In the company analysis the investor assimilates the several bits of information related to the company and evaluates the present and future values of the stock. The risk and return associated with the purchase of the stock is analysed to take better investment decisions. The valuation process depends upon the investors’ ability to elicit information from the relationship and inter-relationship among the company related variables. The present and future values are affected by a number of factors and they are given in fig.
The Competitive Edge of the Company
Major industries in India are composed of hundreds of individual companies. The in the information technology industry even though the number of companies is large, few companies like Tata InfoTech, Satyam computers, Infosys, NIIT etc., control the major market share. Like-wise in all industries, some companies rise to the position of eminence and dominance. The large companies are successful in meeting the competition. Once the companies obtain the leadership position in the market, they seldom lose it. Over the time they would have proved their ability to withstand competition and to have a sizeable share in the market. The competitiveness of the company can be studied with the help of
➢ The market share
➢ The growth of annual sales
➢ The stability of annual sales
The Market Share
The market share of the annual sales helps to determine a company’s relative competitive position within the industry. If the market share is high, the company would be able to meet the terms of sales in 1997. While analyzing the market share, the size of the company also should be considered because the smaller companies may find it difficult to survive in the future. The leading companies of today’s market will continue to lead at least in the near future. The companies in the market should be compared with like product groups otherwise, the results will be misleading. A software company should be compared with other software companies to select the best in that industry.
Growth of Sales
The company may be a leading company, but if the growth in sales in comparatively lower than another company, it indicates the possibility of the company losing the leadership. The rapid growth in sales would keep the shareholder in a better position than one with the stagnant growth rate. The company of large size with inadequate growth in sales will not be preferred by the investors. Growth in sales is usually followed by the growth in profits. Investor generally prefers size and the growth in sales because the larger size companies may be able to withstand the business cycle rather than the company of smaller size.
The growth in sales of the company is analysed both in rupee terms and in physical terms. Physical term is very essential because it shows the growth in real terms. The rupee term is affected by the inflation. Companies with diversified sales are compared in rupee terms and percentage of growth over time.
Stability of Sales
If a firm has stable sales revenue, other things being remaining constant, will have more stable earning and wide variations in capacity utilization, financial planning and dividend. Periodically all the financial newspapers provide information about the market share of different companies in an industry. The fall in the market share indicates the declining trend of the company, even if the sales are stable in absolute terms. Hence, the stability of sales also should be compared with its market share and the competitors’ market shares.
Sales Forecast
The Company may be in a superior position commanding more sales both in monetary terms and physical terms but the investor should have an idea whether it will continue in future or not. For this purpose, forecast of sales has to be done. He can forecast the sales in different ways.
- The investor can fit a trend line either linear or nor linear whichever is suitable.
- Historical percentage of company sales to the industry sales can be analysed. Even simple least square technique could be used to find out the function Cs = f (I) i.e. Cs – company sales; I – Industry sales.
- The sales growth can be compared with the macro-economic variables like gross domestic product, per capita income and population growth.
- The different components of demand for the company’s product have to be analysed because the demand may arise from different sources. For some product the demand may be from the consumers as well as from the industries. For example, steel and petroleum products are demand by consumers and industries.
- The demand for the substitutes and competitors’ product also should be analysed using least square techniques.
Earnings of the Company
Sales alone do not increase the earnings but the costs and expenses of the company also influence the earnings of the company. Further, earnings do not always increase with the increase in sales. The company’s sales might have increased but its earnings per share may decline due to the rise in costs. The rate of change in earnings differs from the rate of change of sales. Sales may increase by 10% in a company but earnings per share may increase only by 5%. Even though there is a relationship between sales and earnings, it is not a perfect one. Sometimes, the volume of sales may decline but the earnings may improve due to the rise in the unit price of the article. Hence, the investor should not depend only on the sales, but should analyse the earnings of the company.
The income for the company is generated through operating sources and nonoperating sources. The sources of operating income vary from industry to industry. For the service industry no tangible product is involved and income is generated through sales of services. Take the case of commercial bank, its income is the interest on loans and investments. Interest income is referred to operating income. But in the case of industries producing tangible goods earnings arise from the sale of goods.
The companies, in addition to the revenue from sales, may get revenue from other sources too. The non-operating income may be generated from interest from bonds, rentals from lease, dividends from securities and sale of assets. The investor should analyse the income source diligently whether it is from the sale of assets or it is from investments. Sometimes earning per share may seem to be attractive in a particular year but in actual case the revenue generated through sales may be comparatively lower than in the previous year. The earnings might have been generated through the sale of assets.
The investor should be aware that income of the company may vary due to the following reasons.
➢ Change in sales
➢ Change in costs
➢ Depreciation method adopted
➢ Depletion of resources in the case of oil, mining, forest products, gas etc.
➢ Inventory accounting method
➢ Replacement cost of inventories
➢ Wages, salaries and fringe benefits
➢ Income taxes and other taxes.
Capital Structure
The equity holders’ return can be increased manifold with the help of financial leverage, i.e., using debt financing along with equity financing. The effect of financial leverage is measured by computing leverage ratios. The debt ratio indicates the position of the long term and short term debts in the company finance. The debt may be in the form of debentures and term loans from financial institutions.
Preference Shares
In the early days the preference share capital was never a significant source of capital. At present, many companies resort to preference shares. The preference shares induct some degree of leverage in finance. The leverage effect of the preference shares is comparatively lesser than the debt because the preference share dividends are not tax deductible. If the portion of preference share in the capital is larger, it tends to create instability in the earnings of the equity shares when the earnings of the company fluctuate. Sometimes the preference share may be convertible preference share; in that case it dilutes the earnings per share. So the investor should look into the preference share component of the capital structure.
Debt
Long term debt is an important source of finance. It has the specific benefit of low cost of capital because interest is tax deductible. The leverage effect of debt is highly advantageous to the equity holders. During the boom period the positive side of the leverage effect increases the earnings of the share holders. At the same time, during recession the leverage effect inducts instability in earnings per share and can lead to bankruptcy. Hence, it is important to limit the debt component of the capital to a reasonable level. The limit depends on the firm’s earning capacity and its fixed assets.
(i) Earnings Limit of Debt
The earnings determine whether the debt is excessive or not. The earnings indicate the probability of insolvency. The ratio used to find out the limit of the debts is the interest coverage ratio i.e., the ratio of net income after taxes to interest paid on debt. The ratio shows the firm’s ability to pay the interest charges, the number of times interest is covered by earnings.
(ii) Assets Limit to Debt
This asset limit is found out by fixed assets to debt ratio. The financing of fixed assets by the debt should be within a reasonable limit. For industrial units the recommended ratio level is below 0.5.
Management
Good and capable management generates profit to the investors. The management of the firm should efficiently plan, organize, actuate and control the activities of the company. The basic objective of management is to attain the stated objectives of company are achieved, investors will have a profit. A management that ignores profit does more harm to the investors than one that over emphasizes it. The good management depends on the qualities of the manager. Koontz and O’Donnell suggest the following as a special trait of an able manager:
➢ Ability to get along with people
➢ Leadership
➢ Analytical competence
➢ Industry
➢ Judgement
➢ Ability to get things done
Since the traits are difficult to measure, managerial performance is evaluated against setting and accomplishing a verifiable objective. If the investor needs greater proof of excellence of management, he has to analyse management ability. The analysis can be carried out on the following ways:
- The background of managerial personnel contributes much to the success of the management. The manager’s age, educational background, advancement within the company, levels of responsibility achieved and the activities in the social sphere can be studied.
- The record of management over the past years has to be reviewed. For several companies what the top management have done during its tenure in office are given in the financial weeklies and monthlies along with critical comments. This gives an insight into the ability of the top management.
- The management’s skill to have market share ahead of others is a proof of managerial success. The investor can rely on this type of management and choose the stock.
- The next criterion the investor should analyse is the company’s strength to expand. A firm may expand from within and diversify products in the known lines. Sometimes it may acquire an other company to expand its market. The horizontal or vertical expansion of the production is a health sign of an efficient management.
- The management’s ability to maintain efficient production by proper utilization or plant and machinery has to be analysed. Suitable inventory planning and scheduling have to be drafted and worked out by the management.
- The management’s capacity to finance the company adequately has to be studied. Accomplishing the financial requirement is a direct reflection of managerial ability. The management should adopt a realistic dividend policy in relation to earnings. A realistic dividend policy boosts the image of the company’s stock in the market.
- The functional ability of management to work with employees and union is another area of concern. A union poses a threat to the smooth functioning of the firm. In this context the management should be able to maintain harmonious relationship with the employees and unions.
- The management’s adaptability to scientific management and quality control techniques should be analysed. The management should be able to give due weightage to maintain technical competence.
After analyzing the above mentioned factors, the investor should select companies that possess excellent management and maintain the competitive position of the company in the market. The investor should also remember that the individual traits of a single manager alone cannot make the company profitable and there should be a strong management system to do so.
Operating Efficiency
The operating efficiency of a company directly affects the earnings of a company. An expanding company that maintains high operating efficiency with a low break-even point earns more than the company with high break-even point. If a firm has stable operating ratio, the revenues also would be stable.
Efficient use of fixed assets with raw materials, labour and management would lead to more income from sales. This leads to internal fund generation for the expansion of the firm. A growing company should have low operating ratio to meet the growing demand for its product.
Operating Leverage
If the firm’s fixed cost is high in the total cost the firm is said to have a high degree of operating leverage. Leverage means the use of a lever to raise a heavy object with a small force. High degree of operating leverage implies, other factors being held constant, relatively small change in sales result in a large change in return on equity. This can be explained with the help of the following example.
Let us take firm A and B. The firm A has relatively small amount of fixed charges say, INR 40,000. Firm A would not have much automated equipment, so its depreciation and maintenance costs are low. The variable cost per cent is higher than it would be if the firm used more automated equipment, In the other case firm B has high fixed costs, INR 1,20,000.
Here the firm uses automated equipment (with which one operator can turn out many units at the same labour cost) to a much larger extent. The break-even occurs at 40,000 units in firm A and 60,000 units in firm B. The selling price (P) is INR 4; the variable cost is INR 3 for firm A and INR 2 for firm B percent.
The break-even occurs when ROE (return on equity) = 0, and hence, when earnings before interest and taxes (EBIT) = 0.
EBIT = 0 = PQ – VQ – F
Here P is the average sales price per unit of output, Q is units of output, V is the variable cost per unit, and F is the fixed operating costs. The break-even quantity is = F / (P-V)
For Firm A = INR 40,000/INR 4 – INR 3 = 40,000 units
Firm B = INR 1,20,000/INR 4 – INR 2 = 60,000 units
To a large extent, operating leverage is determined by technology. For example, telephone companies, iron and steel companies and electric utilities have heavy investments in fixed assets leading to high fixed costs and operating leverage. On the other hand cosmetics companies, and consumer goods producing companies may need significantly lower fixed costs, and hence lower operating leverage.
The investor should understand the operating leverage of the firm because the firm with high operating leverage is affected much by the cyclical decline. The operating efficiency of the firm determines the profit expectation of the company.
Financial Analysis
The best source of financial information about a company is its own financial statements. This is a primary source of information for evaluating the investment prospects in the particular company’s stock. Financial statement analysis is the study of a company’s financial statement from various viewpoints. The statement gives the historical and current information about the company’s operations. Historical financial statement helps to predict the future. The current information aids to analyse the present status of the company.
The two main statements used in the analysis are:
➢ Balance sheet
➢ Profit and loss account
The Balance Sheet
The balance sheet shows all the company’s sources of funds (liabilities and stockholders’ equity) and uses of funds at a given point of time. The balance sheet can either be in the horizontal form or vertical form. Table show the balance sheet of Sky Company in horizontal and vertical form respectively.
The balance sheet provides an account of the capital structure of the Sky Company. The network and the outstanding long term debt are known from the balance sheet. The debt has certain advantages in terms of cost and market acceptability. The use of debt creates financial leverage beneficial or detrimental to the shareholders depending on the size and stability of earnings.
If revenues are stable and certain, a large amount of debt can be carried and it is beneficial to the shareholder. If the earnings fluctuate, the debt should below in the capital structure, so that the payment of interest may not be detrimental to the shareholders. It is better for the investor to avoid a company with excessive debt component in its capital structure. From the balance sheet, liquidity position of the company can also be assessed with the information on current assets and current liabilities. The overall ability to pay its short term obligations can be found out.
The Profit and Loss Account
Analysis of the financial condition of the company requires a report on the flow of funds too. The income statement reports the flow of funds from business operations that takes place in between two points of time. It lists down the items of income and expenditure. The difference between the income and expenditure represents profit or loss for the period. It is also called income and expenditure statement. Profit and loss account of the Sky Ltd., is given in table. The investor should be aware of the limitations of the financial statements.
Limitations of Financial Statements
- The financial statements contain historical information. This information is useful; but an investor should be concerned more about the present and future.
- Financial statements are prepared on the basis of certain accounting concepts and conventions. An investor should know them.
- The statements contain only information that can be measured in monetary units. For example, the loss incurred by a firm due to flood or fire is included because it can be expressed in monetary terms. The loss incurred by the company due to the loss of reputation is not given in the statement because it cannot be measured in monetary unit.
- Sometimes management may resort to manipulation of data and window dressing. This can be carried out by
- Method of charging depreciation
- Valuation of inventory
- Revaluation of fixed asset
- Changing the accounting year
An investor should scrutinize the financial statements to find out the manipulations, if any. The auditors’, report and notes to the balance sheet give vital clue to the investor in this regard. Analysis of financial statements should be undertaken only after nullifying the effects of any such manipulation.
Analysis of Financial Statement
The analysis of financial statements reveals the nature of relationship between income and expenditure, and the sources and application of funds. The investor determines the financial position and the progress of the company through analysis. The investor is interested in the yield and safety of his capital. He cares much about the profitability and the management’s policy regarding the dividend.
Towards this end, he can use the following simple analysis.
➢ Comparative financial statements
➢ Trend analysis
➢ Common size statements
➢ Fund flow analysis
➢ Cash flow analysis
➢ Ratio analysis
Comparative Financial Statement
In the comparative statement balance sheet figures are provided for more than one year. The comparative financial statement provides time perspective to the balance sheet figures. The annual data are compared with similar data of previous years, either in absolute terms or in percentages.
Trend Analysis
Here percentages are calculated with a base year. This would provide insight into the growth or decline of the sale or profit over the years. Sometimes sales may be increasing continuously, and the inventories may also be rising. This would indicate the loss of market share of the particular company’s product. Likewise sales may have an increasing trend but profits may remain the same. Here the investor has to look into the cost and management efficiency of the company.
Common Size Statement
Common size balance sheet shows the percentage of each asset item to the total assets and each liability item to the total liabilities. Similarly, a common size income statement shows each item of expense as a percentage of net sales. With common size statement comparison can be made between two different size firms belonging to the same industry. For a same company over the years common size statement can be prepared.
Fund Flow Analysis
The balance sheet gives a static picture of the company’s position on a particular date. It does not revel the changes that have occurred in the financial position of the unit over a period of time.
The investor should know,
- How are the profit utilized?
- Financial source of dividend
- Source of finance for capital expenditures
- Source of finance for repayment of debt
- The destiny of the sale proceeds of the fixed assets and
- Use of the proceeds of the share for debenture issue or fixed deposits raised from public.
These items of information are provided in the funds flow statement. It is a statement of the sources and applications of funds. It highlights the changes in the financial condition of a business enterprise between two balance sheet dates. The investor could see clearly the amount of funds generated or lost in operations. He could see how these funds have been divided into three significant uses like taxes, dividends and reserves. Moreover, the application of long term funds towards the acquisition of current assets can be found out. This would reveal the real picture of the financial position of the company.
Cash Flow Statement
The investor is interested in knowing the cash inflow and outflow of the enterprise. The cash flow statement is prepared with the help of balance sheet, income statement and some additional information. It can be either prepared in the vertical form or in the horizontal form. Cash flows related to operations and other transactions are calculated. The statement shows the causes of changes in cash balance between two balance sheet dates. With the help of this statement the investor can review the cash movements over an operating cycle. The factors responsible for the reduction of cash balances in spite of increase in profits or vice versa can be found out.
Ratio Analysis
Ratio is a relationship between two figures expressed mathematically. Financial ratio provides numerical relationship between two relevant financial data. Financial ratios are calculated from the balance sheet and loss account. The relationship can be either expressed as a percent or as a quotient. Ratios summarise the data for easy understanding, comparison and interpretation. Financial ratios may be divided into six groups.
They are listed below:
➢ Liquidity Ratios
➢ Turnover Ratios
➢ Leverage Ratios
➢ Profit Margin Ratios
➢ Return on Investment Ratios
➢ Valuation Ratios
Liquidity Ratio
Liquidity means the ability of the firm to meet its short term obligations. Current ratio and acid test ratio are the most popular ratios used to analyse the liquidity. The liquidity ratio indicates the liquidity in a rough fashion and the adequacy of the working capital.
Turnover Ratios
The turnover ratios show how well the assets are used the extent of excess inventory, if any. These ratios are also known as activity ratios or asset management ratios. Commonly calculated ratios are sales to current assets, sales to fixed assets, sales to inventory, receivable to sales and total assets to turnover. Each ratio has a specific application. Sales to current asset ratio shows the utilization of the current assets and sales to fixed asset ratio indicates the fixed asset utilization. The sales to inventory management. The receivable to sales gives a view of the receivable management.
The Leverage Ratios
The investors are generally interested to find out the debt portion of the capital. The debt affects the dividend payment because of the outflow of profit in the form of interest. The financial leverage affects the risk and return aspects of holding the shares. The total debt to total assets ratio indicates the percentage of borrowed funds in the firm’s assets.
Interest Coverage Ratio
This shows how many times the operating income covers the interest payment.
Interest coverage ratio = E B I T/Interest
Profitability Ratio
Profitability ratios relate the firm’s profit with factors that generate the profits. The investor is very particular in knowing net profit to sales, net profit to total assets and net profit to equity. The profitability ratios measure the overall efficiency of the firm.
Net Profit Margin Ratio
This ratio indicates the net profit per rupee of sales revenue
Net Profit Margin = P A T/Sales
Return on Assets
The return on asset measures the overall efficiency of capital invested in business.
Return on assets = Net income/Total assets
Return on Equity
Here, the net profit is related to the firm’s capital
Return on equity = Net Profit/Net worth
Valuation Ratios
The shareholders are interested in assessing the value of the shares. The value of the
share depends on the performance of the firm and the market factors. The performance
of the firm in turn depends on a host of factors. Hence, the valuation ratios provide a
comprehensive measure of the performance of the firm itself.
Book Value Per Share
This ratio indicates the share of equity shareholders after the company has paid
all its liabilities, creditors, debenture holders and preference shareholders. At the time of
liquidation, the shareholders can know what remains after making all the payments. In
ordinary time also it helps the shareholder to find out his real position in the company.
Book value per share = Eqity share capital + Reserve/Total number of equity shares outstanding
OR
= Networth – Preference share capital/Total number of equity shares outstanding
Dividend to Market Price
Dividend is the regular income received by the shareholder. The shareholder would like to know the relationship between the market price and the dividend. Suppose “A” company pays INR 4 per share and the market value is INR 50. Then
Dividend yield = Dividend per share/Market price per share x 100
= 4/50 x 100 = 8%
Even though the “A” company provides 40 percent dividend its actual yield is low because of the high market price. Whenever companies plough back their profits to settle the loans or for expansion program, the yield would be low. At the same time, if the company distributes profits to shareholders the yield may be high. This may not be proper indicator. The earnings per share is treated as a better guide in investment decisions.
Earnings Per Share
Earnings per share is the earnings after tax divided by the number of common shares outstanding.
EPS = E A T/Number of shares outstanding
Lerner and Carleton have given a model for the EPS.
EPS = (I – T) [R + (R – 1) L/E] E / Number of common shares outstanding
EPS - Earnings per share
T - Effective tax rate (Tax exposure/EBT)
R - Before tax return on assets (EBIT/A)
I - Effective interest rate (Interest expense / liabilities)
E - Equity
The model gives a comprehensive outlook of the earnings per share. According to the model the earnings per share is effected by the following factors.
- Utilisation of assets in the company
- Margin on sales
- Effective cost of the borrowed funds
- Debt-equity ratio
- Equity base of the company
- Effective tax rate paid by the company
Growth in Earnings
Further, the growth in earnings also influences the value of the stock. The growth in earnings depends on the earnings retained and reinvested in the firm.
The rate of return on equity also influences the growth rate
Growth rate = Retention rate x Return on equity = RR x ROE
The same can be rewritten as follows:
Growth rate = RR x Sales/Total assets x Total assets/Equity x Net income/Sales
RR = Retained earnings / Net income = RE/NI
Substituting and rearranging we get
Growth Rate = RE/NI x NI/Sales x Sales/TA x TA/EQ = RE/EQ
This analysis is known as DuPont analysis because it was popularized by DuPont Company.
Price Earnings Ratio
One of the most common financial parameters used in the stock market is the price earnings ratio (P/E). it relates the share price with earnings per share. Most of the news papers along with the stock price quotations give the P/E ratio too. The P/E ratio is the multiplying factor that the market is willing to offer to the company’s future earnings. In the “A” company’s earnings per share is INR 6 and price INR 50, then:
Price – Earnings Ratio = Market price per share/Earnings per share
= INR 50/INR 6 = 8.33 times
The P/E of 8.33 means that the market is prepared to pay INR 8.33 for every rupee of future earnings. The past performance is the base for the estimate. High P/E ratio indicates high expectation of the market regarding the growth of future earnings of the company. The P/E ratio has links with other financial parameters like dividend payout, dividend growth rate and the cost of company’s funds. Large dividend payouts, high dividend growth rates and low cost of funds will result in high P/E ratios.
The investors generally compare the P/E ratio of the company with that of the industry and market. A P/E ratio lower than industry means that the stock is underpriced. Investors should be careful n comparing the scrip’s P/E with the industry’s P/E because sometimes, the industry P/E may be high due to overheated market. In such a situation, the industry’s P/E should be moderated to acceptable levels. The investor can also forecast the future P/E ratio and compare it with the present P/E to assess the extent of under pricing of the particular share. Forecast can be done by studying fundamental factors and applying statistical techniques using past P/E data. The comparison of the estimated P/E ratio with the actual P/E ratio leads to one of these three conclusions given below:
- If the current P/E ratio is larger than the E (P/E) ratio, the stock is overpriced. It is better to sell the shares before the fall in price.
- If the current P/E ratio is smaller than the E (P/E) ratio, the stock is underpriced and it could be a best buy with the expectation of the rise in price.
- If the current P/E ratio equals the E(P/E) ratio, the stock is correctly priced. No significant changes in prices are likely to occur.
Intrinsic Value
The true economic worth of the share is its intrinsic value. The fundamental analysis find out the intrinsic value of a share of using the following formula:
Intrinsic value of a share = normalized EPS x Expected P/E ratio
The expected P/E ratio can be found out by
E(P/E) = Cash dividend / E(EPS) / Discount rate – growth rate = D/E(EPS) / K – g
The numerator is:
Payout ratio = Cash dividend per share / Expected earnings per share = D/E (EPS)
To forecast the P/E, the analyst should have the following details:
➢ Stock’s risk – adjusted discount rate (K)
➢ Growth rate (g)
➢ Cash dividend per share (D)
➢ Earnings per share (EPS)
➢ Pay out ratio (D/E)
The simple technique adopted by the analyst is as follows:
Intrinsic value = Average P/E ratio over the years x Present earnings per share
OR
= Average P/BV ratio over the years x Present book value per share
This calculation is based on the assumptions that
- The trend in the profitability of the immediate past and the present will continue to be the same.
- The average P/E, P/BV and average earnings to equity ratio remain constant over a period of time.
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