A cynic was on the right track when he claimed, “The sumptuousness of a company’s annual report is in inverse proportion to its profitability that year.”
Investors contemplating the purchase of shares in a specific listed company can get hold of its latest annual report – either in hard copy by requesting a copy from the company or its share registry, or these days simply by downloading it from the Internet. The latter is faster and this approach also facilitates searching.
Such reports nowadays are usually quite bulky documents, typically containing 100 to 150 or so pages. The size comes about because of the requirements under the Corporations Act and the Listing Rules of the Australian Securities Exchange (ASX), and the need to comply with Australian Accounting Standards. Most “mum and dad” investors would probably not wish to stgote the time needed for reading such weighty documents from cover to cover, so what should they concentrate on?
A good start might be to look at dividends, net tangible assets, earnings, the gearing ratio and the company’s growth rate. Investors should focus on “per share” figures, rather than the millions of dollars totals which often make the headlines.
Each report will include a balance sheet, an income statement and a statement of changes in equity, amongst a lot of other information. Together these make up the financial statements (often just referred to as the company’s “financials”).
The annual reports will also contain a lot of additional information, including statements by the directors certifying the accuracy of the accounts and often also by the chief executive officer commenting on the results and the company’s prospects. Also set out are detailed notes to the accounts and a report by the independent external auditors.
Dividends and net tangible assets figures are discussed in this Part 1. Earnings, gearing ratios and growth rates will be discussed in Part 2.
Dividends are important for investors in two separate ways – because of the clues they give as to the company’s future prospects and because they tell the shareholders what cash they are going to get from their investment.
The latter aspect is particularly important for some categories of investor, such as self-funded retirees.
Only some of the total earnings available for a company’s ordinary shares in respect of any one year are usually distributed to its shareholders in the form of dividends. The rest are “ploughed back”, in other words retained in the business.
Dividing the total earnings (net of any preference dividends) by the total ordinary dividend payout for the year (interim plus final distributions) gives the “dividend cover” – a yardstick which gives a rough indication as to how secure the continuation of the rate of dividend might be.
The “dividend yield” is obtained by dividing the dividend figure (in cents per share) by the market price of the share (also expressed in cents).
However, dividing a historical dividend figure by a current market price can often be misleading, as the latter reflects investors’ views of the future rather than the past.
Apart from that, it should be noted that the apparent annual return from ordinary shares as measured by the dividend yield is not at all comparable with the return from fixed interest investments, as the true return from shares includes the capital growth element.
Dividend declarations need to indicate the “franking ratio”, in other words the proportion of the distribution which is franked and therefore associated with an imputation credit. For fully franked dividends the franking ratio is 100 per cent.
To make yields from franked dividends properly comparable with returns from alternative investments they should be “grossed-up” by multiplying by 1.429, in order to reflect the current 30 per cent company tax rate.
Net Tangible Assets
The “net tangible asset backing per ordinary share” figure, often abbreviated “NTA”, is one possible measure of the worth of a share, although its usefulness is subject to some reservations. It can be compared to the market value of the share.
In an ongoing company the various measures related to income tend to be more relevant, as the asset backing of a share is not normally available to shareholders unless the company is placed in liquidation or makes a capital return, or unless a takeover offer reflecting this backing is made and accepted.
In any case, a company’s assets are usually much more valuable on a “going concern” basis.
On the other hand, in the case of a company in financial difficulties and facing bankruptcy, the book values used for the assets may turn out to have been too high and not realisable under the fire sale conditions that are then likely to prevail.
Book values can also be too low rather than too high, particularly if assets have not been revalued recently in order to allow for inflation and the costs of replacement.
If there is only one class of ordinary shares then the “per share” figure is obtained by dividing the company’s adjusted total net assets (gross assets less intangibles) by the total number of ordinary shares on issue.
A low NTA in comparison to the issue price of shares in a float is a prima facie indication that the promoters have been too greedy, at the expense of subscribers to the issue. This greatly increases the risk that these investors will be showing a loss once the new shares are listed.
When Rupert Murdoch was quizzed about his alleged interference with the editors of his newspapers, he responded: “I read their balance sheets, not their editorials.”
Sophisticated investors contemplating an investment in a particular listed company will usually want to study its latest annual report. If their time is limited there are five key aspects that they may wish to concentrate on.
Dividends and net tangible assets were analysed in Part 1. This Part 2 discusses earnings, gearing ratios and growth rates.
Companies report their profits (earnings) on both a “before income tax” and an “after income tax” basis. For analytical purposes non-recurring profits need to be disregarded.
The ratio of profits before tax to total shareholders’ funds is a measure of the efficiency of a company. For example, a company which consistently underperforms the Commonwealth Bond rate on this yardstick would clearly make its shareholders better off by liquidating and allowing them to make such a risk-free investment instead.
In practice this concept needs some modification, because regard also has to be had to growth expectations, but it provides a useful starting point for identifying risks and weaknesses.
The calculations are best done using weighted average shareholders’ funds for the year.
“Earnings per ordinary share” (usually referred to as “eps”) are obtained by dividing a company’s net profit (notionally adjusted where contributing shares exist) less the preference dividends (if any) by the total number of ordinary shares on issue. Such a figure is best expressed in cents per share.
Suitable adjustments will also be required if the company has made any issues or repaid any capital during the year, and also if convertible securities or options exist.
The “earnings yield” is obtained by dividing the eps figure (in cents per share) by the current market price of the share (also expressed in cents). This is another measure of the performance of the company to an investor and can be compared with interest rate levels generally.
It is really a much more useful yardstick than the “dividend yield” discussed previously, which – because it is a function of the payout ratio decided on by the directors – ignores the fact that ordinary shareholders benefit from a company’s earnings irrespective of whether these are actually distributed or not.
Other things being equal, the higher the earnings yield the better the value inherent in a transaction for a purchaser. However, things are never equal and some apparent bargains may be quite illusory. Distortions can arise from the mechanical nature of the arithmetic.
As indicated above, investors are much more interested in the future than in the past – and market prices reflect such expectations. Dividing the last published earnings figure by a current market value can sometimes produce a nonsense result, especially if losses or significantly reduced profits for subsequent years are now expected.
A more common way of looking at the above-mentioned concept is to divide the market price per share by the earnings per share figure, instead of the other way round. The result, this time expressed as a number and not as a percentage, is called the “price earnings ratio” or “PER” (sometimes shortened to just “PE”).
In effect, the PER represents the number of years’ purchase available. Other things being equal, the lower the PER the better the value is for a buyer and the worse for a seller.
Although price earnings ratios are regarded as modern and are frequently quoted in newspaper listings and in brokers’ circulars and the like, this alternative approach is for many purposes not as useful as the less popular earnings yield described above.
The latter can more readily be compared directly with other yields, such as those obtainable on fixed interest securities or property, and also with interest rates generally, including especially the cost to the investor of using borrowed money – as well as with the dividend yield on the shares being considered and on other shares.
A company’s shareholders’ funds divided by its total assets, with the result usually expressed as a percentage, is called the “proprietary ratio”. It is a measure of the how safe the company is – the greater the proportion of the total value of the company represented by the shareholders’ equity the less the likelihood of creditors ever being able to institute receivership or liquidation proceedings.
However, in times of prosperity the use of other peoples’ money (provided the interest rate is lower than the return achieved on the funds employed) can considerably increase the yield on shareholders’ funds and, from that point of view, the lower the proprietary ratio the better.
There is obviously no “ideal” ratio – investors must (as always) do a trade off between risk and reward.
The process of using outside funds to supplement the proprietors’ money in this way is called “gearing” or “leverage”. The “gearing ratio” is obtained by dividing the total outside liabilities by the shareholders’ funds.
The fact that a company has a low gearing ratio and thus good capacity for additional borrowings and the scope for returning capital or engaging in expansion moves may make it an attractive takeover target for companies in the reverse situation.
The company’s growth rates per annum for sales, total earnings, earnings per share, NTA per share, and so on, are also worth study.
These may need adjustment for capital changes, but, subject to that, can be compared with the rate of inflation to see the extent to which the company is genuinely improving its performance and also as to how it is performing relative to its peers.
Average annual growth rates over a period such as five years are traditionally used for such an exercise.