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[analyst]

P/E – What is it all about?


The most commonly used valuation metric by investors is the price to earnings ratio or commonly referred to as the P/E ratio. Though commonly used, it is also misunderstood for various reasons. Here is an attempt to simplify this valuation metric.

How is P/E calculated?

It is calculated by dividing market price of a stock by EPS (earnings per share). EPS in turn is calculated by dividing the net profit of the company by the number of shares outstanding.

Having calculated the P/E, what does it stand for?

Lets assume a stock is trading at Rs 100 and its EPS is Rs 20. The P/E multiple is 5 (100 upon 20). Assuming that the company’s EPS is likely to be Rs 20 each year, it will take 5 years for the investor to realize Rs 100. Of course, the assumption here is that the company’s EPS is not growing at all.

Now taking the example of commonly traded stocks like Infosys and Tisco. While the former trades at a P/E multiple of 25 times, the latter trades at 7 times. Why is it so? It is believed that the stock price of a company tracks its long-term earnings growth potential. In an economy, some companies (or sectors) are likely to grow at a faster (like say software or pharma) rate. So, the P/E multiple of companies from these sectors are likely to be higher and vice versa. Depending upon growth expectations, the P/E multiple could vary.

There is one crucial factor here i.e. expectations. Though Infosys may be trading at 25 times earnings, if EPS is expected to grow by 25% per annum, the investor could realize the money in four years.

P/E – Is it a discount or a multiple?

There are two ways of quoting P/E valuations:

Tisco is currently trading at Rs 350 discounting its earnings by 5.5 times



Tisco is currently trading at Rs 350 at a P/E multiple of 5.5 times

Which is right? The answer to this lies in the formula for calculating P/E itself.

P/E is Market price divided by EPS. If we were to reverse the formula,

Market price = P/E multiplied by EPS. Stock prices reflect future earnings potential and not past performance. Discounting the current price with historical EPS is not a right way to analyse companies.

Take a hypothetical case. If Tisco’s EPS for the next year is expected at Rs 50 and the growth in EPS is around 15%, the market price is calculated by multiplying Rs 50 with 15 times i.e. Rs 750. When determining the stock price, one does not discount earnings but multiply earnings.

What is the ‘right’ P/E multiple for a stock?

The answer to this question is not easy. In the previous example, we have assigned a P/E multiple of 15 times because EPS is expected to grow by 15% in the immediate year. Is this the right way? Not necessarily. Here, it is important to understand industry characteristics of the company.

For a commodity stock like Tisco, EPS tends to grow at a faster rate when steel prices are recovering or are at the peak and the EPS is likely to decline at a faster rate during downturns. To qualify this statement, if we look at EPS growth of Tisco from 1994 to 2004, the compounded growth in earnings is 17%. However, the CAGR growth in the last three years was 193% (the recovery phase). So, if one believes that steel demand is likely to trace long-term economic growth and that 15% growth is unsustainable, the P/E multiple should be ideally much lower than 15 times. Similarly, the long-term growth prospects for software companies could be much higher than commodities. So, the P/E multiple for software stocks could be at a premium.

Determining the P/E multiple for a stock/sector also depends on:

Historical performance – Why does Infosys trade at a higher P/E multiple compared to Satyam? By historical performance, we mean, focus of the management (without unrelated diversifications), ability to outperform competitors in downturn/upturns and promise vs performance. This can be gauged if one looks at the last three to five year annual reports of a company.



The sector characteristics – Margin profile, whether it is asset intensive and intensity of competition. Less asset intensive sectors (say, FMCG) are considered defensive and therefore, could trade a premium to the overall market.



And more importantly, expectations. Take the case of textile stocks. Expectations of significant growth opportunities post the 2005 quote regime phase out has resulted in upgradation of P/E multiple of the textile sector.

When is P/E not useful?



Economic cycles - In FY02, Tisco was trading at a P/E multiple of 20.5 times its FY02 earnings. Was it expensive? Based on FY05 expected earnings, Tisco is trading at a P/E multiple of 5 times its earnings (at Rs 250). Is it cheap? If one ignored Tisco in FY02 on the basis that it was ‘expensive’ on the P/E multiple in FY02, the opportunity loss is as much as 350%. Businesses operate in cycles. During downturn, EPS will be low but P/E will be inflated and vice versa. At the same time, during expansionary phase, corporates invest in capacities. In this case, high depreciation costs suppress earnings. P/E, in this context, may mislead investors.



Not actively tracked – There are number of companies in the Indian stock market that are not actively tracked by investors, analyst and institutions. For example, Infosys’ average price was Rs 2 in FY94 and the P/E multiple was 17 times. At times, P/E multiple may be lower because some sectors/stocks are not in the limelight.



Expectations – On the downside, some stocks may be trading at a significant premium because earnings expectations are higher. High P/E also does not mean a good stock to buy. What if the expectations are unrealistic? One needs to exercise caution to this extent.



Means little as a standalone number – P/E, as a standalone number, means little. Besides P/E, it is also important to look at margins, return on net worth, cash generating ability and consistency in performance over the years to assign a value to a stock.



Market sentiment – During bear phases or when interest in stocks is low, valuations could be depressed. Since equities are considered less attractive during these periods, valuations are likely to be below historical average or below earnings growth prospects.

When is P/E useful?

A powerful metric – Unlike metrics like discounted cash flow method and so on, P/E is relatively a simple and at the same time, a powerful metric from a retail investor perspective. Though the factors behind determining the ‘right’ P/E multiple are important, a historical perspective of a stock’s P/E could make this exercise less complex.

To conclude, valuation of stocks involves subjectivity. A person X may assign a higher P/E multiple to the stock as compared to a person Y depending on the risk profile and growth expectations. In the end, it all boils down to how the company is likely to perform.

It is not that stock market is always right when it comes to valuing a stock! As Mr. Benjamin Graham puts it “in the short term, the market is a 'voting' machine whereon countless individuals register choices that are product partly of reason and partly of emotion. However, in the long-term, the market is a 'weighing' machine on which the value of each issue (business) is recorded by an exact and impersonal mechanism”. Watch the earnings!

[analyst]

Free cash flow: Is it free after all?


The best things in life are said to be free and the same holds true for cash flow! Investors love companies that produce plenty of free cash flow (FCF). It signals a company's ability to repay debt, pay dividends, buy back stock and facilitate the growth of business – all important undertakings from an investor's point of view. In the past we have given our readers a perspective on valuation parameters like price to earnings (P/E) and price to book value (P/BV). While both these valuation parameters reflect the present earning capabilities, they do not signal the ‘future’ prospects.

How and what of FCF
The formula for calculating Free Cash Flow (FCF) is as:

Net Profit + Depreciation – Capital expenditure – Changes in working capital – Dividend

FCF takes into account not only the earnings of the company but also the past (depreciation) and present capital expenditures, capital inflows and investment in working capital. Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF due to revenue growth, efficiency improvements, cost reductions, share buy backs, dividend distribution (from subsidiaries) or debt elimination can reward investors in the future. Better free cash flows are therefore a reason for the investment community to cherish. On the other hand, an insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business

From a company’s point of view
A better FCF definitely indicates better efficiency on the part of the company. But what is pertinent for investors to note is that simply assessing the FCF on the basis of its absolute value is not prudent. It is imperative to also assess as to what components have contributed to the same.

Let us take a hypothetical example of two companies, A and B, both of which have garnered the same FCF for the current financial year.


Estimated free cash flow
(Rs) Company A Company B
Net profit 75 120
Add: depreciation / amortisation 20 5
Less: Capital expenditure 5 15
Add/ (Less): Decrease /(Increase)
in wkg capital 10 (10)
Less: Dividend 20 20
Free cash flow 80 80

Prima facie although appearing similar, if you delve a little deeper there is a stark difference in their performances. While company ‘A’, despite having lower earnings has benefited by adding back depreciation and decrease in working capital, company ‘B’ has invested in capex and working capital. This indicates that while company ‘B’ is investing for future growth, company ‘A’ is not sufficiently geared up for the impending challenges. This also means that investors in company ‘B’ can expect ‘rewards’ in future while those in company ‘A’ should sit up and take notice of what is ailing it.


FY06E Price FCF P/FCF
SBI 612 203.9 3.0
ONGC 874 131.3 6.7
Tisco 354 26.2 13.5
BHEL 831 31.6 26.3
Infosys 2039 51 40.0
Ranbaxy 965 19.6 49.2
HLL 132 1.9 69.5


From a sector’s point of view
As explained earlier, cash flows are dependant on the capital expenditure and working capital liabilities borne by the company. This however, differs as per the dynamics of the sector in which the company is operating and should be seen in that light. While sectors like banking require minimum expenditure on capex (as a % of their turnover) those in pharma, engineering, FMCG or commodity sectors require to invest a substantial amount in R&D and capacity expansions. Thus, you would find SBI trading at a very attractive price to free cash flow valuation of 3 times, while an equally competitive Infosys is trading at 40 times (due to lower cash flows).

To conclude...
FCF is not only a mirror image of the present but also a sneak preview into the future. The implications of the components of cash flow may not be explained in the annual reports, but is left to the investor’s prudence to diligently scrutinize the same and try to read between the lines. The legendry investor Benjamin Graham once said, “The individual investor should act consistently as an investor and not as a speculator. This means that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase.

Free cash flow, is not free after all!

[analyst]

Why sales growth is an essential element of identifying growth stocks

By Philip B. Capelle

Sales of a growth company, by definition, must be expanding at a rapid rate. The company’s product or service should not only be in great demand, but it should show characteristics that would lead you to believe that demand will presently for several years or more to come. Companies that sell faddish products like Hoola Hoops or Cabbage Patch dolls aren’t interesting. Instead, the company’s goods or services should be in line with the macro trends in the economy that may last for possibly ten years or longer. You may have witnessed what has happened to stocks that rode the major trends in the environment, medical services, and software industries, to name a few. These trends more than likely will continue to grow in the years ahead, and other macro trends will also develop. What you are looking for from a company’s sales is a record of impressive growth, the likelihood that the record will continue, and the proof that the sales effort is a profitable one.

Ideally, recent quarterly and annual sales figures will demonstrate impressive double growth. As a rule of thumb, you should expect a growth rate of at least 20%. It’s not uncommon to find a small growth company with sales growth of 50% to 100% or more. These astronomical rates normally don’t last too long because they are for the most part unsustainable. Nevertheless, a company that is growing at 75% may be a good investment, because nobody realistically expects that kind of growth to last too long. Most growth stock investors are quite pleased with sales that grow from 20% to 30% annually, year after year.

If sales growth has accelerated lately at an above-average pace, it’s worth finding out why. Perhaps a company may have just released a new product that’s selling like gangbusters. Maybe some large customers have just signed up for their service. An acceleration in sales for those reasons can be the start of an exciting growth phase for the stock of the company in question. Pharmaceutical stocks can jump five to ten points in a day when a new drug is approved. Although not as dramatic, the same thing happens with small growth stocks that add a new product or service to their existing line.

You should study the quarterly figures to make sure each quarter is progressing favourably versus the same quarter of a year or two ago. Growth companies that are ramping up should have very few, if any, quarterly results that don’t meet and beat the same quarter of a year ago. If you do discover a quarter that’s not too impressive, try to find out the reason for the less than robust results. There could be a legitimate reason such as a slowdown in the economy or a delay in bringing a new product to market. Quarterly figures are also subject to seasonal tendencies depending on the business. Although quarterly results are important, at least because the stock market thinks so, you should really place your emphasis on annual results. Twelve-month sales figures have a way of smoothing out the twists and turns of the quarterly data. If the annual comparisons don’t stack up, move on to the next stock. In today’s dynamic economy there are numerous companies with businesses that are expanding rapidly, so you need only settle for the best, for those that demonstrate consistently high growth.

Sales figures can be broken down in several ways to give you additional insights as to how a business is doing and how it is growing. In the annual report, you’ll find a consolidated statement of income. This will break revenues down into various categories. Each segment may be broken down even further in the footnotes that follow the financial statements. A business that sells just one product may list sales of that product and interest income from corporate investments. Obviously, you need look no further in this case.

More complex businesses may list several sources of revenue. Here you should be looking for signs of some positive trends in the most significant as well as developing sources of revenue. For instance, assume that the company’s core business, which represents 65% of revenues, is growing at 30%, but that rate of growth has been slowing somewhat. On the other hand, a segment that represents only 30% of the business is expanding at a rate of 75% annually. At these rates of growth, within a few years the smaller segment may now become the company’s most important source of income. Examples of this were found in companies that relied heavily on work for the defense department, but because of the cold war’s ending shifted over to civilian work. There’s nothing necessarily wrong with a company whose emphasis is changing. Just be sure to take note of where its income is coming from. Do you still want to own the company if its primary business looks like it is heading toward widgets and away from buggy whips?

Although not all segments of a company’s business will grow at exact the same rate, perhaps you will find that no one area is necessarily outpacing any other to a great degree. In this case, the company’s balance of revenue may be unchanged for some years to come. In other words, what you see now is what you get.

Businesses that go global are in line with one of the megatrends that shows no signs of abating. You should consider it a real plus if your company has successfully undertaken an international sales effort. In the footnotes you will often find reference to the last few years’ growth in nondomestic sales. Because this figure probably represents far less than half of sales of a small company, in many cases you should expect to find international sales growing at a very rapid clip. Companies with an international focus, as evidenced by a rapidly growing presence overseas, are demonstrating an opportunistic approach that will only serve to help in their efforts to grow the business.

Generally speaking, businesses either provide a service or manufacture and sell products. There is, of course, a great deal of overlap between these two categories. For instance, companies that sell products may also be heavily involved in servicing those goods.

Nevertheless, this discussion focuses on the concept of a company either providing a service or producing and selling a product.

In today’s highly competitive world, service companies must either perform an existing service with a high degree of excellence or help meet a customer’s needs with a new approach if they wish to stay in business long, much less prosper. Service companies that exploit new high technology to more effectively get a job done or bring goods to market at cheaper prices are rapidly establishing footholds for themselves. Examples of this are the increasing demand for home health care and the explosion in the growth of retail outlets with huge discount superstores. Some of these ideas have applicability to some, but not all, of a variety of service industries, including health care, retail, restaurants, cable television, and financial services.

You should also determine why customers are flocking to a company’s service. Are sales growing because they provide equal or better service at a lower cost? Is the growth in sales being fueled by the opening of new outlets? Are same store sales growing impressively? What about the closure rate? Try to find out if additional services are being added to the current channels of distribution. Have you noticed how some convenience stores now sell burgers and lotto tickets? Franchises can bring in revenue from a variety of sources, including licensing fees, royalties, and the sales of products to the franchisees.

If a service company is growing fast, you will want to know their current level of market penetration. Are they just beginning to tap a large market, or has their growth just about topped out? For instance, H & R Block has a base of potential demand of millions of American taxpayers. This enabled the company to grow steadily over the years as it continued to carve out a larger share of the market. Sales grew from about $319 million to well over $1 billion from 1981 to 1990. This service-based franchise business once added electronic filing, which has been a real boost to their business as it is preferred by both taxpayers and the IRS.

Office Depot took advantage of the desire by businesses to save on costs wherever possible. This chain of discount office supply superstores grew from a startup in 1986 to the largest service of its kind. In 1991, sales were way over the $1 billion mark. As you might expect, the shares of both of these companies appreciated impressively during the period.

With companies that manufacture and sell products, you will need to find out why their product is a hot seller and why this demand should continue to grow over the years ahead. What problem does their product solve? How does it make life easier? What is the major benefit to purchasing their product? Does it do something new or is it cheaper and/ or more useful than a competitor’s product? The answers to questions like these will give you a good idea of a company’s potential for sustained growth over a period of several years. What you want to avoid are businesses whose flame burns brightly for a short period of time and then goes out quickly. These burnouts can occur quickly, especially as technology continues to evolve. So be careful to make sure your product-oriented selections have staying power. Try to find product businesses that operate in a niche market.

It was easy to classify industries in the past. You had the following industries: autos, steels, papers, utilities, and so on. The technological explosion has spawned substantial growth and an explosion in a number of industries now in existence. Indeed, many small companies can lay claim to being the originator and leading player in a highly specialized niche/mini-industry. Indeed, their position can often be very secure due to their ownership of a proprietary product. Because customer demands for products can change quickly, you will want to know what’s being done to upgrade the company’s products. Find out what’s being spent on research and development and how effective these expenditures have been in the past. You need more than research and development dollars; your company needs results.

Trade journals can also serve as a useful guide in indicating the status of a company’s offerings within its industry. Obviously, you will want to see your purchase candidate near or at the top of the standings. These surveys are often very valuable clues as to just how much acceptance a product has when in the hands of the customers that they need to satisfy.

Software companies provide a product that is relatively inexpensive to manufacture. On the other hand, some product companies may have a substantial investment in their manufacturing facility. If their plant is only being used at 40% of its capacity, they have room to grow before adding another plant. Unit sales, as opposed to dollar sales, could grow at a 30% compounded rate for over three years before a new plant would be needed. Should their current plant be running at or near capacity, you will need to know what their expansion plans are. The company should not lose future sales because it hasn’t geared up for increased demand. In addition, you may not want to be in the stock if the expansion is going to be costly and create a drag on its earnings for several quarters

[analyst]

How fear destroys your trading profits

By Tony Plummer
Detrimental Habits

Because fear is an important — and regular — feature of markets, it is important that traders learn how to cope properly with it. The main problem is that the mental habits (i.e., the fundamental sub-conscious thought patterns) which are normally used to cope with fear, are inappropriate for coping with financial markets. There are three such habits which need to be addressed. Each of these three patterns will exist to some degree in any one individual; but it is probable that one pattern will be more dominant than the others. The patterns are:

(1) the minimisation of fear;

(2) the protection of the self-image; and

(3) the protection of personal space.

In essence, every item of information perceived by an individual will automatically be compared with these three imperatives. If expectations do not match events, then the automatic impact response will be one of fear. This is then followed by a secondary response: people who normally seek to minimise fear will feel the fear every acutely; those who seek to protect their self-image will respond to the fear by projecting hostility; and those who seek to protect their personal space will respond to the fear by becoming angry.

The Minimisation of Fear

A person whose behaviour is dominated by the need to minimise fear will tend to search for, and concentrate on, potential threats. The greatest threat to a trader’s well-being is, quite obviously, losing capital. There is therefore a natural tendency to try and avoid losses — and the fact that losses are not always avoidable serves only to emphasise the dangers. The in-built habit of trying to avoid mistakes has two deleterious side-effects.


First, if the market begins to move against a trader, there will be a natural tendency to look only at information which justifies the original view. This will delay the (perhaps inevitable) decision to cut the loss-making position. Losses may therefore be greater as a result.

Second, if the market moves in favour of the trader, there will be a tendency to look only at information which confirms that the market may retrace back to the trader’s starting level. This will accelerate the decision to take the profit. Profits will therefore be smaller as a result. Overall, the fear of making losses only ensures that returns are biased downwards.
In addition to a mediocre trading performance, the habit of focusing attention on potential threats also uses up valuable energy. As a result, very little energy is left over to learn new strategies and tactics. Indeed, when naked fear does break through — as it inevitably does — the individual is likely to freeze up completely. The subconscious is unable to cope with the emotion because it has become used to trying to avoid it.

Fearful individuals do not make natural traders. One part of the solution is (eventually!) to learn that the world is not necessarily as dangerous as childhood experiences have evidenced. The other, more immediate, part of the solution is to adopt trading practices which automatically reduce the individual’s exposure to fear. Where possible, such practices should incorporate the use of price objectives.

The protection of the self-image

A person whose behaviour is controlled by the need to protect a particular self-image will focus attention on obtaining approval from others. Feelings of low self-esteem are generated when this approval is not forthcoming for some reason. However, the ‘gift’ of approval may be either real or imaginary: it is possible to feel that approval is in some way withheld, even when the approval is in fact forthcoming; and at extremes, it is possible to feel that approval would not be forthcoming if anyone knew ‘the truth’. As a result, it is possible to suffer from feelings of low self-esteem even if no one else is actually involved.

This unfortunate situation arises because — in Western culture at least — we are trained during childhood not to make mistakes. It doesn’t matter whether we are rewarded for avoiding mistakes or punished for making them, the result is the same: we end up being afraid to make mistakes and the instinctive drive of inquisitiveness is suppressed. Different people respond in different ways, of course, so not everybody will avoid trying anything new (otherwise there would be no progress!). But those individuals who, for whatever reason, have been exposed to the fear of ignominy as a child will inevitably regard any mistake as being intrinsically unacceptable simply because it is a ‘mistake’.

Individuals who are particularly energised by the need to protect their self-image are going to experience acute feelings of low self-esteem when losses are incurred. The basic lesson to be learnt, of course, is that making a loss does not automatically ‘devalue’ the essential worth of an individual as a human being. However, it is a lesson which is difficult to learn, given the power of childhood programming. The only practical solution is to direct attention away from the need to make every trade a success and direct it instead towards the need to make the whole activity of trading a success.

The protection of personal space

Individuals who seek to protect their personal space will tend to have strong mental ego boundaries and, crucially, will try and obtain control over anything that may influence their lives. In order to achieve such control, the world is mentally classified into two parts: the part which is non-threatening and which can therefore be assumed to be ‘unchanging’, and the part which is active and which is therefore threatening. Having made this distinction, it is then possible to direct the necessary mental and physical resources towards the control of the potential threat; and where possible, of course, this control will be exerted directly.

Obviously the degree to which this strategy is successful will depend on an individual’s ability to distinguish between the threatening and the non-threatening. The ability is usually developed during the process of learning by mistakes: each successive mistake heightens awareness of the need to exert control over actual and potential threats. However, the strategy also depends on the extent to which circumstances are threatening in the first place. There is a world of difference between knowing that one person in a crowd might throw a stone at you and knowing that everyone in a crowd is going to throw stones at you. In the former case, the process of separating the threatening from the non-threatening is both possible and useful. In the latter case, however, the process is irrelevant!

Financial markets are, in a sense, like the second example. If the trader uses the simplifying assumption that the structure of the market is unchanging for the period that the trade is in place, then losses will present themselves as strong information ‘shocks’. The trader will automatically focus attention on the cause of the shock and will subconsciously recognise the situation as being uncontrollable. Not surprisingly, the emotional response will be one of anger and frustration. The lesson which is eventually absorbed by the process of learning by these sort of mistakes is that trading is to be avoided!

People with a strong predilection towards protecting their personal space — and who, therefore, subconsciously assume that they can exert some degree of control over price movements — cannot automatically become successful traders. They will need to understand that financial markets do not necessarily behave according to desires and that their instinct towards control has to be directed internally rather than externally.

Conclusion

The simple point to be made, therefore, is that the mental habits which are usually developed to cope with fear — and which broadly involve strategies to minimise fear, to protect a self-image and to protect personal space — usually militate against successful trading. This is simply because the habits are not suitable for financial markets. Since everybody has one or more of these particular mental habits to some degree, it follows that most people are not going to make an automatic success of trading: losses are likely to be large; stress will be high and (when it is experienced over a sustained period of time) will use up vital energy resources and create illness; and the associated emotions are likely to be negative and unfulfilling. It is important, therefore, to look at ways to resolve these problems.

[analyst]

EVA: The cutting-edge stock selection tool

By Vincent van Doorn




On a recent business trip in Europe, visiting different companies over several days, 1 encountered many managers talking about shareholder value. Besides being a nice topic to talk about with portfolio managers and company managers alike, it appeared to me that shareholder value, as interpreted by company managers, is a concept that has wide semantic scope. One company raved about a changing shareholder structure being shareholder value enhancing. Another company, in a notorious cyclical business, thought it would enhance its shareholder value by diversifying into non-cyclical businesses.

The clever reader understands immediately that this creates undefined possibilities to enhance the intrinsic value of the funds under management by either going short or long these interpretations I will try to explain a framework of shareholder value as a function of capital employed, the cost of capital and the return on capital employed. This framework gives you an ample tool to calculate and evaluate a company’s performance over its total capital. This means, regardless of the capital structure, a company’s performance can be measured and evaluated periodically. However, 1 leave it up to you to determine and discuss the different definitions of shareholder value that companies use in their drive for enhancing their share price performance.

The Merchant of Venice, EVA and DCF

A pound of flesh. No more, no less ... There are many books and methods that describe in more or less detail what 1 am about to explain here. All require a detailed understanding of balance sheet items and lines in the profit and loss statements invented mainly for tax reduction purposes. Apparent and of pivotal importance is to understand that a firm’s value is derived from cash from operations discounted over the life of a company. 1 would like to highlight two books that stand alone in taking this concept one step further: The Quest for Value, by G. Bennett Stewart and Valuation by Mckinsey & Company. Both books point to the intellectual fathers of the value approach and the concept of cash flow and its present value method, namely professors Merton Miller and Franco Modigliani.

Bennett Stewart shows us a method measuring the value of a company in any given year with a concept he calls Economic Value Added or EVA. EVA is basically the difference between the operating profit and the cost of capital employed. Any year that a company is in business and generates more operating profit than its capital charge, it is creating economic value. By discounting this spread, taking the present values of all future EVAs at the rate of the cost of capital employed, you get the cumulative present value of all future EVAS. Add this to the current capital and you derive the value of a company.

Again it should not be surprising to the alert reader that this EVA method will come to the same valuation as would be achieved through discounting all future cash flows. This is correct and hence, a pound of flesh can equal only a pound of flesh. However, the beauty of EVA is that it is more than calculating the value of a company. EVA incorporates a thinking about financial structures that also facilitates a better understanding of the mechanics in a balance sheet and P&L. Pure cash flow analysis will miss crucial opportunities by disregarding companies with negative cash flows. Most importantly, EVA gives you a very handy set of tools to understand and question management’s actions and value its progress year by year.

Capital Employed

Except for a happy few in this world, we would not be living in our owned pieces of real estate without the ability to leverage ourselves. Most banks are more than eager to help you fulfill your dream, however at a cost. In order to calculate a cash return, subtract from your sale price all the cash that has been borrowed plus the down payment plus cash payments for home improvements. All cash left is profit before taxes. In other words, to define a return, the total amount of cash invested in a particular venture must be added up. Capital employed is defined as all cash invested in a company during its lifetime. For our purpose this means all cash invested in going-concern business activities in order to produce an operating return.

Whether this cash is equity or debt does not concern us at this stage. All the extra investment for home improvement is cash invested and thus capital employed to make your stay a little more pleasant. A prudent home owner has kept meticulous records of all the cash invested over time, both for tax purposes and for calculating the value in lieu of a transaction. This was the easy part. Now try to find capital employed in an average company annual report, good luck!

What concerns us is to define the total cash amount invested over time in a company. Admittedly this is almost impossible to find due to a lack of published historical figures. But as usual it is better to be approximately right than precisely wrong. A good starting point is an examination of the net assets in the balance sheet: begin by looking three or four years back in history in order to adjust figures and cumulate them to the future. In order to determine all the cash that has been provided to the company, the net assets should be adjusted for.

Marketable securities: subtract these because this is capital most likely used for other than going-concern business activities, ergo non-operational. Cash-rich companies, such as Novartis and Roche, both pharmaceutical companies, can undermine their total return on all capital when their return on liquidities is underperforming vis a vis their return on operating capital. Do the calculations for Novartis or Roche and you will see this is currently the case!

The present value of non-capitalized leases should be added to fixed assets (this is capital locked up in the company). These items are mostly off balance, but mentioned in the footnotes. This is capital locked up unless a company is able to sell the leases to third parties or break a lease without penalty, which is most likely the case only with A-location retail property leases.

Cumulative goodwill amortization and cumulative exceptional losses or gains should be added back to net assets as well. According to Dutch accounting standards a company has to book all its goodwill at once against its equity. When Wolters Kluwer, a Dutch publisher, acquired CCH, it had to change its accounting method. The goodwill of CCH was greater than Wolters Kluwer’s equity. This would have given a nice return on negative equity (ROE). I rest my case...

Writing down assets because of lower valuations is prudent. But for our purpose, to find a return on all cash invested, it is not helpful. Therefore written-off assets should be added back. Assets that were too expensive do not give you cash back or result in a store credit of any kind. This method, practiced by Alcatel Alsthom, a French conglomerate, makes for a nice increase in ROE but does not tell us what the real performance is off all the cash that was invested in the past.

You can make a case to capitalize cumulative cash that has been spent as R&D. 1 am in favor of doing this as 1 am in favor of capitalizing all cash investments made to build and strengthen brands. In the case of the former you can argue that this will smooth the cost of huge R&D projects over the economic life of a project. Current shareholders are punished unfairly in the short term if a large cash outlay in R&D depresses the snapshot value of a company due to low or even negative cash flows and returns in the year under review.

In case of the latter, 1 see brands as an asset and therefore cash outflows to build and strengthen brands as cash investments and not as costs.

Without going into an academic exercise, which we could easily do, 1 would like to stress the fact that it is imperative to use a consistent capital base method in order to judge a company’s progress. Companies that employ an increasing pool of operating capital need to make a return that is higher than the cost of that capital. The difference between success and failure is the difference between capital destruction and capital creation. This brings us to the next subject: how to measure a return on capital employed.

Return on Capital Employed

As 1 wrote earlier, capital and returns can be calculated in many ways using different capital bases. Return on equity, total assets, investment and maybe someone will try to calculate the return on debt one day! All of the above can give you false indications of how the underlying businesses are performing. The same counts for profitability. Net profits, EBIT, and EBITDA are all meaningful in one way or another. However, as investors, we are looking for the true yield on all cash invested. In other words the amount of profit that is available to return to all capital providers of a company. Whether the tax authorities enjoy a larger or smaller piece of that yield does concern us. Whether credit institutions demand higher interest rates for their capital does concern us because of the tax implications. We are looking for the cash return that can be distributed to all capital providers. Therefore any other yardstick is less meaningful and a derivative from the true yardstick: return on capital employed.

In order to come to a true economic return, a few adjustments should be made to net profits. Net profits are a good starting point and must be adjusted for operating and financing distortions. These distortions were made either to facilitate tax reductions or to smooth net earnings. After the adjustments we will have a cleaner figure that represents a true economic profit.

Operating distortions are amortization of goodwill, which should be added back, fluctuations in tax reserves, fluctuations in other reserves/provisions, unusual gains/losses and increases in LIFO reserves. Remember we are not questioning these items in the P&L or passing judgment on them; all we want to know is what the true economic return is on all cash invested in a company.

Financing distortions are after-tax interest charges that are added back to eliminate the effects of capital structure. The debt/equity ratio is covered by the average cost of capital which we will discuss later. We want to find a measure that gives us an operating performance over total capital. With this in mind we can also use this measure to test performance against similar companies disregarding their mix of debt to equity.

The times when companies blatantly used provisions to smooth their net income streams are gone. But, as we can see in every reporting season, the quality of net earnings is more often dubious than not. Unfortunately the truth can only be found in the footnotes of an annual report. So, unless a company releases a detailed half-year report, you have to wait for the current annual to be published to evaluate a company’s performance.

A word of caution. Before you start a meticulous quest for distortions, remember the following. Time has a cash value for most of us who work, so be reasonable and look for the distortions that make up 80% of what you are looking for. Be sure that for every adjustment to net profits you make an adjustment to net assets as well.

Different businesses demand different priorities of adjustments: you are looking for good or bad performing capital, not a Ph.D. in Finance.

Cost of Capital

Cost of capital, the last of the three musketeers. Providers of capital demand a reward for their capital. That reward equals the cost of capital, or capital charge, of a company. The cost of capital varies with the mix of debt to equity and its perceived business risk, beta. Beta is a measure of the company’s stock price volatility versus the overall market. Volatility lessens with increased predictability of a company’s cash flow stream and vice versa.

It is widely known that a risk-free reward equals the long-term yield of a government bond (there is ample academic proof for this). Measured over a long period, the risk-free rate equals roughly 6%. Also widely known is the typical risk premium for equity, which equals 6%. Therefore an all-equity-financed company with a beta of one generates a cost of capital of 12%.

A different way of calculating the cost of capital can be done only if the information in the annual report is detailed. Line by line you can figure out what the different interest rates of debt classes demand. Since total capital changes during the year, a weighted average cost of capital (WACC) should be calculated.

Last but not least you can take the interest charge as your starting point and take this over total debt to come to an average cost of debt.

Where the Former Three Meet, Value Begins

Capital employed, return on capital employed and cost of capital are the three main pillars to measure a firm’s ability to create economic value. This economic value will sooner or later be translated into an increased intrinsic value, but more importantly, an increased market value, which you as a shareholder would very much appreciate. If the cost of capital is deducted from its return we have a spread that, when multiplied by capital employed, gives us EVA or economic value added.

(Return of capital minus Cost of capital) * Capital employed at beginning of year = EVA

By calculating the present value of all future EVAs and adding these to the enterprise value plus any surplus cash, we arrive at a company’s total value. The companies that over time will create the most economic value are the companies that have the largest spread between return and cost of capital and the largest increase of capital employed over time! Companies with negative EVAs are busy destroying economic value, which results in a lower intrinsic value per share and ultimately in a lower share price. The managements of these companies better have good restructuring stories to tell unless their businesses are going through the bottom of a performance cycle. Otherwise it is probably wiser to buy that risk-free government bond

[analyst]

Financial analysis of companies for intelligent investing

By N. J. Yasaswy |



A company publishes its balance sheet every year, which contains useful financial data on various aspects of its operations. A good analyst looks at the overall quality of the balance sheet before attempting a detailed analysis. Some pointers in this direction:


Are there any serious qualifications in the report of auditors?

Are there any important notes in fine print at the end of the balance sheet?

Are there any changes in accounting policies during the year?

Are there any important observations in the report of directors?

Do you notice any window-dressing of the balance sheet by manipulating inventories, depreciation, loans and advances, etc.?
Trend Analysis

Analysts make a trend analysis of performance over the past five to ten years to get an overall picture. Trend analysis is made in respect of sales, cost of sales, gross profit, net profit (before tax), net profit (after tax), net worth, debt, dividend policy, bonus and Rights issues, return on net worth, earnings per share, etc.

Analysis of Funds Flows

Funds are needed for long-term purposes (namely, fixed assets) and for short-term purposes (namely, working capital). Prudent financial management insists that short-term funds should not be diverted for long-term purposes. A proper balance should be maintained between the company’s own funds (namely, net worth) and borrowed funds (namely, loans) to ensure that the company’s solvency is protected.

Ratio Analysis

Equity analysts attach great importance to the following ratios in financial analysis:

1.Earnings per share (EPS)

This indicates the post-tax profits earned per share. The higher the better.



2. Price-Earnings ratio (P/E ratio)

This ratio indicates the relationship between the market price of the share and the earnings per share. In February 1994, the All-India all industry composite P/E ratio, as computed by Capital Market was 41.3. Whether a particular company’s P/E ratio is high or low may be understood with reference to the all-industry average, and also with reference to the specific industry average.



3. Book value per share

This ratio indicates the asset-backing available for each share. The higher the book value per share, the better it is for the company.



4. Return on net worth

This indicates the post-tax return on the shareholder’s funds. The higher the better.



5. Dividend cover

This indicates the extent to which equity dividends are protected by the earnings. The higher the better.



6. Profitability of sales

This indicates the profitability or otherwise of the sales. The higher this ratio, the better the profitability.



7. Debt-Equity ratio

Debt (i.e., loans) is measured as a percentage of equity (i.e., shareholders’ funds). The lower the ratio, the better.



Several financial ratios can be added to the above list. For example: gross profit margin, cash earnings per share, interest cover, etc. In Table 1, we have given the average P/E ratios for selected industries.

An equity investor is interested not so much in a historical P/E ratio, but a projected P/E ratio. The current market price has to be evaluated in the context of a projected P/E ratio for the current year, not based on the past year’s data. Similarly, cash EPS is becoming more popular among investors in assessing the cash flow position of a company.

Limitations of Ratio Analysis Before concluding our discussion on financial ratios, it is necessary to point out that what has been given above is only a partial list of financial ratios. There are many more. Depending upon the purpose of analysis, specific ratios may be selected. Conclusions drawn on the basis of one or two ratios may not be well balanced. All the relevant ratios must be studied in their context. There are no standard or normative ratios uniformly applicable to all companies. Finally, financial ratios are only tools. The utility of a tool depends largely on the manner and skill with which it is used.



It is necessary to point out the inherent limitations of balance sheets based on which these financial ratios are computed. Balance sheets are prepared on the basis of certain accounting principles relating to depreciation, valuation of inventories, treatment of income and expenses relating to prior periods, etc. Unfortunately, there are no accounting policies which are universally followed. Many disclosures and notes are in fine print. One often has to read between the lines to draw meaningful conclusions. Moreover, one should not arrive at any significant conclusion based on one’s study of the balance sheet for just one particular year. It is essential that trends for four or five years are thoroughly investigated in order to arrive at meaningful conclusions.

Interfirm Comparisons

Financial ratios of firms operating in the same industry can be compared to assess their relative strengths and weaknesses. Obviously no two companies will be identical in all respects. However, if they are operating in the same industry, catering to the same type of customers, selling the same class of goods and services, it is necessary to compare their financial performance so that a meaningful appraisal can be attempted. Such an exercise is called Interfirm comparison.

Interfirm comparison of key financial ratios alerts one as to what is happening in a company vis-a-vis its competitors. Companies seek to identify their strengths and build on them. Also, be on guard against their vulnerabilities, to be forewarned is to be forearmed: interfirm comparison provides a business such a perspective in comparative terms.

After making a critical appraisal of the financial and the non-financial dimensions of a company, the investor should combine the results of company analysis with the totality of fundamental analysis by relating it to economic and industry analysis. If such a comprehensive view is not taken, you may make wrong investment decisions.

Fortunately, you need not worry about calculating all these ratios for all the companies. The Bombay Stock Exchange publishes an Official Directory, which has a very comprehensive and loose-leaf weekly update service. Several leading magazines like Capital Market, Dalal Street Journal, Fortune India, Express Investment Week, Business India, Business World, Business Today, Chartered Financial Analyst, etc., periodically publish the fundamental data of a large number of companies. If you can find time to analyse the financial data readily available from these sources it should be quite sufficient. Ready-to-use software packages are also available.

[analyst]

The importance of dividends in valuing a share

By Individual InvestorTM Research |



There is no superior indication of financial achievement in a publicly-held company than a trend of rising dividends. Dividends are real money, a spendable return on one’s investment. Dividends are the surest confirmation of a company’s profitability, since dividends can arise only from the reality of earnings.

The dictionary tells us that value is “proper price; the quantity of money that an article is likely to command in the long run, as distinct from its price in an individual instance” This wisdom sometimes escapes investors in relating their holdings to price. In fact, the very essence of successful investing involves an identification of value. And the payment of dividend is a most fundamental signal of value in the stock market, though it often gets overlooked during the periodic bouts of irrational exuberance.

To fully understand the significance of dividend yield, it is necessary to analyze two other important measures of value in stocks: book value and price/earnings ratio.

While dividend yield expresses the “bottom line,” or the ultimate measure in the worth of a company’s shares, these two measures, however imperfect they may be, can be of great use. They can fill in some of the details as to what is happening in the stock market and with an individual stock, and they can confirm the conclusion reached by assessing the dividend. In turn, this leads to a re-evaluation of the term total return when determining the value of a stock.

Book Value

Particularly pertinent observations on book value were offered by the father of value investing Benjamin Graham in a 1974 interview, which was published in an American newspaper. Graham, the author of Security Analysis, The Intelligent Investor and numerous other financial and investment classics.

Graham suggested that investor should purchase shares as they would buy a business: after carefully examining a company’s fundamental situation, its assets, liabilities, financial condition, etc., and carefully noting the company’s price in relation to the figure of its book value.

The book value per share of a company’s equity shares is obtained by dividing its total equity capital and reserve by the number of issued shares. Book value is the minimum net worth of a company, below which, if the stock market were rational, the company’s share price should not fall.

But the stock market is not always rational. Also, most accounting techniques overlook the effects of inflation on assets. Therefore, book value figures can often be vastly understated; and stock prices sometimes fall even below those bargain basement levels.

Graham preferred shares that demonstrated a combination of favorable investment factors, including asset values of at least two-thirds of the market price. It was in these stocks that he was most comfortable.

The major theme of his work reminds investors that the greater the premium above book value, the less certain the basis for determining intrinsic value, and the more this “value” depends on the changing moods and measurements of the stock market. According to Graham, an investor should concentrate on shares selling reasonably close to asset value, but certainly at no more than 30 percent above that figure. “Purchases made at such levels, or lower, may with logic be regarded as related to the company’s balance sheet, and as having a justification or support independent of the fluctuating market prices,” he said.

Book value, therefore, can be a significant measure of value in the stock market. But there are no guarantees that stocks purchased near book value will immediately rise. Other fundamental measures also should be applied to each stock selection, especially those regarding the safety of the dividend.

Other Fundamentals Are Also important

In his book The Intelligent Investor, Benjamin Graham cautioned that a share does not become a sound investment merely because it can be bought close to its asset value. The investor also should demand a satisfactory ratio of earnings to price, a sufficiently strong financial position and the prospect that earnings will at least be maintained over the years. However, the investor with a stock portfolio of low price-to-book-value ratios can take a much more independent and detached view than those who had paid high multiples of both earnings and tangible assets.

“As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high,” noted Graham.

Why Dividends Are So Important

There is no superior indication of financial performance in a publicly-held company than a trend of rising dividends. Dividends are real money, a spendable return on one’s investment. Dividends are the surest confirmation of a company’s profitability, since dividends can be paid only from real earnings.

It is easy for any perspective investor to grasp that it is usually either higher earnings, or management’s reasonable expectation of higher earnings, that prompt an increase in dividend.

Even an investor who does not require income from his or her stocks needs to appreciate that a track record of dividends provide a floor of safety under the price of a share. Because so many investors in the stock market pay close attention to dividend yield, when the price of a stock falls to a level that creates an attractive return, large sums of long-term investment capital are drawn into the market and the decline is halted. A stock that pays no dividend has no such safeguard on its price.

For a, company to hike its dividend, there must exist strong prospects for improvement in its earnings. In addition, the foreseeable future must hold good growth potential. Clearly, the dividend will not be raised if future earnings are in doubt. A company may declare an “extra” dividend in a windfall year but is loathe to increase its regular cash dividend unless it can maintain them in the future . A rising dividend trend is so important, in fact, that it should be included in calculations of total return.

[analyst]

The commandments of value investing

By Janet Lowe |



Benjamin Graham is regarded as the father of value investing and his books are investment classics. Securities Analysis (first published in 1934) and The Intelligent Investor (first published in 1949) continue to sell steadily. In addition to this legacy, he has permanently influenced many successful investors, including Warren Buffett, the wealthiest man in America; William Ruane, founder of the super-successful Sequoia Fund; and well-known investor Walter Schloss.

Ben was a prophet in a very specialized but important realm of life. He preached commandments that any investor can use as stars when navigating the vast and mysterious seas of the investment world. An individual investor, who is not under pressure to shoot comets across the heavens but would like to earn a smart and substantial return, especially can benefit from Ben’s guidance. In greatly simplified terms, here are the 14 points Graham most consistently delivered in his writing and speaking. Some of the counsel is technical, but much of it is aimed at adopting the right attitude:

1. Be an investor, not a speculator

“Let us define the speculator as one who seeks to profit from market movements, without primary regard to intrinsic values; the prudent stock investor is one who (a) buys only at prices amply supported by underlying value and (b) determinedly reduces his stock holdings when the market enters the speculative phase of a sustained advance.”

Speculation, Ben insisted, had its place in the securities markets, but a speculator must do more research and tracking of investments and be prepared for losses if they come.

2. Know the asking price

Multiply the company’s share price by the number of company total shares (undiluted) outstanding. Ask yourself, if I bought the whole company would it be worth this much money?

3. Rake the market for bargains

Graham is best known for using his “net current asset value” (NCAV) rule to decide if the company was worth its market price.

To get the NCAV of a company, subtract all liabilities, including short-term debt and preferred stock, from current assets. By purchasing stocks below the NCAV, the investor buys a bargain because nothing at all is paid for the fixed assets of the company. The 1988 research of Professor Joseph D. Vu shows that buying stocks immediately after their price drop below the NCAV per share and selling two years afterward provides an excess return of more than 24 percent.

Yet even Ben recognized that NCAV stocks are increasingly difficult to find, and when one is located, this measure is only a starting point in the evaluation. “If the investor has occasion to be fearful of the future of such a company,” he explained, “it is perfectly logical for him to obey his fears and pass on from that enterprise to some other security about which he is not so fearful.”

Modern disciples of Graham look for hidden value in additional ways, but still probe the question, “what is this company actually worth?” Buffett modifies the Graham formula by looking at the quality of the business itself. Other apostles use the amount of cash flow generated by the company, the reliability and quality of dividends and other factors.

4. Buy the formula

Ben devised another simple formula to tell if a stock is underpriced. The concept has been tested in many different markets and still works.

It takes into account the company’s earnings per share (E), its expected earnings growth rate (R) and the current yield on AAA rated corporate bonds (Y).

The intrinsic value of a stock equals:

E(2R + 8.5) x Y/4

The number 8.5, Ben believed, was the appropriate price/to/earnings multiple for a company with static growth. P/E ratios have risen, but a conservative investor still will use a low multiplier. At the time this formula was printed, 4.4 percent was the average bond yield, or the Y factor.

5. Regard corporate figures with suspicion

It is a company’s future earnings that will drive its share price higher, but estimates are based on current numbers, of which an investor must be wary. Even with more stringent rules, current earnings can be manipulated by creative accountancy. An investor is urged to pay special attention to reserves, accounting changes and footnotes when reading company documents. As for estimates of future earnings, anything from false expectations to unexpected world events can repaint the picture. Nevertheless, an investor has to do the best evaluation possible and then go with the results.

6. Don’t stress out

Realize that you are unlikely to hit the precise “intrinsic value” of a stock or a stock market right on the mark. A margin of safety provides peace of mind. “Use an old Graham and Dodd guideline that you can’t be that precise about a simple value,” suggested Professor Roger Murray. "Give yourself a band of 20 percent above or below, and say, “that is the range of fair value.”

7. Don’t sweat the math

Ben, who loved mathematics, said so himself: “In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.”

8. Diversify, rule #1

“My basic rule,” Graham said, “is that the investor should always have a minimum of 25 percent in bonds or bond equivalents, and another minimum of 25 percent in common stocks. He can divide the other 50 percent between the two, according to the varying stock and bond prices.” This is ho-hum advice to anyone in a hurry to get rich, but it helps preserve capital. Remember, earnings cannot compound on money that has evaporated.

Using this rule, an investor would sell stocks when stock prices are high and buy bonds. When the stock market declines, the investor would sell bonds and buy bargain stocks. At all times, however, he or she would hold the minimum 25 percent of the assets either in stocks or bonds — retaining particularly those that offer some contrarian advantage.

As a rule of thumb, an investor should back away from the stock market when the earnings per share on leading indices (such as the Dow Jones Industrial Average or the Standard & Poor’s composite index) is less than the yield on high-quality bonds. When the reverse is true, lean toward bonds.

9. Diversify, rule #2

An investor should have a large number of securities in his or her portfolio, if necessary, with a relatively small number of shares of each stock. While investors such as Buffett may have fewer than a dozen or so carefully chosen companies, Graham usually held 75 or more stocks at any given time. Ben suggested that individual investors try to have at least 30 different holdings, even if it is necessary to buy odd lots. The least expensive way for an individual investor to buy odd lots is through a company’s dividend reinvestment program (DRP).

10. When in doubt, stick to quality

Companies with good earnings, solid dividend histories, low debts and reasonable price/to/earnings ratios serve best. “Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices,” Ben said. “They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes — in fact, very frequently — they make mistakes by buying good stocks in the upper reaches of bull markets.”

11. Dividends as a clue

A long record of paying dividends, as long as 20 years, shows that a company has substance and is a limited risk. Chancy growth stocks seldom pay dividends. Furthermore, Ben contended that no dividends or a niggardly dividend policy harms investors in two ways. Not only are shareholders deprived of income from their investment, but when comparable companies are studied, the one with the lower dividend consistently sells for a lower share price. “I believe that Wall Street experience shows clearly that the best treatment for stockholders,” Ben said, “is the payment to them of fair and reasonable dividends in relation to the company’s earnings and in relation to the true value of the security, as measured by any ordinary tests based on earning power or assets.”

12. Defend your shareholder rights

“I want to say a word about disgruntled shareholders,” Ben said. “In my humble opinion, not enough of them are disgruntled. And one of the great troubles with Wall Street is that it cannot distinguish between a mere troublemaker or “strike suitor” in corporate affairs and a stockholder with a legitimate complaint that deserves attention from his management and from his fellow stockholders.” If you object to a dividend policy, executive compensation package or golden parachutes, organize a sharcholder’s offensive.

13. Be Patient

“... every investor should be prepared financially and psychologically for the possibility of poor short-term results. For example, in the 1973-1974 decline the investor would have lost money on paper, but if he’d held on and stuck with the approach, he would have recouped in 1975-1976 and gotten his 15 percent average return for the five-year period.”

14. Think for yourself

Don’t follow the crowd. “There are two requirements for success in Wall Street,” Ben once said. “One, you have to think correctly; and secondly, you have to think independently.”

Finally, continue to search for better ways to ensure safety and maximize growth. Do not ever stop thinking.

[analyst]

How active lists reveal the market’s trend

By ichard J. Maturi |



Many investors put a lot of store in economic and stock indicators, which purport to foretell the direction of the overall stock market and individual stocks. Each indicator has its advantages and shortcomings. Some possess better track records and more avid followers than others, but knowledge of each can’t but benefit any serious investor. Sift through the following indicators to find which will work best with your investment strategy.

Active Lists

Since the list of actively traded stocks typically represents only about 1 per cent of the overall issues traded and can account for 10 to 15 per cent of the trading volume, backers of the active lists indicator stress it makes sense to be aware of and track the trends flowing from the active lists.

Noting price trends of the active popular and unpopular stocks on the list can point out shifts in investor sentiment. This can contribute to advance warning of industry groups currently moving in or out of favor, the future direction of the market as a whole and, the potential of individual securities.

The appearance or disappearance of stocks in specific industry groups documents changes in market leadership, representing shifts in market sentiment. If the trend continues for several weeks, proponents of the theory recommend actively tracking the price direction of both the industry and individual stocks with chart trendlines. In addition, recognition of chart patterns and the application of other technical analysis techniques aid the investor in uncovering buying and selling opportunities.

If the prognosis of market direction and industry group positioning proves correct, it makes sense that the most active stocks stand to make the greatest moves in the desired direction. The use of active list information, in conjunction with other technical analysis tools, can help the investor ferret out the right stocks for purchases or short selling.

The appearance on the most active list of a particular stock or several stocks in one industry signals explosive interest that the investor can utilize to generate excess investment returns.

Complementing the most active list, the most per cent up in price list shows which stocks are making the biggest price surges and the per cent volume change behind that price thrust. Locating a stock on both the most active list and most per cent up in price indicates the stock has an extremely active following, translating into major price moves.

Strong price gains, coupled with good volume increases could either indicate stock price recovery from an oversold position or renewed interest in the industry and the individual stock’s future prospects.

Naturally, one day’s activity does not constitute a trend, pieced together with additional days’ and weeks’ data it can form a picture of future trends. Also, cross-checking the industry most active and per cent up lists from exchange to exchange can help determine if the move is across the board or isolated to a particular market or capitalization.

Followers of action on the active list generally use the data from several weeks to construct a Most Active List Moving Average Index to focus in on the trends. It is considered bullish if the moving average continues to make new highs with gains in the market or resists making new lows in a declining market, and bearish if the moving average fails to make new highs in an advancing market or makes new lows in a receding market.

Advance/Decline (Breadth) Indicator

Tracking the ratio of advances to declines points to market direction. As a general rule, when the net indicator rises to a positive three or above it’s bullish for the market, and when the net indicator falls to a minus three or below it’s bearish for the market.

Others construct the advance/decline line to track the action of the market and discern future trends. In order to plot your own advance/decline line market barometer, subtract the declines from the advances to arrive at your first chart plot. Next, add or subtract the next day’s advance/decline difference from the previous day’s number to arrive at the second chart plot. From then on, you add or subtract the current day’s advance/decline difference from the previous cumulative total. (See Table 1 Determination of Chart Plots.)

To achieve the best results from use of advance/decline data, plot the advance/decline line on the same chart as the Dow Jones and the other appropriate index (or indexes).

If the above averages are rising in tandem, the market uptrend should continue in force. Along the same line, if the averages are declining and the advance/decline line also shows a negative trend, the bear market is in full force. However, if the advance/decline line starts to reverse direction from the averages, be alert for a turn-around in the overall market thrust.



Often, the market averages continue their upward ascent despite the market’s losing steam and eventually reversing direction. The advance/decline breadth indicator helps investors avoid being caught up in the euphoria of a rising index in the face of worse times ahead. In favor of this breadth indicator, most major tops have been marked by a divergence of the Dow Jones Industrial Average and the advance/decline line path. This parting of the ways can occur anywhere from a month to a year or more in advance of the market reversal.

The first reported use of the advance/decline market breadth indicator originated in the 1920s by Cleveland Trust Company economist, Colonel Leonard Ayers. Thirty years later James Hughes popularized the breadth indicator in an investment newsletter for the Wall Street firm of Auchincloss, Parker & Redpath.

Even later, Harvey A. Krow developed an advance/decline ratio by dividing the advances by the declines. Employing 10-day ratios, some advance/decline followers use a variety of ratio percentages to project additional uplegs, declines, or other market shifts

[analyst]

How to rebalance your investment portfolio?



Let’s face it, if you take big risks you will either win big or lose big. As Will Rogers once said, “Don’t gamble. Take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”

Like dollar cost averaging, formula-investment strategies enable you to take profits, buy more shares when prices decline and reduce risk. Using predetermined sell points to rebalance you portfolio works well when you allocate assets. This diversified investment mix will prevent you from losing your shirt, as many investors do, when experiencing extreme stock- and bond-market volatility.

Rebalancing Your Diversified Portfolio

The rebalancing strategy goes one step further than the other formula plans. When you rebalance, you maintain the same constant percentage mix in your diversified portfolio. The size and allocation of the percentage portions can be tailored to your specific situation. To cut your risk in the stock and bond markets, you could divide your portfolio into fifths, with 20 per cent each in stocks, gold, international stocks, U.S. corporate bonds and money funds. Every year, you must check the total value of your portfolio and place 20 per cent of that total into each of your investment segments. This rebalancing usually dictates some switching around and some tax consequences if the money is not invested in a retirement savings plan. By rebalancing, though, you actualise your profits and dollar-cost-average with the investments that have faltered temporarily.

How It Works

Let’s look at how rebalancing a diversified portfolio works during two different ten-year periods from 1978 through 1988 and for ten years ending in 1993. Assume that at the end of 1978 you placed 20 per cent of your investment, or $5,000, each in shares through the Vanguard Index 500 Fund (an equity fund that mimics the performance of the S&P 500), the United Services Gold Fund (gold), the Scudder International Fund (international stock), the Fidelity Capital and Income Fund (bonds), and a money-market fund. At the end of the year, the total value of your portfolio rose by $7,389. Divided by five, you obtain $1,477.80, the sum that should be in each fund for the next 12 months. At the end of 1980, you check your total again. The portfolio grew to $9,659 — divided by five, that leaves $1,942 in each fund.

Rebalancing works well for several reasons. Investments such as those listed previously tend to move in contrary directions. If one does poorly, another may produce offsetting gains. Because you are dollar-cost-averaging, you buy low and sell high when you rebalance. Rebalancing eliminates market-timing decisions.

Let’s see how the timing works with the funds we just mentioned. In 1981 — a bad year for stocks because interest rates were at double-digit levels — Vanguard Index 500 lost 5.2 per cent, the United Services Gold Fund dropped 27.9 per cent and the Scudder International Fund 2.6 per cent. Only the money fund, which paid 17.3 per cent interest, survived the interest-rate debacle. The $9,659 you ended 1980 with falls to $9,433 by the end of the year. You have lost 2.34 per cent on your investment, or $226. With all of your money in stocks, on the other bond, you would have lost $502. With all of your money in gold, you would have lost $2,695.

Your $9,433 at the end of 1981 ($1,887 for each investment sector) would have surged in 1982, for that year inaugurated our record bull market. Stocks gained 21.3 per cent and money funds yielded 12.8 per cent; at the same time precious metals rebounded to a 72.5 per cent return. As a result, your total portfolio grew to $12,298.

Don’t be too impressed with these numbers. Past performance is no indication of future results; if that were the case everyone capable of reading a newspaper would be rich. The portfolio we back-tested and rebalanced from year-end 1978 to year-end 1988 grew to $23,606, reflecting an annual average return of 16.7 per cent. Unfortunately, no one knows where today’s portfolios will be in ten years from now.

Rebalancing the same portfolio for ten years ending in 1993 achieved similar results. Investment conditions changed. The results show that you earned less in the most recent ten-year period compared to the period ending in 1988. But don’t forget, the market earned less. What you got was a lower risk/return.

By keeping 20 per cent in each fund annually the portfolio grew at an 8 per cent annual rate. This is half the return for the same portfolio that gained 16.7 per cent for ten years ending in 1978.

You earned less, but diversification worked. In 1990 the average growth fund lost over 5 per cent and international stock funds dropped 11 per cent.

How did our mix perform? We had a bad year. The Vanguard Index 500 lost 3.3 per cent. The U.S. Gold Fund dropped 34.2 per cent. Scudder International fund declined 8.9 per cent, Fidelity Capital and Income lost 3.8 per cent. Fortunately our money fund gained 8 per cent. Since we had 20 per cent in each asset we lost 8.4 per cent in 1990.

Sometimes you have to take your lumps, even when you diversify. But look what happened in the following year. The markets rallied and our diversified portfolio gained a respectable 12.4 per cent. Big winners were the Vanguard 500 Fund and the Fidelity Capital and Income Fund which both gained 30 per cent.

As you can see the whole is always greater than the sum of its parts. If you have a diversified portfolio of mutual funds, you may have different winners and losers each year. But what’s important is that you get the best overall return with the least amount of risk.

Safety is the KeyThe important point about rebalancing is the process: spreading your risks and realizing your profits without trying to guess the best time to buy or sell.

Rebalance Based on Your Risk Level

The 20-per cent rebalancing tactic works well for reducing risk. This percentage breakdown may not be ideal for everyone, however. A couple approaching retirement should take less risk than a young professional couple with a combined income of more than $125,000 a year. Younger people can afford to seek growth and take more risk because they can buy and hold for a longer time as well as anticipate a longer period of generating (probably rising) income. The pre-retirement couple may want some growth, but they also need safety. They would be aghast to see the value of their portfolio drop 20 per cent a few years before they retire.

This is why it is important to match investment risk with financial needs and risk tolerance. When you look at your risk level and income and growth requirements, you can set a better investment mix. Examine the following factors:

How closely do investments move in tandem with each other? You want a mix where the investments will move in opposite directions part of the time. In the halls of finance, that is known as how well investments correlate with one another.

You want to combine investments to obtain the best return with the least amount of price volatility. Ideally, you will lower your margin of error every month and still receive the kind of return you need to build your wealth. If you could choose between an investment offering an annual return of 16 per cent with a price fluctuation, or margin of error, of 24 per cent, or an investment mix providing a 12 per cent return with a 12 per cent margin of error, which would you choose? The answer depends on how much you want to risk. Hint: Before choosing the former offering, think honestly about how you would feel if you lost nearly $2,500 on each $10,000 you invested in a single year.

Constructing an investment mix to obtain the best return with the lowest margin of error — taking into account an individual’s risk parameters — is known in finance as optimizing your portfolio. (I wonder what academic coined a word as forbidding as optimization to explain a concept as simple as finding the best investment mix with the least amount of risk?)



When you mix your portfolio properly, you can boost your return and lower the monthly price hit, or risk of losses in the event you have to sell (see Table 1). If you were a low-risk investor who wanted some growth from stocks, but also safety, you simply could adopt one of our model portfolios. Using that, you would put 40 per cent in Vanguard Index 500, 43 per cent in the Scudder International Fund, 5 per cent in U.S. Gold Fund, and 12 per cent in a money fund. (We have eliminated the bond fund because this existing mix would have a better margin of error than a portfolio that included bonds.)

Rebalancing based on these percentages over the ten years ending in March 1993 would have given you an annual rate of return of 13.3 per cent. During that same period the S&P 500 gained 14.40 per cent a year. You earned 92 per cent of the return on the market, but with about one-third less risk.

This mix of funds give you the best return with just a tab more risk based on the annual margin of error, which is also known as the standard deviation. You earned over 13 per cent a year with a margin of error of about 13. That’s a lot more return than portfolios, which are divided in quarters. Group I and Group II under performed Group III or the higher risk mix and their margins of error were 12.7 per cent.

Take Group III anytime. You could have bought and held the four funds for ten years. If you did, you earned 10.5 per cent a year. You were diversified, but failed to maximize your return. Twenty-five per cent of your money was invested in precious metals, which is a highly volatile investment. This portfolio is less risky than a 100 per cent stake in stocks, but large positions in gold and cash drag down the performance.

If you want to keep it simple, the 50/50 mix works well. You earn 89 per cent of the return on the market with less risk. You earned 98 per cent of the return on the higher risk mix of Group III, but the portfolio was 12 per cent less risky.

[analyst]

Mr. Market and YOU


"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.' This was how Benjamin Graham defined 'investment'. And rightly so! At these times, when the markets are witnessing high levels of volatility, it becomes an ardent need for stockbuyers to understand this difference between a speculative activity and investment. It requires just a misguided step for investor to turn his investment venture into a speculative misadventure.

In this regard, Graham's parable of 'Mr. Market' stands in good stead. This is, probably, one of the best metaphors ever created for explaining how stocks can become mispriced. Through this parable, Graham asks investors to imagine a non-existing person called Mr. Market who is your (investor's) partner in a private business. He appears daily and names a price (stock quotation) at which he would either buy your interest or sell you his. Now, despite the fact that both Mr. Market and you have stable business interests, his quotations are rarely so. At times, he falls so ecstatic that he sees only the favourable factors affecting business. And this is the time he would name a very high buy-sell price because he fears that if he does not quote such a high price, you would buy his interest in the enterprise and rob him of imminent gains.

And then there are times when this very Mr. Market is so depressed that he sees nothing but trouble ahead for both business and the world. These are the occasions when he would name a very low price, as he is terrified that if he does not do so, you would burden him (sell him) with your interest in the business.

Now, Graham says that if you were a prudent investor or a sensible businessman, you would not let Mr. Market's daily communication determine your view of the value of your interest in the enterprise. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But at the rest of the time, you would be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

What Graham tells investors through this parable of Mr. Market is that they should look at market fluctuations in terms of the Mr. Market example. They should make these fluctuations as their friend rather then their enemy. This means that they should neither give in to temptations that rising markets bring with them nor should they think of doom when the markets are falling incessantly.

Coming back to the abovementioned definition of an investment operation, investors need to have a long-term (two to three years) perspective when making their investment decision. Only then would the promised safety of principal and an adequate return accrue to them. Now, the term 'adequate return' typically varies from investor to investor. A high-risk investor would demand a high return from his investment from the extra bit of risk he is taking. On the other hand, a low-risk investor would settle for a relatively lower return. Having said that, in a rising market, expectations tend to be on the higher side without a fundamental premise. Here is where 'Mr. Market' could mislead you. If you believe that 15% per annum is an 'adequate return', then stick to that irrespective of whether it is a bull market or a bear market. Otherwise, you are changing i.e. risk profile is changing, which is not required.

As Graham says, '...in the short term, the market is a 'voting' machine whereon countless individuals register choices that are product partly of reason and partly of emotion. However, in the long-term, the market is a 'weighing' machine on which the value of each issue (business) is recorded by an exact and impersonal mechanism.' Happy investing!

[analyst]

Family Matters

If a company is invested big in its subsidiaries, look at its consolidated numbers.


A company is the sum of its parts. Besides the divisions it owns and operates, a company might also have an interest in other businesses through its subsidiaries (companies in which its equity stake exceeds 50 per cent) and associate companies (below 50 per cent). For instance, although Reliance Industries, the Reliance group flagship, is known as a petrochemicals and petroleum company, it also owns a piece of its subsidiaries and associate companies like Reliance Infocomm and Reliance Energy. It has a stake in their profits or losses, which should get appropriately reflected in its numbers.
The family picture. The law requires a company to present the accounts of its subsidiaries in its annual report. Also, it has to add their revenues, profits, assets and liabilities to its own corresponding numbers. This is referred to as ‘consolidation of accounts’. This summation is done in proportion to the company’s holding in each subsidiary. For example, say Company X has a 50 per cent stake in Subsidiary A, which records a profit of Rs 10 crore in a given year. When it consolidates its accounts, Company X will add Rs 5 crore (50 per cent of Rs 10 crore) to its net profit figure as its share of profits from Subsidiary X. Since they capture a company’s interests in other businesses, consolidated numbers give a more realistic picture of its return on investment.

Indian promoters have been an active lot when it comes to floating subsidiaries. They take the subsidiary route to expand primarily because the regulations force them to or it makes business sense. Banks, for instance, can venture into non-banking areas like mutual funds only through a separate company. Usually, though, it is business considerations like tax benefits, prospects and dynamics with partners that influence a company’s decision to float subsidiaries. For example, Ranbaxy sells drugs in the US and Europe through its Dutch subsidiary, as Holland provides generous tax shelters to companies. Or, a new business takes time to build, and rather than take on the burden of financing and nurturing it, promoters prefer to do it through another company.

How’s the company? The effect of subsidiaries and associate companies on the parent company’s financials varies across companies. For example, as on March 2004, ITC had six fully owned subsidiaries, one joint venture and minority stakes in three associate companies. In 2003-04, these 10 entities contributed Rs 418 crore to ITC’s consolidated net sales of Rs 6,889 crore (6.1 per cent) and Rs 23 crore to its consolidated net profit of Rs 1,616 crore (1.4 per cent). In percentage terms, these other businesses are too small to currently make a difference to ITC and therefore can even be ignored.

Now, take Tata Tea, which had four subsidiaries. The subsidiaries accounted for 75 per cent of its consolidated sales of Rs 3,049 crore and 55 per cent of its consolidated net profit of Rs 205 crore. That’s a sizeable contribution. Any analysis of Tata Tea that excludes its subsidiaries would grossly understate the real worth of the company. Depending on the amount of business being routed by a company through its subsidiaries and the state of these subsidiaries, consolidation changes the parent’s numbers for the better (Tata Tea, Bharti Tele-Ventures) or for the worse (Satyam Computer).

As these examples show, consolidated numbers are the best available representation of the complete picture of a company’s state of affairs. It forces companies to make more disclosures and brings their financial statements in line with global norms. Although consolidated numbers have been the norm in developed countries for many years now, India adopted this standard only from 1 April 2001. Before that, analysts would painstakingly deconstruct a company’s holdings and work the spreadsheets to arrive at guesstimates. Now that presenting consolidated accounts is a regulatory requirement, you get it readymade in the annual report.

[analyst]

Learn to Peg It Right

A crash course in how to assess ‘value’ in share issues from companies that do not have a performance track or any peers.



Investing in a company, says legendary investor Warren Buffett, is a bit like seeking out a mate. You have to have more than a passing acquaintance with the company, get to know it well–and be ready to commit for a lifetime. Of course, even Buffett, despite his characteristic conservatism, was "polygamous" in terms of the number of companies he owned, but his point is well taken: know what you’re committing to, and get a sense of the relative merits (and demerits) of your chosen one among a peer set.
But what do you do when you don’t know anything about a company that is coming to the market to raise funds–or if you have nothing to benchmark it against? Would you commit yourself to a perfect stranger? Would you get all mixed up with an entity you can’t get a measure of– because there’s nothing to compare it with?

Consider the upcoming IPO (awaiting Sebi clearance) from YES Bank, India’s newest, which began operations in September 2004. There are several banks that are listed on the bourses, and so there is a large enough peer set to evaluate YES Bank against–and decide if it’s worthy of investment. But since YES Bank itself doesn’t have a sufficiently long track, you don’t really know the first thing about it, do you? In Buffett’s analogy, wouldn’t investing in it be a bit like committing yourself to the young woman who moved into your neighbourhood just yesterday–about whom you know nothing more?

Then again, consider some recent IPOs from companies that operate in sectors where there wasn’t any or much listed action in the Indian stock markets: Jet Airways (airlines), India Bulls (online trading), Bharati Shipyard (shipbuilding), PTC India (power trading) and Gokaldas Exports (garments exports). How do you get the measure of a company when there is nothing to compare it with–in terms of size or quality of offering? How do you know you’re dealing with a David or a Goliath? Here are some pointers.

Know the business. To take a cue from Buffett’s successful strategy, buy into a business you understand. Samir Rach, head of research, Emkay Share and Stock Brokers says: "It is unlikely that you will discover value when you don’t understand the intricacies of a business. And to understand a business, a good starting point is to use common sense."

Even where you don’t have a peer set, you can begin to understand the business by reading the company’s prospectus. The industry overview section in the prospectus, for instance, offers a detailed explanation of the business and its dynamics. The section on risk factors addresses the concerns relating to the industry, and specifically the company.

For instance, the Bharati Shipyard’s prospectus spelt out the factors that would influence the fortunes of the shipbuilding business. And a diligent investor would have gleaned from India Bulls’ prospectus that over 90 per cent of its revenues comes from its broking subsidiary, India Bulls Securities, making the company susceptible to the vagaries of a bear market.

Says S. Subramanian, head of investment banking, Enam Financial Consultants: "The unique dynamics of the industry, the market conditions surrounding the company, and the regulatory issues it faces, will all point to the specific basis of valuation that should be used to assess investment worthiness in an IPO."

All companies bring out details of their financial performance in their IPO prospectuses; established businesses share five-year historical financial statements with potential investors. What this means is that YES Bank’s prospectus will only detail its track record over the short time it has been around, whereas a Gokaldas Exports’ prospectus had a longer track to showcase, even though the company was an unlisted player all along.

"With information of this kind in your quiver, you can well assess the company’s business model, anticipate its net cash flows and check for consequent returns on capital employed," adds Subramanian.

Global benchmarks. Reading the prospectus and understanding the business is one thing, assessing fair value of a company is quite another. And that job is made more difficult in the case of unlisted businesses, in the absence of benchmarks. Some investment advisors suggest that you use established global standards as a basis of comparison and appraisal–but it is critical to factor in the differences in growth expectations among different markets.

"Draw out the differences between operational realities in the domestic market and in the global markets, which could be the key differentiating factor in arriving at profitability estimates," says Vaibhav Kapoor, CIO, IL&FS. For instance, the valuations of Singapore Airlines and Virgin Blue were used to benchmark the Jet Airways IPO to factor in the risk associated with the airline business. But it was just as important to factor in the variances in the three airlines’ market growth rates, airline usage levels and quantum of funds required to maintain their growth pace.

Likewise, comparing two companies in different industries in the domestic market amounts to flawed logic–even if the two businesses seem similar. For instance, says one investment advisor, it would be disastrous to compare Jet Airways with a heavy engineering company locally. While both companies may be highly capital-intensive, the latter operates in a regulation-free environment and does not have to wait for government approval to venture into new markets or explore new territories.

Know the promoters. Never commit to a potential mate without meeting the ‘parents’. In other words, get to know the promoters and the management. Says Subramanian: "Promoters are an important consideration across the board: even when analysing companies with comparable listed peers, never overlook promoter quality."

Adds Prithvi Haldea, MD, PRIME Database: "Valuation is in the buyer’s mind. The critical success factor for any company is its promoter. Everything falls in place, including the price of the offering, if a good promoter backs the company."

How do you appraise promoter quality? Haldea suggests that you look at another listed venture from the same promoter. If there isn’t one such, research the promoters’ expertise, experience and previous performance. For instance, in the case of YES Bank, a greenfield project with no antecedents, the promoters’ background and experience should speak for itself. Experts believe that the YES Bank IPO will be evaluated first on the basis of its management’s competencies, then on the market conditions it operates in, and then its ability to price its cost of funds towards the lower end of the range for the industry.

Apart from reading the IPO prospectus closely, do some online research. A good starting point: www.watchoutinvestors.com, a site sponsored by the Ministry of Company Affairs’ Investor Education and Protection Fund, and developed by PRIME Database. The site contains details on over 38,000 entities and 15,000 individual promoters against whom some form of regulatory action has been initiated.

"Investing in a company with no proven track record," says investment strategist Gul Teckchandani, "is akin to venture capitalism in some manner." Or, to invoke Buffett’s analogy again, like getting hitched while on a blind date. Don’t go in blind, choose wisely and well, commit for a lifetime–and savour the rewards of the relationship.

[analyst]

Get to the Bottom of It

The P&L account sheds light on a company’s operations and profitability.



When it comes to a company you own, more than anything else, you are interested in knowing how much profit or loss it made. After all, that’s what moves share prices. Companies post their annual results in newspapers, but in an unabridged form. The result details are revealed only later in the annual report, specifically in a section called the profit and loss (P&L) account. The company’s performance in the given year is given under four main heads and presented along with the numbers for the year before that to facilitate comparison.
Income. This tells you how much money your company earned during the year and how. Companies report revenues under two heads: those earned from the business it is in (termed ‘sales’ or ‘turnover’ for manufacturing companies, and ‘income’ for companies in a service business) and those from activities unrelated to its main business (‘other income’). Bajaj Auto, for example, manufactures two-wheelers. So, the money it makes by selling two-wheelers is its turnover, but the money it earns from the sale of assets or from its investments is other income.

Other income pads up a company’s profits, and therefore requires adjustments. If you are evaluating how a company’s business is doing, ignore its other income. If you are trying to assess your company’s health, consider income from investments (as it can be of a recurring nature), but ignore that from sale of assets (as it is of a non-recurring nature). The break-up of other income, as of other entries in the P&L account, is tabulated elsewhere in schedules.

The market doesn’t take too kindly to other income being consistently high, as it means the management is leaning on non-business areas to earn profits. Other income generally comes from investments. Since companies mostly invest their cash in debt instruments, they earn a lowly 5-7 per cent. Now, if a company is earning more than that from its business, as the good ones easily do, its overall returns (as a percentage of the total capital employed or shareholder funds) tends to suffer.

Expenses. This gives an account of how much and where a company spends its money during the year. Every company incurs expenses. The main expense head depends on the business a company is in. Raw materials are the main expense for a manufacturing company, employee salaries for a services company. This main cost head is what you need to check for–whether it has increased over the previous year and whether the revenue growth justifies this increase. If not, there is reason to be wary and something worth delving deeper into.

Profits. There are various kinds of profits. To start with, there is the operating profit. The difference between income and expenses, it shows how much money your company has made from operations. A company incurs various financial costs, namely, interest (cost of loans), depreciation (phased write-off of plant and machinery expenses) and taxes. Deducting these from the operating profit gives the profit after tax or the net profit, which is the commonly quoted profit figure. For a true picture of net profit, adjust it for ‘exceptional items’ like income from sale of assets or VRS expenses.

A company can make an operating profit, but end up with a net loss. Typically, it happens with companies when they start out, as income take time to reach a critical mass, even as they feel the pinch of loans taken to get the business moving and the outgo towards depreciation is high in the initial years.

Appropriations. This shows what a company has done with the net profit it earned during the year. Typically, it boils down to distributing part of it to shareholders as dividends and putting back the remainder into the business by appropriating it into general reserves. A company passing on incremental amounts into both avenues is said to be doing good.

[analyst]

Are the tills ringing?

Use the cash flow statement to assess whether a business is self-sustaining or not.




Cash is the lifeline of a business. Without it, a business cannot survive for long. The cash flow statement captures how this lifeline moves in and out of a company, and is a good place to check its liquidity position. It shows whether a company’s business is self-sustaining, or if it has to fall back on loans, trade concessions and accounting tricks to make ends meet.
When it comes to assessing a company’s liquidity, the profit and loss (P&L) account and the balance sheet aren’t enough. These two statements are prepared on an accrual basis, which recognises revenues (and expenses) even if it hasn’t resulted in a cash inflow (outflow). They include various non-cash entries like depreciation, which can overstate or understate the true liquidity position of a company. The cash flow statement, however, strips away all such accounting items and tells you how much cash your company has generated during that period, from where and how it has used this money. It has three parts:

Net cash from operations. The all-important section of the cash flow statement, it gives an account of the cash generated by a company from its core business. A positive value means the business is making money, while a negative value means it is losing money. If this amount is increasing from year to year, it shows the business is generating more and more cash, which is good.

The starting point for calculating cash flow from operations is the net profit figure. To this, all non-cash expenses are added back, as these are mere accounting entries–no cash has gone out. The main adjustment relates to depreciation, which is the cost of using a fixed asset. Although a company pays cash for an asset at the time of purchase, it writes it off over many years. Since companies don’t incur any cash outflow on this account, depreciation is added back to the net profit to calculate cash flows.

Cashing in

Microsoft, the world’s most cash-rich company, with a $90 billion (Rs 41,000 crore) treasure chest, recently announced a $75 billion payback to shareholders by way of dividends and buybacks. Back home too, there are companies sitting on a pile of cash. The top five:

Satyam Computer (Rs 1,815 cr)
Infosys (Rs 1,630 cr)
Adani Exports (Rs 938 cr)
Reliance Energy (Rs 860 cr)
Hindustan Lever (Rs 806 cr)


Unlike reported profits, which can be manipulated with some deft accounting, the cash flow statement provides insights into a company’s true numbers. Take the case of Rolta. For the 18-month period ended June 2003, this IT company’s consolidated net profit fell from Rs 93.7 crore to Rs 79.1 crore. Its net cash from operating activities had plunged sharply from Rs 94 crore to Rs 29.6 crore. Going deeper, one found that Rolta’s trade receivables– the money its clients owed it– had shot up from Rs 40 crore to Rs 136.1 crore. In other words, it was doing business, but there were unusual delays in receiving payments. This raised the possibility of defaults, which, if true, would get reflected in subsequent years. If your company’s business is not generating a positive cash flow, or there’s an unusual decline as in the example above, it may be a cause for concern.

Net cash from investing. This shows the usage of cash for investment purposes. Besides using cash in running operations, a company might be using cash to invest in other companies, or to buy plant and machinery, or to lend funds. These are all cash outflows. Similarly, it might be receiving cash in the form of dividends, interest income or capital gains from its investments. Unlike net cash from operations, a negative value here isn’t a cause for concern. Usually, if a company is in expansion mode, and is buying assets, its net cash flows from investing tends to be negative. Sale of assets and investments brings in cash, which could turn cash flows from investing activities positive.

Net cash from financing. This shows the effect of various financing-related activities on a company’s cash flows. Loans and capital is cash coming in. Repayment of loans, payment of dividends and interest income is cash going out.

The sum of these three heads gives the ‘net cash flow from business’. More than the figure, the reason behind the figure is more important. If this figure is falling, even negative, because of new capital expenditure or investments, it is acceptable if those investments will pay back in the future. But if it is due to operations slowing down, it is reason to worry.

[analyst]

Your Company’s Report Card

It gives a complete picture of a company's performance in a financial year.




When you buy shares in a company, you buy a stake in its business. As a shareholder, you are entitled to know from your company what it is doing with your money, how it has performed, what its business plans are, who the people running the show are–basically everything related to its working. Information that helps you decide whether to invest in it or not.
What is it?

The one document that packs it all in is the annual report. Published on a yearly basis, the annual report gives a complete picture of a company’s performance in the previous financial year. In earmarked sections, it carries information that would be of use to everyone interested in the company–shareholders, bankers, suppliers, customers, and analysts, among others. This includes its latest performance, its financial health, profiles of its management team and board of directors, and its perception of the business, among other things.

Companies have to send their annual reports to their shareholders at least 21 days before their annual general meeting (AGM), which is to be held within six months of the financial year closing. Most Indian companies follow an April-to-March financial year. Some companies, notably the multinationals, follow a calendar year (January to December) to correspond with their parents’ financial period.

Although companies declare their annual results within two months of closing the year, they take up to four months to process their accounts and dispatch their annual reports, which dilutes the immediacy of these reports. The annual report for a company that has a March closing is likely to reach you between June and August. Typically, it’s the good companies, with clean books and good accounting practices, that are the early birds. If an annual report reaches you towards the end of the mandated period, it is something to be wary about.

Annual reports have come a long way, as disclosures standards have improved, shareholders have become more demanding and companies more image-conscious. The 10-page, black-and-white, no-nonsense report has given way to a veritable coffee table book. Increasingly, companies are investing more in annual reports, focussing both on design and content.



It gives a complete picture of a company’s performance in a financial year.



They are choosing themes, commissioning design houses and copywriters, using glossy paper, doing layouts that are easy on the eye. As a shareholder, your focus should be on the numbers and information, on what they reveal and what they conceal (and believe us, there’s a lot of things many conceal).

What does it contain?

Regulatory bodies–in India, it’s the Department of Company Affairs (DCA) and the Institute of Chartered Accountants of India (ICAI)– specify a standard format for annual reports and some minimum disclosure norms for companies to follow.

However, over and above that, a company is free to share more information, and spend more words and paper on business aspects it considers important. And the good companies do just that. Typically, companies follow this sequence:

Governance reports
The balance sheet
The profit and loss account
Notes to accounts
Statement of cash flows
Subsidiary performance
The financial jargon and mass of numbers in these reports can be intimidating–but not if you know what to look for and how to read it. Over the next few issues, we will analyse each of these various sections–which numbers and information to focus on, and how to interpret them. We suggest you keep handy an annual report of a company whose stock you own so that you can relate these principles to your company–and make informed decisions about your stock investments.

[analyst]

The Need to Diversify






Reduce risk without compromising returns.

In our article Risk versus Return we highlight how every investment has a risk attached. And how the higher the risk, the higher should be the expected return from any investment. This probably then imply that if you want to reduce the risk in your portfolio, the only choice for you is to move your investments into low yielding investments. Right? Wrong.


Diversification across investments is another way to reduce the risk of your portfolio.

To understand how, look at this simple example (it involves some basic statistical concepts but don’t get turned off, its simple to understand and you can get into the calculations only if you want) -

Say, there are two assets A and B. Both assets have a potential return of 10% and a standard deviation (a statistical measure which measures the variability (i.e. risk) of the potential returns) of 20%. Also, the returns of both these assets are uncorrelated i.e. the performance of Asset A is not dependent at all on the performance of Asset B.

Now assume you invest equally in both these assets. Your weighted potential return (0.5 * 10% + 0.5 * 10%) will equal 10% - this is the same return as that for the individual assets. However, due to the fact that you have now spread your risk over two uncorrelated assets, the standard deviation (i.e. risk) of your portfolio will be 14.1% (lower than the 20% for each individual asset). Refer to the supporting Statistical Analysis if you want to understand how.

It is important to understand what this means.

You would have been able to reduce the risk profile of you’re the returns on your portfolio to 14.1% (from 20% for an individual asset) without having to compromise on your returns, merely by diversifying. So, by choosing two assets whose returns are not correlated (this is important) like say Stock A which is a pharmaceutical company and Stock B which is a software company, you can reduce your risk while not necessarily having to reduce your returns.

In summary, there are two things that are important to keep in mind while planning your investments -


1. Every asset has a risk attached to it.

And, the higher the risk, the higher should be its expected returns.


2. Don’t put all your eggs in one basket.

By diversifying across assets, you can reduce your risk without necessarily having to reduce your returns. You don’t have to get into calculating standard deviation of the return of your assets, you need to just be aware that if you diversify your portfolio, your overall portfolio risk will be lower.

To get the maximum benefit of reducing your risk through diversification spread your portfolio across different assets whose returns are not 100% correlated. Different assets should ideally span across different asset classes such as fixed income, equity, real estate, gold as well as different investment options within these asset classes e.g within equity shares, your exposure should be to companies in different sectors; or within fixed income investments, partly government risk and partly corporate risk.

[analyst]

The ‘Zero Debt’ status


by Ashok Kanetkar




From time to time we come across a company management boasting of its 'zero debt' status. The underlying message it tries to convey is that debt is bad. It is not an empty boast because some effort is required to reach the state but, as investors, we must ask whether the management has pursued the right policy.

A company does not become debt free suddenly. 'Zero debt' status is achieved after pursuing a specific policy for a certain number of years. Indications that the company is following the policy of controlling its debt are available to those who keep track of the balance sheet. As investors, we have to judge the efficacy of that policy.

Debt is a burden on a company because payment of interest is a direct drain on the profits and cashflow. Further, interest is a fixed expense, independent of how many units are produced. In a bad year this can be very discomforting. Therefore any management trying to improve its profit margin by cutting down on a major fixed expense like interest is to be commended. Yet, we advise readers to go deeper and judge for themselves what is prompting the management to follow such a policy. We must know whether it is excess of cash assets or bankruptcy of spirit and initiative.

There are examples of companies generating large amount of cash with very limited fixed assets. In their case we also observe a considerable increase in sales against a much smaller increase in fixed assets. These companies generally have a consumer monopoly. Warren Buffet calls them the 'toll bridge' type.

If our company falls under this category then we should have no objection for the absence of debt. In fact we should object to large cash assets and demand that they either be invested in another equally good business or returned to the shareholders. Many companies under these circumstances take the 'buyback' route though some times this is only to consolidate the majority holder's position.

We also find companies with stagnant sale but steadily increasing net profits, main reason being declining expenditure on interest and depreciation. In such cases absence of competition tempts the management into milking the old plant dry. This to our mind is not a desirable situation. Chief reason for our disdain is that such a situation cannot remain for too long. Eventually the stagnancy in sales starts a decline and then it becomes very difficult to cover the lost ground.

This problem is seen mainly in capital goods manufacturing companies that have enjoyed monopoly in the market for some time. Management becomes either complacent or conservative and refrains from investing in new technology and equipment. Occasionally a desire to show increasing profit forces the management into lowering the debt burden.

Management may argue that the market conditions are adverse and therefore funds are being conserved so that when the situation changes they can be invested fruitfully. So, if sales are stagnant and net profits are increasing due to lowering interest payments and depreciation we have good grounds to suspect that the management is turning towards conservative policies and growth is stifled.

Not having any burdens can some times be an indication of slackened zest. Individuals, in the evening of their life show these tendencies. They do not wish to have any tensions and embarrassment and so desist from borrowing. This is a state of mind and our task is to judge whether the management is facing such a problem. This is not easy to judge from the balance sheet but talking to people within the company and to certain select customers or dealers can offer some clues.

Sustained growth in sales and operating profits is a sign of a dynamic entity. To bring this about new technologies and state of the art equipment is necessary which in turn calls for investment in Research, Development and machinery. Occasionally a company may have to invest more than it has in its cash account, which calls for borrowing. If the management shirks from borrowing and if investment in a key area suffers, company quickly loses its edge. Long-term future of the company is jeopardized to gain some short-term peace of mind.

There have been cases of companies sitting on huge amounts of cash and not investing it in any worthwhile projects. This exasperates the shareholders because they sense a lack of spirit and adventure. They wish to see company breaking new grounds while the shortsighted policies of the management keeps it in the same old groove. In business many times growth is synonymous with survival. Those companies, which constantly strive for growth, are also the ones that manage to negotiate harder times better than the rest.

Business calls for taking certain calculated and acceptable risks. Borrowing money is an integral part of this philosophy. If a company management keeps boasting that it has no debt it may also mean that it has no desire to take any risks and is happy to remain in its cocoon. Though excessive and indiscriminate debt is not good it would be na? to assume that all debt is bad. If this was the case then only creditworthy companies would be those that don't borrow and then where will the bankers go?

For investors, therefore, it is wise to take the boast of 'zero debt' with a pinch of salt. They should try to find out the real reasons why the company is following such a policy. Possibly internal generation of cash is capable of taking care of all investments in which case we have no reason to complain. Yet if that investment is not large enough to take advantage of existing situation or to break into new areas to go on a greater growth curve then the company must borrow to realize its full potential. A lack of desire to borrow in the face of growth opportunity may clearly indicate weakening of a desire to grow.

In conclusion we would like to say that excessive debt is bad but a lack vision and initiative is worse. This is a malaise investors must spot quickly. Taking chances is the key to success and it is better to have tried and failed than not to have tried at all. If one has to borrow money to try out an idea then one should do so. As investors we would like to be closer to such people than to those who disguise lack of spirit and complacency and call it caution.



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[analyst]

What are PNs & sub-accounts?.


Participatory notes and sub-accounts are two entry routes for suspect funds. Sub-accounts are generally foreign private companies and individuals on whose behalf a FII is permitted (under Sebi rules) to invest and who would otherwise not be eligible to register asFIIs. Participatory notes are contract notes through which an FII invests in, say, Indian equities, on its proprietary account; but the purchase is funded by an overseas investor on whose behalf the investment is made. The expert group report admitted that "this helps in keeping the investor’s name anonymous" and that such investors "prefer to avoid making disclosures required by various regulators". From data that Sebi shared with the group (but not with the investing public) there are ominous signs visible.(See sideshow: The Participatory Route). Almost half of all FII inflows appear to come through the PN route.

Yet the expert group did not ban the use of PNs or sub-accounts byFIIs, though the Reserve Bank held that the issue of PNs should not be permitted. In his dissent note, the RBI representative on the group said, "Trading of these PNs will lead to multi-layering, which will make it difficult to identify the ultimate holder ofPNs. Both conceptually and in practice, restriction on suspicious flows enhance the reputation of markets and lead to healthy flows."

In fact, the RBI was also of the view that sub-accounts should not exist as a separate class of investors. But the rest of the expert group–two finance ministry representatives and one from Sebi–did not endorse the RBI’s views. And so PNs and FII sub-accounts continue to play a big part in FII inflows.



What is corporate governance?

Now coming to the listed company, if they have paid-up capital of Rs 3 crore plus, then they have to give a corporate governance report. This report contains various details like, how many board meetings were held during the year, what is the composition of directors, what remuneration they have been paid, when were the last three general meetings of the company held, what committees were formed by the company etc. Three committees are mandatory, these are the audit committee, remuneration committee and investors grievances committee. Then, they need to give the price movement of shares on any one stock exchange, in the last 12 months, as also the shareholding pattern. What needs to be highlighted is, as per the number of shares held, how many shares are dematted. So this entirely covers secretarial information of the company.