Chapter 14: Company Analysis Flashcards
1
Q
What would the analysis of a company’s comprehensive income tell you?
A
whether management is making good use of the company’s resources.
2
Q
What does the analysis of a company’s comprehensive income tell you about?
A
whether management is making good use of the company’s resources.
3
Q
What is the possible reason for an increasing company’s revenue?
A
- price or volume of product increase
- introduced new products
- expand to new market
- consolidate with another company acquired in takeover
- receive an initial contribution from a new plant or diversification program
- Gain market share of competitors
- launch an aggressive advertising and promotional campaign
- benefit from new industry legislation
- temporarily increased when a strike occurred at a major competitor
- upswing in the business cycle occurred
4
Q
why a analysts need to isolate the main factors affecting revenue?
A
to evaluate developments for their positive or negative impact on future performance
5
Q
What does an analyst should take a look after revenue?
A
cost of sales (operation costs)
6
Q
What kind of performance of operating costs that indicate a company is having difficulty keeping overall cost under control and the consequence?
A
If they have a rising trend over several years. This could lead to a loss of potential profit.
7
Q
What is the major factor that impact the gross profit margin of a company?
A
The cost of raw materials. (Companies rely on commodities such as copper or nickel, for example, may have to cope with wide swings in raw material costs from one year to another)
8
Q
What are the reasons for a company to pay unusually high dividends? (>65%)
A
- stable earning
- 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
9
Q
What are the reasons for a company to pay low dividends?
A
- earnings reinvested
- growing earning may indicate a future increase in the dividend
- cyclical earnings at their peak, along with a company policy to maintain the same dividend in food and bad times
- policy for buying back shares rather than distributing the high dividends.
10
Q
What should you consider in analyzing the statement of financial position?
A
capital structure (debt and equity) and the effect of leverage
11
Q
What should you consider in analyzing capital structure?
A
- if there’s large debt issue approaching maturity (they may refinance by new securities)
- Retractable securities (company may have to refinance if investors choose to retract) and 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
12
Q
When do the earnings of a compnay are said to be leveraged?
A
if the capital structure contains debt or preferred shares -> can affect EPS quicklier in both direction when using leverage.
13
Q
what are other features that you should analyze a company apart from revenue, operation cost, capital structure, and leverage before investing in common share?
A
- Qualitative analysis (assess management effectiveness and other intangibles)
- liquidity of common shares (how easy to sell or buy)
- continuous monitoring.
14
Q
What are the warning signs you can find in the Notes of the Financial statements?
A
- Changes in accounting practices or auditors (revenue and profit might change just because of that. A change of auditor might be a sign that they don’t agree in how certain’s transaction treated)
- A series of mergers and takeovers (can acquire a series of smaller companies to make statement better or hide the loss of parent company)
15
Q
Why we should use trend analysis?
A
because one-year ratio have limited value on their own and they become meaningful when comparing with other ratios (compare with a different year or with similar companies or with industry averages)
16
Q
How analysts identify trends?
A
- Selecting a base period, treating figure or ratio for that period as 100
- dividing it into the comparable ratios for subsequent period.
17
Q
What is the advantage of trend ratios?
A
- show changes clearly
- simple and easy than the alternative
18
Q
What is the disadvantage of trend ratios?
A
- If the base period is not truly representative, the trend line is misleading
- Impossible to use if the base period figure is negative.
19
Q
When compare to industry ratio, should you use the current average or historical industry standards?
A
both to get a fair and thorough analysis.
20
Q
what are the four types of ratios are commonly used to analyze a company’s financial statements?
A
- Liquidity ratio
- Risk analysis ratios
- Operating performance ratio
- Value ratios
21
Q
What is liquidity ratio?
A
Used to judge the company’s ability to meet its short-term commitments (ex: working capital raito = current assets/current liabilities)
22
Q
What is risk analysis ratios?
A
Show how well the company can deal with its debt obligations (ex: debt-to-equity ratio)
23
Q
What is operating performance ratios?
A
illustrate how well management is making use of the company’s resources (ex: net profit margin ratio)
24
Q
What are value ratios?
A
show the investor what the company’s shares are worth or the return on owning them (ex: price-to-earnings ratio P/E)
25
What do you need to notice when using ratios to analyze?
1. Ratios must be used in the context
2. Ratios are not proof just clues
3. ratio is not the same for all companies (supermarket vs producing company)
26
What are the common liquidity ratios?
1. Working capital ratio
| 2. Quick ratio (the acid test)
27
What is working capital ratio ? (Current ratio)
= Current assets/current liabilities
| Ex: if it = 2.8 means they have 2.84 of cash and equivalents to pay for every 1 dollar current liabilities.
28
When analyzing working captial ratio, what should you notice?
- What are the current asset, cash or inventory, what is the inventory turnover rate, credit terms, ...
- Current ratio does not translate to multiples (20 is not 10 times better than the company has 2, because >5 have been an unnecessary accumulation of funds.
- Different business have different working capital requirements (cycle of produce and sell is quick then they don't need too much current asset because they can receive money from the sale)
29
What is quick ratio? (the acid test)
= (current assets - inventories)/current liabilities
- Show how well current liabilities are covered by cash and by items with a ready cash value.
- No standard for quick ratio but >=1 is considered good liquid position. However, sometimes <1 is still also good.
30
What are the common ratio of risk analysis ratio?
1. Asset coverage ratio
2. Debt-to-equity ratio
3. Cash flow-to-total debt outstanding ratio
4. Interest coverage ratio
31
What is asset coverage ratio?
- shows a company's ability to cover its debt obligations with its assets after all non-debt liabilities have been satisfied
- Show the next tangible assets (NTA) of the company for each $1000 of total debt outstanding -> enable debtholder to measure the protection provided by tangible assets after all liabilities have been met.
32
How to calculate asset coverage ratio?
= [tangible assets - (current liabilities - short term debt)]/total debt outstanding
- Ex: =5 means company has 5000$ for each 1000$ of total debt outstanding.
- Industry standards for this ratio vary.
33
What is the tangible asset?
= total assets - goodwill and other intangible assets
34
What is debt-to-equity ratio?
shows the proportion of borrowed funds used relative to the investment made by shareholders
35
How to calculate debt-to-equity ratio?
= total debt outstanding / equity
- if too high -> borrowed excessively -> risk
- ex: = 0.20 or 20% means debt is about 20% of equity.
36
What is cash flow-to-total debt outstanding ratio?
- Gauges (đánh giá) a company’s ability to repay the funds it has borrowed.
- Short-term borrowings must normally be repaid or rolled over within a year. Corporate debt issues commonly have sinking funds requiring annual cash outlays.
- > A company’s cash flow from operating activities should therefore be adequate to meet these commitments.
37
What kind of activities cash flow used in cash flow-to-total debt outstanding ratio?
- from operating activities (measure ability to generate funds internally)
- Other things being equal, a company with a large and increasing cash flow is better able to finance expansion using its own funds, without the need to issue new securities.
- The increased interest or dividend costs of new securities issues may reduce cash flow and earnings, and issues of convertibles or warrants may dilute the value of common stock.
38
How to calculate cash flow from operating activities?
```
Company profits
+ All deductions not requiring a cash outlay, such as amortization
– All additions not received in cash
+ The change in net working capital
= Cash flow from operations
```
39
Why does they use cash flow from operating activities rather than profit alone when calculating ratio?
Because of the substantial size of non-cash items on a statement of comprehensive income -> it is considered to be a better indicator of the ability to pay dividends and finance expansion.
40
When does cash flow from operating activities is particularly useful?
when comparing companies within the same industry -> it can reveal whether a company can meet its debts no matter how the profit is.
-> the cash flow statement puts cash flow from operating activities into perspective as a source of funds available to meet financial requirements
41
How to calculate the ratio cash flow to total debt outstanding?
= Cash Flow from Operating Activities / Total Debt Outstanding
- > high ratio is positive
- > low ratio is negative
- there is minimum standards to assess debt repayment capacity and provide another perspective on debt evaluation. (For example, for retail stores might be 0.2 to 1 over five years, meaning that annual cash flow in each of the last five fiscal years was at least 20% of total debt outstanding)
42
How long is the period that analysts usually calculate the trend of cash flow too total debt outstanding?
- 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.
43
What does the interest coverage reveal?
- Show the ability to pay the interest charges on its debt based on profit that it has available to pay the interest.
- Important because a company’s inability to meet its interest charges could result in bankruptcy.
- For all kinds of interest because Default on any one debt may lead to default on other debts.
44
Is interest coverage ratio considered to be the most important quantitative test of risk when considering a debt security?
Yes. The greater the coverage, the greater the margin of safety.
45
What is a common practice related to interest coverage ratio?
- Is to set criteria to assess the adequacy of interest coverage. (EX: you may decide that an industrial company’s annual interest requirements the last five years should be covered at least three times in each year. At this level you would consider its debt securities to be of acceptable investment quality)
46
What is interest coverage standard mean?
- It indicate the likelihood that a company will be able to meet its interest obligations.
- A company may fail to meet the coverage standards while still meeting its debt obligations. However, its securities would be considered a much higher risk because the company lacks an acceptable margin of safety.
47
When analyzing interest coverage, should you calculate on year or year-to-year trend?
- year-to-year trend.
- Ideally, this ratio will increase year by year to exceed the standard. A stable trend where the company meets the minimum standard is also considered acceptable.
48
When should you analyze further a company's financial position?
- If there is a deteriorating trend (xu hướng xấu đi) suggests that further analysis is required to determine whether the company’s financial position has seriously weakened.
- For aberrations in the trend (can be result of prolonged strike) may drop ratio a single year, but will probably not impair the company’s basic financial soundness.
49
When should you revaluate the investment quality of a debt issue?
- A steep decline in earnings. Particularly if the decline is prolonged, it may indicate a fundamental deterioration (suy thoái cơ bản) in the company’s financial position.
- A sudden reversal (đảo chiều đột ngột) from a profit to a loss also merits close scrutiny (xem xét kỹ lưỡng).
- A rapid build-up in short-term borrowings, could also reduce the investment quality of a company’s debt securities.
50
How to calculate the interest coverage ratio?
= Profit Before Interest Charges and Taxes / Interest Charges
- Standards vary from industry to industry, and even for in the same industry based on past earnings records and future prospects.
(A high interest coverage ratio is not required for utility companies. By contrast, 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.)
51
What are the common ratio in Operating performance ratio?
1. Gross profit margin ratio
2. Net profit margin ratio
3. Net return on common equity ratio
4. inventory turnover ratio
52
What is Gross profit margin ratio?
- Useful both for calculating internal trend lines and for making comparisons with other companies
= (Revenue - Cost of Sales) / Revenue
- Indicate the efficiency of management in turning over the company’s goods at a profit -> shows the company’s rate of profit after allowing for the cost of sales.
- Especially useful in industries like food products and cosmetics, where both the turnover rate and competition level are high.
53
What is net profit margin ratio?
- Important indicator of the efficiency of a company’s management after taking both expenses and taxes into account.
= (Profit - Share of Profit of Associates) / Revenue
- it effectively sums up in a single figure management’s ability to run the business.
54
What is Net return (after tax return) on common equity ratio?
- Shows the dollar amount of earnings that were produced for each dollar invested by the company’s common shareholders.
= Profit / Total Equity
- The trend 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. Further quantitative analysis is needed -> shows that shareholders' 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.
55
What is inventory turnover ratio?
- Measures the number of times that a company’s inventory is turned over in a year.
= Cost of Sales / Inventory
- Can be expressed as a number of days required to achieve turnover. (= 365/Inventory turnover ratio).
- A high turnover ratio is considered good because the company requires a smaller investment in inventory than one producing the same revenue with a low turnover.
- vary from industry to industry. (ex: food industry vs aircraft manufacturers).
56
What kind of industries that have high and what industries have low inventory turnover ratio?
- high-turnover industries include those involved in baked goods, cosmetics, dairy products, groceries, and meat packing—in other words, industries dealing in perishable goods and quick-consumption, low-cost items.
- low-turnover industries include distillers, producers of fur goods, heavy machinery manufacturers, steel plants, and wineries.
57
What does it mean when a company has an above-average inventory turnover rate for its industry?
- Indicates a better balance between inventory and sales volume. The company is unlikely to be caught with too much inventory if the price of raw materials drops or the market demand for its products falls. There should also be less wastage due to deterioration in quality or marketability.
- If inventory turnover is too high in relation to industry norms, the company may have problems with shortages resulting in lost sales.
58
What are the reasons for A company to have a low inventory turnover rate?
* The inventory contains an unusually large portion of unsaleable goods.
* The company has over-bought inventory.
* The value of the inventory has been overstated.
59
How important is the way inventory position. is managed?
directly affects the company’s earnings and the rate of return earned on the company’s common equity. (Because a large part of a company’s working capital is usually tied up in inventory)
60
What is value ratio?
- Value ratios (market ratios) measure the way the stock market rates a company by comparing the market price of its shares to information in its financial statements.
- Price alone does not tell analysts much about a company unless there is a common way to relate the price to dividends and earnings.
61
What are the common ratios in Value ratio?
1. PERCENTAGE DIVIDEND PAYOUT RATIOS
2. EARNINGS PER COMMON SHARE
3. DIVIDEND YIELD
4. EQUITY VALUE PER COMMON SHARE
5. PRICE-TO-EARNINGS RATIO
6. DIVIDEND DISCOUNT MODEL
62
What is dividend payout ratio?
- indicates the percentage of the company’s profit that is paid out to shareholders in the form of dividends
= (Common Share Dividends / Profit) * 100
- unstable because they are tied directly to the earnings of the company.
- If dividends > earnings for the year, the payout ratio > 100%. Dividends are then taken out of retained earnings, which erodes the value of the shareholders’ equity.
63
What is earnings per common share ratio? (EPS)
- shows the earnings available to each common share
= Profit / Weighted Average Number of Common Shares Outstanding
- Important element in judging an appropriate market price for buying or selling common stock.
- In practice, a 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.
64
What is dilution of the stock’s value?
- Dilution occurs when the number of shares outstanding increases (convertible securities, warrant, employee stock options), which results in each existing shareholder owning a smaller percentage of the company.
- Fully diluted EPS can be calculated on common stock outstanding plus common stock equivalents (all possibilities)
65
What factors should you consider when estimating the dividend possibilities of a stock?
* The amount of profit for the current fiscal year
* 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)
66
What is dividend yield on common stock?
- Is the annual dividend rate expressed as a percentage of the current market price of the stock -> represents the investor’s return on the investment.
= (Indicated Annual Dividend per Share / Current Market Price) * 100
-> allow quick comparison between the shares of different companies.
67
What should you consider to make a thorough comparison?
• 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
Consider all these factors during a company analysis, in addition to yield, and preferably over several years.
68
What is The equity value per common share ratio (book value per common share)?
- Measures the net asset coverage for each common share if all assets were sold and all liabilities were paid.
= Equity / Number of Common Shares Outstanding
- sometimes used in appraising common shares (in reality, it is very different from market price)
- This disparity (chenh lech) between equity and market values is usually accounted for by the actual or potential earning power of the company.
69
What is Price to earning ratio? (P/E)
- the most widely used of all financial ratios because it combines all the other ratios into one figure.
- It represents the ultimate evaluation of a company and its shares by the investing public.
- only for common stocks.
= Current Market Price of Common Shares / Earnings per Share
- The company with the lower P/E ratio is usually the better buy.
70
What is The main reason for calculating EPS, apart from determining dividend protection?
- is to compare it to the share’s market price.
- The P/E ratio expresses this comparison in one convenient figure, showing that a share is selling at so many times its actual or anticipated annual earnings. This figure allows you to compare the shares of one company with those of another.
71
what are the 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
- > All these factors are taken into account when investors and speculators collectively decide what price a share is worth.
72
How to use P/E to compare the different companies?
- the companies should usually be in the same industry.
- Analysts also consider individual company P/Es in relation to the relevant market index or average. They compare that number with an average relative P/E over some period of time, such as three years or five years.
73
What is the advantage of P/E ratio?
- Determine a reasonable value for a common stock at any time in a market cycle. By calculating a company’s P/E ratio over a number of years, you will find considerable fluctuation, with high and low points. 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.
- A study of the P/E ratios of competitor companies and that of the relevant market subgroup index also provides a perspective.
- As a rule, P/E ratios increase in a rising stock market or with rising earnings. Earnings that increase over time are a favourable sign; the company’s stock price should also rise over time. Investors see rising earnings as a positivedevelopment and are willing to pay a higher price for the stock. The increase in the stock price is usually greater than the increase in earnings; therefore, the P/E ratio increases. The reverse is true in a declining market or when earnings decline.
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. Because the P/E ratio is an indicator of investor confidence, its highs and lows may vary from market cycle to market cycle. Much depends on changes in investor enthusiasm for a company or an industry over several years. The P/E ratios of individual stocks are also affected by many factors specific to individual companies, such as comparative growth rates, earnings quality, and risk due to leverage or stock liquidity.
74
What is the dividend discount model (DDM) for?
- Show how companies with stable growth are priced in theory.
- The model relates a stock’s current price to the present value of all expected future dividends into the indefinite future.
- a useful way to think of stock valuation
75
What are the assumption of DDM (constant or Gordon growth model)?
- The DDM assumes
+ There is an indefinite stream of dividend payments, whose present values can be calculated.
+ These dividends will grow at a constant rate
(The discount rate used is the market’s required or expected rate of return for that type of investment).
76
How to calculate DDM (constant or Gordon growth model)?
```
Price = [div0 (1 +g)] / (r-g) = div1 / (r-g)
P= The current intrinsic value of the stock in question
div0 = The dividend paid out in the current year
div1 = The expected dividend paid out by the company in one year
r = The required rate of return on the stock
g = The assumed constant growth rate for dividends
```
77
Where are the three critical questions for The investment quality assessment of preferred shares ?
* 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?
78
What are the 4 keys to answer the three critical questions for The investment quality assessment of preferred shares?
1. Preferred dividend coverage ratio
2. Equity (or book value) per preferred share
3. Dividend payments
4. Credit assessment
79
What is Preferred dividend coverage ratio?
Like interest coverage, the 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, as it indicates the company has little difficulty in paying its preferred dividend requirements. Typically, preferred dividend coverage is calculated for the last five years, and a trend is plotted. Ideally, a rising or stable trend is revealed. The calculation of this ratio is beyond the scope of this textbook.
80
What is Equity (or book value) per preferred share?
Preferred shares rank before common shares in any liquidation, winding up, or distribution of assets. When the preferred shareholders’ claims have been met, the holders of common shares are entitled to what is left. Analysts like to see that 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. The calculation of equity per preferred share is beyond the scope of this textbook.
81
What is Dividend payments?
As an analyst, you should ask whether the company has established a record of continuous dividend payments to its preferred shareholders. You can obtain this information from individual company annual reports.
82
What is Credit assessment?
Just as with bonds, a company’s preferred shares may be rated by one of the recognized securities rating services. During your analysis, you should ask what the rating is and is it high enough to merit investment.
83
How rating can affect price of preferred share?
An unexpected change in the rating of a preferred share issue usually affects the shares’ market price. An unexpected downgrade to a lower rating has negative implications, whereas an upgrade is a favourable development.
84
How to choose a preferred share?
Other factors need to consider include marketability, volume of trading, and research coverage by investment firms. And:
• What features 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.
