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One of the first sources many newcomers to share market investing use to find potential shares in which to entrust their investment dollars is analyst recommendations.  After all, it is the job of the analyst to know everything there is to know about a company.  Why not simply go with their recommendation and buy what they recommend?

Last week in the Sector Scan column, Cleo Nanni from Novus Capital provided an overview of the energy sector and listed several shares to consider for investment.  His preferred gas play was Australia’s largest energy company, Woodside Petroleum (WPL).

There are several reasons for investigating WPL on your own.  The first is a recommendation such as you read in last week’s sector scan is a truncated version of the analyst’s complete research.  What you get is a conclusion, not all the thinking that went into the conclusion.

The second is that analysts can be wrong.  This is not to imply that your research will lead to a better outcome.  However, some people are more comfortable when they take the opportunity to match their own thinking against an analyst’s conclusion.

Finally, share market investing over the long haul takes effort learning how to learn.  There is no better way to do that than to dig into the company’s “numbers” and look behind the numbers as well.

In this article, we will look at WPL (Woodside Petroleum) by the numbers, using select fundamental analysis ratios.  In a separate article, we will take another step and look behind the numbers.  

As you know, fundamental analysis of a company for potential investment involves researching six key predictors of future business and share market performance.  They are:

1.    Liquidity or Solvency
2.    Debt or Leverage
3.    Operating Efficiency
4.    Profitability
5.    Market Valuation

For each of these categories there are a variety of financial ratios one can construct from information readily available in a company’s financial statements.  We will look at a few ratios in each category, beginning with liquidity.

To begin with, you can download the latest WPL company report here on Woodside’s website.

Liquidity or Solvency Ratios

All businesses have assets and most have debts, some of which are payable within a fiscal year.  Liquidity ratios measure how quickly a company can convert assets into cash to meet current bills without sacrificing ongoing operations.  The two most widely used measures are the Current Ratio and the Quick Ratio.  Both ratios divide current assets by current liabilities, but the quick ratio strips out inventories from the equation.

A ratio of 1 means a company has just enough to meet its current liabilities should the need arise, which it rarely does.  Experts tell us 1.5 is a minimally acceptable current ratio.  For WPL, the current ratio is .86 and the quick ratio is .76.

At face value, these are not very impressive numbers.  However, as you know, any ratio needs a point of comparison.  We need to know how WPL compares to other companies in the ASX Energy Sector and even better, how it compares to a similar competitor.

While the Novus analyst also recommended the second largest company in the sector – ORG (Origin Energy), its business model differs from WPL.  ORG is an integrated Oil and Gas provider, which means it does business in the extended energy supply chain.  Simply put, ORG operates electrical generation and distribution facilities, which WPL does not.  The third largest company in the energy sector, STO (Santos Limited) provides a better comparison.  The following table shows the two liquidity ratios for WPL, STO, and the ASX Energy Sector.

 WPLSTOSector
Current Ratio.863.265.04
Quick Ratio.763.094.5

 

By the numbers, it appears WPL has some liquidity concerns.  Since liquidity is all about meeting current debt obligations, let us move on to looking at how WPL is using debt.

Debt or Leverage Ratios

The Debt to Equity Ratio is a measure of how much a company relies on “other people’s money” to operate versus how much it relies on its own money – shareholder equity.  For WPL the D/E Ratio is .421, or 42%.  For Santos, the ratio is .415, or 41.5%.  Lower numbers here mean a company is using less leverage, or debt, to operate.

Although larger companies like WPL and STO can generally handle larger debt loads, the D/E Ratio taken in isolation doesn’t tell you anything about possible trends in the use of debt.  Has the company’s debt been steadily increasing over the past years?  

 If so, in the case of WPL when you couple a relatively high debt with a relatively low liquidity, you could be looking at trouble if business conditions take a dramatic turn for the worse.  The following table shows Total Liabilities for both WPL and STO for the past 3 years:

 Total Liabilities 2008Total Liabilities 2009Total Liabilities 2010
WPL 7,9979,4988,510
STO5,3244,3946,166

 

This tells us neither company is showing an increasing trend, although STO’s liabilities did increase year over year while WPL’s declined.  

Operating Efficiency/Profitability Ratios

We are going to look at one ratio that measures Operating Efficiency – Fixed Asset Turnover-and 2 ratios that measure profitability – Return on Equity and Return on Assets.  Here is the table for our target company, WPL, and its comparison company, STO.

 WPLSTO
Fixed-Asset Turnover.25.14
Return on Equity (ROE)15.056.84
Return on Assets (ROA)6.552.13

 

Fixed Asset Turnover measures how effective company management is at using what it has invested in property, plant, and equipment (PP&E) to generate sales.  While neither share looks very good on this measure, investors need to remember not to overvalue a single ratio.  Fixed Asset Turnover always looks worse in industries where there is a time lag between investing in an asset and the asset going “on-line” to generate sales.

ROE and ROA are measures of profitability and in the case of WPL would seem to support the assumption the company has invested in assets that have yet to begin generating sales.

Return on Equity compares net income to shareholder equity to show how much shareholders earned on their investment.  The higher the ratio, the better.  Financial experts feel an ROE between 15% and 20% represents solid performance.  

Return on Assets measures the relationship between a company’s profit and its total assets.  ROE is the preferred ratio here, since there are vast differences in the size of the asset base needed across industries to turn a profit.  However, with the exception of the financial industry, most financial experts think a minimum ROA is around 5%.  You can see WPL is comfortably above that benchmark.

Market Valuation Ratios

Market valuation ratios are unique among financial ratios in that the numerator – Price – is not fully dependent on factors internal to the company.  The current Price per Share (PPS) reflects what market participants as a whole are willing to pay for shares of the company.

The most favored ratio here is the venerable P/E, which uses earnings per share as the denominator in the ratio equation.  However, many investors believe accounting black magic can manipulate reported earnings, so they prefer ratios based on harder numbers, like sales or cash flow.  

Here is a table comparing WPL, STO, and the Energy Sector on some of these market valuation ratios:

 WPL STOEnergy
Sector
Price to Sales (P/S) 8.385.211.34
Price to Earnings (P/E)24.8531.6922.65
Price to Earnings Growth (PEG)1.061.48 1.11
Price to Cash Flow (P/CF)16.817.6N/A

 

Looking at WPL strictly by the numbers above, there is really nothing that jumps off the page and screams “Buy Me!”  The P/S is slightly lower than the sector average, which means investors see more sales generated from each investment dollar.  Both the P/E and the P/EG are closely in line with sector averages, so what is the attraction in investing in WPL?

The numbers are solid but not spectacular.  For the rest of the WPL story, we have to look behind the numbers.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.