myinvestingnotes.blogspot.my (Bullbear Buffett Stock Investing Notes)

Keep INVESTING Simple and Safe (KISS) ****Investment Philosophy, Strategy and various Valuation Methods**** The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy. It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!****Warren Buffett: Rule No. 1 - Never lose money. Rule No. 2 - Never forget Rule No. 1.

Showing posts with label measuring business performance. Show all posts

Sunday, 18 April 2010

Evaluate a business using ratios

Ratio analysis is a useful tool that is widely used to measure business performance. There are various groups of people who need information about the performance of a business.

Business success can be defined as "the achievement of business objectives". Measuring success will therefore depend on a business's objectives. For most businesses this is profit.

The financial performance ratios facilitate performance measurement between and within businesses. Note that such ratios are meaningless in isolation and should be assessed in relation to a comparator or benchmark, which could include:

the previous year
the budget
an internal division or department
a competitor.

Care should be taken to compare like with like. There will be natural differences in ratios according to the nature of a business, its size, its age and the industry within which it operates. Additionally, the period of comparison should be considered. Ratios will usually fluctuate in the short term and therefore a medium- to long-term comparison should be used.

LIMITATIONS OF RATIOS

Ratios do not provide answers to every question and their interpretation can be subjective. They are a useful guideline to business performance but only a starting point for a full analysis. They are generally calculated on historic accounting information, which may itself include assumptions and estimates.

OTHER INDICATORS OF SUCCESS

A variety of information will present the best overall picture of a business, such as

other information included in a company's annual report (for public listed companies);
the age and nature of a business;
any recent changes in the business, such as new products or market; and
any changes in the industry within which the business operates and the wider economy.

NON-FINANCIAL PERFORMANCE MEASURES (NFPM)

These include

market share,
customer loyalty,
productivity,
quality, and
investment in research and development.

NFPMs should be used alongside financial performance measures to provide a balanced view of a business.

Know the uses and limitations of financial performance ratios.

Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

Calculate investor ratios

Investor ratios are used by existing and potential investors of mostly publicly listed companies. They can be obtained or calculated where necessary from publicly available information.

EARNINGS PER SHARE (EPS)

This is a popular profitability statistic used by financial analysts. 'Earnings available for distribution' is bottom-line net profit attributable to shareholders after all other costs have been deducted. Many remuneration packages are linked to EPS growth.

EPS = Earnings available for distribution / Number of shares in issue

PRICE/EARNINGS (P/E) RATIO

The P/E ratio applies to publicly listed companies and is a key measure of value for investors. A P/E ratio of 10 means that investors are willing to pay 10 times previous year's earnings for each share. Generally, the higher the P/E ratio, the higher the growth prospects perceived by investors.

P/E ratio = Share price / EPS

DIVIDEND YIELD

This measures cash paid to shareholders as dividends. This should be compared to capital growth, to measure the overall return to shareholders.

Dividend yield = Dividend per share / Price per share

Mature businesses tend to have higher dividend yields than young businesses, as the latter reinvest most of their earnings. Investors looking for high-income investments choose high-dividend yield companies.

DIVIDEND COVER

This follows a similar principle to 'interest cover'. It measures how many times a business can pay its dividends from its earnings. It is used as a measure of dividend risk.

Dividend cover = EPS / Dividend per share

It also measure the proportion of profits retained in a business versus paid out as dividends. For example, a dividend cover 3 times shows that a business has paid one third of its profits to shareholders and retained two-thirds. Retained earnings are an important source of finance and therefore dividend cover is often high.

Use investor ratios to see if business goals are aligned with investor goals.

Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

Measure long-term solvency and stability

Long-term solvency ratios measure the risk faced by a business from its debt burden. Debt interest must be paid irrespective of cash generation or profits. Consequently, the amount of profit that can be reinvested in the business or paid as dividends is diluted. An excessive debt burden will restrict the ability of a business to raise further debt finance.

THE GEARING RATIO

Gearing (or leverage) is a measure of a business's long-term financing arrangements (or capital structure). It is essentially the proportion of a business financed via debt compared to equity.

Gearing ratio = (Interest bearing debt - Cash) / [Equity + (Interest bearing debt - Cash)]

The ideal proportion is subject to the nature of a business and the current economic climate. In practice many businesses have gearing levels less than 50%. The higher the gearing, the greater the risks from dilution of earnings and sensitivity to changes in interest rates.

THE DEBT RATIO

This measures the ability of a business to meet its debts in the long term. It is a measure of 'security' for financiers. The ratio should certainly be less than 100% and many believe it should be less than 50%.

Debt ratio = Total debts (current and non-current liabilities) / Total assets (current and non-current assets)

The risk posed from high debt and gearing ratios can be mitigated by high interest cover.

INTEREST COVER

This measures how many times a business can pay its interest charges (or finance expenses) from its operating profit (or profit before interest and tax). Ideally a business should be able to cover its interest at least 2 or more times.

Interest cover (times) = Operating profit (EBIT) / Finance expenses

The ability to service debt is a measure of risk to debt providers, shareholders and ultimately the business itself.

NET DEBT TO EBITDA

Although not a traditional measure of long-term solvency, the 'net debt to EBITDA' ratio has become increasingly popular with banks as a measure of gearing. (EBITDA stands for 'earnings before interest, taxes, depreciation and amortization'.)

Net debt to EBITDA (times) = (Interest bearing debt - Cash) / EBITDA

Banks will typically lend a business up to 5 times its earnings. Cash generated from operations can be substituted for EBITDA.

Use gearing and debt ratios to calculate long-term risk levels.

Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

Measure short-term solvency and liquidity

Short-term solvency is the ability to meet short term debts from liquid assets. Liquid assets include money on short-term deposit and trade receivables, but not inventories, which cannot be quickly turned into cash.

LIQUIDITY versus PROFITABILITY

In the short term liquidity is more essential to financial stability than profitability. Cash generated from operating activities is a major source of liquid funds, as measured by the statement of cash flows. There may be other priorities for funds from operating activities, therefore it is important to have sufficient liquid assets to meet short-term debts.

CASH FLOW

The cash operating cycle is the length of time between paying out cash for inputs and receiving cash from sales. It is a useful measure of the time taken to generate cash. Cash flow forecasts enable businesses to predict and deal with liquidity problems before they arise. It is one of the most important measures of future solvency.

THE CURRENT RATIO

Current ratio = Current assets / Current liabilities

This is a standard test of short-term solvency and simply measure if a business can meet its current liabilities from its current assets. Depending upon the nature of the business, the current ratio should usually be greater than 1, depending upon the speed of inventory turnover.

THE QUICK RATIO (or ACID TEST RATIO)

Quick ratio = (Current assets less inventory) / Current liabilities

This is a more reliable short-term solvency measure because inventory is not easily convertible into cash for many businesses. This ratio should be close to 1, depending upon the business.

INTERPRETING LOW AND HIGH RATIOS

Don't interpret current and quick ratios too literally. Different businesses operate in different ways. Low ratios are not always indicative of insolvency risk and high ratios are not always healthy.

LOW RATIOS.

For example, a high volume retailer, such as a supermarket could have healthy liquidity but very low current and quick ratios. Supermarkets have relatively low inventories as their goods are mainly perishable and turnover quickly. They have minimal receivables as customers pay in cash. In addition, their purchasing power results in long trade payable payment periods. Therefore overall - relatively low current assets and relatively high current liabilities.

HIGH RATIOS.

A poorly managed business with slow-selling inventories and many outstanding receivables may have high current and quick ratios.

Short-term solvency is the ability to pay short-term debts from liquid assets.

Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

Measure Profitability

Measure Profitability

The business with the largest profit is not necessarily the best performer. Profit should be measured in relation to the size of the investment required to achieve that level of profit. Therefore, the best measure of profitability is 'return on investment'.

MEASURING 'RETURN'

Gross profit margin % = Gross Profit / Revenue

This measures the margin made on top of direct costs. A relatively high sales margin demonstrates the ability of a business either to charge a premium price or to control input costs. It is useful when benchmarking against similar businesses in the same industry.

Net profit margin % = Operating profit / Revenue

This is similar to gross margin but takes account of operating expenses. Net profit margin measures the ability to control costs. Operating profit is preferred to other profit totals, as it exclude finance and taxation costs, which can vary between businesses and years.

MEASURING 'INVESTMENT'

The most common definition of 'investment' is capital employed, which is equity plus non-current liabilities (alternatively, total assets less current liabilities). Capital employed is effectively the amount invested in a business by both shareholders and debt holders.

Asset turnover (times) = Annual revenue / Capital employed

This shows how well the finance invested in a business, subsequently invested in assets, has been utilised to generate sales. It measures the amount of revenue earned from each $1 invested. Asset turnover demonstrates the number of times assets generate their value in terms of revenue each year. It is sometimes referred to as a measure of activity. A relatively high asset turnover could indicate efficient use of assets, although the measure is sensitive to the valuation of assets.

MEASURING RETURN ON INVESTMENT/CAPITAL EMPLOYED

'Return on Investment' (ROI) has many permutations, the most common of which are

return on capital employed (ROCE);
return on net assets (RONA);
return on total asset (ROTA);
return on equity (ROE); and
accounting rate of return (ARR).

They are all essentially measuring the same thing - profit as a percentage of the investment required to achieve that profit. ROI is also used in internal investment appraisal.

ROCE = Net profit margin x Asset turnover

ROCE = Operating profit / Revenue) x (Revenue / Capital employed)

Analysing the net profit margin or asset turnover will help to explain a high or low ROCE.

Profit should be measured in relation to the amount of capital employed.

Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

Measuring Business Performance

Business success can be measured using ratios. Financial performance ratios can facilitate performance measurement. Let us look at the following:

Profitability
Short-term solvency and liquidity
Long-term solvency and stability
Investor ratios

Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

My 18 points guide to Successfully compounding your money in Stocks

Be a good stock picker.
Think as a business owner.
Always look at value rather than the price. Do the homework.
Buy and hold is alright for selected stocks.
Compounding is your friend, get this to work its magic.
Mr. Market is there to be taken advantage of. Do not be the sucker instead. BFS;STS.
Always buy a lot when the price is low.
Never buy when the stock is overpriced.
It is alright to buy when the selected stock is at a fair price.
Phasing in or dollar cost averaging is safe for such stocks during a downtrend, unless the price is still obviously too high.
Do not time the market for such or any stocks.
By keeping to the above strategy, the returns will be delivered through the growth of the company's business.
So, when do you sell the stock? Almost never, as long as the fundamentals remain sound and the future prospects intact.
The downside risk is protected through only buying when the price is low or fairly priced.
Tactical dynamic asset allocation or rebalancing based on valuation can be employed but this sounds easier than is practical, except in extreme market situations.
Sell urgently when the company business fundamental has deteriorated irreversibly.
You may also wish to sell should the growth of the company has obviously slowed and you can reinvest into another company with greater growth potential of similar quality. However, unlike point 16, you can do so leisurely.
In conclusion, a critical key to successful investing is in your stock picking ability.

http://myinvestingnotes.blogspot.com/2012/07/my-18-points-guide-to-successfully.html

11 Lessons From Peter Lynch

Peter Lynch taught me:

1. Behind every stock is a company. Find out what it’s doing.
2. Never invest in any idea you can’t illustrate with a crayon.
3. Over the short term, there may be no correlation between the success of a company’s operations and the success of its stock. Over the long term, there’s a 100% correlation.
4. Buying stocks without studying the companies is the same as playing poker – and never looking at your cards.
5. Time is on your side when you own shares of superior companies.
6. Owning stock is like having children. Don’t get involved with more than you can handle.
7. When the insiders are buying, it’s a good sign.
8. Unless you’re a short seller, it never pays to be pessimistic.
9. A stock market decline is as predictable as a January blizzard in Colorado. If you’re prepared, it can’t hurt you.
10. Everyone has the brainpower to make money in stocks. Not everyone has the stomach.
11. Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

Lynch’s advice had a profound effect on my stock market approach. He taught me that investment success isn’t the result of developing the right macro-economic view or deciding when to jump in or out of the market. Success is about researching companies to identify those that are likely to report positive surprises.

Capital Expenditure

A great company with a Durable Competitive Advantage will have a ratio of Capital Expenditures to Net Income of less than 25%. Less is better.

Capital Expenditures are expenses on:
- fixed assets such as equipment, property, or industrial buildings
- fixing problems with an asset
- preparing an asset to be used in business
- restoring property
- starting new businesses

A good company will have a ratio of Capital Expenditures to Net Income of less than 50%.

A great company with a Durable Competitive Advantage will have a ratio of less than 25%.

Less is better.

Benjamin Graham's 113 Wise Words

The true investor scarcely ever is forced to sell his shares, and at all times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement."

Philip Fisher's Wise Words

"The refusal to sell at a loss, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process.

More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous."

(Common Stocks and Uncommon Profits)

The Ultimate Hold-versus-Sell Test

Here is the overriding primary test, followed by observations on why it is so critically important:

Knowing all that you now know and expect about the company and its stock (not what you originally believed or hoped at time of purchase), and assuming that you had available capital, and assuming that it would not cause a portfolio imbalance to do so, would you buy this stock today, at today's price?

No equivocation. Yes or no?

Answers such as maybe or probably are not acceptable since they are ways of dodging the issue. No investor probably buys a stock; they either place an order or do not.

Here is the implication of your answer to that critical test: if you did not answer with a clear affirmative, you should sell; only if you said a strong yes, are you justified to hold.

Some thoughts on Analysing Stocks (KISS)

Ideally a stock you plan to purchase should have all of the following charateristics:

• A rising trend of earnings dividends and book value per share.
• A balance sheet with less debt than other companies in its particular industry.
• A P/E ratio no higher than average.
• A dividend yield that suits your particular needs.
• A below-average dividend pay-out ratio.
• A history of earnings and dividends not pockmarked by erratic ups and downs.
• Companies whose ROE is 15 or better.
• A ratio of price to cash flow (P/CF) that is not too high when compared to other stocks in the same industry.

Margin of Safety Concept: Stocks should be bought like groceries, not like perfume

The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.

Chapter 20 - “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?