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Tutorial 4 - Micro fundamentals

Tutorial 4 - Micro fundamentals

Executive Summary

After completing this tutorial, an investor will understand what is meant by micro-fundamental analysis, especially the importance of ratio analysis. We start by introducing the real basics like how one would read the share price page and then move on to analysing a company's financial statements. The analysis of financial statements is a discussion of the Income Statement and the Balance Sheet. What is more important, though, is an understanding of what ratio analysis is and how to use various valuation methods. In conclusion, an investor will also understand what market capitalisation and what indices are.

Micro-Fundamental Ratios

One of the major activities of fundamental analysis is the analysis of financial statements. Much of this analysis is carried out by calculating various ratios derived from accounting and other data, such as the share price, and then interpreting these ratios. The goal is to place a fair value on a share. Earnings and dividends of a company are regarded as simple indicators of the fundamental strength of a specific company. These figures are easily accessible as they are printed on the share price page in newspapers. The primary benefit of having such figures lies in the ability of the private investor to analyse and manipulate such figures to his advantage. With this in mind it is important to have an understanding of how such figures are calculated, and their practical significance.

How does one read the share price page?

This is the usual format of the share price information in the daily newspapers:

PE

EY

DY

NAME

BUY

SELL

LAST

4.6

22.0

21.1

ABC

650

660

5.8%

6.0

16.7

4.0

XYZ

1125

1245

3.1%

Column

Explanation

PE

Price earnings ratio i.e. price of the share divided by its historical earnings per share (EPS).

EY

Earnings yield i.e. the earnings per share expressed as a percentage of the price.
(Note: This ratio is the inverse of the price earnings ratio.)

DY

Dividend yield i.e. the dividend per share (DPS) expressed as a percentage of the price

NAME

Abbreviation of the share name

BUY

Price at which the share is offered for purchase. (Note that all prices are expressed in cents per share except for some convertible debentures, which are sometimes expressed as a percentage of their nominal value.)

SELL

Price at which the share is offered for sale (Note: this is not necessarily the price investors will receive for their shares.)

LAST

Last price at which the share was traded

RP

H

L

DM

DM%

YM%

DV

660

660

650

10+

1.5

27.9

7600

1245S

1280

1250

35-

2.7

66.4

31550

Column

Explanation

RP

Ruling Price. This is equal to the last cash sale of the day, unless there was a higher buying or lower selling price, which is denoted by a "B" or an "A" or "S" respectively.

H

Highest price received for the day.

L

Lowest price received for the day.

DM

Day's move - up or down

DM%

Day's move as a percentage of its price

YM%

Year's move as a percentage. (Note: The date from which this is calculated is given in the explanation at the top of the prices page.)

DV

Day's volume. (Note: Sometimes given in hundreds, and sometimes in thousands

Market Rating

P/E's, Earnings yields and "market ratings" are often confusing. At first glance, shares with very high P/E ratios (or low earnings yields) seem the least attractive, yet they will be described as "highly rated". Others with a low P/E ratio (or very high yield) will be considered "poorly rated". This paradox needs further explanation. The market rating of a share is simply the price at which the shares are trading viewed in relation to the past earnings levels. If the price is high in relation to past earnings we say the share is "highly rated", and if the share is low in relation to earnings, we say that the share is "poorly rated".

Introduction to Financial Statements

To understand more about the analysis and valuation of shares we will be looking at the Income Statement and Balance Sheet (in a simplistic form as published in the financial press). We will then be calculating and interpreting ratios based on these financial statements. And finally work through a few valuation techniques. When you do research on different companies by looking at their annual reports, you will typically come across two separate financial statements: the balance sheet and the income statement (also known as the statement of profit and loss). These two statements are very significant for companies as they can be used to describe the company's health and effectiveness of management.

Balance Sheet - The balance sheet gives investors a general overview of a company's financial situation. That is, it tells investors exactly what a company owns (assets) and who it owes (liabilities). Assets and liabilities are listed in order of liquidity (relative ease of convertibility to cash), from most liquid to least liquid. Assets appear on the left hand side of the balance sheet and liabilities on the right hand side. For simplicity's sake, think of a balance sheet as an indicator of net worth: that is, how much a company is worth "on the books."

Income Statement - The income statement tells investors about the company's profits and losses for a specific time period. Expenses are subtracted from income to determine a firm's profit or loss. Unlike the balance sheet, the income statement does not look at the company's financial health (total net worth). Instead, it looks at how much revenue a company is able to create. If you were to think of the balance sheet as an indicator of net worth, you can think of the income statement as a company's profitability: that is, how much it can make in a given time frame.

These two statements are intertwined and should be looked at by all people who are considering investing their hard earned money in a particular company. You should look at a company's balance sheet to see exactly how much it is worth (remember, this is a book value representation rather than market capitalisation), and look at the income statement to see how profitable the company is. Obviously, if it has a negative net worth (its liabilities are greater than its assets) or if it has a negative income, then the company might not be the best place to invest your money.

Introduction to the Income Statement

The income statement is one of the three financial statements, the other two are the balance sheet and cash flow statement, with which investors need to become familiar with. The purpose of this section is to provide the less-experienced investor with an understanding of the components of the income statement in order to simplify investment analysis and make it easier to apply it to your own investment decisions.

The Income Statement is the cumulative effect of the period's (normally 12 months) trading. All expenses for the period are subtracted from the income. What remains is the profit made by the company during that period. The illustrated income statement is in summarised format as is normally published in the business section of newspapers.

In the context of company's financial reporting, the income statement summarises a company's revenues (sales) and expenses bi-annually and annually for its fiscal year. The final net figure, as well as various other figures in this statement, is of major interest to the investment community. Many professionals still use the term "P&L," which stands for profit and loss statement, but this term is seldom found in print these days. In addition, the terms "profits," "earnings" and "income" all mean the same thing and are used interchangeably.

In the multi-step income statement, four measures of profitability are revealed at four critical junctions in a company's operations, namely gross, operating, pre-tax and after tax. One last general observation: Investors must remind themselves that the income statement recognises revenues when they are realised (i.e., when goods are shipped, services rendered and expenses incurred). With accrual accounting, the flow of accounting events through the income statement does not necessarily coincide with the actual receipt and disbursement of cash. The income statement measures profitability, not cash flow.

Income Statement Accounts

Net Sales (a.k.a. sales or revenue): These all refer to the value of a company's sales of goods and services to its customers. Even though a company's "bottom line" (its net income) gets most of the attention from investors, the "top line" is where the revenue or income process begins. Also, in the long run, profit margins on a company's existing products tend to eventually reach a maximum that is difficult on which to improve. Thus, companies typically can grow no faster than their revenues.

Cost of Sales (a.k.a. cost of goods (or products) sold (COGS), and cost of services): For a manufacturer, cost of sales is the expense incurred for raw materials, labour and manufacturing overhead used in the production of its goods. While it may be stated separately, depreciation expense belongs in the cost of sales. For wholesalers and retailers, the cost of sales is essentially the purchase cost of merchandise used for resale. For service-related businesses, cost of sales represents the cost of services rendered or cost of revenues.

Gross Profit (a.k.a. gross income or gross margin): A company's gross profit does more than simply represent the difference between net sales and the cost of sales. Gross profit provides the resources to cover all of the company's other expenses. Obviously, the greater and more stable a company's gross margin, the greater potential there is for positive bottom line (net income) results. More recently, gross profit has been referred to as "Earnings before interest, taxation, depreciation and amortization" (EBITDA).

Operating Income (a.k.a. operating profit): Deducting depreciation and amortization from a company's gross profit produces operating income or operating profit. This figure represents a company's earnings from its normal operations before any so-called non-operating income and/or costs such as interest expense, taxes and special items. Income at the operating level, which is viewed as more reliable, is often used by financial analysts rather than net income as a measure of profitability.

Interest Expense (a.k.a. finance costs): This item reflects the costs of a company's borrowings. Sometimes companies record a net figure here for interest expense and interest income from invested funds.

Pre-tax Income (a.k.a. profit before taxation): Another carefully watched indicator of profitability, earnings garnered before the income tax expense is an important step in the income statement. Numerous and diverse techniques are available to companies to avoid and/or minimise taxes that affect their reported income. Because these actions are not part of a company's business operations, analysts may choose to use pre-tax income as a more accurate measure of corporate profitability.

Income Taxes (a.k.a. taxation): As stated, the income tax amount has not actually been paid, it is an estimate, or an account that has been created to cover what a company expects to pay.

Special Items or Extraordinary Expenses: A variety of events can occasion charges against income. They are commonly identified as restructuring charges, unusual or non-recurring items and discontinued operations. These write-offs are supposed to be one-time events. Investors need to take these special items into account when making inter-annual profit comparisons because they can distort evaluations.

Net Income (a.k.a. net profit or net earnings): This is the bottom line, which is the most commonly used indicator of a company's profitability. Of course, if expenses exceed income, this account caption will read as a net loss. After the payment of preference dividends, if any, net income becomes part of a company's equity position as retained earnings. Supplemental data is also presented for net income on the basis of shares outstanding (basic) and the potential conversion of share options, warrants etc. (diluted).

Comprehensive Income: The concept of comprehensive income, which is relatively new (1998), takes into consideration the effect of such items as foreign currency translations adjustments, minimum pension liability adjustments and unrealized gains/losses on certain investments in debt and equity. The investment community continues to focus on the net income figure. The aforementioned adjustment items all relate to volatile market and/or economic events that are out of the control of a company's management. Their impact is real when they occur, but they tend to even out over an extended period of time.

Example of the Income Statement

Income Statement for 12 months for ABC Limited

% Growth

Current Year

Previous Year

#1

Turnover (T/O)

20%

1 200

1 000

#2

Operating Profit

10%

110

100

#3

Other

5

-2

#4

Earnings Before Interest & Tax (EBIT)

17%

115

98

#5

Interest Paid

11%

20

18

#6

Earnings Before Tax (EBT)

19%

95

80

#7

Taxation

20%

30

25

#8

Profit After Tax

18%

65

55

#9

Associate Companies

25%

5

4

#10

Outside Shareholders

-2

-1

#11

Preference Dividends

-2

-2

#12

Profit Attributable to Ordinary Shareholders

18%

66

56

#13

Dividends Paid

18%

22

19

#14

Retained Profits for the year

18%

44

37

#15

Retained Profits at the start of the year

23%

200

163

#16

Retained Profits at the end of the year

22%

244

200

#17

Number of Issued Shares

850

800

#18

Weighted Average Number of Shares

825

800

#19

Dividends per Share (DPS)

13%

2.6

2.3

#20

Earnings per Share (EPS)

14%

8.0

7.0

#21

Headline EPS

2%

7.4

7.3

1. Turnover/Revenue/Sales is the total income the company receives from its core business. This includes revenue from the sale of products, commissions, etc. But excludes items such as interest received, investment income, the sale of fixed assets and all other income not derived through normal business. Ratio analysis includes turnover growth (#46) and operating margin (#48).
2.The Operating Profit is calculated by subtracting all expenditure from turnover. Such expenditure includes the cost of sales (products etc.), other expenses such as salaries & wages, rental, etc. But excludes interest paid, taxation and expenses, not normal to the business, such as losses made from the sale of fixed assets, retrenchment costs, etc. Ratio analysis includes turnover growth (#46), operating margin (#48) and operating profit growth (#47).
3. Other, includes all income and expenditure not derived from normal business transactions. This can include profits/or losses on the sale of fixed assets, retrenchment costs, the cost of discontinuing certain operations, etc. The key is that these amounts should be once-off items.
4.The operating profit and other (#2 + #3) add up to the Earnings Before Interest and Tax (EBIT). For example: EBIT = Operating profit plus Other = 110 + 5 = 115
5. Interest Paid is normally set off against interest received and other investment income. The interest is linked to the interest bearing debt as shown in the balance sheet. Ratio analysis includes interest cover (#49) and debt/equity (#61).
6.EBIT, less interest paid (#4 - #5) results in Earnings Before Taxation (EBT). For example: EBT = EBIT less interest paid = 115 – 20 = 95. Ratio analysis includes EBT Growth (#50).
7. Taxation Paid, includes income tax as well as secondary tax on companies (STC). Ratio analysis includes effective tax rate (#51).
8. Profit After Tax, is the net profit of the company from all of its own operations, after interest and tax (#6 - #7) payments. But before income from associates, share of the profits attributable to outside shareholders and preference shareholders. For example: Profit after tax = EBT less taxation = 95 – 30 = 65
9. Income from Associate Companies, refers to those companies where ABC Ltd has a material stake in, but not control. Normally this interest will be between 20-50%. The amount represents the after-tax portion from such investments.
10. Outside Shareholders, represent the portion of current profits attributable to non-ABC Ltd investors. This occurs where the company does not have a 100% interest in one of its subsidiary companies. For example: it only owns 80%, then the total 100% of profits are included in the income statement and 20% of the after tax portion subtracted at this level.

11. Preference Dividends, refer to a certain class of shareholders that qualify for a dividend before ordinary shareholders. As we are interested in the earnings applicable to ordinary shareholders, this amount is subtracted.
12. Profit Attributable to Ordinary Shareholders, is the bottom line (#8 + #9 - #10 - #11) available for distribution to ordinary shareholders. If ABC were 100% owned by you this would theoretically be the amount you could take out of the company. Refer also to earnings per share (EPS )(#20). For example = Profit attributable to ordinary shareholders = Profit after tax plus Associate Companies less Outside Shareholders and Preference dividends. = (65 + 5) – (2 + 2) = 70 – 4 = 66
13. Dividends Paid, is that part of the profit the board of directors decides to pay out to the ordinary shareholders. Rarely are all of profits paid out as a dividend, as the company would need to retain a portion for investment in growth. Refer also to dividends per share (DPS)(#19.)
14. Retained Profits for the year, is the difference between the profits attributable and dividends payable (#12 - #13) to ordinary shareholders. This is the portion of profits retained in the company to be used for reducing debt, investing for further growth, or any other reason that the directors see fit. Ratio analysis includes dividend cover (#53) and retention rate (#54).
15. Retained Profits at the start of the year, is the cumulative retained profits since the founding of the company
16. Retained Profits at the end of the year, is purely the sum (#14 + #15) of the retained profits for- and at the beginning of the year.
17. Number of Issued Shares, is the total number of shares at the end of the period. This number is used for balance sheet purposes.
18. Weighted Average Number of Shares, is the result of the opening number of issued shares, plus those issued during the year. The newly issued shares are weighted, based on their date of issue. Since they were not in issue for the total period, and therefore, did not contribute to profits for the whole period, the weighting ensures comparability of results.
19. Dividends per Share (DPS), is total dividends declared, (#13 / #17) expressed on a per share basis. For example: DPS = Dividends Paid / Number of shares in Issue = 22/850 = 2.6cps.
20. Earnings per Share (EPS), are the profit attributable to ordinary shareholders, divided by the weighted average number of shares (#12 / #18). This is, therefore, the profit attributable to the holder of one ordinary share. For example: EPS = Profit attributable to ordinary shareholders/ Weighted average number of shares = 66 / 825 = 8.0cps
21. Headline EPS, is the earnings per share figure adjusted for items not considered to be of an ordinary nature of the business. In our example, the "other" was subtracted (added back if it was a loss) to reach headline earnings. This adjusted figure was then divided by the weighted average number of shares in issue (#12 - #3 / #18). For example: HEPS = Profit attributable to ordinary shareholders less Other / Weighted average number of shares = 66 – 5 / 825 = 61 / 825 = 7.4cps. Headline EPS gives the investor a better idea of sustainable earnings.
Care should be taken when analysing a company to ensure that these 'once-off' items that management adds back for headline purposes are in fact of a once-off nature. In practice it is worth noting that the majority of such items normally result in Headline EPS being higher than normal EPS. But the theory behind using headline (sustainable) figures for valuation purposes remain sound.

The Balance Sheet

A company's financial statements, namely the balance sheet, the income statement and the cash flow statement, are a key source of data for analysing the investment value of its share price. A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements. If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyse it and how to read it.

Today, there are numerous sources of independent company research, online and in print, which can do the "number crunching" for you. However, if you are going to become a serious share investor, a basic understanding of the fundamentals of financial statement usage is a must. In this section, we help you to become more familiar with the overall structure of the balance sheet.

It is important to note that a balance sheet is a snapshot of the company's financial position at a single point in time or a certain date. It is divided into total capital employed and total assets. The two totals will always balance. The illustrated balance sheet is in summarised format as is normally published in the business sections of newspapers.

Reading the Balance Sheet

The balance sheet is divided into two parts that, based on the following equation, must equal each other, or balance each other out. A company's balance sheet is comprised of assets, liabilities and shareholder's equity. The relationship of these items is expressed in the fundamental balance sheet equation: Assets = Liabilities + Equity

The meaning of this equation is important. Generally sales growth, whether rapid or slow, dictates a larger asset base, higher levels of inventory or stock, receivables or debtors and fixed assets (plant, property and equipment). As a company's assets grow, its liabilities and/or equity also tends to grow in order for its financial position to stay in balance.

How assets are supported, or financed, by a corresponding growth in payables or creditors, debt liabilities and equity reveals a lot about a company's financial health. For now, suffice it to say that depending on a company's line of business and industry characteristics, possessing a reasonable mix of liabilities and equity is a sign of a financially healthy company. While it may be an overly simplistic view of the fundamental accounting equation, investors should view a much bigger equity value compared to liabilities as a measure of positive investment quality, because possessing high levels of debt can increase the likelihood that a business will face financial troubles. Assets represent things of value that a company owns and has in its possession or something that will be received and can be measured objectively. This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings. Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity, referred to as shareholders' equity in a listed company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.

  • Current Assets - Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes include cash and cash equivalents, accounts receivable and inventory. Cash, the most fundamental of current assets, also includes non-restricted bank accounts and cheques. Cash equivalents are very safe assets that can be readily converted into cash. Accounts receivables consist of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit; these obligations are held in the current assets account until they are paid off by the clients. Lastly, inventory represents the raw materials, work-in-progress goods and the company's finished goods. Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm caries none. The makeup of a retailer's inventory typically consists of goods purchased from manufacturers and wholesalers
  • Non-Current Assets - Non-current assets are assets that are not turned into cash easily, are expected to be turned into cash within a year and/or have a life-span of more than a year. They can refer to tangible assets such as machinery, computers, buildings and land. Non-current assets also can be intangible assets, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated.
  • Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.

On the other side of the balance sheet are the liabilities. Liabilities are the financial obligations that a company owes to outside parties such as creditors, suppliers, tax authorities, employees etc. They are obligations that must be paid under certain conditions and time frames. Like assets, they can be both current and long-term. Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet. Current liabilities are the company's liabilities which will come due, or must be paid, within one year. This is includes both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan.

Shareholders' equity is the initial amount of money invested into a business. In other words, a company's equity represents retained earnings and funds contributed by its shareholders, who accept the uncertainty that comes with ownership risk in exchange for what they hope will be a [good return on their investment] (link to be confirmed). If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder's equity account. This account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other.

The Importance of dates

A balance sheet represents a company's financial position for one day at its fiscal year end, for example, the last day of its accounting period, which can differ from our more familiar calendar year. Companies typically select an ending period that corresponds to a time when their business activities have reached the lowest point in their annual cycle, which is referred to as their natural business year.

In contrast, the income statements and cash flow statements reflect a company's operations for its whole fiscal year, i.e. 365 days. Given this difference in "time", when using data from the balance sheet (akin to taking a photographic snapshot) and the income/cash flow statements (akin to taking a video movie) it is more accurate, and is the practice of analysts, to use an average number for the balance sheet amount. This practice is referred to as "averaging", and involves taking the two preceding year-end figures (2008 and 2007), let us say for total assets and adding them together, and dividing the total by two. This exercise gives us a rough but useful approximation of a balance sheet amount for the whole current year, which is what the income statement number, let us say net income, represents. In our example, the number for total assets at year-end 2009 would overstate the amount and distort the return on assets ratio (net income/total assets).

Since a company's financial statements are the basis of analysing the investment value of a share, this discussion we have completed should provide investors with the "big picture" for developing an understanding of balance sheet basics.

Example of the Balance Sheet

Balance Sheet: ABC Limited

Current Year

Previous Year

#22

Share Capitol

12

10

#23

Distributable Reserves

244

200

#24

Non-distributable Reserves

20

20

#25

Ordinary Shareholders' interest

276

230

#26

Outside Shareholders' interest

12

10

#27

Total Shareholders' interest

288

240

#28

Long-term Liabilities

115

95

#29

Other (deferred taxation)

4

3

#30

Total Capital Employed

407

338

Current Year

Previous Year

#31

Fixed Assets

210

157

#32

Investments and loans

10

10

#33

Goodwill/intangibles

100

100

#34

Net Current Assets

86

71

#35

Current Assets

234

195

#36

Inventories

120

100

#37

Accounts Receivable

100

83

#38

Cash & Bank

14

12

#39

Current Liabilities

148

124

#40

Interest Bearing

43

36

#41

Other

105

88

#42

Total Assets

407

338

#43

Net Asset Value(NAV)

32.4

28.8

#44

Net Tangible Asset Value(NTAV)

20.7

16.3

#45

Current Assets NAV

10.1

9.0

22. Share Capital includes the share capital as well as the share premium. The total figure is the original amount that shareholders invested in the company at the time of issuing the shares.
23. Distributable Reserves are basically retained profits, as calculated in the Income Statement. It represents all company profits since start-up not paid out to shareholders. The reason for retaining such profits is usually for re-investment.
24. Non-distributable Reserves originated for example, on the revaluation of fixed property or other investments. Because these profits will be realised only on the day the investments are sold, such profits would only be distributable at that stage.
25.The first three items (#22 + #23 + #24) add up to the Ordinary Shareholders' Interest. In theory if the company sells all of its assets at the recorded prices and pays off all debts, the net amount will then be available for distribution to shareholders. Ratio analysis includes Net Asset Value (NAV) (#43), Return on Equity (ROE) (#58), Debt/Equity (#61) and Price/NAV (#65). For example:

Share Capital

12

10

Plus Distributable Reserves

244

200

Plus Non-distributable Reserves

20

20

Equals Ordinary Shareholders' interest

276

230

26. Outside Shareholders' Interest represents that portion of shareholders' funds attributable to non-ABC Ltd investors. This occurs where the company does not have a 100% interest in one of its subsidiary companies. For example it only owns 80%, then the other 20% of shareholders' funds are shown at this level.
27. Total Shareholders' Funds are the sum of ordinary and outside shareholders' interest (#25 + #26). For example:

Ordinary Shareholders' interest

276

230

Plus Outside Shareholders' interest

12

10

Equals Total Shareholders' interest

288

240

28. Long-term Liabilities are external debt to be paid back over a period longer than a year. The company pays interest (#5) on this debt. Ratio analysis includes the Debt/Equity ratio (#61).
29. Other normally only includes interest-free debt, such as deferred tax.
30. Total Capital Employed is the total amount of capital currently used in the company. This includes the shareholders' funds as well as long-term debt (#27 + #28 + #29). On shareholders' funds, dividends (#13) are paid and on long-term debt, interest (#5). This figure balances with Total Assets (#42). For example:

Ordinary Shareholders' interest

276

230

Plus Outside Shareholders' interest

12

10

Equals Total Shareholders' interest

288

240

Ratio analysis includes Return on Capital (ROC) (#60) and Debt/Equity (#61).

31.Fixed Assets consist of property, plant & machinery, vehicles, computer equipment, etc. - basically assets with a life span longer than one year used as company infrastructure.

32.Investments and loans include loans to subsidiary companies, investments in associate companies and other smaller investments.

33.Goodwill is an intangible asset. Normally goodwill is created when the company acquires another company. If the total shareholders' funds of the acquired company are, say R100, but the purchase price R150, the surplus paid is called goodwill. It is also sometimes known as cost of control. Ratio analysis includes the Net Tangible Asset Value (#44).

34.Net Current Assets are the difference between current assets and current liabilities (#35 - #39). It is also known as Working Capital. For example:

Current Assets

235

195

Less Current Liabilities

148

124

Equals Net Current Assets

87

71

35. Current Assets, are all assets with a life span of less than a year, and includes inventory, accounts receivable and cash & bank (#36 + #37 + #38). For example:

Inventories

120

100

Plus Accounts Receivable

100

83

Plus Cash & Bank

15

12

Equals Net Current Assets

235

195

36. Inventory (stock), includes unsold products, raw material to be used in the production process as well as work-in-process.
37. Accounts Receivable consists of the trade debtors (clients owing the company money). This is applicable only for companies selling goods or rendering services on a credit basis.
38. Cash & Bank is cash on hand at the end of the period, as well as the company's bank balance.
39. Current Liabilities is cash on hand at the end of the period, as well as the company's bank balance.

Interest Bearing

43

36

Plus Other

105

88

Equals Net Current Assets

148

124

40. Interest Bearing Debt includes the short-term portion of the long-term liabilities (#28). Where the company's bank is in an overdraft, this is also included. Ratio analysis includes Debt/Equity (#61).
41. Other current liabilities are all non-interest bearing liabilities which have to be paid within a year. It includes trade creditors, the receiver of revenue and shareholders for dividends.
42. Total Assets are all long-term assets plus current assets less current liabilities (#31 + #32 + #33 + #34). The Total Capital Employed was used to finance these assets. This figure balances with Total Capital Employed (#30). Ratio analysis includes Return on Capital (ROC) (#60). For example:

Fixed Assets

210

157

Plus Investments and loans

10

10

Plus Goodwill/intangibles

100

100

Plus Net Current Assets

87

71

Equals Net Current Assets

407

338

43. Net Asset Value (NAV) is the Ordinary Shareholders' Funds divided by total number of shares issued (#25 / #17). For example: NAV = Ordinary Shareholders' Interest (Funds) /Total number of shares issued = 276/850 = 32.4cps. In theory if the company sells all of its assets at recorded prices and pays off all debt, the net amount will then be available for distribution to shareholders. Share prices should rarely trade below this value. Ratio Analysis includes NAV Growth (#57), Return on Equity (ROE) (#58) and Price/NAV (#65).
44. Net Tangible Asset Value (NTAV) is NAV less goodwill expressed on a per share basis (#25 - #33 / #17); basically the historical cost of setting up a similar operation. For example: NTAV = Ordinary Shareholders' Interest (Funds) less Goodwill / Tangibles divided by the total number of shares issued = 276 – 100 / 850 = 176/850 = 20.7cps. Ratio analysis includes Return on TNAV (#59), ROE (#58) and Price/NAV (#65).
45. Current Assets NAV can be seen as a conservative liquidation value for the company. It is calculated by dividing the net current assets by the total number of shares issued (#34 / #17). For example: Current Assets NAV = Net Current Assets / Total number of shares issued = 87 / 850 = 10.1. Where long-term liabilities (#28 - #31 - #32 > 0) exceed the fixed assets, loans and investments, a further downwards correction is made. Theoretically a company should never trade below this value. Ratio Analysis includes Price/Current Assets NAV.

Analyse the balance sheet with financial ratios

With a greater understanding of the balance sheet and how it is constructed, we can look now at some techniques used to analyse the information contained within the balance sheet. The main way this is done is through financial ratio analysis. Financial ratio analysis uses formulas to gain insight into the company and its operations. For the balance sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the company's financial condition along with its operational efficiency. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.

The main types of ratios that use information from the balance sheet are financial strength ratios and activity ratios. Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged. This can give investors an idea of how financially stable the company is and how the company finances itself. Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables). These ratios can provide insight into the company's operational efficiency. There are a wide range of individual financial ratios that investors use to learn more about a company.

Ratio Analysis
  1. Interest Cover (#49)
  2. Effective Tax rate (#51)
  3. Return on Equity (ROE) (#58)
  4. Return on Tangible Assets (#59)
  5. Price/Earnings (P/E) (#63)
  6. Price/Net Asset Value (P/NAV) (#65)

Ratio Analysis: ABC Limited

Balance Sheet: ABC Limited

#46

Turnover Growth

20%

#47

Operating Profit Growth

10%

#48

Operating Margin

9.2%

10.0%

#49

Interest Cover

5.8

5.4

#50

Earnings before tax (EBT) Growth

19%

#51

Effective Tax Rate

32%

31%

#52

Profit Attributable to Ordinary Shareholders Growth

18%

#53

Dividend Cover

3

#54

Retention Rate

66%

67%

#55

Earnings per share (EPS) Growth

14%

#56

Headline EPS Growth

2%

#57

Net Asset Value (NAV) growth

22%

#58

Return on Equity (ROE)

26%

#59

Return on Tangible Assets

46%

#60

Return on Capital (ROC)

24%

#61

Debt/Equity (Gearing)

50%

50%

#62

Share Price (Cents per Share) (CPS)

100

80

#63

Price/Earnings (P/E)

13.6

11.0

#64

Dividend Yield (DY)

2.6%

2.9%

#65

Price/Net Asset Value (P/NAV)

3.1

2.8

46. Turnover growth is important as an indicator of the growth phase of the company. Profits can grow by increasing revenue, or decreasing costs. The latter can normally be decreased only to a certain extent. If turnover growth grinds to a halt (#1), then profits become static. Turnover growth should at least exceed inflation, otherwise it is a tell-tale sign of a company reaching maturity.

For example:

Current Year

Previous Year

% Growth

Turnover

1200

1000

20%

47. Operating Profit Growth is a combination of turnover growth and operating margin growth. If turnover grows faster than operating profit (#2), it is a sign the company's expenses are increasing at a rate faster than sales. The company might be losing its competitive edge, might be engaged in a price war, etc. If operating profit increases more rapidly than turnover, it might indicate the company has become more competitive, reaching critical mass, etc. This is a good sign, as long as turnover is also growing at a rate faster than inflation, otherwise it could be a construed as a company with declining, or slow growing turnover. To ensure profit growth it could be cutting down on important costs such as marketing or research & development. Over the longer-term this would definitely be negative for the company.

For example:

Current Year

Previous Year

% Growth

Operating Profit

110

100

10%

48. Operating Margin is the operating profit divided by turnover (#2 / #1). For example: Operating Margin = Operating profit/ Turnover = 110 / 1200 = 9.2%

A margin of 10% would signify the company makes a R10 profit for every R100 sales. The higher the margin, the better the type of products or services sold. Companies selling branded products have much higher margins than do those selling commodity type products. Excellent companies have margins in excess of 10%. A company with a margin below 2% is a higher risk type of business. A loss of 1% on the margin could lead to a 50% drop in profits. The direction of this margin is vital. Refer to the section on Operating Profit Growth (#47).

Current Year

Previous Year

Operating Margin

= Operating profit
Turnover
= 110
1200
= 9.17%

= Operating profit
Turnover
= 100
1000
= 10.0%

49. Interest Cover is one of the most important ratios to consider for financial risk. There are enough uncertainties regarding the future of a company. There is no need to invest in companies with a higher risk of possible bankruptcy. The calculation is earnings before interest and tax (EBIT) divided by net interest paid (#4 / #5).

For example:

Interest cover = EBIT /Net interest paid = 115 /20 = 5.75 times

A three times cover means there are sufficient profits to pay the current interest charge three times. This is normally the minimum cover required from an investment. Below this level, we would very rarely contemplate an investment. Small Cap companies should have a slightly higher interest cover, say above 5 times, to compensate for the higher risk business model.

  1. Earnings before tax (EBT) Growth (#6) are the net effect of operating profit and finance charges. This is, therefore, the growth of the core business before associates and outside shareholders are taken into account.
For example:

Current Year

Previous Year

% Growth

EBT

115

98

17%

  1. The Effective Tax Rate is purely taxation paid divided by earnings before tax (EBT) (#7 / #6). For example: Effective Tax Rate = Taxation Paid x 100% / Earnings before tax (EBT) = 30 x 100% / 95 = 32%. This should be compared with the statutory tax rate, currently 28%. A tax rate materially below this level calls for further investigation. If the tax rate increase to normal levels it will have a negative effect on earnings per share (EPS) and the share price.
  2. Profit Attributable to Ordinary Shareholders Growth can be misleading, especially if there was a material increase in the number of shares issued. Many companies make acquisitions without paying cash. Instead they issue shares in their company to the previous owners of the newly acquired company. In the following year, the total profit of the new company is added, making it appear as if the company had enjoyed a huge increase in earnings. The Earnings per Share (EPS) growth figure is a better figure to compare for it takes the higher number of issued shares into consideration.
For example:

Current Year

Previous Year

% Growth

Profit

115

98

17%

  1. Dividend Cover is the number of times the company's profits cover dividend payments. The average for SA companies is three times. This figure's only importance is that together with the Return on Equity (ROE) (#58), it indicates the sustainable growth rate of earnings. For example: Dividend Cover = Profit Attributable to Ordinary Shareholders/Dividends Paid = 66 / 22 = 3 times.
  2. Retention Rate is calculated as retained profits for the year, divided by the Profit Attributable to Ordinary Shareholders (#14 / #12). It is the profit retained by the company to be re-invested to ensure further growth. Combined with Return on Equity (ROE) (#58), sustainable earnings growth can be calculated. For example: Retention Rate = Retained Profits/ Profit Attributable to Ordinary Shareholders = 44 / 66 = 67%
  3. Earnings per Share (EPS) Growth is the year-on-year growth in earnings per share (#20). This is one of the most widely used ratios and a strong determinant of share prices. The Headline EPS Growth (#56) is more important and even more widely used.
For example:

Current Year

Previous Year

% Growth

EPS

8.0

7.0

14%

  1. Headline EPS Growth is the growth in the core earnings of the company (#21) expressed on a per share basis. This is probably the most important influence on the share price. In the short-term the actual growth is not so important, what is vital, however, is where the actual growth differs from the analysts' forecasts, as the share price might then react quite volatile over the short-term.
For example:

Current Year

Previous Year

% Growth

HEPS

7.4

7.3

2%

  1. Net Asset Value (NAV) Growth is calculated as the growth in NAV (#43) from one year to the next, but adjusted for the payment of dividends (#19). The formula is the current year's NAV (#43) plus the current dividend (#19) divided by the previous year's NAV (#43).
For example:

NAV Growth = Current year's NAV plus Dividends / Previous year's NAV = 32.4 cps + 2.6 cps / 28.8 cps = 35cps/ 28.8cps = 1.215 -1 x 100 = 22%.

This is, therefore, the actual increase in shareholders' value. It is also known as the Adjusted Return on Equity (ROE).

  1. Return on Equity (ROE) is probably the most important ratio to calculate. The correct way to calculate this figure is to divide the headline Profits Attributable to Ordinary Shareholders by the weighted average Ordinary Shareholders' Funds. This is, however, a tedious and sometimes misleading calculation.
For example:

ROE% - Profits Attributable to Ordinary Shareholders / Weighted average Ordinary Shareholders' Funds = 66 x 100%/ 276 = 24%.

Our preferred method is both simpler and affords a better answer. Simply divide this year's Headline EPS (#21 / #43) by the opening Net Asset Value (NAV of the previous year). The reason for using the previous year's NAV is to compare the return with a return of a fixed interest investment - or the return you receive at a bank.

For example:

ROE% = Current HEPS / Opening NAV = 7.4 x 100%/ 28.8 = 26%

If you can receive a higher return at the bank (which also has lower risk), the company is not a very profitable business. The higher the return, the better quality the business, and the higher should be the growth in EPS. Theoretically the ROE times the Retention Rate (#54) results in the sustainable growth rate of the company. Although the Return on Capital (#60) is more important from a business point of view, we are equity investors and, therefore, our eventual returns are better measured by the Return on Equity (ROE).

The ROE can also be used to forecast next year's Headline EPS. First you use the current and historic ROE, then forecast next year's ROE based on these figures. Your forecast Headline EPS would then be your forecast ROE multiplied by the current NAV.

For example:

Forecast HEPS = Forecast ROE% x Current NAV = 1 x [1 – 0.74) x 32.4 = 8.42 cps

  1. Return on Tangible Assets is a useful calculation for newly listed companies, as well as those that grow rapidly by means of acquiring other companies. Because prices paid for acquisitions are normally higher than their Net Asset Values (NAV) (#43), most acquisitions include an amount of goodwill (#33). This amount can be higher than tangible assets. Because the amount paid includes this goodwill, the NAV normally grows out of proportion to the earnings per share (EPS) (#20). Likewise the Return on Equity (ROE) (#58) is lower and not indicative of the underlying sustainable growth of the company. The Return on Tangible Assets is a better proxy of sustainable growth for the company. And also better to forecast future Headline EPS. The Return on tangible assets calculation is similar to that of the ROE calculation but instead of using #43 (opening Net Asset Value or NAV of the previous year), you use #44 (opening net tangible asset value or NTAV of the previous year).
For example:

Return on Tangible Assets = HEPS x 100%/ Opening NTAV = 7.4 cents x 100% / 16.3 cents = 45%

  1. Return on Capital (ROC) refers to the total return on assets or capital before the providers of the capital are compensated. The providers - firstly the providers of debt - are compensated by interest payments and, secondly, shareholders that have a right on the residual after interest and taxation. This figure is calculated by adding back after tax interest payments (#12 + (#5 x (1 - #51))) and dividing by the total capital employed of the previous year (#30). The result is the earnings power of total assets.

For example: ROC = Net Profit + (Interest Paid x (1 – Effective Tax Rate))/ Total Capital Employed = 66 + 20 x ( 1 x 0.68) / 338 = 66 + 13.6 / 338 = 79.6 / 338 = 24%

Combined with the Debt/Equity ratio (#61) the result is Return on Equity (ROE) (#58).

  1. The Debt/Equity Ratio (also known as the company's gearing) illustrates the amount of debt used in the capital structure. We calculate this ratio by adding the long-term interest bearing debt to the short-term interest bearing (under current liabilities) and subtracting the Cash & Bank (under current assets) (#28 + #40 - #38). This amount is then divided by Total Shareholders' Funds (#27).

For example: Debt/Equity = (LT + ST interest bearing debt) - (Cash + Bank) x 100%/Total Shareholder's funds = (115 + 43) – 14 x 100% / 288 = 158- 14 x 100% /288 = 144 x 100% /288 = 50%

Although debt is normally frowned upon, the correct amount of debt can greatly enhance the Return on Equity (#58) and, therefore, shareholder value, with a minimum increase in the risk of the company. As long as the interest cover (#49) is above 3 times, we are satisfied the company can afford its debt. If the company's return on capital/assets (ROC) (#60) is higher than the interest rate (after-tax) paid on its debt, gearing will enhance shareholder's returns. It is only when the ROC is lower than the interest rate that debt is a problem. In such cases, where the ROC is so low, we would prefer not to be invested in the company anyhow.

  1. Share Price (Cents per Share) (CPS) is the ruling share price expressed in cents per share. It is the last price at which the share traded. The total value of the company can be calculated by multiplying this price with the total number of issued shares (#17). This total value is also referred to as Market Capitalisation.
  2. The Price/Earnings (P/E) ratio is one of the most commonly used methods of relative value. The normal calculation is the current share price divided by the latest reported Headline Earnings per Share (EPS) (#62 / #21).

For example: PE = Current share price / HEPS = 100cps / 7.4cps = 13.5 times.

If a company is trading at a 5 PE it means that if the EPS remains constant, an investor will wait 5 years to recoup his total investment. The lower the PE (assuming all companies grow EPS at the same rate), the cheaper, therefore, the share. In the table below are two companies, the one on a PE (Year 1) of 5 another on 10. Company A would, therefore, seem to be the cheaper of the two. Company A, however, grows EPS at 5% a year, Company B at 40%. The growth in EPS will result in Company A being on a 4,1 PE and Company B on a 2.6 PE in year 5. At identical share prices, therefore, Company B will suddenly seem cheaper.

Year 1

Year 2

Year 3

Year 4

Year 5

Company A: EPS

20.0

21.0

22.1

23.2

24.3

EPS Growth

5%

5%

5%

5%

Price/earnings (PE)

5.0

4.8

4.5

4.3

4.1

Company B: EPS

10.0

14.0

19.6

27.4

38.4

EPS Growth

40%

40%

40%

40%

Price/earnings (PE)

10.0

7.1

5.1

3.6

2.6

From the above it is clear that the PE have to be used in conjunction with the EPS growth to enable a fairer idea of relative value. Refer to the PEG ratio (#66). From time to time, analysts talk about the "forward PE" of a company. This is the Share Price divided by the forecast headline EPS of the following year.

  1. Dividend Yield (DY) is calculated as the dividend per share (DPS) divided by the current share price (#19 / #62).

For example: Dividend Yield (DY) = Dividends per share x 100% / Current share price = 2.6cps x 100%/ 100cps = 2.6%
It can, therefore, be compared to the interest rate (after allowing for tax) one can earn from other investments. The main difference is that dividends normally grow, whereas the return from fixed interest investments remains constant. The dividend yield is useful only for mature companies with a low retention rate. These are normally slower growing companies. Fast growing companies normally pay small dividends or no dividends as they need to plough all their profits back into their business.

  1. Price/Net Asset Value (P/NAV) together with return on equity (ROE) (#58) is one of the most powerful valuation tools, but is seldom used correctly. The calculation is simply the current share price divided by the NAV (#62 / #43).

For example: P/NAV = Current share price / NAV = 100cps / 32.4 = 3.1 times

The higher the ROE the higher the P/NAV should be. This can be explained with reference to fixed interest investments. If you can earn 10% (after tax) interest at your bank, your ROE would be 10%. If you invest R100, your investment would be worth R100 or trade on a P/NAV of 1 and you would earn R10 interest. If this is the benchmark return and someone else also has R100 invested, but at 5%, surely you would not be willing to exchange your investment on a one for one basis. Because the interest on the other R100 is only R5, you would have to have two of these investments to earn the same R10 return. The other R100 is, therefore, actually only worth R50, or should trade on a 0.5 times P/NAV.

Why is the PEG ratio a better predictor of profit than the PE ratio?

It is common practice for investors to use the price-to-earnings ratio (PE ratio or price multiple) to determine if a company's share price is overvalued or undervalued. A share is undervalued when it is trading below its true value. The difficulty is knowing what the "true" value actually is. Analysts will usually recommend an undervalued share with a strong buy rating.

Companies with a high P/E ratio are typically growth shares. However, their relatively high multiples do not necessarily mean that their shares are overpriced and not good buys for the long term.

Let us take a closer look at what the P/E ratio tells us: P/E Ratio = Current Share Price/ Earnings per Share (EPS).

There are two primary components here, the current share price and the earnings of the company.

Earnings are very important to consider. After all, earnings represent profits, for what every business strives for. Earnings are calculated by taking the hard figures into account, namely revenue, cost of goods sold, salaries, rent, etc. These are all important to the livelihood of a company. If the company is not using its resources effectively it will not have positive earnings, and problems will eventually arise. Here in South Africa, we use the headline earnings per share (HEPS) figure to provide a better idea of the company's earnings sustainability. The earnings per share figure is adjusted for items not considered to be of an ordinary nature of the business. This adjusted figure was then divided by the weighted average number of shares in issue. Care should be taken when analysing a company to ensure that these 'once-off' items that management adds back for headline purposes are in fact of a once-off nature. In practice it is worth noting that the majority of such items normally result in Headline EPS being higher than normal EPS. But the theory behind using headline, and thus sustainable, figures for valuation purposes remain sound.

Because the P/E ratio uses past twelve months earnings, it gives a less accurate reflection of its growth potential. The relationship between the price/earnings ratio and earnings growth tells a much more complete story than the P/E on its own. The PEG ratio is a widely used indicator of a share's potential value. It is favoured by many over the price/earnings (PE) ratio because it also accounts for growth. The PEG ratio or the Price/Earnings to Growth ratio is formulated as: PEG ratio = P/E ratio / Forecast average HEPS Growth

The number used for annual growth rate is the forward, predicted growth and a five-year time span. Keep in mind that the numbers used are projected and, therefore, can be less accurate. Looking at the value of PEG of companies is similar to looking at the P/E ratio: a lower PEG ratio means that the share is more undervalued.

Comparative Value

Let us demonstrate the PEG ratio with an example. Say you are interested in buying shares in one of two companies. The first is an IT company with a forecast 20% annual growth in net income and a P/E ratio of 50. The second company is in a beer company. It has lower forecast headline earnings growth at 10% and its P/E ratio is also relatively low at 15.

Many investors justify the share valuations of technology companies by relying on the assumption that these companies have enormous growth potential. Can we do the same in our example?

IT Company: P/E ratio (50) divided by the forecast headline earnings growth rate (20) = PEG ratio of 2.5

Beer Company: P/E ratio (15) divided by the forecast headline earnings growth rate (10) = PEG ratio of 1.5

The PEG ratio shows us the 'popular' high-technology company, compared to the beer company, does not have the growth rate to justify its higher P/E ratio, and its share price appears overvalued, particularly when this comparison is made. Subjecting the traditional P/E ratio to the impact of future earnings growth produces the more informative PEG ratio, which provides more insight about a share's current valuation. By providing a forward-looking perspective, the PEG is a valuable evaluative tool for investors attempting to discern a share's future prospects.

The PEG ratio as an indicator

The PEG ratio is a widely employed indicator of a share's possible true value. Similar to price/ earnings (PE) ratios, a lower PEG ratio means that the share is undervalued more. It is favoured by many over the PE ratio because it also accounts for growth. If a company is growing at 30% a year, then the share's P/E ratio could be 30 to have a PEG of 1.

The PEG ratio of 1 is sometimes said to represent a fair trade-off between the values of cost and the values of growth, indicating that a share is reasonably valued given the expected growth. A crude analysis suggests that companies with PEG values between 0 and 1 may provide higher returns.

The PEG ratio, despite its wide use, is only a rule of thumb and has no accepted underlying mathematical basis. Its specific mathematical deficiency is explained here.

The PEG ratio's validity at extremes in particular (when used, for example, with low-growth companies) is highly questionable. It is generally only applied to so-called growth companies (those growing earnings significantly faster than the market).

When the PEG is quoted in public sources it may not be clear whether the earnings used in calculating the PEG is the past year's EPS or the expected future year's EPS. Here at PSG Securities Ltd , we consider it preferable to use the expected future or forecast growth rate.

It also appears that unrealistically high future growth rates (often as much as 5 years out, reduced to an annual rate) are sometimes used. The key is that management's expectations of future growth rates can be set arbitrarily high; this is a self-serving ploy where the objectives are to keep themselves in office and to make the share artificially attractive to investors. A prospective investor would probably be wise to check out the reasonableness of the future growth rate by checking to see exactly how much the most recent period's earnings have grown, as a percentage, over the same period one year ago. Dividing this number into the future P/E ratio can give a decidedly different and perhaps a more realistic PEG ratio.

Advantages of the PEG ratio

Investors may prefer using the PEG ratio because it explicitly puts a value on the expected growth in earnings of a company. The PEG ratio can offer a suggestion of whether a company's high P/E ratio reflects an excessively high share price or is a reflection of promising growth prospects for the company.

Disadvantages of the PEG ratio

The PEG ratio is less appropriate for measuring companies without high growth. Large, well-established companies, for instance, may offer dependable dividend income, but little opportunity for growth.

A company's growth rate is an estimate. It is subject to the limitations of projecting future events. Future growth of a company can change due to any number of factors, namely: market conditions, expansion setbacks, and hype of investors. Also, the convention that "PEG=1" is appropriate is somewhat arbitrary and considered a rule of thumb metric.

The simplicity and convenience of calculating PEG leaves out several important variables. First, the absolute company growth rate used in the PEG ratio does not account for the overall growth rate of the economy, and hence an investor must compare a share's PEG ratio to average PEG ratio's across its industry and the entire economy to get any accurate sense of how competitive a share is for investment. A low (attractive) PEG ratio in times of high growth in the entire economy may not be particularly impressive when compared to other shares, and vice versa for high PEG ratio's in periods of slow growth or economic recession.

In addition, company growth rates that much higher than the economy's growth rate are unstable and vulnerable to any problems the company may face that would prevent it from keeping its current rate. Therefore, a higher-PEG ratio share with a steady, sustainable growth rate (compared to the economy's growth) can often be a more attractive investment than a low-PEG ratio share that may happen to just be on a short-term growth "streak". A sustained higher-than-economy growth rate over the years usually indicates a highly profitable company, but can also indicate a scam, especially if the growth is a flat percentage no matter how the rest of the economy fluctuates.

The PEG also has no implicit or explicit correction for inflation (i.e., a company with growth equal to the rate of inflation is not growing in real terms). Hence, the PEG ratio lacks a coherent conceptual framework, and is used primarily as a somewhat intuitive metric of the extent of the growth/price trade-off.

Finally, the volatility of highly speculative and risky shares, which have low price/earnings ratios due to their very low price, is also not corrected for in PEG calculations. These shares may have low PEG's due to a very high short-term (less than one year) PE ratio (e.g. 100% growth rate from R1 to R2 share) that does not indicate any guarantee of maintaining future growth or even solvency.

P/NAV versus ROE

So-called growth investors often frown upon the Price/NAV ratio, but research has confirmed that low P/NAV companies do outperform the averages. Below is research performed by David Dreman and extracted from his book Contrarian Investment Strategies, which shows the performance of US stocks divided into the P/NAV Quintiles on an annual basis for the period starting in 1970 and ending in 1996.

Price/NAV: 1 January1970- 31 December1996

P/NAV Quintiles

Total Return

Low P/NAV

18.8%

2

16.2%

3

14.5%

4

13.8%

High P/NAV

12.0%

Market

15.3%

The above shows that you should outperform the averages simply by selecting companies in the lowest P/NAV Quintile. This is confirmed by the results of the 40-year research done on Wall Street.

P/E versus P/NAV

The PEG ratio is fast becoming one of the most frequently used valuation techniques, although it is inherently unstable. The more volatile the historic growth rate the less accurate this method of valuation. Hence the forecast growth as well as the EPS base is the most important variables, companies with volatile track records and/or declining profitability will need further investigation. This is illustrated in the following example where we assume the company has a dividend cover of 3 times:

Year 1

Year 2

Year 3

Year 4

Year 5

NAV

112

121

136

157

175

ROE

18%

13%

18%

23%

18%

EPS

18

15

22

31

28

EPS Growth

-19%

50%

43%

-10%

As is clear the NAV shows an upward trend, whereas the EPS figures declined in Year 2 and again in Year 5. The NAV is therefore a less volatile base. Secondly the ROE is clearly less volatile than the EPS growth, which actually slips into negative territory in 2 of the 5 years. The compound EPS growth over the period was 12% and the average ROE 18%.

If we assume that the historical trend was similar, we would have valued the company at a 12 times P/E on the PEG method, the values for each year are illustrated below. The volatile valuations on a P/E basis is clear, down in year 2 and again in year 5. Below this we show our valuations based on P/NAV and the average ROE of 18%. The trend here is much more in line with what one would expect. This is due to using the less volatile NAV as base. If one had invested in year 2 when the market rated the share on a PEG valuation at 172, one could have more than doubled the value of one's investment in 2 years if one had sold in year 4 at 371. In the 3 years where the ROE was at the average of 18% the valuations would have been in line, its only when the company does better or worse than its average that the valuations diverge. You will see that in year 2 there is a 38% and in year 4, a 22% difference.

Year 1

Year 2

Year 3

Year 4

Year 5

P/E of 12

213

172

259

371

334

P/NAV at 18% ROE

213

238

259

289

333

Difference

0%

38%

0%

-22%

0%

The PEG factor works excellently where a company, for example, shows a 20% increase in EPS year after year. But unfortunately the majority of companies in the real world are not able to show such sustainability in short-term results. Therefore we believe our P/NAV and ROE as well as our P/Sales models are superior valuation tools.

The Relationship with ROE

Price/NAV levels have a direct correlation with return on equity (ROE). The higher the ROE the higher should the Price/NAV be.

Research carried out in the US markets by Aswath Damodaran shows the outperformance of stocks selected on a high ROE and low P/NAV basis

Portfolios were chosen by filtering or screening all NSYE stocks; High represents the top 25% of the universe and low the bottom 25%.

P/BV vs. ROE, 1982 - 1991

Returns

82

83

84

85

86

87

88

89

90

91

Ave.

Compound

High ROE/ Low P/NAV

37.6

34.8

20.5

46.6

33.6

(8.8)

23.5

37.5

(26.7)

74.2

27.2

27.1

Low ROE/ High P/NAV

14.6

3.1

(28.8)

30.2

0.6

(0.6)

7.2

16.6

(11.0)

28.7

6.1

5.2

S& P 500

40.4

0.7

15.4

31.0

24.4

(2.7)

9.7

18.1

6.2

31.7

17.5

18.6

Over the period the high ROE low P/NAV portfolios returned 27% per year vs. the low ROE High P/NAV portfolios of 5,2% and the market return of 18,6%. The correct relationship can be deduced from the PEG factor. If one assumes a PEG factor of 1 (as we proved earlier on) the correct P/E should equal the EPS growth rate or the fair value should equal EPS x EPS growth rate. As the EPS is nothing but the ROE x Opening NAV and the EPS growth equals ROE x retention rate it doesn't take a genius to calculate the formula for the correct P/NAV levels for stocks.

It is important not be biased in favour of companies trading on low Price/NAV levels because earnings on intangibles are normally less vulnerable to competition than those requiring a pure cash investment. Furthermore, companies with small capital investments can - under favourable conditions - grow sales and profits at a faster rate and at lower expense than companies that need large capital investments due to capacity constraints.

On Wall Street, research shows that superior returns can be achieved by simply selecting the lowest P/NAV stocks. In this way one's portfolio will be biased towards below average types of companies. By linking the ROE to P/NAV one can include highly profitable companies in your portfolio. But more importantly this is also done at reasonable prices. This method is successful because it normalises the EPS and therefore P/E ratio, and - especially where a company has had a particularly good or bad year - investors will not be caught up in the crowd mania.

Another reason is that the method forces investors to also look at the balance sheet and not purely at the EPS line. Any businessman will tell you that the return or potential return on any project is the major consideration in every business decision, yet very few analysts have any idea of this return and yet they are quite free and quick with their recommendations.

The Cash Flow Statement

Complementing the balance sheet and income statement, the cash flow statement, a mandatory part of a company's financial reports, records the amounts of cash and cash equivalents entering and leaving a company. The cash flow statement allows investors to understand how a company's operations are running, where its money is coming from, and how it is being spent. Here you will learn how the cash flow statement is structured and how to use it as part of your analysis of a company.

The Structure of the Cash Flow Statement

The cash flow statement is distinct from the income statement and balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net income or net profit, which, on the income statement and balance sheet, includes cash sales and sales made on credit. Cash flow is determined by looking at three components, by which cash enters and leaves a company, namely core operations, investing and financing.

Cash Flow from Operations

Measuring the cash inflows and outflows caused by core business operations, the operations component of cash flow reflects how much cash is generated from a company's products or services. Generally, changes made in cash, accounts receivable (debtors), depreciation, inventory (stock) and accounts payable (creditors) are reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in revenue, expenses and credit transactions (appearing on the balance sheet and income statement) resulting from transactions that occur from one period to the next. These adjustments are made because non-cash items are calculated into net income (from the income statement) and total assets and liabilities (from the balance sheet). So, because not all transactions involve actual cash items, many items have to be re-evaluated when calculating cash flow from operations.

For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value of an asset that has previously been accounted for. That is why it is added back into net sales for calculating cash flow. The only time income from an asset is accounted for in cash flow statement calculations is when the asset is sold.

Changes in accounts receivable (debtors) on the balance sheet from one accounting period to the next must also be reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the company from customers paying off their credit accounts, the amount by which accounts receivable has decreased is then added to net sales. If accounts receivable increase from one accounting period to the next, the amount of the increase must be deducted from net sales because, although the amounts represented in accounts receivable are revenue or income, they are not cash.

An increase in inventory or stock, on the other hand, signals that a company has spent more money to purchase more raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net sales. A decrease in inventory would be added to net sales. If inventory was purchased on credit, an increase in accounts payable or creditors would occur on the balance sheet, and the amount of the increase from one year to the other would be added to net sales.

The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings.

Cash Flow from Investing

Changes in equipment, assets or investments relate to cash from investing. Usually cash changes from investing are a "cash out" item, because cash is used to buy new equipment, buildings or short-term assets such as listed shares. However, when a company divests of an asset, the transaction is considered "cash in" for calculating cash from investing.

Cash Flow from Financing

Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from financing are "cash in" when capital is raised, and they are "cash out" when dividends are paid. Thus, if a company issues preference shares to the public, the company receives cash financing; however, when interest is paid to preference shareholders, the company is reducing its cash.

Cash Flow Statement for Company XYZ for the Year Ended 31 December 2010

Cash Flow from Operations

Net Earnings

R2 000 000

Additions to Cash

Depreciation

R10 000

Decrease in Accounts Receivable (Debtors)

R15 000

Increase in Accounts Payable (Creditors)

R15 000

Increase in Taxes Payable

R 2 000

Subtractions from Cash

Increase in Inventory (Stock)

(R30 000)

Net Cash from Operations

R2 012 000

Cash Flow from Investing

Equipment

(R500 000)

Cash Flow from Financing

Credit Notes Payable

R10 000

Cash Flow for Year Ended 31 December 2010

R1 522 000

From this cash flow statement, we can see that the cash flow was R1 522 000. The bulk of the positive cash flow stems from cash earned from operations, which is a good sign for investors. It means that core operations are generating business and that there is enough money to buy new inventory (stock). The purchasing of new equipment shows that the company has cash to invest in inventory for growth. Finally, the amount of cash available to the company should ease investors' minds regarding the credit notes payable, as cash is plentiful to cover that future loan expense.

Of course, not all cash flow statements look this healthy, or exhibit a positive cash flow. But a negative cash flow should not automatically raise a red flag without some further analysis. Sometimes, a negative cash flow is a result of a company's decision to expand its business at a certain point in time, which would be a good thing for the future. This is why analysing changes in cash flow from one period to the next gives the investor a better idea of how the company is performing, and whether or not a company may be on the brink of bankruptcy or success.

Cash Flow/EPS Ratio

A business is only worth the cash that the owner will receive from the business over its lifetime. The classical definition based on this obvious statement is as follows: The value of any business is equal to the free cash flow the business will produce over its lifetime discounted to the net present value.

In an inflationary environment it is obvious that R100 in your pocket today will buy more than the same amount ten years from now. That is why the future cash receipts are discounted back to return a value today. As explained under valuations the reason why we do not use the Discounted Cash Flow (DCF) as a valuation method is due to the fact that the detail required for such valuations are not only almost impossible to forecast but also leaves a misguided sense of accuracy. That is the reason that we have constructed certain rule of thumb valuation methods that are within grasp of most investors. Not only are these methods easier to use and requires less input, the answer is pretty much the same as the more extensive theoretical valuation methods.

Having said that, the major assumption is that the EPS is a good proxy for cash flow. Although EPS and cash flow is bound to be similar over the life of a business, large intermediate differences should set the alarm bells off. A business where cash flow is consistently materially below EPS or even negative has a much larger chance of failing as a good cash generator. Expensive lessons from the past have taught us that investments in potential bankrupt companies can be minimised if one only invests in companies with strong cash flow ability. Accountants have leeway to play with EPS figures, but cash does not lie!

Although the statement of cash flow together with all its notes can be rather lengthy we are only interested in the net cash flow provided by operating activities (normally found at the start of the cash flow statement). Companies normally disclose this item in one of the following ways:

Current Year

Previous Year

CASH FLOW FROM OPERATING ACTIVITIES

Receipts from customers

1100

987

Payment to suppliers

(1025)

(930)

Dividends received

30

25

Net interest paid

(20)

(15)

Income taxes paid

(27)

(23)

Net cash provided by operating activities

58

44

OR

Operating profit before tax & interest

68

56

Depreciation

4

3

Amortisation

16

12

Provisions

8

2

Interest paid

(3)

(2)

Taxation paid

(20)

(15)

Changes in working capital (debtors, creditors, inventory etc.)

(15)

(12)

Net cash provided by operating activities

58

44

In order to compare this figure with EPS one needs to subtract capital expenditure to maintain operations. Unfortunately this figure is not always readily available, in practice we therefore subtract depreciate

Net cash provided by operating activities

58

44

(Less) Depreciation

(4)

(3)

Adjusted cash provided by operating activities

54

41

Cash Flow Per share

6.55

5.13

HEPS

7.4

7.3

Cash Flow/EPS

0.89

0.7

To calculate the cash flow per share, we divide this figure by the weighted average number of shares. For example: Cash flow per share = Cash provided by operating activities / Weighted average number of shares = 54 /825 = 6.55

To calculate the cash flow/ EPS ratio, we divide the cash flow per share figure by the HEPS number. For example: Cash flow/ EPS ratio = Cash flow per share / HEPS = 6.55/ 7.4 = 0.89.

Any ratio above 0.75 can be considered very good, while any ratio consistently below 0.50 should be questioned by the investor. If a company cannot convert its profits into cash something materially might be wrong.

Tying the Cash Flow Statement with the Balance Sheet and Income Statement

As we have already discussed, the cash flow statement is derived from the income statement and the balance sheet. Net earnings from the income statement is the figure from which the information on the cash flow statement is deduced. As for the balance sheet, the net cash flow in the cash flow statement from one year to the next should equal the increase or decrease of cash between the two consecutive balance sheets that apply to the period that the cash flow statement covers. (For example, if you are calculating a cash flow for the year 2009, the balance sheets from the years 2008 and 2009 should be used.)

A company can use a cash flow statement to predict future cash flow, which helps with matters in budgeting. For investors, the cash flow statement reflects a company's financial health: basically, the more cash available for business operations, the better. However, this is not a hard and fast rule. Sometimes a negative cash flow results from a company's growth strategy in the form of expanding its operations. By adjusting earnings, revenues, assets and liabilities, the investor can get a very clear picture of what some people consider the most important aspect of a company: how much cash it generates and, particularly, how much of that cash stems from core operations.

Conclusion-to-financial-statements'>Conclusion to financial statements

The balance sheet, along with the income and cash flow statements, is an important tool for investors to gain insight into a company and its operations. The balance sheet is a snapshot at a single point in time of the company's accounts - covering its assets, liabilities and shareholders' equity. The purpose of the balance sheet is to give users an idea of the company's financial position along with displaying what the company owns and owes. It is important that all investors know how to use, analyse and read this document.

Valuations

Although there are numerous theoretical methods to value shares, these valuation methods lead to confusion, as the input required is normally not within reach of investors. The detail required for valuation techniques such as Discounted Cash Flows (DCF) are not only almost impossible to forecast but also leaves a misguided sense of accuracy. Therefore we have constructed certain rule of thumb valuation methods that are within grasp of most investors. Not only are these methods easier to use and requires less input, the answer is pretty much the same as the more extensive theoretical valuation methods.

Rule of the Thumb 1
(PEG based on P/E):

Rule of the Thumb 2:
PEG based on P/NAV)

#59 Sustainable Return on Tangible Assets

#59 Sustainable Return on Tangible Assets

Multiplied by 66%

#72 Multiplied by 80%

#69 equals sustainable growth rate

The result multiplied with itself (squared)

The result multiplied by 50% and then 100

#67 equals suggested PE

#71 equals suggested P/NAV>

#21 multiplied with Headline EPS

#43 multiplied with NAV

#68 Suggested Value

#68 Suggested Value

OR if the company has no goodwill (#33) in its Balance Sheet then:

Sustainable Return on Equity (ROE)

#58 Sustainable Return on Equity (ROE)

Multiplied by 66%

Multiplied with itself (squared)

#69 equals sustainable growth rate

The result multiplied by 50% and then 100

#67 equals suggested PE

#71 equals suggested P/NAV

#21 multiplied with Headline EPS

#43 multiplied with NAV

##68 Suggested Value

#68 Suggested Value

ABC Limited

#62

Share Price

100

#63

Price/Earnings (P/E)

13.5

#21

Headline EPS

7.4

#65

Price/Net Asset Value (P/NAV)

3.1

#43

Net Asset Value (NAV)

32.4

#44

Net Tangible Asset Value (NTAV)

20,7

Method 1: PEG based on P/E ratios

  1. The Price/Earnings (P/E) ratio is one of the most commonly used methods of relative value. The normal calculation is the current share price divided by the latest reported Headline Earnings per Share (EPS) (#62 / #21). If a company is trading at a 5 PE it means that if the EPS remains constant, an investor will wait 5 years to recoup his total investment. The lower the PE (assuming all companies grow EPS at the same rate), the cheaper, therefore, the share. In the table below are two companies, the one on a PE (Year 1) of 5 another on 10. Company A would, therefore, seem to be the cheaper of the two. Company A, however, grows EPS at 5% a year, Company B at 40%. The growth in EPS will result in Company A being on a 4,1 PE and Company B on a 2.6 PE in year 5. At identical share prices, therefore, Company B will suddenly seem cheaper.

Year 1

Year 2

Year 3

Year 4

Year 5

Company A: EPS

20.0

21.0

22.1

23.2

24.3

EPS Growth

5%

5%

5%

5%

Price/earnings (PE)

5.0

4.8

4.5

4.3

4.1

Company B: EPS

10.0

14.0

19.6

27.4

38.4

EPS Growth

40%

40%

40%

40%

Price/earnings (PE)

10.0

7.1

5.1

3.6

2.6

From the above it is clear that the PE have to be used in conjunction with the EPS growth to enable a fairer idea of relative value. Refer to the PEG ratio (#66). From time to time, analysts talk about the "forward PE" of a company. This is the Share Price divided by the forecast headline EPS of the following year.

  1. The PEG ratio is fast becoming the valuation method of choice among analysts worldwide. The calculation is P/E Ratio (#63) / Forecast average headline EPS Growth over next 5 years.

For example: PEG ratio = P/E ratio / Forecast average HEPS Growth = 13.5 x 100% / 2 = 675%

By using the PEG ratio we envisage to outperform by selecting not only companies with low P/E ratios as such, but those companies with P/E ratios low relatively to their headline EPS growth. Our objective is to target the better companies trading on low P/Es. To be of value, a company's PE must be lower than its growth rate, or the PEG ratio must be below 100%. The most prevalent mistake normally made is with the calculation of forecast average headline EPS growth or the sustainable growth rate (#69). Furthermore, although widely used, this method is unstable when applied to companies showing volatile EPS trends. A better method - one that should always be used as a test of the PEG based on PEs - is the Price/NAV PEG ratio. The two long-term valuations (i.e. PEG (P/E %) and PEG/NAV) are all based on the PEG, the lower the PEG the better value the company shows.

Over Value

> 126%

Fair Value

76% - 125%

Under Value

35% - 75%

Speculative

< 34%

If Fair Value is equal to 100 and a 25% margin of error is taken on both sides, then when a share is trading above 140 it will be pointing to a possible overvalued situation. Between 75 and 125 illustrates a fairly valued position. When the PEG is between 35 and 75, this is where the best values can be found. Below 35 times the share is either very cheap or insiders know of bad news that has not yet been announced. This is why we classify these shares as speculative. Investors should ensure that they have a lot of knowledge about these speculative shares before investing.

Below we illustrate three possible methods. Method A (refer to #69 for more detail) is the incorrect method to use, and depending on the circumstances either B or C may be used.

Method A

Based on Previous years' Growth:

#56

Headline EPS Growth

2%

#66

PEG Factor (PE/EPS Growth)

681%

#67

Suggested PE

2

#68

Suggested Value per share

15

Method B

Based on Sustainable ROE:

#58

Return on Equity (ROE)

26%

#54

Retention Rate

66%

#69

Sustainable Growth Rate

17%

#66

PEG Factor (PE/EPS Growth)

80%

#67

Suggested PE

17

#68

Suggested Value per share

126

Method C

Based on Sustainable Return on Tangible Assets:

#59

Return on Tangible Assets

46%

#69

Sustainable Growth Rate

30%

#66

PEG Factor (PE/EPS Growth)

45%

#67

Suggested PE

30

#68

Suggested Value per share

222

  1. The Suggested PE should be equal to the forecast growth rate (#69) and is then multiplied with the Headline EPS (#21) to result in a Suggested Value per share (#68) or, your valuation.
  2. The Suggested Value is your valuation of the share. Based on fundamental research, a share should be bought only if this value is substantially above the prevailing share price.
  3. The Sustainable Growth Rate is one of the most important inputs in the valuation process. Method A - using the most recent year's EPS growth - is incorrect. In this example it was 2%. The end result is an extremely low suggested value. Method B is correct if the company does not grow by acquisitions and, therefore, has no goodwill (#33) on the balance sheet. The return on Equity (ROE) multiplied by the retention rate results in the sustainable growth rate (#58 x #54).

For example: Sustainable Growth Rate = ROE% x Retention Rate = 26% x 66% = 17%

If it has goodwill, the ROE will be lower than the actual return the company can earn on its assets. Then Method C will be the best method to use. Calculate the return on tangible assets (#59) and use this as base to calculate the sustainable growth rate (#59 x 66%) and, therefore, the PE ratio at which the company should grow. The important factor is the return used must be seen as sustainable for at least the next 5 years.

For example: Sustainable Growth Rate = RTA x Retention Rate = 45% x 66% = 30%

Although the actual formula for sustainable growth is ROE x Retention rate, the fact that two similar companies have different dividend policies should not make a difference in their valuations. Most SA companies have a 3 times dividend cover or 66% retention rate. As a rule of thumb the PE that a company should trade on should be equal to its ROE, or where applicable, its return on tangible assets times 66% (#58 x 66%), or (#59 x 66%).

Method 2: PEG based on P/NAV

  1. Price/Net Asset Value (P/NAV) together with return on equity (ROE) (#58) is one of the most powerful valuation tools, but is seldom used correctly. The calculation is simply the current share price divided by the NAV (#62 / #43).

For example: P/NAV = Share price / Net Asset Value (NAV) = 100c /32.4c = 3.1 times

The higher the ROE the higher the P/NAV should be. This can be explained with reference to fixed interest investments. If you can earn 10% (after tax) interest at your bank, your ROE would be 10%. If you invest R100, your investment would be worth R100 or trade on a P/NAV of 1 and you would earn R10 interest. If this is the benchmark return and someone else also has R100 invested, but at 5%, surely you would not be willing to exchange your investment on a one for one basis. Because the interest on the other R100 is only R5, you would have to have two of these investments to earn the same R10 return. The other R100 is, therefore, actually only worth R50, or should trade on a 0,5 times P/NAV. Below we illustrate four possible methods. Method A or B should only be used when the company has no goodwill on its Balance Sheet. Our Rule of thumb methods are under B and D.

Method A

Based on Sustainable ROE: (No Goodwill)

#58

Return on Equity (ROE)

26%

#70

Forecast EPS for following Year

8.42

#69

Sustainable Growth Rate (#58 x #54) (26% x 66%)

17%

#63

Forward P/E (#62/ # 70) (100c / 8.42)

12

#63

Calculated Current P/E ( x #21)

15

#66

PEG Factor (PE/EPS Growth) (#63/ #69) (15/ 17%)

88%

#67

Suggested PE (Equals #69)

17

#68

Suggested Value per share (#67 x #21 = 17 x 7.4)

121

  1. The Forecast EPS for the following Year can be calculated by multiplying the sustainable Return on Equity (ROE) with the NAV (#58 x #43).

For example: Forecast EPS = ROE% x NAV = 26% x 32.4 = 8.42cps

This is used in Method A below. One will see that this method is fairly similar to method B used earlier by the PEG based on P/E ratios. The ROE (#58) used is the same and so is the calculation of the Sustainable Growth Rate (#69). The difference is here we calculate the forecast EPS for the following year and then calculate the forward P/E (#62 / #70). But from hereon it gets rather difficult. The forward P/E must now be worked back to return the 'calculated current P/E'. The Formula for this is (Forward P/E x (1 + Sustainable Growth Rate)).

For example: Calculated current P/E = Forward P/E x Sustainable Growth Rate = 12 x 17 = 2.04

This figure is now multiplied by the current HEPS (#21) (i.e. 7.4)

For example: 2.04 x 7.4cps = 15

The next step is the PEG factor, which is calculated as Current PE / Sustainable Growth Rate

For example: PEG factor = Current PE / Sustainable Growth Rate =15 / 17% = 88%

Next we have the Suggested P/E (#67) (i.e. 17), which is the same as the Sustainable Growth Rate (#69) (i.e. 17%). The final calculation of the suggested value is once again complicated, as one first has to re-work the forecast EPS back. The calculation is Suggested P/E x (Forecast EPS / (1+ Sustainable Growth Rate)). We can agree that this is a very complicated calculation.

For example: Suggested value = Suggested PE (#67) x (Forecast EPS)(#70) / (1+ Sustainable Growth Rate))= 17 x 8.3/(1 + 0.17) = 141 / 1.17 = 121cps.

If you use our rule thumb method illustrated under Method B, you will find that it is much easier and the answer does not differ by much.

Method B

Rule of Thumb Method: (No Goodwill)

#43

Net Asset Value (NAV)

32.4

#65

Price/Net Asset Value(P/NAV)

3.1

#58

Return on Equity (ROE)

26%

#71

Suggested P/NAV (#68 x #68) x 0.5 x 100

3.4

#68

Suggested Value per share (#71 x #43) (3.4 x 32.4)

110

To calculate the suggested P/NAV the formula is:

Suggested P/NAV = (ROE x ROE) x 0.5 x 100)= (0.26 x 0.26) x 0.5 x100 = 0.0676 x 0.5 x 100 = 3.4

The Suggested P/NAV is then multiplied with the Net Asset Value (#43) to result in a Suggested Value per share or, your valuation.

For example: Suggested Value per share = Suggested P/NAV x NAV = 3.4 x 32.4 = 110cps

Based on fundamental research, a share should be bought only if this value is substantially above the prevailing share price.

  • Buy when: Suggested Value > Current Share Price
  • Sell when: Suggested Value < Current Share Price

Suggested Value > Current Share Price 110c > 100c (Buy)

However, method A and B is only correct if the company does not grow by acquisitions and, therefore, has no goodwill (#33) on the balance sheet. If it has goodwill (like in our example), the calculated ROE will be lower than the actual return the company can earn on its assets. The answer will therefore be very far of the mark. Then Method C will be the best method to use

Method C

Based on Sustainable Return on Tangible Assets:

#44

Net Tangible Asset Value(NTAV)

20.7

#59

Return on Tangible Assets

46%

#70

Forecast EPS for following Year

9.5

#69

Sustainable Growth Rate

30%

#63

Forward P/E

11

#63

Calculated Current P/E

14

#66

PEG Factor (PE/EPS Growth)

47%

#67

Suggested PE

30

#68

Suggested Value per share

217

Calculate the return on tangible assets (#59) and multiple with the NTAV to result in the forecast EPS for the following year (#59 x #44).

For example: Forecast EPS = NAV x RTNAV = 20.7 x 0.46 = 9.5cps

The important factor is the return used must be seen as sustainable for at least the next 5 years. From the return, the sustainable growth rate can be calculated for use in the normal PEG valuation. Although the actual formula for sustainable growth is ROE x Retention rate, the fact that two similar companies have different dividend policies should not make a difference in their valuations. Most SA companies have a 3 times dividend cover or 66% retention rate.

For example: Sustainable Growth Rate = RTNAV x Retention Rate = 0.46 x 0.66 = 30%

As in Method A one must then first work the Forward P/E back to a calculated current P/E.

For example: Forward P/E = Current Share Price / Forecast EPS = 100 cents/ 9.5 cents = 11

The next step is to calculate the Current P/E ratio. The forward P/E must be worked back to return the 'calculated current P/E.

For example: Current PE = Forward P/E x (1 + Sustainable Growth Rate)+ 11 x (1 + 0.30) = 11 x 1.30 = 14.3 (14)

The next step is the PEG factor, which is the calculated Current PE (#63) / Sustainable Growth Rate (#69).

For example: PEG Factor = Forward PE / Sustainable Growth Rate = 14/ 0.30 = 46.6 (47%)

The next step is the Suggested PE ratio, which should be equal to the forecast growth rate (#69). The Suggested P/E (#67) is multiplied with the Forecast EPS (#70) and then divided by the Sustainable Growth Rate to result in a Suggested Value per share or, your valuation.

For example: Suggested value per share = Suggested P/E x EPS /(1+ 0.30) = 30 x 9.4/ 1.30 = 282/ 1.30 = 217 cps

Based on fundamental research, a share should be bought only if this value is substantially above the prevailing share price.

  • Buy when: Suggested Value > Current Share Price
  • Sell when: Suggested Value < Current Share Price

Suggested Value > Current Share Price 217c > 100c (Buy)

That is why our rule of thumb under Method D is simpler and more of a reliable method to use.

Method D

Rule of Thumb Method:

#65

Price/Net Asset Value(P/NAV)

3.1

#72

Sustainable ROE adjusted for Return on Tangible Assets

37%

#71

Suggested P/NAV

6.48

#68

Suggested Value per share

210

Where the company had no goodwill we would have used the 26% ROE. With goodwill the ROE calculation is Return on tangible assets x 80%. The suggested P/NAV formula remains (ROE x ROE) x 0.5 x 100) (see Method B). The answer is in line with that under method C, but much easier to calculate.
As a rule of thumb the PE that a company should trade on should be equal to its ROE or where applicable its return on tangible assets times 66% (#58 x 66%) or (#59 x 66%).

  1. The Suggested P/NAV is multiplied with the Net Asset Value (#43) to result in a Suggested Value per share (#68) or, your valuation. The suggested P/NAV formula remains (ROE x ROE) x 0.5 x 100).

For example: Suggested P/NAV = (ROE x ROE) x 0.5% x 100 = (0.36 x 0.36) x 0.5 x 100 = 0.1296 x 0.5 x 100 = 0.0648 x100 = 6.48

  1. The Sustainable ROE adjusted for Return on Tangible Assets is the ROE to be used in order to calculate the suggested P/NAV (#71) to be used in our rule of the thumb method. The ROE (#58) needs to be adjusted upwards to compensate for the higher return on tangible assets. The correct adjustment is linked to the size of the NTAV (#44) in relation to NAV (#43). To simplify usage we simply multiple the sustainable return on tangible assets with 80% (#59 x 80%) to result in the sustainable ROE that we use in our calculation.

For example: Sustainable ROE adjusted for RTAV = Return on tangible assets x 80% = 0.46 x 0.8 = 36.8 (37%)

  1. Suggested value or your valuation is the suggested P/NAV (#71) multiplied with the Net Asset Value (NAV) (#43).

For example: Suggested value = P/NAV x Net Asset Value (NAV) = 6.48 x 32.4 = 210cps
Based on fundamental research, a share should be bought only if this value is substantially above the prevailing share price.

  • Buy when: Suggested Value > Current Share Price
  • Sell when: Suggested Value < Current Share Price

Suggested Value > Current Share Price 210c > 100c (Buy)

Conclusion

An understanding of micro fundamental analysis, especially the terminology used in ratio analysis, is not only useful for when you read financial comments on a company and analysis of its fundamentals, but also important to your financial wellbeing. There is no need for you to know the ratios off by heart but rather use them as a quick reference guide as well to compare two companies with each other.

In this tutorial, we discussed the most important ratios, which will help you determine whether a share is worthwhile investing in and if this is good value for your money. The ideal company to look for, if you had a magic wand, would be a company that is undervalued, profitable, has hardly any or has manageable financial risk and whose management is positive about future prospects. Would you invest your time and money in such a company?

Support

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Thank you for your support and happy trading!

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