Indicators of Performance and Investment Strategy
Potential investors are concerned with the future level of a company’s performance
Company’s performance affects both the profitability and variability of the cash flows
Indicators of company performance
- 1. Capital structure
- 2. Liquidity
- 3. Debt Servicing
- 4. Profitability
- 5. Share Price
- 6. Risk
Capital structure
Proportion of finance (capital) obtained through debt or equity Measured as
Debt to equity ratio =
Higher debt levels increase financial risk (company may not be able to meet interest payments)
Proprietorship Ratio =
Indicates long-term stability
A higher ratio indicates less reliance on external funding
Liquidity
The ability of a company to meet it’s short-term financial obligations
Commonly used measure
Current Ratio =
Easy to calculate
Fails to consider to illiquid nature of certain current assets (inventory)
Liquid Ratio =
Only considers those assets that are readily convertible to cash
The higher the net current and liquid ratios, the better the liquidity position of the company
Debt servicing
How effectively the company can meet it’s debt related obligations
Interest cover =
Ratio should be greater than two
Profitability
Wide variation in measurement of profitability
EBIT to total funds =
EBIT to long-term funds =
After-tax earnings of shareholders funds =
Earnings per share (EPS): measures the earnings that are attributed to each ordinary share after abnormal items
EPS frequently reported in media
Share price
Share price represents the opinion of investors as to the present value of future net cash flows of the company
Price-based performance indicators include
- (a) Price to earnings (P/E)
ð Share price divided by earnings per share
ð Indicates investors valuation of future earnings prospects of the company
ð The higher the P/E the more optimistic the outlook for the future
- (b) Market price to Net tangible assets
ð Is a measure of the theoretical premium or discount that a company’s share price is trading relative to its net tangible assets
Risk
Variability of the share price
Two components to risk (price variability)
- (a) Systematic risk
ð Arises from factors affecting the whole market
ð Example, state of the domestic economy and the world economy
- (b) Non-systematic risk
ð Arises from firm-specific factors
ð Example, management competence, labour productivity, financial and operational risks
ð Non-systematic risk can be eliminated by forming a well-diversified portfolio
ð Systematic risk is often referred to as beta
Pricing of Stocks
Cum dividend and ex dividend
- Dividends are payments made to shareholders, expressed as cents per share
- Dividends are declared at one date and paid at a later specified date
- During the period between the two dates, that shares have the future dividend entitlement attached (Cum dividend)
- Once the dividend is paid the shares are traded as ex dividend
- Theoretically the share price will fall on the ex dividend date by the size of the dividend
- Example
ð Share price cum dividend $1.00
ð Dividend $0.05
ð Theoretical ex dividend price $0.95
Bonus share issues
- Where a company has accumulated reserves it may distribute these to existing shareholders by making a bonus issue of additional shares
- As with dividends, there will be a downward adjustment in share price when shares go ex bonus
- As no new capital is raised, there is no change in the assets or expected earnings of the company
- Example if a bonus 1:4 issue is made
ð Cum bonus (cb) price $10.00
ð Market value of 4 c.b shares $40.00
ð Theoretical value of 5 x.b shares $40.00
ð Theoretical value of 1 x.b share $8.00
Share Splits
Involves the division of the number of shares on issue
Involves no fundamental change in the structure, or asset value of the company
Theoretically the share price will fall in the proportion of the split
Example, 1 for 1 split
- Cum split price $10.00
- Theoretical ex split price $5.00
Pro-Rate Rights Issue
Involves an increase in the companies issued capital
Typically issued at a discount to market price
Theoretically the market price will fall, by an amount dependent upon
- The number of shares issued
- The size of the discount
Example, Market price cum rights $2, with 1:4 rights issue priced at $1.80
- Cum rights (c.r) price $2
- Market value of 4 c.r shares $8
- Plus new cash from 1:4 issue $1.80
- Market value of 5 c.r shares $9.80
- Theoretical price of one share $1.96
Pricing up the pro-rate right issue
- = theoretical price one c.r share – Right issue price
- = 1.96-1.80
- = $0.16
Company’s performance affects both the profitability and variability of the cash flows
Indicators of company performance
- 1. Capital structure
- 2. Liquidity
- 3. Debt Servicing
- 4. Profitability
- 5. Share Price
- 6. Risk
Capital structure
Proportion of finance (capital) obtained through debt or equity Measured as
Debt to equity ratio =
| Market value of debt/ |
| Market value of equity |
Higher debt levels increase financial risk (company may not be able to meet interest payments)
Proprietorship Ratio =
| Shareholder’s funds/ |
| Total assets |
Indicates long-term stability
A higher ratio indicates less reliance on external funding
Liquidity
The ability of a company to meet it’s short-term financial obligations
Commonly used measure
Current Ratio =
| Current Assets/ |
| Current liabilities |
Easy to calculate
Fails to consider to illiquid nature of certain current assets (inventory)
Liquid Ratio =
| Current Assets – Inventory/ |
| Current liabilities – bank overdraft |
Only considers those assets that are readily convertible to cash
The higher the net current and liquid ratios, the better the liquidity position of the company
Debt servicing
How effectively the company can meet it’s debt related obligations
Interest cover =
| Earnings before Finance lease charges, interest and tax/ |
| Finance lease charges and interest |
Ratio should be greater than two
Profitability
Wide variation in measurement of profitability
EBIT to total funds =
| EBIT/ |
| Shareholders funds plus borrowings |
EBIT to long-term funds =
| EBIT/ |
| Total funds less short-term debt |
After-tax earnings of shareholders funds =
| Profit after tax/ |
| Shareholders funds |
Earnings per share (EPS): measures the earnings that are attributed to each ordinary share after abnormal items
EPS frequently reported in media
Share price
Share price represents the opinion of investors as to the present value of future net cash flows of the company
Price-based performance indicators include
- (a) Price to earnings (P/E)
ð Share price divided by earnings per share
ð Indicates investors valuation of future earnings prospects of the company
ð The higher the P/E the more optimistic the outlook for the future
- (b) Market price to Net tangible assets
ð Is a measure of the theoretical premium or discount that a company’s share price is trading relative to its net tangible assets
Risk
Variability of the share price
Two components to risk (price variability)
- (a) Systematic risk
ð Arises from factors affecting the whole market
ð Example, state of the domestic economy and the world economy
- (b) Non-systematic risk
ð Arises from firm-specific factors
ð Example, management competence, labour productivity, financial and operational risks
ð Non-systematic risk can be eliminated by forming a well-diversified portfolio
ð Systematic risk is often referred to as beta
Pricing of Stocks
Cum dividend and ex dividend
- Dividends are payments made to shareholders, expressed as cents per share
- Dividends are declared at one date and paid at a later specified date
- During the period between the two dates, that shares have the future dividend entitlement attached (Cum dividend)
- Once the dividend is paid the shares are traded as ex dividend
- Theoretically the share price will fall on the ex dividend date by the size of the dividend
- Example
ð Share price cum dividend $1.00
ð Dividend $0.05
ð Theoretical ex dividend price $0.95
Bonus share issues
- Where a company has accumulated reserves it may distribute these to existing shareholders by making a bonus issue of additional shares
- As with dividends, there will be a downward adjustment in share price when shares go ex bonus
- As no new capital is raised, there is no change in the assets or expected earnings of the company
- Example if a bonus 1:4 issue is made
ð Cum bonus (cb) price $10.00
ð Market value of 4 c.b shares $40.00
ð Theoretical value of 5 x.b shares $40.00
ð Theoretical value of 1 x.b share $8.00
Share Splits
Involves the division of the number of shares on issue
Involves no fundamental change in the structure, or asset value of the company
Theoretically the share price will fall in the proportion of the split
Example, 1 for 1 split
- Cum split price $10.00
- Theoretical ex split price $5.00
Pro-Rate Rights Issue
Involves an increase in the companies issued capital
Typically issued at a discount to market price
Theoretically the market price will fall, by an amount dependent upon
- The number of shares issued
- The size of the discount
Example, Market price cum rights $2, with 1:4 rights issue priced at $1.80
- Cum rights (c.r) price $2
- Market value of 4 c.r shares $8
- Plus new cash from 1:4 issue $1.80
- Market value of 5 c.r shares $9.80
- Theoretical price of one share $1.96
Pricing up the pro-rate right issue
- = theoretical price one c.r share – Right issue price
- = 1.96-1.80
- = $0.16
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