cash flow from operating activities frequently provides a broader picture of a company’s earning power than profit alone. (better indicator)”
      - “A relatively high ratio of cash flow to total debt outstanding is considered positive, whereas a low ratio is negative. ”
      - “analysts usually calculate the cash flow-to-total debt outstanding ratio for each of the last five fiscal years. An improving trend is desirable. ”
      - “A declining trend may indicate weakening financial strength unless the individual ratios for each year are well above the minimum standards”
      - calculation: cash flow from operating activities / total debt outstanding
    - - “The interest coverage ratio reveals the ability of a company to pay the interest charges on its debt based on profit that it has available to pay the interest.”
      - “The ratio also indicates whether there is a margin of safety for interest coverage. H”
      - “must consider all interest charges. Default on any one debt may lead to default on other debts.”
      - “ the most important quantitative test of risk when considering a debt security. ”
        “Overall, the greater the coverage, the greater the margin of safety.”
      - calculation: profit before interest charges and taxes/ interest charges
      - “In general, the lower the ratio, the more a company is burdened by interest charges to cover its debt.”
        ratio: 8.21/1 means “it shows that the company had $8.21 of profit out of which to pay every $1.00 of interest owing.”
      - “A high interest coverage ratio is not required for utility companies. ”
        “the profits of retail companies are likely to be more volatile, so a higher coverage ratio is necessary to provide a greater margin of safety.”
  - - - “useful both for calculating internal trend lines and for making comparisons with other companies,”
      - calculation : (Revenue - cost of sales) / revenue
      - “This ratio is especially useful in industries such as food products and cosmetics, where both the turnover rate and competition level are high”
        iBooks.
      - “The gross margin is an indication of the efficiency of management in turning over the company’s goods at a profit. In other words, it shows the company’s rate of profit after allowing for the cost of sales.”
    - - “an important indicator of the efficiency of a company’s management after taking both expenses and taxes into account”
      - Calculation: (profit- share of profit of associates) / revenue
      - “The calculation shows how much of the money the company collected as revenue remains as its profit.”
      - “Not all companies have made investments in associates. Therefore, for comparisons between companies or from one year to another, the profit must be shown before the share of profit of associates is added in.
    - - “measures the number of times that a company’s inventory is turned over in a year”
        “ a number of days required to achieve turnover”
      - calculation: cost of sales/ inventory
      - “A high turnover ratio is considered good because the company requires a smaller investment in inventory ”
      - e.g. 3.13/a means: turn over its inventory 3.13 times over the span of a year or every 116.61 days (365/ 3.13)
      - “Inventory turnover rates vary from industry to industry. ”
        e.g. food, cosmetics, dairy, groceries , meat packing perishable goods, (quick assumption/ low-cost items) have high turnover
      - “Examples of low-turnover industries include distillers, producers of fur goods, heavy machinery manufacturers, steel plants, and wineries.”
      - “A company may have a low inventory turnover rate for any of the following reasons”
        
        “The inventory contains an unusually large portion of unsaleable goods.
        
        • The company has over-bought inventory.
        
        • The value of the inventory has been overstated.”
    - - “The net (or after tax) return on common equity ratio, which shows the dollar amount of earnings that were produced for each dollar invested by the company’s common shareholders”
      - calculation : profit/ total equity
      - “indicates management’s effectiveness in maintaining or increasing profitability in relation to the common equity capital of the company.”
      - “A declining trend suggests that operating efficiency is waning”
        investment is being used less productively
      - “This ratio is very important for common shareholders because it reflects the profitability of their capital in the business.”
      - 0.0908/1 mean: $0.09 earned for each dollar invested
  - - - “indicates the percentage of the company’s profit that is paid out to shareholders in the form of dividend”
      - calculation : common share dividends / profit * 100
      - e.g. 32.8% means: “paid out 32.08% of available earnings as dividends in the year; therefore, 67.92% was reinvested in the business.”
      - “Dividend payout ratios are generally unstable because they are tied directly to the earnings of the company, which change from year to year.”
        if dividends are greater than earnings for the year, the payout ratio will exceed 100%, erodes the value of the shareholders' equity
    - - “The EPS ratio, which shows the earnings available to each common share”
      - calculation : profit/ weighted average number of common shares outstanding
      - “A rising trend in EPS has favourable implications for the price of a stock”
      - “ common stock’s market price reflects the anticipated trend in EPS for the next 12 to 24 months, rather than the current EPS. Thus, it is common practice to estimate EPS for the next year or two.”
      - “Fully diluted EPS can be calculated on common stock outstanding plus common stock equivalents such as convertible preferred stock, convertible debentures, stock options (under employee stock-option plans), and warrants.”
      - “When estimating the dividend possibilities of a stock, you should consider the following factors”
        
        “The stability of profit over a period of years
        
        • The amount of retained earnings and the rate of return on those earnings
        
        • The company’s working capital
        
        • The policy of the board of directors
        
        • Plans for expanding (or contracting) operations
        
        • Government dividend restraints (if any)”
        
        “The amount of profit for the current fiscal year”
    - - “The dividend yield on common stock is the annual dividend rate expressed as a percentage of the current market price of the stock. It represents the investor’s return on the investment”
      - Calculation : indicated annual dividend per share / current market price *100
      - e.g. 3.81% means: common stock is 3.81% of the current market place
      - consider the following factors
        
        “The differences in the quality and record of each company’s management
        
        • The proportion of earnings reinvested in each company
        
        • The equity behind each share”
    - - “The equity value per common share ratio, also called book value per common share, measures the net asset coverage for each common share if all assets were sold and all liabilities were paid”
      - calculation : equity/ number of common share outstanding
      - “This disparity between equity and market values is usually accounted for by the actual or potential earning power of the company. ”
    - - most widely used of all financial ratios
      - calculation: current market price of common shares / earnings per share
      - the share is selling at so many times its actual or anticipated annual earnings ; e.g. 10:1 means: selling at 10 timess earnings
      - “Two types of elements determine the quality of an issue and are therefore represented in the P/E ratio”
        
        “Tangible elements contained in financial data, which can be expressed in ratios relating to liquidity, earnings trends, profitability, dividend payout, and financial strength
        
        • Intangible elements, such as quality of management, nature and prospects for the industry in which the issuing company operates, its competitive position, and its individual prospects”
      - “In practice, however, most investment analysts and firms make their own projections of a company’s earnings for the next twelve-month period.”
        many variables involved in forecasting earning, should be cautious
      - “If the highs and lows of a particular stock’s P/E ratio remain constant over several stock market cycles, they indicate selling and buying points for the stock”
      - “ if two companies of equal stature in the same industry both have similar prospects but different P/E ratios, the company with the lower P/E ratio is usually the better buy.”
      - “As a rule, P/E ratios increase in a rising stock market or with rising earnings. ”
      - “Generally, it is assumed that when investor confidence is high, P/E ratios are also high, and when confidence is low, P/E ratios are low.”
    - - “how companies with stable growth are priced, at least in theory. ”
      - “The DDM assumes that there will be an indefinite stream of dividend payments, whose present values can be calculated.”
        “It also assumes that these dividends will grow at a constant rate”
      - calculation : Price (intrinsic value of stock ) = Div1 / (r-g)
      - e.g. price = 33.33 means: the stock has an intrinsic value of $33.33, if selling for $25, the stock would be undervalued
- - - - “• Do the company’s earnings provide ample coverage for preferred dividends?
      - • For how many years has the company paid dividends without interruption?
      - • Is there an adequate cushion of equity behind each preferred share?”
    - - Preferred dividend coverage ratio
        
        “indicates the margin of safety for preferred dividends. It measures the amount of money a firm has to pay dividends to preferred shareholders”
        the higher the ratio the better
      - Equity ( book value) per preferred share
        
        “the minimum equity value per preferred share in each of the last five fiscal years is at least two times the dollar value of assets that each preferred share would be entitled to receive in the event of liquidation.”
      - Dividend payments
        
        “whether the company has established a record of continuous dividend payments to its preferred shareholders.”
      - Credit assessment
        
        “shares may be rated by one of the recognized securities rating services.”
        “An unexpected downgrade to a lower rating has negative implications, whereas an upgrade is a favourable development.”
  - - - “What features (such as cumulative dividends or sinking funds) and what protective provisions have been built into the issue?
      - • Is the yield from the preferred acceptable compared to yields from other, similar investments?”
    - - “Is the outlook for the common stock positive? A conversion privilege is valuable only if the market price of the common rises above the conversion price during the life of the conversion privilege.
      - • Is the life of the conversion privilege long enough? The longer the life of the conversion privilege, the greater the opportunity for the market price of the common and preferred to respond to favourable developments.”