Through my readings, I discovered that the famous investor Warren Buffet selects potential companies to invest based on the management effectiveness of the companies. After acquiring companies with good management, Warren Buffet lets the original management continue with their management of the company. There is usually no replacement of the original management after acquisition since the managment has already have a proven track record in profitability and a good organisational culture in place.
I shall share some pointers I learnt through my research on what makes a good management. My sharing is by no means exhaustive as the knowledge of good business management is vast beyond measure and constantly evolving.
A good management focuses on four indicators namely:-
1. Product and service quality
2. Reliability
3. Speed of execution
4. Adaptability
1. Product and service quality
The product or service offered by a company to it's customers must always be of the best quality possible. Products or services of the best possible quality will completely meet the needs of the customers and may even offer higher value than the expectations of customers. On the internal side of the organisation, the managment will put in place every controls to make sure the final product or service is of the best possible quality to meet customers' expectations and beyond.
For example, in a hotel, all product and service offering from the hotel rooms and furnishings, customer service by staffs, hotel food offering and ambience will need to be of the best quality based on the type of the hotel standards. The hotel should meet the expectations of it's customers, if not exceed their expectations in terms of it's products and services offered. To do so, the hotel must seek ways to find out what are the expectations of it's customers so as to better meet their expectations. The hotel must also seek feedback from it's customers on it's products and service offering so as to constantly maintain and even improve their standards in terms of product and service quality.
So, one indictor of management effectiveness is the product and service quality that the company is offering to it's customers. A lot goes into the strategic planning and execution by the management in order to reach the final presentation of it's quality product and service offering to it's customers. It is by no means easy.
2. Reliability
Reliability means how consistent the product and service offering can meet the expectations of the customers of a company. No use offering quality products and services that only meet the expectations of customers sometimes and while at other times, the products and services offered fail to meet the expectations of customers. An effective management must ensure consistency in it's product and service such that it will be able to meet the expectations of all it's customers all the time.
For a hotel, this means hotel rooms must be periodically maintained. Phone calls at the service counter must be answered within a set time. Room guests must always get their rooms at exact set times for check-ins and check-outs must be finished within a set time (as fast as possible) to prevent any delay to the schedule of the guests. Food must be prepared and always served at exact set times for the room guests.
As one can see, reliability is based on consistency in standards. A good management always strives to maintain a consistent standard in the quality of it's product and service so that the product and service quality is not only good but most importantly also consistently good.
3. Speed of execution
The quality product and service offered must be able to meet the expectations of customers fast enough. There are different expectations in terms of speed of execution depending on what type of products or services are offered. However, generally customers will expect a reasonable time frame within that the product and service must be offered to them. The product and service must always be ready any moment to answer the needs and expectations of customers whenever required.
In a hotel, speed of execution in the product and service offered is more evident. To most hotel guests, time is of essence. The challenge of the hotel is to meet the personal schedule of every hotel guests so that no guests are delayed when they should expect to get their service on time.
It is by no means easy in terms of manpower and execution in order to answer the needs of every hotel guests on time so that no one gets delayed. This is thus another indicator of management effectiveness to make sure the product and service is offered with fast enough speed of execution to meet the expectations of customers at an agreed time frame.
4. Adaptability
This is another test of management effectiveness, the ability to make sudden changes when required to respond to changing needs of the customers. For a hotel, if a guest ask for a food that is not found on the food menu of the hotel restaurant, a good hotel service standard will mean the hotel will still try it's best to answer the unique needs of the guest. The hotel can promptly send personel to buy the ingredients for the new food and prepare it if possible. Or the hotel can try to order the food if it is available from another hotel nearby. The idea here is not to reject the requests of customers as much as possible, but instead try it's best to be flexible to make sudden changes to answer a different new expectation of the customer.
This is another test of management and organisational effectiveness, to be flexible always to anticipate sudden changes to the needs of it's customers.
Conclusion
These four indicators of management effectiveness are by no means easy to reach. However, the management that can better meet these four indicators will have in place strategies and execution measures to ensure the productivity of the organisation is always on the high side.
For an investor, one should look out for good management of businesses to invest in.
Showing posts with label Fundamental analysis. Show all posts
Showing posts with label Fundamental analysis. Show all posts
Wednesday, January 19, 2011
Friday, December 18, 2009
Looking at financial health of a company using debt ratios
A company can fund its operations and growth by using equity and debts. There are some debt ratios available that investors and analysts use to do a simple check into the financial health of a company. I shall provide a simple discussion on a few debt ratios with their uses and any limitations.
Debts is part and parcel of a company's capital structure. It is uncommon to find a company totally without any form of debts. However, there exists highly profitable companies (though the minorities) that do not require debts funding but all funding for the operations and growth of the company can be provided for by its retained earnings. Such excellent companies also boast of consistent high amounts of free cashflows in their accounts. As such, they employ minimal or no debts in funding their operations and growth. It is important to know where a company stands in terms of its amount of debts. A company that employs high amount of debts may run the risk of not being able to pay its debts when due and thus result in possible risk of bankruptcy.
To ascertain whether a company is financially healthy and is not employing a high debt load and burden, debt ratios are commonly used. To understand the use of such debt ratios, we need to first look at the two types of liabilities a company can incur. These two types are operational and debt liabilities. Liabilities falling under operational type include accounts payable, taxes payable and any forms of operating expenses. Liabilities falling under debts nature include notes payable, and any forms of short-term borrowings and long term borrowings.
Debt-Equity Ratio
Debt-equity ratio compares the total liabilities to shareholders' equity of a company. It reveals how much leverage a company engages. There is no hard and fast rule to tell whether a company is excessively leveraged. However, if a company is consistently more significantly leveraged to its similar competition in an industry, it may be a potential red flag for the company.
In looking at debt-equity ratio, the lower the ratio the better the financial health of a company. A lower ratio means lower total liabilities compared to the equity of a company. In using this ratio, one is considering the total liabilities which include both operational and debts liabilities. So, this ratio provides only a general look into all liabilities carried by the company compared to its equity. It does not focus on only the debts portion alone but also include other operational liabilities as well.
Capitalisation ratio
Capitalisation ratio provides a look into the amount of debts carried in a company's capital structure.
As capitalisation ratio considers only the debts portion compared to the total capital structure (capital raised by lenders and shareholders), it provides a more meaningful look into the composition of a company's capital structure. A lower capitalisation ratio indicates better financial position for a company.
Interest coverage ratio
Interest coverage ratio measures how easily a company can pay its interests on outstanding debts.
An interest coverage ratio of at least 1.5 or more is preferred. A lower interest coverage ratio may suggest that a company is taking on a high amount of interest expenses from a high amount of debts. A high interest coverage ratio also means a company has the capacity to further take on larger amount of debts (e.g. for expansion and growth opportunities) when required.
Cashflow to debt ratio
Cashflow to debt ratio provides a comparison between the operating cashflow and the total debts of a company. The total debts of a company will include short-term borrowings, current portion of long term debts and non-current portion of long term debts. This ratio seeks to measure how much the cash generated from operations can cover all total debts of a company.
Sometimes, free cashflow can also be used to substitute operating cashflow in the calculation. This will provide a more stringent measurement of the ability of the free cashflow generated by a company to cover its total debts. A high cashflow to debt ratio is preferred as it suggests the ability for the cashflows of a company to cover its total debts.
Conclusion
Debt ratios generally provide a look into the amount of debts carried by a company and measures the ability of a company to carry its debts at a financially healthy level. Almost all companies will carry different amounts of debts. Companies in different industries may also carry very different amount of debts. One should compare similar companies in an industry when using such financial ratios as the capital structure of companies in different industries may differ widely. Nevertheless, debt ratios help an investor to check for any potential warning signs on the financial health of a company. When assessing a company, amount of debts carried is only one component to look at. To have a better assessment of a company, an investor should look at the company holistically in many aspects, not just its capital structure alone.
Debts is part and parcel of a company's capital structure. It is uncommon to find a company totally without any form of debts. However, there exists highly profitable companies (though the minorities) that do not require debts funding but all funding for the operations and growth of the company can be provided for by its retained earnings. Such excellent companies also boast of consistent high amounts of free cashflows in their accounts. As such, they employ minimal or no debts in funding their operations and growth. It is important to know where a company stands in terms of its amount of debts. A company that employs high amount of debts may run the risk of not being able to pay its debts when due and thus result in possible risk of bankruptcy.
To ascertain whether a company is financially healthy and is not employing a high debt load and burden, debt ratios are commonly used. To understand the use of such debt ratios, we need to first look at the two types of liabilities a company can incur. These two types are operational and debt liabilities. Liabilities falling under operational type include accounts payable, taxes payable and any forms of operating expenses. Liabilities falling under debts nature include notes payable, and any forms of short-term borrowings and long term borrowings.
Debt-Equity Ratio
Debt-equity ratio compares the total liabilities to shareholders' equity of a company. It reveals how much leverage a company engages. There is no hard and fast rule to tell whether a company is excessively leveraged. However, if a company is consistently more significantly leveraged to its similar competition in an industry, it may be a potential red flag for the company.
In looking at debt-equity ratio, the lower the ratio the better the financial health of a company. A lower ratio means lower total liabilities compared to the equity of a company. In using this ratio, one is considering the total liabilities which include both operational and debts liabilities. So, this ratio provides only a general look into all liabilities carried by the company compared to its equity. It does not focus on only the debts portion alone but also include other operational liabilities as well.
Capitalisation ratio
Capitalisation ratio provides a look into the amount of debts carried in a company's capital structure.
As capitalisation ratio considers only the debts portion compared to the total capital structure (capital raised by lenders and shareholders), it provides a more meaningful look into the composition of a company's capital structure. A lower capitalisation ratio indicates better financial position for a company.
Interest coverage ratio
Interest coverage ratio measures how easily a company can pay its interests on outstanding debts.
An interest coverage ratio of at least 1.5 or more is preferred. A lower interest coverage ratio may suggest that a company is taking on a high amount of interest expenses from a high amount of debts. A high interest coverage ratio also means a company has the capacity to further take on larger amount of debts (e.g. for expansion and growth opportunities) when required.
Cashflow to debt ratio
Cashflow to debt ratio provides a comparison between the operating cashflow and the total debts of a company. The total debts of a company will include short-term borrowings, current portion of long term debts and non-current portion of long term debts. This ratio seeks to measure how much the cash generated from operations can cover all total debts of a company.
Sometimes, free cashflow can also be used to substitute operating cashflow in the calculation. This will provide a more stringent measurement of the ability of the free cashflow generated by a company to cover its total debts. A high cashflow to debt ratio is preferred as it suggests the ability for the cashflows of a company to cover its total debts.
Conclusion
Debt ratios generally provide a look into the amount of debts carried by a company and measures the ability of a company to carry its debts at a financially healthy level. Almost all companies will carry different amounts of debts. Companies in different industries may also carry very different amount of debts. One should compare similar companies in an industry when using such financial ratios as the capital structure of companies in different industries may differ widely. Nevertheless, debt ratios help an investor to check for any potential warning signs on the financial health of a company. When assessing a company, amount of debts carried is only one component to look at. To have a better assessment of a company, an investor should look at the company holistically in many aspects, not just its capital structure alone.
Sunday, November 29, 2009
Looking at liquidity (short-term financial health) of a company
I have discussed in an earlier post on "cash conversion cycle" as an important determinant of a company's short-term financial health (see http://jeremyowinvestingexperience.blogspot.com/2009/11/cash-conversion-cycle-important.html). Cash conversion cycle is an important yet often overlooked metric in assessing a company's short-term liquidity (working capital position). Why is it important to look at a company's short-term liquidity? It tells us the short-term financial health of the company, whether it has a positive working capital position.
Working Capital = Current Assets - Current Liabilities
It is important for a company to have a positive working capital position so that it's current assets can meet it's current liabilities (over a one year short-term period). If the current assets of a company is not able to meet it's current liabilities, a company will have to raise cash (by employing debts or other forms of capital raising) to meet it's current liabilities failing which in most drastic case may mean bankruptcy for the company.
Types of current assets and their amounts held by a company can influence it's liquidity and short-term financial health
There are various items that are considered as current assets that can be converted to cash in a one year short-term period (e.g. cash and cash equivalents, equities held for trading or sometimes called marketable securities or short-term investments, accounts receivables and inventory). The breakdown of all these current assets held by a company can be found under it's balance sheet statement.
It is important to understand how each of these types of current assets can affect the company's short-term financial health. Cash and cash equivalents are the most liquid of all the types of current assets that can be converted readily into cash to pay off current liabilities. Next in order are equities held for trading or any equivalent short-term investments that can be readily converted into cash. Accounts receivables are also fairly liquid depending on the estimated number of days a company needs to wait to receive payments for their goods sold or service rendered. Inventory is the least liquid assets held by a company because the company has to go through the entire process of selling and waiting for payments on the goods sold.
Thus, it is important to evaluate carefully the proportion of each type of current assets held by a company to determine it's short-term liquidity and financial health. A company may have a much higher total current assets than it's total current liabilities. However, if a substantial proportion of the current assets consists of inventory, it maybe quite worrying should a company not be able to sell it's goods under the inventory held. If a company has a trend over the years of high amount of assets held in it's inventory, this maybe a red flag for greater financial problems to come especially if the company also has a poor "cash conversion cycle" (high number of days required for the entire cash conversion cycle). All these may suggest difficulty in selling the company products and the company also has difficulty in collecting payments from products sold if the cash conversion cycle is poor. A high amount of current assets held in inventory may not always necessarily be a bad sign provided the company has an excellent cash conversion cycle.
Based on the order of liquidity of the various types of current assets, it may suggest that a higher amount of current assets held in cash and cash equivalents is best since it can be most readily converted into cash to meet the current liabilities. This is true only to a certain extent. If the company has a trend of having too much assets held in cash and cash equivalents, it may also suggest that the company is unable to deploy it's cash to productive use to grow it's business and make meaningful returns.
Thus, when evaluating any types of current assets, similar to evaluating any single metric of measurement, one has to be careful not to make any sweeping mistakes in judgment by not considering other metrics of measurements together in order to see the big overall picture of a company's investment worthiness. A trend of high amount of current assets held in inventory with a trend of increasing revenue, increasing net income, increasing gross and net margins and increasing positive cashflows may instead paint a good picture instead of a grim outlook based on making a biased judgment on looking at a trend of high amount of assets held in inventory alone.
Financial ratios to evaluate a company's liquidity and short-term financial health
When evaluating liquidity of a company, there are various financial ratios one can consider such as current ratio, quick ratio and cash conversion cycle. I have already discussed cash conversion cycle in my earlier post. I shall discuss current ratio and quick ratio, and then provide a comparison between these different types of financial ratios. All the figures used in the calculations of the financial ratios discussed below can be found under the current assets and current liabilities of the balance sheet statement.
Current ratio
Current ratio is the simplest financial ratio to determine the liquidity of a company. It is also the most commonly used and stated financial ratio by analysts and investment firms. The current ratio only measures the short-term financial health of a company by considering whether its current assets is able to meet its current liabilities. Thus, a current ratio of more than 1 is preferred so that a company's current assets can meet its current liabilities fully. The shortfall with using this financial ratio is that it does not consider the types of current assets and their amount held as mentioned above. By using this financial ratio, one is assuming that all current assets can be readily converted into cash to meet the current liabilities which often is not the case (e.g. inventory that cannot be sold quickly or accounts receivables that cannot be realised quickly).
Quick ratio
Another financial ratio that considers only the more liquid assets that can be converted into cash to meet the current liabilities is the quick ratio. As seen in the formula above, inventory is not considered in the caculation since it is not easily converted into cash (offers least liquidity). As such, quick ratio is a more conservative financial ratio than current ratio when assessing the short-term liquidity and financial health of a company. A quick ratio of more than 1 is preferred so as to allow the more liquid assets to meet the current liabilities fully.
Cash conversion cycle
Cash conversion cycle is another way to measure a company's liquidity based on considering the days in inventory, days in receivables and days payable outstanding (see my previous post on cash conversion cycle http://jeremyowinvestingexperience.blogspot.com/2009/11/cash-conversion-cycle-important.html). Cash conversion cycle is a better measurement of the liquidity and short-term financial health of a company by considering how fast the company sells it's goods held in inventory, how fast it receives payments for goods sold or services rendered and how long it can be able to delay it's payments to suppliers of goods. A company that can sell goods fast, receives payments fast and have sufficient time to pay it's suppliers has a shorter cash conversion cycle (in terms of shorter number of days) and thus a better liquidity and working capital position (ability to raise cash fast from it's operations) to meet it's currrent liabilities.
Thus, cash conversion cycle maybe a better and more critical way to measure a company's liquidity. Most often, it is a poor cash conversion cycle that drags down a company's liquidity and short-term financial health more so than the amounts and types of current assets held.
In conclusion, a careful investor does not base his assessment on any single metric alone. It is the overall assessment of a company based on many factors of consideration that matters because considering any single metric in isolation may result in an inaccurate judgement of a company's investment worthiness.
Working Capital = Current Assets - Current Liabilities
It is important for a company to have a positive working capital position so that it's current assets can meet it's current liabilities (over a one year short-term period). If the current assets of a company is not able to meet it's current liabilities, a company will have to raise cash (by employing debts or other forms of capital raising) to meet it's current liabilities failing which in most drastic case may mean bankruptcy for the company.
Types of current assets and their amounts held by a company can influence it's liquidity and short-term financial health
There are various items that are considered as current assets that can be converted to cash in a one year short-term period (e.g. cash and cash equivalents, equities held for trading or sometimes called marketable securities or short-term investments, accounts receivables and inventory). The breakdown of all these current assets held by a company can be found under it's balance sheet statement.
It is important to understand how each of these types of current assets can affect the company's short-term financial health. Cash and cash equivalents are the most liquid of all the types of current assets that can be converted readily into cash to pay off current liabilities. Next in order are equities held for trading or any equivalent short-term investments that can be readily converted into cash. Accounts receivables are also fairly liquid depending on the estimated number of days a company needs to wait to receive payments for their goods sold or service rendered. Inventory is the least liquid assets held by a company because the company has to go through the entire process of selling and waiting for payments on the goods sold.
Thus, it is important to evaluate carefully the proportion of each type of current assets held by a company to determine it's short-term liquidity and financial health. A company may have a much higher total current assets than it's total current liabilities. However, if a substantial proportion of the current assets consists of inventory, it maybe quite worrying should a company not be able to sell it's goods under the inventory held. If a company has a trend over the years of high amount of assets held in it's inventory, this maybe a red flag for greater financial problems to come especially if the company also has a poor "cash conversion cycle" (high number of days required for the entire cash conversion cycle). All these may suggest difficulty in selling the company products and the company also has difficulty in collecting payments from products sold if the cash conversion cycle is poor. A high amount of current assets held in inventory may not always necessarily be a bad sign provided the company has an excellent cash conversion cycle.
Based on the order of liquidity of the various types of current assets, it may suggest that a higher amount of current assets held in cash and cash equivalents is best since it can be most readily converted into cash to meet the current liabilities. This is true only to a certain extent. If the company has a trend of having too much assets held in cash and cash equivalents, it may also suggest that the company is unable to deploy it's cash to productive use to grow it's business and make meaningful returns.
Thus, when evaluating any types of current assets, similar to evaluating any single metric of measurement, one has to be careful not to make any sweeping mistakes in judgment by not considering other metrics of measurements together in order to see the big overall picture of a company's investment worthiness. A trend of high amount of current assets held in inventory with a trend of increasing revenue, increasing net income, increasing gross and net margins and increasing positive cashflows may instead paint a good picture instead of a grim outlook based on making a biased judgment on looking at a trend of high amount of assets held in inventory alone.
Financial ratios to evaluate a company's liquidity and short-term financial health
When evaluating liquidity of a company, there are various financial ratios one can consider such as current ratio, quick ratio and cash conversion cycle. I have already discussed cash conversion cycle in my earlier post. I shall discuss current ratio and quick ratio, and then provide a comparison between these different types of financial ratios. All the figures used in the calculations of the financial ratios discussed below can be found under the current assets and current liabilities of the balance sheet statement.
Current ratio
Current ratio is the simplest financial ratio to determine the liquidity of a company. It is also the most commonly used and stated financial ratio by analysts and investment firms. The current ratio only measures the short-term financial health of a company by considering whether its current assets is able to meet its current liabilities. Thus, a current ratio of more than 1 is preferred so that a company's current assets can meet its current liabilities fully. The shortfall with using this financial ratio is that it does not consider the types of current assets and their amount held as mentioned above. By using this financial ratio, one is assuming that all current assets can be readily converted into cash to meet the current liabilities which often is not the case (e.g. inventory that cannot be sold quickly or accounts receivables that cannot be realised quickly).
Quick ratio
Another financial ratio that considers only the more liquid assets that can be converted into cash to meet the current liabilities is the quick ratio. As seen in the formula above, inventory is not considered in the caculation since it is not easily converted into cash (offers least liquidity). As such, quick ratio is a more conservative financial ratio than current ratio when assessing the short-term liquidity and financial health of a company. A quick ratio of more than 1 is preferred so as to allow the more liquid assets to meet the current liabilities fully.
Cash conversion cycle
Cash conversion cycle is another way to measure a company's liquidity based on considering the days in inventory, days in receivables and days payable outstanding (see my previous post on cash conversion cycle http://jeremyowinvestingexperience.blogspot.com/2009/11/cash-conversion-cycle-important.html). Cash conversion cycle is a better measurement of the liquidity and short-term financial health of a company by considering how fast the company sells it's goods held in inventory, how fast it receives payments for goods sold or services rendered and how long it can be able to delay it's payments to suppliers of goods. A company that can sell goods fast, receives payments fast and have sufficient time to pay it's suppliers has a shorter cash conversion cycle (in terms of shorter number of days) and thus a better liquidity and working capital position (ability to raise cash fast from it's operations) to meet it's currrent liabilities.
Thus, cash conversion cycle maybe a better and more critical way to measure a company's liquidity. Most often, it is a poor cash conversion cycle that drags down a company's liquidity and short-term financial health more so than the amounts and types of current assets held.
In conclusion, a careful investor does not base his assessment on any single metric alone. It is the overall assessment of a company based on many factors of consideration that matters because considering any single metric in isolation may result in an inaccurate judgement of a company's investment worthiness.
Wednesday, November 18, 2009
Cash conversion cycle :- important parameter especially for retail businesses to manage!
I come across through my research, one overlooked and seldom discussed but very important metric which is "cash conversion cycle". Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables). Cash conversion cycle is especially important for retail businesses that rely heavily on selling their goods fast and receiving payments fast and being able to delay payment to its suppliers to a suitable time in order to pay them. Cash conversion cycle can also be applicable to other businesses that purchase and hold goods (inventory) to sell to customers.
If cash conversion cycle is not efficient, it may mean significant losses for the business in the end. Inventory pilling up with goods that cannot be sold (even more drastic for perishable goods that cannot be sold that can cause a loss on asset value), customers delaying payments and suppliers chasing for payments; all these can put extreme pressure on the business which may even damage the business permanently if cash conversion cycle is not brought back to an efficient level for a prolonged period of time.
Thus, a business (especially of a retail nature) hope to sell its products as fast as possible (resulting in high inventory turnover), collect payments from its customers as fast as possible for goods sold (resulting in high receivables turnover), but pay suppliers as slowly as possible (resulting in low payables turnover). It is most ideal if a business can sell its goods and collect payments from its customers before it has to pay its suppliers. Most businesses should be able to collect direct payments from its customers unless a business extends credit terms to its customers (of which an investor should be wary since there is a risk that the business may not receive payments from its customers compared to upfront immediate payments for goods sold which has no risk of default on payments since customer payments is immediate upon receipt of goods).
Cash conversion cycle calculation
Cash conversion cycle = Days in Inventory + Days in Receivables - Days Payable Outstanding
This is the basic formula for cash conversion cycle of a business.
Days in inventory, days in receivables and days payable outstanding can be calculated as follows.
Days in Inventory = 365 / Inventory turnover
Inventory turnover =
Cost of sales or Cost of goods sold / Inventory
Days in Receivables = 365 / Receivables turnover
Receivables turnover = Revenue / Accounts receivable
Days Payable Outstanding = 365 / Payables turnover
Payables turnover =
Cost of sales or Cost of goods sold / Accounts payable
As one can see, we need the raw data for Inventory, Cost of sales, Revenue, Accounts receivable and Accounts payable. Figures for Inventory, Accounts receivable and Accounts payable can be found in the Balance Sheet Statement. One should consider using Accounts receivable and Accounts payable both under current assets and current liabilities respectively only since accounts that are current involve assets and liabilities over a one year period (since cash conversion cycle is calculated for a one year period as well). As for revenue and cost of sales, both can be found under the income statement.
One can consider comparing the cash conversion cycle for same company for different years to assess the trend whether a company has decreasing number of days for its cash conversion cycle over the years which is a positive sign or increasing number of days for its cash conversion cycle over the years which may be a negative sign.
Red flags to look at include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these happening for prolonged period of time. Such red flags are especially bad for retail businesses that rely heavily on their ability to optimise their cash conversion cycle.
An example on calculation of cash conversion cycle for one of my invested company (Tat Hong Holdings)
All financial figures are taken from the year 2009 annual report.
Inventory turnover = 390622000 / 217686000 = 1.7944
Days in Inventory = 365 / 1.7944 = 203 days
Receivables turnover = 631761000 / 97725000 = 6.4647
Days in Receivables = 365 / 6.4647 = 56 days
Payables turnover = 390622000 / 182325000 = 2.1424
Days in Payable Outstanding = 365 / 2.1424 = 170 days
Cash Conversion Cycle = 203 + 56 - 170 = 89 days
Thus, Tat Hong Holdings has a cash conversion cycle of 89 days. One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors. Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.
Discussion points:- Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables).
Cash conversion cycle is especially important for retail businesses that need to optimise their cash conversion cycle. However, it can also be applied to assess any businesses that rely on purchasing goods and holding goods to sell.
Red flags to look at include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these escalating for prolonged period of time which may damage the business resulting in significant losses.
One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors.
Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.
If cash conversion cycle is not efficient, it may mean significant losses for the business in the end. Inventory pilling up with goods that cannot be sold (even more drastic for perishable goods that cannot be sold that can cause a loss on asset value), customers delaying payments and suppliers chasing for payments; all these can put extreme pressure on the business which may even damage the business permanently if cash conversion cycle is not brought back to an efficient level for a prolonged period of time.
Thus, a business (especially of a retail nature) hope to sell its products as fast as possible (resulting in high inventory turnover), collect payments from its customers as fast as possible for goods sold (resulting in high receivables turnover), but pay suppliers as slowly as possible (resulting in low payables turnover). It is most ideal if a business can sell its goods and collect payments from its customers before it has to pay its suppliers. Most businesses should be able to collect direct payments from its customers unless a business extends credit terms to its customers (of which an investor should be wary since there is a risk that the business may not receive payments from its customers compared to upfront immediate payments for goods sold which has no risk of default on payments since customer payments is immediate upon receipt of goods).
Cash conversion cycle calculation
Cash conversion cycle = Days in Inventory + Days in Receivables - Days Payable Outstanding
This is the basic formula for cash conversion cycle of a business.
Days in inventory, days in receivables and days payable outstanding can be calculated as follows.
Days in Inventory = 365 / Inventory turnover
Inventory turnover =
Cost of sales or Cost of goods sold / Inventory
Days in Receivables = 365 / Receivables turnover
Receivables turnover = Revenue / Accounts receivable
Days Payable Outstanding = 365 / Payables turnover
Payables turnover =
Cost of sales or Cost of goods sold / Accounts payable
As one can see, we need the raw data for Inventory, Cost of sales, Revenue, Accounts receivable and Accounts payable. Figures for Inventory, Accounts receivable and Accounts payable can be found in the Balance Sheet Statement. One should consider using Accounts receivable and Accounts payable both under current assets and current liabilities respectively only since accounts that are current involve assets and liabilities over a one year period (since cash conversion cycle is calculated for a one year period as well). As for revenue and cost of sales, both can be found under the income statement.
One can consider comparing the cash conversion cycle for same company for different years to assess the trend whether a company has decreasing number of days for its cash conversion cycle over the years which is a positive sign or increasing number of days for its cash conversion cycle over the years which may be a negative sign.
Red flags to look at include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these happening for prolonged period of time. Such red flags are especially bad for retail businesses that rely heavily on their ability to optimise their cash conversion cycle.
An example on calculation of cash conversion cycle for one of my invested company (Tat Hong Holdings)
All financial figures are taken from the year 2009 annual report.
Inventory turnover = 390622000 / 217686000 = 1.7944
Days in Inventory = 365 / 1.7944 = 203 days
Receivables turnover = 631761000 / 97725000 = 6.4647
Days in Receivables = 365 / 6.4647 = 56 days
Payables turnover = 390622000 / 182325000 = 2.1424
Days in Payable Outstanding = 365 / 2.1424 = 170 days
Cash Conversion Cycle = 203 + 56 - 170 = 89 days
Thus, Tat Hong Holdings has a cash conversion cycle of 89 days. One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors. Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.
Discussion points:- Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables).
Cash conversion cycle is especially important for retail businesses that need to optimise their cash conversion cycle. However, it can also be applied to assess any businesses that rely on purchasing goods and holding goods to sell.
Red flags to look at include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these escalating for prolonged period of time which may damage the business resulting in significant losses.
One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors.
Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.
Wednesday, October 28, 2009
A simple walkthrough on comparing companies in my stocks portfolio (Part 2 of 2)
All companies in my portfolio show steady growth in net income and revenue
Based on my last post, I have provided the net income and revenue trends of companies in my stock portfolio. All the companies show a steady growth in their net income and revenue through a 10 years period except for Parkway Holdings and Tat Hong Holdings which show a lower net income for the most recent year because of individual losses on some exceptional items (see my pevious post). I view these recent losses to their net incomes as non-recurring one-off exceptional losses on items which did not stem from any permanent deteroriation in their business fundamentals. So, it should not affect their future growth in net income.
Recapitulation on the different metrics
Net margin
Net margin shows how much of each dollar of revenue a company keeps as earnings after paying all costs of doing business.
Asset turnover
Asset turnover measures how efficient a company is at generating revenue from each dollar of assets.
Financial leverage
Financial leverage shows how much debt a company has relative to shareholders' equity.
Return on asset (ROA) (%)
Return on assets (ROA) shows the amount of profits a company is able to generate per dollar of assets.
Return on equity (ROE) (%)
ROE shows how much returns a company can generate for its shareholders' equity.
Method of presentation
I shall present the comparison of companies in my portfolio through using charts and provide a short discussion after each metric I use to make the comparison. As usual, I do not guarantee any completeness or accuracy in my discussion, data and charts. Readers are encouraged to do own individual assessment and form independent opinions as well.
Note:- All following charts show trends in the different metrics of comparison over a 10 years period except for Tat Hong Holdings which shows only an 8 years trend. The 1st and 2nd year data for Tat Hong Holdings are shown as '0' on the charts as it was not available.
Net income comparison
Based on my last post, I have provided the net income and revenue trends of companies in my stock portfolio. All the companies show a steady growth in their net income and revenue through a 10 years period except for Parkway Holdings and Tat Hong Holdings which show a lower net income for the most recent year because of individual losses on some exceptional items (see my pevious post). I view these recent losses to their net incomes as non-recurring one-off exceptional losses on items which did not stem from any permanent deteroriation in their business fundamentals. So, it should not affect their future growth in net income.
Recapitulation on the different metrics
Net margin
Net margin shows how much of each dollar of revenue a company keeps as earnings after paying all costs of doing business.
Asset turnover
Asset turnover measures how efficient a company is at generating revenue from each dollar of assets.
Financial leverage
Financial leverage shows how much debt a company has relative to shareholders' equity.
Return on asset (ROA) (%)
Return on assets (ROA) shows the amount of profits a company is able to generate per dollar of assets.
Return on equity (ROE) (%)
ROE shows how much returns a company can generate for its shareholders' equity.
Method of presentation
I shall present the comparison of companies in my portfolio through using charts and provide a short discussion after each metric I use to make the comparison. As usual, I do not guarantee any completeness or accuracy in my discussion, data and charts. Readers are encouraged to do own individual assessment and form independent opinions as well.
Note:- All following charts show trends in the different metrics of comparison over a 10 years period except for Tat Hong Holdings which shows only an 8 years trend. The 1st and 2nd year data for Tat Hong Holdings are shown as '0' on the charts as it was not available.
Net income comparison
Based on the chart, it shows that all companies have steady growth in their net incomes over last 10 years (ignoring most recent year's decrease due to the 2008 financial crisis or one-off exceptional item losses). The winner is Keppel Corp with the most significant rise in net income trend. This shows Keppel Corp's ability to grow its earnings at accelerated pace compared to the rest.
Revenue comparison
All companies show steady rise in their revenues over last 10 years. This shows consistent ability to increase sales. A company has to keep increasing sales to grow its business. Otherwise, the business may stagnate over time if sales remain flat over a long period. Flat sales or decreasing sales over a long period may suggest there is no more potential for growth in the company. As investors, one has to decide carefully whether is it wise to invest in a company without much potential for growth (suggesting the business is either mature or losing its economic moat facing tougher competition or facing a more difficult operating environment e.g. due to tougher business regulations).
Net margin comparison
All companies show a steady increase in their net margins over last 10 years. Ignoring any exceptional items for any years affecting the net margins, only Tat Hong Holdings and Keppel Corp's net margins show the most stable increase over last 10 years. Net margin measures the profitability of a business (how much of each dollar of revenue a company keeps as earnings). It also shows whether a company is able to maintain a low cost of doing business. It seems Tat Hong Holdings and Keppel Corp are able to achieve a slightly higher net margin (suggesting their businesses are more profitable and they are able to maintain a low cost of doing business??).
Asset turnover comparison
From the chart, it suggests that SembCorp and Tat Hong Holdings are able to maintain a higher asset turnover over the rest. SembCorp leads the rest by having the highest asset turnover. Asset turnover measures how efficient a company is at generating revenue from each dollar of asset. It also simply measures how productive is the asset of a company. Thus, SembCorp seems to own assets that are highly productive for its business.
Financial leverage comparison
Parkway Holdings and Tat Hong Holdings have slightly lower financial leverage than the rest. All companies have financial leverages lower than 3 which is still not much cause for concern. This suggest that these companies do not have excessively high amounts of debts compared to shareholders' equity, and their capital structure is sound. A company has to use debts and equity to fund it's business. However, businesses that can maintain low financial leverage and yet is profitable for a long period is commendable suggesting that such businesses are funding their operations mainly through earnings made (since such businesses have good economics), and they only need to employ little amounts of debts or none at all.
Return on asset (ROA) (%) comparison
All companies show steadily rising return on asset (ROA) over last 10 years (ignoring one-off non-recurring exceptional increase shown by Parkway Holdings possibly due to gains from disposal of assets when setting up Parkway Life REIT). ROA measures how much profits a company generates on each dollar of asset. A steadily rising ROA suggests a company is able to continually acquire and own assets that are more productive and is also able to use the productive assets efficiently to generate more profits.
Return on equity (ROE) (%) comparison
All companies show steadily rising return on equity (ROE) over last 10 years. Most companies have managed to grow their ROE to current level of more than 15% which is generating good returns for their shareholders' equity. However, only ROE for Parkway Holdings is consistently below the rest for most years and under 15% benchmark for acceptable good overall profitability for most types of businesses (ignoring one-off exceptional increase in 2007 due to gains from disposal of it's assets).
Discussion points:- It is difficult if not impossible to find really cream-of-the-crop companies that are excellent all-rounder in many measured metrics. It is even more difficult to find companies that can consistently out-perform over a long period of time.
I believe as long as a company shows a general rising trend in many metrics of measurements over a long period (more than 10 years) and is perceived to continue doing so in many years to come, it will make good sense to invest in such companies with consistent excellent economics in their favour.
Past performance of a company may not guarantee future performance. An investor after selecting a good company to invest in has to continually monitor the company's progress and watch for any permanent deteroriation in business economics in future years. As long as the company continues to perform well in it's business, it will continually generate good returns (compounded annually) for it's shareholders the longer the shareholders stay invested with such excellent businesses.
Sunday, October 25, 2009
A simple walkthrough on comparing companies in my stocks portfolio (Part 1 of 2)
Why analysing business fundamentals matter to the bona fide investor?
I had earlier exposed myself to some fundamental analysis during this year from my previous post on looking at return on equity (ROE). I have heard before comments from some investors or should I say market players that it may be futile to look at fundamentals of companies when doing investments. These "market players" some who are experienced with the stocks market adopt a technical view when dealing with the stocks market. To them, making profits is simply about investing at the right time just before a particular stocks is foresee to rise significantly in price. It does not matter whether the underlying business of the company is profitable or not. What matters is that the stock price must rise or fall in a short time period for such market players to make their gains (from going long or short). As such, technical analysis by looking at charts and indicators is paramount to their decision to buy into or sell out of a particular stocks at particular opportunate times when the signal for action is clear.
I am not in a position to comment on the merits or demerits of adopting such a methodology to secure gains from the stocks market. Some investors that use technical analysis protray strongly that this method boasts of excellent consistent returns over a long period of time. How true is it? Only the investors themselves who practise investing by technical analysis know it best. My purpose here is not to challenge the method of technical analysis nor to compare between technical analysis and fundamental analysis. I believe there are different investment philosophies that investors can naturally use according to their own personality. As such, it is one's own free will to choose whichever method, be it fundamental analysis or technical analysis or both together to use it according to own investment style.
For me, I adopt a fundamental approach to stocks investing. In one of Warren Buffet's famous investment quotes, the "stock price eventually follows the business", this shows strongly that the price of a stock does regress towards the intrinsic value of the business underlying the stock. As to the time required for a stock to be fairly valued either from an undervalued or overvalued price, it may take weeks, months or even years. Because the stock market is not efficient, prices of securities do get undervalued or overvalued at different periods of time (e.g. bear market or bull market). An astute investor will try to buy stocks at undervalued prices and sell stocks at overvalued prices to make the largest returns on their investments. However, investing can be made most profitable if an investor views investing as long term riding on excellent economics of selected businesses that really make good consistent returns for their shareholders over a long period of time.
There are already examples of such businesses as Coca Cola and Wal-Mart in Warren Buffet's holdings. An examination of our local context reveals businesses such as Wilmar International that have grown in their intrinsic value through the years into a giant enterprise now and is no longer the once "ikan billis" (small fry) that is not heard of. So, are fundamentals of businesses relevant to investing? The answer is yes. If an investor can invest in such companies that have consistent good business economics in their favour, the value of the company will increase many folds over a period of time as the company gains market share and economic moat. By then, an investor's original investment will increase many folds in value when the business has increased in intrinsic value over time. I examine one such company in my portfolio, SembCorp which has a historic low price of around $0.80 per share. I can only hope in my wildest dream that it's stock price may have a chance of revisiting such lows in future which is almost impossible. This company is worth far more in intrinsic value than $0.80 per share (my estimated intrinsic value is $4.55 per share - see earlier post). So, a patient investor who still holds onto shares of SembCorp bought at such low price years back is already seeing high current earnings yield (about 37%) and future earnings yield as long as SembCorp continues to grow in profitability of their businesses in future years. Such an investor has also secured a high current dividend yield and future dividend yield of around 13% assuming SembCorp provides the same amount of dividends per share in future years.
Thus, by looking at fundamentals and going long with a business that is really worthy, an investor can receive excellent returns on investment especially if the investor has invested at such businesses at low undervalued prices. When the intrinsic value of such businesses continue to grow, the investor's capital investment also grows in value as well. A caution though that holding investment of such long nature focuses solely on the growth of the selected business's intrinsic value and ignores market fluctuations in prices over the years.
Net income and revenue trends of companies in my portfolio
As discussed in my previous post on the metric return on equity (ROE), I shall continue to evaluate a few companies in my portfolio based on metrics such as net income and revenue trends, net margin, asset turnover, financial leverage, return on assets (ROA) and return on equity (ROE). Before I begin my discussion, one should note that these metrics provide only some comparison and evaluation on the profitability of companies. Fundamental analysis is simply a broad topic of investment interest that involves so many ways to evaluate a business. Different investors and analysts may adopt different ways to evaluate a business. Every investor has his own unique ways to evaluate a company and the ways may change too. One should never rely heavily on any particular metric or way to evaluate a company, but should always be as objective as possible and is aware that there is always the possibility of misjudging a company.
For me, the above mentioned metrics provide an overview into the evaluation of companies in my portfolio. I shall present the collected data from the various companies' financial statements (found in their annual reports). I do not guarantee the completeness or accuracy of these collected data. Readers are advised to practise caution when reading and using the data.
I will only provide the trends I observed for net income and revenue in these companies over a period of 8 to 10 years. Net income and revenue should grow together consistently for a good business. I personally places more emphasis on a business's ability to generate growth in operating cashflows and free cashflows more than looking at net income and revenue growth because cashflow is more important determinant of a company's ability to generate real cash. Nevertheless, net income and revenue growth are also important as they reveal whether a business is making more sales and earnings through the years.
I had earlier exposed myself to some fundamental analysis during this year from my previous post on looking at return on equity (ROE). I have heard before comments from some investors or should I say market players that it may be futile to look at fundamentals of companies when doing investments. These "market players" some who are experienced with the stocks market adopt a technical view when dealing with the stocks market. To them, making profits is simply about investing at the right time just before a particular stocks is foresee to rise significantly in price. It does not matter whether the underlying business of the company is profitable or not. What matters is that the stock price must rise or fall in a short time period for such market players to make their gains (from going long or short). As such, technical analysis by looking at charts and indicators is paramount to their decision to buy into or sell out of a particular stocks at particular opportunate times when the signal for action is clear.
I am not in a position to comment on the merits or demerits of adopting such a methodology to secure gains from the stocks market. Some investors that use technical analysis protray strongly that this method boasts of excellent consistent returns over a long period of time. How true is it? Only the investors themselves who practise investing by technical analysis know it best. My purpose here is not to challenge the method of technical analysis nor to compare between technical analysis and fundamental analysis. I believe there are different investment philosophies that investors can naturally use according to their own personality. As such, it is one's own free will to choose whichever method, be it fundamental analysis or technical analysis or both together to use it according to own investment style.
For me, I adopt a fundamental approach to stocks investing. In one of Warren Buffet's famous investment quotes, the "stock price eventually follows the business", this shows strongly that the price of a stock does regress towards the intrinsic value of the business underlying the stock. As to the time required for a stock to be fairly valued either from an undervalued or overvalued price, it may take weeks, months or even years. Because the stock market is not efficient, prices of securities do get undervalued or overvalued at different periods of time (e.g. bear market or bull market). An astute investor will try to buy stocks at undervalued prices and sell stocks at overvalued prices to make the largest returns on their investments. However, investing can be made most profitable if an investor views investing as long term riding on excellent economics of selected businesses that really make good consistent returns for their shareholders over a long period of time.
There are already examples of such businesses as Coca Cola and Wal-Mart in Warren Buffet's holdings. An examination of our local context reveals businesses such as Wilmar International that have grown in their intrinsic value through the years into a giant enterprise now and is no longer the once "ikan billis" (small fry) that is not heard of. So, are fundamentals of businesses relevant to investing? The answer is yes. If an investor can invest in such companies that have consistent good business economics in their favour, the value of the company will increase many folds over a period of time as the company gains market share and economic moat. By then, an investor's original investment will increase many folds in value when the business has increased in intrinsic value over time. I examine one such company in my portfolio, SembCorp which has a historic low price of around $0.80 per share. I can only hope in my wildest dream that it's stock price may have a chance of revisiting such lows in future which is almost impossible. This company is worth far more in intrinsic value than $0.80 per share (my estimated intrinsic value is $4.55 per share - see earlier post). So, a patient investor who still holds onto shares of SembCorp bought at such low price years back is already seeing high current earnings yield (about 37%) and future earnings yield as long as SembCorp continues to grow in profitability of their businesses in future years. Such an investor has also secured a high current dividend yield and future dividend yield of around 13% assuming SembCorp provides the same amount of dividends per share in future years.
Thus, by looking at fundamentals and going long with a business that is really worthy, an investor can receive excellent returns on investment especially if the investor has invested at such businesses at low undervalued prices. When the intrinsic value of such businesses continue to grow, the investor's capital investment also grows in value as well. A caution though that holding investment of such long nature focuses solely on the growth of the selected business's intrinsic value and ignores market fluctuations in prices over the years.
Net income and revenue trends of companies in my portfolio
As discussed in my previous post on the metric return on equity (ROE), I shall continue to evaluate a few companies in my portfolio based on metrics such as net income and revenue trends, net margin, asset turnover, financial leverage, return on assets (ROA) and return on equity (ROE). Before I begin my discussion, one should note that these metrics provide only some comparison and evaluation on the profitability of companies. Fundamental analysis is simply a broad topic of investment interest that involves so many ways to evaluate a business. Different investors and analysts may adopt different ways to evaluate a business. Every investor has his own unique ways to evaluate a company and the ways may change too. One should never rely heavily on any particular metric or way to evaluate a company, but should always be as objective as possible and is aware that there is always the possibility of misjudging a company.
For me, the above mentioned metrics provide an overview into the evaluation of companies in my portfolio. I shall present the collected data from the various companies' financial statements (found in their annual reports). I do not guarantee the completeness or accuracy of these collected data. Readers are advised to practise caution when reading and using the data.
I will only provide the trends I observed for net income and revenue in these companies over a period of 8 to 10 years. Net income and revenue should grow together consistently for a good business. I personally places more emphasis on a business's ability to generate growth in operating cashflows and free cashflows more than looking at net income and revenue growth because cashflow is more important determinant of a company's ability to generate real cash. Nevertheless, net income and revenue growth are also important as they reveal whether a business is making more sales and earnings through the years.
There is steady net income growth and revenue growth over the years.
There is steady net income growth over the years except the most recent year when there is an impairment loss on trades receivables for Parkway Holdings due to a default on payment for hospital services. As this is a one-off problem, it will not affect future net income of Parkway Holdings. There is steady growth in revenue over the years.
There is steady growth in revenue over the years. There is steady growth in net income over the years expect for most recent year mainly due to foreign transaction losses. As this is a one-off problem due to change in exchange rates of foreign currencies, it may not affect future net incomes.
There is steady growth in net income and revenue over the years.
Discussion points:- It is important to evaluate business fundamentals of a company when investing in the stock of a company. This ensures an investor can potentially invest in good businesses that increase their intrinsic values over time.
All companies evaluated here shows a steady growth in both net income and revenue over the years. This suggests that their businesses are generally stable and consistently profitable over a period of time. Examining trend over a number of years is important as it checks for consistency in the economics of a business.
I will provide comparison on the net margin, asset turnover, financial leverage, return on asset and return on equity for these companies in a later post.
Tuesday, October 20, 2009
A look at return on equity (ROE)
After picking up some learning on how to value stocks (see earlier posts), I came to the attention of a frequently raised metric for measuring a company's profitability in the various investment literature I have read. This metric is termed return on equity (ROE in short).
Recap on valuation methodologies
Before I embarked on a discusssion on the usefulness of this ROE metric and its possible limitation, I wish to summarise my learning so far on valuing a company to know when it is wise to invest for the highest possible rate of returns. I have discussed the use of earnings yield to estimate how much yield one is getting currently by paying the current price for a stock and also estimating future yield on one's investment at current share price. Earnings yield is the reverse of P/E ratio, using earnings per share (EPS) divided by current share price and calculated as a %. I think this is a better way to determine the current yield one will be getting by investing at current share price compared to using P/E ratio. If EPS is high compared to current share price, one will ensure a high current yield when investing in a company. If the future yield can be projected with high probability based on past consistent growth in EPS of a company, one may be able to look at the future yield on one's current investment. Please refer to my earlier post "Waiting for the perfect pitch - Looking at yield on one's investment" for more details on estimating yield on investment.
The limitation of using P/E ratio is that it is difficult to determine which P/E ratio means undervalued or overvalued for a company (P/E ratio lower than 20? How about P/E ratio lower than 10?). There are many factors to consider when using P/E ratio to value a company, so it is not so easy to estimate a company's worth using P/E ratio alone. Since it is not my intention to discuss P/E ratio in details here, I will leave this for future post.
Another way of valuing a company is using a discounted cashflow (DCF) method. In using this method, one is assuming that continued ability to generate free cashflows by a company is critical for its continued survival and growth. However, as in using other valuation methods like earnings yield and P/E ratio as discussed earlier, all methods carry with them their individual limitations. DCF valuation method does not work for a company with inconsistent or negative free cashflows for most of its operating history. Also, it is not easy to estimate future growth in cashflows and the appropriate discount rate for the future cashflows to its present values. One's estimation is as much a guess compared to another's. So, to account for this uncertainty in estimating the intrinsic value per share for a company, an investor has to practise a conservative approach to invest at a margin below the estimated intrinsic value of a company called the margin of safety. Please refer to my earlier posts on "Determining intrinsic value per share of a stock" for details on using DCF to value a company.
Return on equity (ROE)
Return on equity (ROE) is a popular metric embraced by many investors and analysts for measuring the profitability of a company. How useful is it? ROE consists of three components.
ROE can be artificially inflated by the third component 'Financial leverage'. If the company is taking on large amounts of debts in its capital structure and having low equity base, the high financial leverage computed into the calculation of ROE can make the ROE looks too high to be true. So, an investor has to be careful when dealing with companies with high financial leverage. Investigate carefully why a company is taking on excessive amount of debts in its business. Is there justification for doing so? By being careful, it will possibly save a potential investor of unwelcomed surprises in future when a company shows up as financially unhealthy laden by excessive debts to be cleared.
Often, it is better to approach the evaluation of fundamentals of companies from a pessimistic viewpoint to dig up all possible negatives before considering the positives of the fundamentals of a company. If a company is truely an excellent one, it will stand the test of uncovering negatives about it.
Discussion points:- Return on equity (ROE) is a popular yet important metric for measuring overall profitability of a business. A consistently high ROE of 15% or more suggests that a company may have good business model, economic moat and management effectiveness.
ROE is not a magical sure-win metric. It is important to take note of the third component in this metric (financial leverage) when using ROE. A company that has high ROE but also high financial leverage may warrant further investigation to find out why a company is taking on execssive debts before putting a myopic confirmation to its profitability based on just looking at ROE alone.
Sound investing does not hinge on using only one metric (e.g. ROE) alone to judge a company's worthiness as an investment candidate. As such, ROE can be broken down into its three components to uncover further stories about a company (e..g its net margin, asset turnover and financial leverage).
Also, there are many other ways apart from using ROE to evaluate a company's fundamentals. Nevertheless, ROE continues to be a very useful metric for evaluating a company.
More on the practice of using ROE and its components in evaluating companies in my stocks portfolio in later posts.
Recap on valuation methodologies
Before I embarked on a discusssion on the usefulness of this ROE metric and its possible limitation, I wish to summarise my learning so far on valuing a company to know when it is wise to invest for the highest possible rate of returns. I have discussed the use of earnings yield to estimate how much yield one is getting currently by paying the current price for a stock and also estimating future yield on one's investment at current share price. Earnings yield is the reverse of P/E ratio, using earnings per share (EPS) divided by current share price and calculated as a %. I think this is a better way to determine the current yield one will be getting by investing at current share price compared to using P/E ratio. If EPS is high compared to current share price, one will ensure a high current yield when investing in a company. If the future yield can be projected with high probability based on past consistent growth in EPS of a company, one may be able to look at the future yield on one's current investment. Please refer to my earlier post "Waiting for the perfect pitch - Looking at yield on one's investment" for more details on estimating yield on investment.
The limitation of using P/E ratio is that it is difficult to determine which P/E ratio means undervalued or overvalued for a company (P/E ratio lower than 20? How about P/E ratio lower than 10?). There are many factors to consider when using P/E ratio to value a company, so it is not so easy to estimate a company's worth using P/E ratio alone. Since it is not my intention to discuss P/E ratio in details here, I will leave this for future post.
Another way of valuing a company is using a discounted cashflow (DCF) method. In using this method, one is assuming that continued ability to generate free cashflows by a company is critical for its continued survival and growth. However, as in using other valuation methods like earnings yield and P/E ratio as discussed earlier, all methods carry with them their individual limitations. DCF valuation method does not work for a company with inconsistent or negative free cashflows for most of its operating history. Also, it is not easy to estimate future growth in cashflows and the appropriate discount rate for the future cashflows to its present values. One's estimation is as much a guess compared to another's. So, to account for this uncertainty in estimating the intrinsic value per share for a company, an investor has to practise a conservative approach to invest at a margin below the estimated intrinsic value of a company called the margin of safety. Please refer to my earlier posts on "Determining intrinsic value per share of a stock" for details on using DCF to value a company.
Return on equity (ROE)
Return on equity (ROE) is a popular metric embraced by many investors and analysts for measuring the profitability of a company. How useful is it? ROE consists of three components.
The first component (Net income / Revenue) is also called 'Net Margin'. This first component can also be termed simply 'Profitability' of a company.
Net margin shows how much of each dollar of revenue a company keeps as earnings after paying all costs of doing business. A net margin (expressed in %) of 30% shows that for every dollar of revenue made, $0.30 is left over as earnings after paying off $0.70 for all costs of doing business. So, the higher the net margin (in %) the more profitable is a business.
The second component (Revenue / Assets) is also called 'Asset turnover'. This second component can also be termed simply 'Productivity' of a company.
Asset turnover measures how efficient a company is at generating revenue from each dollar of assets. A high asset turnover means the company is more productive at generating revenue from its excellent assets.
These first two components can be combined to provide the metric 'Return on assets' (ROA) as follows:-
Return on assets (%) = Net margin (%) X Asset turnover
Return on assets (ROA) shows the amount of profits a company is able to generate per dollar of assets. Companies having high ROAs are good at producing profits from their assets.
The third and last component (Assets / Shareholders' equity) is also called 'Financial leverage'. Another common term used to describe this same component is called 'Capital structure' of a company.
Financial leverage shows how much debt a company has relative to shareholders' equity. A high financial leverage ratio (e.g. significantly more than 2) may mean a company is taking on excessive debts which is risky especially if the business of the company is a cyclical or volatile one.
Usefulness of ROE
When the three components discussed above are combined together, they form the metric return on equity (ROE). The usefulness of ROE is that it shows how much returns a company can generate for its shareholders' equity (remaining interest spread among shareholders in the assets of a company after all liabilities are paid). This is shown in the reduced equation:-
ROE = Net income / Shareholders' equity
A company that shows consistently high ROE (15% or higher) over a long period of many years suggests that it is generating good returns for its shareholders. This is testimony to the company's continued profitability in its business model, economic moat and management effectiveness.
Limitation of ROE
ROE can be artificially inflated by the third component 'Financial leverage'. If the company is taking on large amounts of debts in its capital structure and having low equity base, the high financial leverage computed into the calculation of ROE can make the ROE looks too high to be true. So, an investor has to be careful when dealing with companies with high financial leverage. Investigate carefully why a company is taking on excessive amount of debts in its business. Is there justification for doing so? By being careful, it will possibly save a potential investor of unwelcomed surprises in future when a company shows up as financially unhealthy laden by excessive debts to be cleared.
Often, it is better to approach the evaluation of fundamentals of companies from a pessimistic viewpoint to dig up all possible negatives before considering the positives of the fundamentals of a company. If a company is truely an excellent one, it will stand the test of uncovering negatives about it.
Discussion points:- Return on equity (ROE) is a popular yet important metric for measuring overall profitability of a business. A consistently high ROE of 15% or more suggests that a company may have good business model, economic moat and management effectiveness.
ROE is not a magical sure-win metric. It is important to take note of the third component in this metric (financial leverage) when using ROE. A company that has high ROE but also high financial leverage may warrant further investigation to find out why a company is taking on execssive debts before putting a myopic confirmation to its profitability based on just looking at ROE alone.
Sound investing does not hinge on using only one metric (e.g. ROE) alone to judge a company's worthiness as an investment candidate. As such, ROE can be broken down into its three components to uncover further stories about a company (e..g its net margin, asset turnover and financial leverage).
Also, there are many other ways apart from using ROE to evaluate a company's fundamentals. Nevertheless, ROE continues to be a very useful metric for evaluating a company.
More on the practice of using ROE and its components in evaluating companies in my stocks portfolio in later posts.
Thursday, October 8, 2009
Determining intrinsic value per share of a stocks (Part 1 of 2) - Why free cashflows matters to a business and shareholders?
Why the need to determine intrinsic value per share of a company?
Since I started investing in June 2008, I have not conducted a rigourous determination of intrinsic value per share for the stocks I bought. I understood the importance of intrinsic value per share as it reveals how much the business underlying a stocks is worth. However, due to the lack of discipline to follow through the mathematical calculations behind determining intrinsic value per share, I kept procrastinating on learning this technique. This is an important exercise seeking to determine the true value of a company based on its cashflows. If the stocks market is not to be viewed as a speculative playground whereby securities are bought and sold by the minutes or at best only by the hours, this is where determination of intrinsic value for a stocks comes into play for the serious investor who wishes to invest his money carefully into only prospective stocks that are undervalued for their businesses.
Determining intrinsic value per share for a stocks has its place of importance because whether an investor is aware or not, whenever he is buying shares of a company, he is already having a part-ownership in the business of the company. The returns from his investment in the chosen company is determined by the economic prospects of the company and the price he pays for the shares of the company. If the company does well economically and is exceptionally profitable, the investor can expect bountiful returns from his investment (especially if he has invested at undervalued share prices). If the company fails, the investor may risk losing his invested capital in the company. Even if one is adopting a short-term attitude towards holding shares of a company, it still pays to know some important fundamentals about a company before investing one's money in the company as any unpleasant surprises can catch an ignorant investor unprepared even in short time period. There are already some examples of China concept stocks engaged in bad corporate governance and lack of integrity in management that caught investors unaware short-term before they can react.
Free cashflows is the lifeline of a business
Since I seek to be a focused value investor, determining intrinsic value of a business should be one important skill to master. Determining intrinsic value per share of a business depends on the present value of future free cashflows a business can generate over a period of time (usually taken to be 10 years). Free cashflows are the lifeline of a company. The ability to generate continuous free cashflows ensures survival of a business. A business needs to generate free cashflows continuously as free cashflows can be used for purposes such as further investing in the business or payout as dividends to shareholders. A business that is unable to generate free cashflows consistently is destined for failure in a matter of time (as this suggests the business is basically not profitable at all).
Free cashflows = Net cash from operating activities - Capital expenditure
To arrive at positive free cashflows, a company needs to have positive net cash from operating activities. The figure for "net cash from operating activities" can be directly taken from an annual report under the section, "consolidated cashflow statement". A positive net cash from operating activities is important as it shows that the business can generate cash from its operations. A consistent negative net cash from operating activities for a few years maybe a red flag signalling problems with the ability to generate cash from a business's operations. Who wants to invest in a business that cannot even generate cash from its operations? On the contrary, a business that shows consistent growth in its net cash from operating activities over the years shows its excellent business characteristics that allows continued generation of more and more cash from its operations.
Capital expenditure refers to money a company needs to spend on items to keeps its business running and growing at its current rate. Such items include plants, properties and equipments. As such, capital expenditure is a basic necessity to allow the business to maintain its operations and growth. For example, a biscuit making company needs to expend capital to buy a production plant to produce biscuit. It cannot produce biscuit without the necessary production plant with its equipment, so capital expenditure is necessary to produce biscuits. A company that can keep its capital expenditure to a minimum and yet maintain a good rate of growth in business is a good one. An investor can refer to the subsection "cashflow from investing activities" under "consolidated cashflow statement" and look for items such as "investing in/aquisition of plant, property and equipment" to have an idea on how much capital expenditure a company puts into its business.
Thus, free cashflows is whatever free cash left over after necessary capital expenditure is deducted from the net cash produced from a business's operations. An excellent company can produce large amounts of net cash from operating activities while keeping its capital expenditure to its lowest. This is the kind of business an investor will want to invest in, especially if a company can consistently produce significantly large amounts of free cashflows.
Free cashflows can be reinvested into a business to further its growth or to be paid out to shareholders. So, free cashflows is the lifeline of a company, it cannot do without.
More further discussions on determining intrinsic value per share of a company in later posts. I will also seek to critique my own investment portfolio to point out mistakes I committed in purchasing shares of companies that are overvalued based on their intrinsic value per share.
Discussion points:- Free cashflow = Net cash from operating activities - Capital expenditure
It is important to look for companies that shows consistent growth in net cash from operating activites while maintaining low capital expenditure, and yet has high return on equity (ROE).
The ability to consistently generate high free cashflows from a business allows the cash to be reinvested in the business or to be paid as dividends to shareholders.
Since I started investing in June 2008, I have not conducted a rigourous determination of intrinsic value per share for the stocks I bought. I understood the importance of intrinsic value per share as it reveals how much the business underlying a stocks is worth. However, due to the lack of discipline to follow through the mathematical calculations behind determining intrinsic value per share, I kept procrastinating on learning this technique. This is an important exercise seeking to determine the true value of a company based on its cashflows. If the stocks market is not to be viewed as a speculative playground whereby securities are bought and sold by the minutes or at best only by the hours, this is where determination of intrinsic value for a stocks comes into play for the serious investor who wishes to invest his money carefully into only prospective stocks that are undervalued for their businesses.
Determining intrinsic value per share for a stocks has its place of importance because whether an investor is aware or not, whenever he is buying shares of a company, he is already having a part-ownership in the business of the company. The returns from his investment in the chosen company is determined by the economic prospects of the company and the price he pays for the shares of the company. If the company does well economically and is exceptionally profitable, the investor can expect bountiful returns from his investment (especially if he has invested at undervalued share prices). If the company fails, the investor may risk losing his invested capital in the company. Even if one is adopting a short-term attitude towards holding shares of a company, it still pays to know some important fundamentals about a company before investing one's money in the company as any unpleasant surprises can catch an ignorant investor unprepared even in short time period. There are already some examples of China concept stocks engaged in bad corporate governance and lack of integrity in management that caught investors unaware short-term before they can react.
Free cashflows is the lifeline of a business
Since I seek to be a focused value investor, determining intrinsic value of a business should be one important skill to master. Determining intrinsic value per share of a business depends on the present value of future free cashflows a business can generate over a period of time (usually taken to be 10 years). Free cashflows are the lifeline of a company. The ability to generate continuous free cashflows ensures survival of a business. A business needs to generate free cashflows continuously as free cashflows can be used for purposes such as further investing in the business or payout as dividends to shareholders. A business that is unable to generate free cashflows consistently is destined for failure in a matter of time (as this suggests the business is basically not profitable at all).
Free cashflows = Net cash from operating activities - Capital expenditure
To arrive at positive free cashflows, a company needs to have positive net cash from operating activities. The figure for "net cash from operating activities" can be directly taken from an annual report under the section, "consolidated cashflow statement". A positive net cash from operating activities is important as it shows that the business can generate cash from its operations. A consistent negative net cash from operating activities for a few years maybe a red flag signalling problems with the ability to generate cash from a business's operations. Who wants to invest in a business that cannot even generate cash from its operations? On the contrary, a business that shows consistent growth in its net cash from operating activities over the years shows its excellent business characteristics that allows continued generation of more and more cash from its operations.
Capital expenditure refers to money a company needs to spend on items to keeps its business running and growing at its current rate. Such items include plants, properties and equipments. As such, capital expenditure is a basic necessity to allow the business to maintain its operations and growth. For example, a biscuit making company needs to expend capital to buy a production plant to produce biscuit. It cannot produce biscuit without the necessary production plant with its equipment, so capital expenditure is necessary to produce biscuits. A company that can keep its capital expenditure to a minimum and yet maintain a good rate of growth in business is a good one. An investor can refer to the subsection "cashflow from investing activities" under "consolidated cashflow statement" and look for items such as "investing in/aquisition of plant, property and equipment" to have an idea on how much capital expenditure a company puts into its business.
Thus, free cashflows is whatever free cash left over after necessary capital expenditure is deducted from the net cash produced from a business's operations. An excellent company can produce large amounts of net cash from operating activities while keeping its capital expenditure to its lowest. This is the kind of business an investor will want to invest in, especially if a company can consistently produce significantly large amounts of free cashflows.
Free cashflows can be reinvested into a business to further its growth or to be paid out to shareholders. So, free cashflows is the lifeline of a company, it cannot do without.
More further discussions on determining intrinsic value per share of a company in later posts. I will also seek to critique my own investment portfolio to point out mistakes I committed in purchasing shares of companies that are overvalued based on their intrinsic value per share.
Discussion points:- Free cashflow = Net cash from operating activities - Capital expenditure
It is important to look for companies that shows consistent growth in net cash from operating activites while maintaining low capital expenditure, and yet has high return on equity (ROE).
The ability to consistently generate high free cashflows from a business allows the cash to be reinvested in the business or to be paid as dividends to shareholders.
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