Monday, 12 November 2012

Financial Ratios: Profitability Indicators

Now we have move on to the second part of the financial ratio series: the profitability indicator ratios. Previously, we have used the various liquidity measurement ratios to see whether a company has 1) enough assets to pay its short-term obligations and 2) whether the company is able to liquidize its assets into cash in  a short period of time. In other words, the liquidity measurement ratios tell investors whether the company he is investing in is in a safe position.



The profitability indicator ratio is self-explanatory; it tells us whether a company is profitable. By using the word "profitable", I mean that the company is able to make use of its resources effectively to generate profits.

For those studying economics, profit does NOT refer to the economic definition of reducing cost and increasing revenue (although both cases indicate better prospects for the company, of course). You need to adjust to this fact because in the income statement, the terms: "income", "profits" and "earnings" are used interchangeably in financial reporting.



Content:

  1. Profit Margin Analysis
  2. Effective tax rate
  3. Return on Assets (ROA)
  4. Return on Equity (ROE)
  5. Return on Capital Employed (ROCE)

Profit Margin Analysis

In the income statement, there are four levels of profit or profit margins - gross profit, operating profit, pretax profit and net profit. "Profit Margin" refers to the percentage of profit relative to its net sales revenue.

(ie. "Gross Profit Margin" refers to the percentage of gross profit relative to its total net sales revenue. So what does "operating profit margin", "pretax profit margin" and "net profit margin" mean?)

Formulas:




Gross Profit Margin

Gross Profit is the most fundamental profit margin formula, whereby the gross profit is simply derived from the difference between the total net sales revenue and the total costs of sales. Cost of sales represents expense related to labor, raw materials and manufacturing overhead used in the production process. 

Gross Profit = Total net sales revenue - total costs of sales

Looking at this formula, if total costs of sales decrease, the value of gross profit level will increase. Subsequently, the gross profit margin percentage will increase as well. Thus in a sense the gross profit margin tells investors how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. Certainly a higher margin percentage would be more desirable.

However, the gross profit margin does not take into account the operating expenses. This is where the next level of profit margin comes in: the operating profit margin.

Operating Profit Margin

Operating Profit is derived from deducting selling, general and administrative (SG&A) or operating expenses from the gross profit margin.

Operating Profit = Gross Profit - Operating Expenses

Management is key to reducing operating expenses. This ratio should be compared to other companies in the same industry to have a good gauge on the company's management relative to its rivals. The smaller the ratio, the poorer the management in the company.

Pretax Profit Margin

A company has access to a variety of tax-management techniques, which allow it to manipulate the timing and magnitude of its taxable income. Thus the pretax profit margin is a more conservative ratio compared to gross profit margin.

Net Profit Margin

The Net Profit Margin is the decisive ratio for investors to see if the company is profitable. It is the ratio of net income to total net sales revenue.

HOWEVER, DO NOT BE LAZY AND SIMPLY BASE YOUR INVESTMENT DECISION ON THE NET PROFIT MARGIN ALONE!

As we can see, the company can be making profits, however assuming the operating profit margin is showing a declining trend, it means that the company's management is getting poorer, and its performance may be reduced in the future if such a trend continues.

Thus, one should go through the entire process of profit margin analysis, going through each ratio and scrutinize them carefully.


Effective Tax Rate

This relatively simple ratio measures the company's tax rate, which is calculated by comparing its income tax expense to its pretax income.

Formula:

The effective tax rate will influence the net profit figure. Investors look out for high net profit margins in companies, and high net profit margins can be achieved in 2 ways :

  1. Effective Operational results
  2. Effective tax management maneuverings
It is erroneous to say that a low effective tax rate is good. Rather, investors should look at the effective rate throughout the years. If the effective tax rate fluctuates a lot, one would doubt whether the company's high net profit margin is attained from effective operational results or simply through tax evasion. A relatively stable effective tax rate percentage, and resulting net profit margin, would seem to indicate that the company's operational managers are more responsible for a company's profitability than the company's tax accountants.

Return on Assets (ROA)
The ROA is the ratio between the companies net income and its total assets. It tells investors whether the company is making the best use of its assets to generate profit.

Formula:


Obviously, the higher the ratio, the better the use of company's assets. 

However, capital-intensive businesses (with a large investment in fixed assets) are going to be more asset heavy than technology or service businesses. For such capital-intensive businesses, the denominator will have a huge value, causing the ROA to be small, which sometimes can be deceptive to investors.

It is precisely because businesses require different-sized asset bases that investors need to think about how they use the ROA ratio. Investors should analyse the ROA of a company over a period of time to detect positive or negative trends. If peer company comparisons are made, it is necessary that the companies being reviewed are similar in product line and business type. Otherwise, you would be simply comparing apples to orange.

Return on Equity (ROE)

The ROE is the ratio between the companies net income and its total shareholder equity. It measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.

Formula:


However, the ROE has a major loophole. It does not take into consideration the company's debts; a company taking on a disproportionate amount of debt can artifically increase the ROE, which can be deceptive to investors. If a company pays back its debt, the ROE will suffer, and once again investors may be deceived by the small value of the ROE.

The ROE cannot be used in isolation. The value of the ROE needs to be interpreted in the context of a company's debt-equity relationship. An analysis on the return on capital employed (ROCE) would be the solution to the limitations of the ROE.

ONCE AGAIN, THIS TELLS US THAT WE SHOULD NOT BE LAZY AND JUST LOOK AT THE RETURN ON EQUITY AND COME TO AN INVESTMENT DECISION! 

Return on Capital Employed (ROCE)

A more refined version of the ROE, the ROCE is the ratio between the company's net income to its total capital employed, where the capital employed is the sum of the company's total liabilities to shareholder's equity. By comparing net income to the sum of a company's debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company's profitability.

Formula:


The ROCE is arguably the most important profitability indicator.  Factoring the company's debt  into a company's total capital provides a more comprehensive evaluation of how well management is using the debt and equity it has at its disposal. 


Conclusion
We have discussed a few other financial ratios, this time under the category of profitability indicator. One may be tempted to simply look through the profitability indicators without going through its liquidity measurement ratios. However, it is recommended that both should be taken into account when making investment decisions; the liquidity measurement ratio after all ensures safety of a company as it shows whether the company can pay its debts or liquidize its assets to clear its debt in the short term.

Remember the last golden rule: Diligence and patience is key to success.


Acknowledgements










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Friday, 9 November 2012

Financial Ratios: Liquidity Measurement

Finally, here comes the technical aspect of value investing. It is important to note that from now on, content will be highly abstract, which will require moments of pausing to comprehend what you've just read. It takes great effort to understand the formulas of the different ratios, and just simply quoting them blindly in your research won't do you any good. This is simply the first part of financial ratios where we look into the ability of a company to pay off its short term liabilities by comparing the company's more liquid assets to its liabilities.




There will be other financial ratios to look into such as profitability ratios, debt ratios, operating performance ratios, cash flow indicator ratios and investment valuation ratios.

 Although it is important to go through all these ratios, you may also need to take into account other factors like management, background of the company, insider activity and many more (these factors cannot be calculated with formulas. However, we can evaluate these factors through careful scrutiny of the company's annual reports).


REMEMBER, VALUE INVESTING IS ALL ABOUT DILIGENCE AND PATIENCE. 

YOU REAP WHAT YOU SOW!

DON'T BE LAZY AND SIMPLY RELY ON 1 OR 2 RATIOS TO MAKE YOUR INVESTMENT DECISIONS. 

YOU WILL REGRET IT.

 
 
Contents:
  1. Current ratio
  2. Quick ratio
  3. Cash Conversion cycle

Current Ratio

The most basic liquidity indicator that gives investors a clue on whether a company's current assets (eg. cash, cash equivalents, marketable securities, receivables and inventory) are readily available to clear its short-term debts.

Formula:

Limitations:

  • It does not take into account the duration of converting the company's assets into cash.
  • If it takes very long to convert the company's assets into cash, the company is highly non-liquid, and the figure of this ratio may be "misleading". 
  • Company ABC can have a current ratio of 3.0 (its current assets are 3 times more than its current liabilities!) However, if these assets takes 5 years to convert into cash, in the short run the company may not be able to clear its debt - You can only clear liabilities with cash (IMPT CONCEPT).

Quick Ratio

A stricter liquidity ratio (compared to the current ratio) that only involves the most liquid current assets there are to cover current liabilities. Therefore, a higher ratio means a more liquid current position. 

Formula:



Limitations:
  • Similar to the current ratio, it does not take into account the duration of converting the company's assets into cash. 
  • However, the problem is reduced as we are only including the company's more liquid assets in the formula.



Cash Conversion Cycle
Preface: This is very difficult to understand. It takes me many days to digest this concept. However, this is the most important liquidity measurement compared to the current ratio and the quick ratio.

The Cash Conversion Cycle (CCC) expresses the duration that of a company to convert its inventory  into sales and subsequently into cash. The shorter the duration, the more liquid the company is and the safer the position of the company is; after all, the company has no problems meeting its short-term obligations. 

 Ultimately, the CCC is the solution to the limitations of the current and quick ratios!

 Note: The duration is measured in number of days

Formula:

Now here is the most challenging concept in this post. Take a moment to understand each formula carefully. Each components (DIO, DSO and DPO) have their own respective formula.

Days inventory Outstanding = 
Avg. Inventory (Average of the previous year-end and this year's ending inventory figure)
Cost of goods sold / 365

The denominator can also be represented as cost of goods sold per day.

Example: 
Total cost of goods sold for the year: $200000
Cost of goods sold per day = $200000/ 365 = $547.94
Previous year-end inventory figure = $300000
Current year-end inventory figure = $280000
Average accounts receivables = $290000
Days Sales Outstanding = 290000/547.94 = 529 (3 s.f)

Conclusion: It takes approximately 529 days for the company to turn over (or liquidate) its entire inventory, and in most cases, this is considered highly non-liquid.




Days Sales Outstanding =



Average Accounts Receivables (Average of the previous year-end and this year's end account receivables figure)
Net annual sales / 365


The denominator can also be represented as net sales per day.
Example: 
Net Sales for the year: $100000
Net sales per day = $100000/ 365 = $273.97
Previous year-end account receivables = $300000
Current year-end account receivables = $280000
Average accounts receivables = $290000
Days Sales Outstanding = 290000/273.97 = 1058 (4 s.f)

Conclusion: It takes approximately 1058 days for a company to collect its annual sales that go into accounts receivables (credit purchases). Again, highly non-liquid. Can you imagine it takes about 3 years to simply collect the year's sales revenue??


Day Payables Outstanding =

Average Accounts Payable (Average of the previous year-end and this year's end accounts payable figure)
Cost of sales / 365

The denominator can also be represented as net sales per day.

Example: 
Cost of sales for the year: $500000
Cost of sales per day = $500000/ 365 = $1369.86
Previous year-end account payables = $200000
Current year-end account payables = $100000
Average accounts payables = $150000
Days Sales Outstanding = 150000/1369.86 = 110 (3 s.f)

Conclusion: It takes approximately 110 days for the company to pay its obligations to its suppliers. Please note that a low figure is not necessarily better, if not worse. 

Although the DPO shows how long it takes for a company to pay back its suppliers, the days payable outstanding also shows how long a company can make interest on the money made. The larger the DPO, the better.  This is because the larger the number, the more interest the company is able to earn by placing their money in the bank.  

That is why in the CCC formula, the DPO is subtracted from the sum of DSO and DIO rather than added.


Applying the CCC formula, we have 529 + 1058 - 110 = 1477

Remember the definition of CCC? So what is the significance of this number? 
Answer: It takes 1477 days to convert its inventory  into sales and subsequently into cash. 


Conclusion:
We have looked into 3 important liquidity measurement ratios, the most important one being the cash conversion cycle. There are many other liquidity measurement ratios, but many are similar to these ratios. However, obviously we can't simply measure a company's liquidity and base our investment decisions on its liquidity alone. We will be looking into other ratios in the subsequent posts such as profitability ratios, debt ratios, operating performance ratios, cash flow indicator ratios and investment valuation ratios. Meanwhile, thank you for your time in reading this post.

Have a great day ahead.



Acknowledgements:
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Thursday, 8 November 2012

Golden Rules of Value Investing

In this post, we will be looking into several golden rules of value investing, and it is of utmost important to recognize them before dwelling into the actual technical concepts of analyzing companies' fundamentals. They are so important that if you fail to apply these rules in your investment, you are high likely to lose.

 Content:

  1. Companies have intrinsic value
  2. Always have a margin of safety
  3. The efficient market hypothesis is wrong
  4. Diligence and patience are keys to success



Companies have intrinsic value.

 (Intrinsic value - The actual value of a security, as opposed to its market price or book value.)

 The defining rule for value-investing; if you do not believe in this principle, you can no longer be regarded as a value investor, or even an investor for that matter. 

The company's stock price can change even when the company's intrinsic value is the same. Understanding this, value investors will not be psychologically affected by vast market swings, since they believe in the company's intrinsic value. 

   



 Here is a story, a financial one, that I've chanced upon recently - The Tulip Mania. This story probably demonstrates the importance of this rule, because ultimately if the Dutch were to recognize the "intrinsic value" of the tulip, the investing bubble would not have occurred.

 Disclaimer: This story has been highly summarized for easier reading and according to my understanding of this story. 

Forget about the history of tulip and how it became popular in Europe, just understand that at that time, tulips were highly sought after by wealthy Englishmen. A virus hit the tulip plantations throughout Europe, giving the tulips their mesmerizing color schemes. With this new type of infected tulips, the English were even more dazzled by the tulips' beauty, and the tulip became even more popular.

 The virus retarded the tulips' growth, making it even harder to increase the supply of these exotic tulips. By 1634, the beauty of these tulips became widespread across Europe. Even the lowest members of society were after these tulips! Due to its limited supply and increasing demand for it, the prices of tulip soared exponentially. 
The demand for rare tulips increased so much in 1636, that they were traded on Amsterdam's Stock Exchange and in Rotterdam, Harlaem, Leyden, Alkmar, Hoorn, and other towns. For the first time, symptoms of gambling became apparent too. Stockbrokers, ever alert for a new speculation, dealt largely in tulips. They used every trick in the book to produce price fluctuations.

 At first, as with all gambling mania, confidence was high - everybody gained. The tulip-brokers speculated in the rise and fall of tulip stocks. They made large profits, buying when prices fell, and selling when they rose.

 Many individuals suddenly grew rich. People now rushed to trade in tulips. Everyone imagined that the passion for tulips would last for eternity. They believed that wealthy people from across the globe would travel to Holland, and pay ridiculously high prices for these tulips. In fact, many Europeans, including the midde-class citizens, were selling their assets like houses and  luxuries just to get their hands on this "limited commodity".
          
Now, would you trade a house for these tulips???


 Finally, there comes a point where the "smart" ones began to see the madness of this tulip trade. They have come to realize that the price of tulips cannot go higher. With this in mind, the wealthy ones no longer bought the flowers for their gardens, but to sell them in order to lock in their profits. The sale of tulips started off slowly, then evolved into a panic-stricken rush.

 At the end of the tulip mania, many find themselves stuck with these "beautiful tulips", as there is no longer any demand for them, and for all that they have sacrificed - their homes, their wealth, their luxuries, this is truly a catastrophic moment for many Europeans. 



This story reinforces two ideas: 

  1. Always invest according to a company's intrinsic value
  2. Do not simply jump onto the bandwagon! (remember the bandwagon effect in the earlier post?)


    Always have a margin of safety



Do not buy stocks at their full prices - buy them at discounted prices. Remember the example of Armani Exchange (AX)?
Because if you do so, you not only maximize your profits when the price of the stock rises, you also reduce your loss when the price of the stock falls.
 

 It's really simple. Assuming you are looking at a stock of a shoes company,  you have done your work and came up with its intrinsic value of $10. (In later posts, I will be discussing on how to calculate this.) You would want to wait till its price drops to, let's say, $5. If you successfully get your hands on this stock for $5, you would have provided yourself a margin of safety.

 If the price of the stock falls to $3, you would lose only $2 whereas if you had bought the stock at its intrinsic value, you would lose $7! However, if the price of the stock rises to $13, you would gain $8 whereas if you had bought the stock at its intrinsic value, you would only gain $3.



Remember him?

Benjamin Graham, the father of value investing, only bought stocks when they were priced at two-thirds or less of their intrinsic value. This was the margin of safety that he felt was necessary to earn the best returns while minimizing investment downside.

 The efficient market hypothesis is wrong.

I hope this point no longer needs to be explained. The fact that stocks CAN be under- or over-valued is sufficient to prove this point.

Diligence and patience are keys to success



As cliche as it may sound, this is 100% applicable to investment in general, not just for value-investing. 

And for goodness sake, you reap what you sow! If you don't do your homework and thoroughly analyse the company's fundamentals, you are doomed to failure. Simply relying on broker's advice to pick your stocks won't do you good. Do you really think the brokers are there to help you? If the broker realize that the price of the stock is going to rise, he is going to quit his job, draw out his entire savings, and dump them into this stock! Do you think he would simply let others know of such valuable information?

Also, sometimes you'll decide that you want to invest in a particular company because its fundamentals are secure, but you'll have to wait till the price of the stock falls until it hits a discounted price. It may take another 5 to 10 years for that to happen, but rest assured, you will be greatly rewarded for your patience. 

 When you hold a stock, patience also plays a key role. Do not sell your stock simply because the market shows bearish trend! (Again, the bandwagon effect!) Wait for market reversals, it may take 10 years or even more than that, but once again, rewards will be handsome.

 Note: There are circumstances where investors are forced to sell their stocks regardless of their will.  They need immediate cash to pay for the cost of living, clear their debts etc. As such, I would honestly recommend investment only to those that are rich, because after all, the prospect of losing their investment would not be as devastating to them as that to those who are less well-off.  Those who have less capital with them will find themselves succumbing more often to their emotional fear, which is a path to failure in investment (needs verification, but this is my hypothesis based on my observations. Do keep this in mind though).
Conclusion: 
We have established the golden rules of value investment. Some of these rules are even applicable to investment in general (There are more rules to abide by in general investment, and I may be exploring them some time later). Do not take these rules lightly; after all, many investors fail simply because they have forgotten these rules. 

 In subsequent posts, I will be discussing on technical concepts pertaining to analyzing a company's fundamentals, as well as establishing the risks involved in value investment specifically. 

 Thank you and have a great day ahead.

Acknowledgements:
http://www.businessweek.com/2000/00_17/b3678084.htm

 http://winninginvestor.quickanddirtytips.com/what-are-the-differences-between-investing-and-trading.aspx

 http://www.thetulipomania.com/

 www.investopedia.com

 Jan Arps (n.d.). The Complete Idiot's Guide to Technical Analysis.




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Wednesday, 7 November 2012

Introduction to Value investing

What is value investing?

 Value investing is the selection of stocks that trade for less than their true value, or in finance parlance, intrinsic value. In other words, value investors buy stocks that are currently undervalued, believing that in the long term, the prices of stocks would adjust such that it corresponds with the company's fundamentals. 

 Sounds hard to understand? I would like to illustrate this using an example of my favorite shirt brand: Armani Exchange (AX).

Disclaimer: All prices of AX products are fictitious and are just meant for illustration purposes. 

 Say I want to get this cool T-shirt (and seriously, it looks freaking cool), if I were to go to an AX outlet on a random day, the price of this shirt would easily cost you $200. You will be quite stupid to buy it then. As a "value investor", you would wait for the right opportunity to get it for less. For example, AX holds an annual sale during Chinese New Year, whereby all its products would be 50% discounted. It is then probably the right time to get it for half its price. In extreme cases, you would not even be satisfied with such discount. You would wait for a clearance sale which gives discounts up to 70%, and at that time you would get your dream shirt for just $60. 
Apply this idea to stocks and you have value investing, plain and simple. Any time you buy a stock, you want the market price to be lower than its intrinsic value. You've made yourself some gain already by purchasing the stock at a lower price!

Some famous value investors are as follows:

 Warren Buffet


 Benjamin Graham


 Seth Klarman


Walter Schloss


Irving Kahn
Irving Kahn



Why are stocks undervalued in the first place? 

 Irrational decisions by investors
Humans are just being humans; People invest irrationally based on psychological biases rather than analysis of market fundamentals. They buy when the price of a particular stock is rising or when the value of the market as a whole appears to be rising. Such a phenomenon is known as the "bandwagon effect", whereby people do certain things simply because other people are doing them, regardless of their own beliefs. In this case, people simply buy a particular stock because others are doing so, or at least the prices of the stock are showing as such (bullish trend).
A random picture of a bandwagon. LOL

Even the most professional investors tend to make the most irrational decisions, especially when the price of a particular stock is decreasing or when the value of the market as a whole appears to be declining.

Afraid of the idea of potentially losing their entire wealth, they accept a certain loss by selling at ridiculously low prices instead of keeping their losses on paper and waiting for market reversals. They have neglected the company's fundamentals in order to mitigate their losses. Rather than trusting in the company's fundamentals and believing that the company can pull through turbulent times, they succumb to their fear, and when the market's vicissitudes come to an end, that particular stock that he just sold increase in price, and all that the poor investor can do is to sit down and hate himself.



Other reasons
Of course there are other reasons why stocks can be undervalued. Sometimes stocks are simply "hidden" in the stock market; they are not featured in the headlines or are simply not glamorous at all. They often go unnoticed, and it is the job of a value investor to identify these stocks.



Occasionally, a company may not be performing too well, or even suffer from losses. However, just because a company experiences one negative event doesn't mean that the company isn't still fundamentally valuable or that its stock won't bounce back. Many investors forget this important concept, and often in their panic, they sell the stock in order to quickly get rid of it.



Conclusion:
I hope through this chapter I have given you a clearer picture of what value investing is all about, and how stocks become undervalued. In subsequent posts, I will be establishing the key rules of value investing or rather investment in general (which would be reinforced over and over again) as well as discussing on some value investing strategies. 

Have a good day ahead. 

Acknowledgements: 
Investopedia has been a great guide to me, and it is through this website that I've picked up value investing. For this post, content is mainly obtained and paraphrased from investopedia. (I can't really introduce any new content in this post.) However, for subsequent discussions, additional research is necessary - ie. the golden rules of investment, early financial history, investment vs trading etc. Sources will be quoted in each post so as to avoid accusations of plagarism.

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