Chapter 14 - CSC.pdf

Company Analysis 14 CHAPTER OVERVIEW In the previous chapter, we examined fundamental analysis from a macroeconomic and an industrial perspective. In this chapter, we discuss company analysis, which fundam...

Company Analysis 14 CHAPTER OVERVIEW In the previous chapter, we examined fundamental analysis from a macroeconomic and an industrial perspective. In this chapter, we discuss company analysis, which fundamental analysts use to measure the actual or expected profitability of the securities issuer. You will learn to examine financial statements and use various financial ratios to determine whether a company is a good prospect for investment. LEARNING OBJECTIVES CONTENT AREAS 1 | Identify the factors involved in performing Performing Company Analysis company analysis to determine whether a company represents a good investment. 2 | Explain how to analyze a company’s financial Interpreting Financial Statements statements using trend analysis and external comparisons. 3 | Assess company performance using financial Analyzing Financial Ratios ratios. 4 | Distinguish among the criteria used in Assessing Preferred Share Investment assessing the investment quality of preferred Quality shares. © CANADIAN SECURITIES INSTITUTE 14 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. asset coverage ratio inventory turnover ratio capital structure liquidity ratios cash flow net current assets cash flow-to-total debt outstanding ratio net profit margin ratio current ratio operating performance ratios debt-to-equity ratio preferred dividend coverage ratio dividend discount model price-to-earnings ratio dividend payout ratio quick ratio dividend yield return on common equity ratio earnings per common share risk analysis ratios equity value per common share ratio trend ratios financial ratios value ratios gross profit margin ratio working capital interest coverage ratio working capital ratio © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 3 INTRODUCTION As we learned in the previous chapter, some form of fundamental analysis of relevant factors is necessary to make successful investment choices. In that chapter, we discussed the macroeconomic and industrial factors that are used in fundamental analysis. In this chapter, we focus on company analysis, during which analysts narrow their focus to examine the investment potential of the issuing company itself. Company analysis is the process of examining company-specific factors that can influence investment decisions. During this process, analysts scrutinize a company’s financial information in an effort to answer the following questions: Are the company’s securities a good investment? Do they fit into an investment strategy? How will general or specific changes in economic or market factors affect the company? Are there risk factors or strengths hidden in the financial statements that may not be readily apparent after a quick review of the company? Is there more to the company than is reported in its press releases or in news stories? In short, what do the financial numbers tell you about the company? One of the goals in performing company analysis is to identify risks and opportunities. This analysis does not eliminate risk, but it can help reduce it. This chapter provides you with tools to analyze a company’s financial statements to determine its investment potential. PERFORMING COMPANY ANALYSIS 1 | Identify the factors involved in performing company analysis to determine whether a company represents a good investment. Fundamental analysts use a company’s financial statements to determine its financial health and potential profitability. You may want to review the accounting principles learned in Chapter 11 before proceeding through this chapter. STATEMENT OF COMPREHENSIVE INCOME ANALYSIS The analysis of a company’s comprehensive income tells you whether management is making good use of the company’s resources. REVENUE A company’s ability to increase revenue is an important indicator of its investment quality. Clearly, revenue growth is desirable, whereas flat or declining revenue trends are less favourable. Likewise, high growth is usually preferable to a low or moderate rate. However, an analyst should keep informed of the reasons for increase in a company’s revenue. A company’s revenue might increase for any of the following reasons: It increased the prices or volumes of its products. It introduced new products. It expanded into a new geographic market. © CANADIAN SECURITIES INSTITUTE 14 4 CANADIAN SECURITIES COURSE      VOLUME 2 It consolidated with another company acquired in a takeover. It received an initial contribution from a new plant or diversification program. It gained market share at the expense of competitors. It launched an aggressive advertising and promotional campaign. It benefited from new industry legislation. Sales temporarily increased when a strike occurred at a major competitor. An upswing in the business cycle occurred. With this knowledge, the analyst can isolate the main factors affecting revenue and evaluate developments for their positive or negative impact on future performance. OPERATING COSTS After studying revenue, the next step is to look at cost of sales. By calculating cost of sales as a percentage of revenue, you can determine whether costs are rising, stable, or falling in relation to sales. A rising trend over several years may indicate that a company is having difficulty keeping overall costs under control and is therefore losing potential profits. A falling trend suggests that a company is operating cost effectively and is likely to be more profitable in the future. You should determine the main reasons for any changes in a company’s ability to pay its operating costs, which you can measure using the gross profit margin ratio. Although it may be difficult to identify the causes, it is important to understand them because of the effect they can have on a company’s cost structure. DID YOU KNOW? The cost at which a company obtains its raw materials has a major impact on its gross profit margin. Companies that rely on commodities such as copper or nickel, for example, may have to cope with wide swings in raw material costs from one year to another. On the other hand, the introduction of new products or services with wider profit margins can improve profitability. DIVIDEND RECORD A company’s dividend record shows how much it generally pays out in the form of dividends to shareholders. The company may have an unusually high dividend payout rate (more than 65%, for example) for any of several reasons: Stable earnings that allow a high payout Declining earnings, which may indicate a future cut in the dividend Earnings based on resources that are being depleted, as in the case of some mining companies Similarly, a low payout may reflect any of the following factors: Earnings reinvested back into a growth company’s operations Growing earnings, which may indicate a future increase in the dividend amount Cyclical earnings at their peak, along with a company policy to maintain the same dividend in good and bad times A company policy of buying back shares, rather than distributing earnings through higher dividend payouts © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 5 STATEMENT OF FINANCIAL POSITION ANALYSIS A thorough analysis of the statement of financial position helps you understand a company’s overall financial situation. It can reveal important aspects of the company’s operations and other factors that may affect its earnings. For example, a company with low interest coverage will be limited in its dividend policy and financing options. In analyzing the statement of financial position, you should consider the capital structure and the effect of leverage. THE CAPITAL STRUCTURE The capital structure of a company refers to the distribution of debt and equity that comprise the company’s finances. Analysis of a company’s capital structure provides an overall picture of its financial soundness because it reveals the amount of debt used in its operations. Analysis may indicate the need for future financing. As well as the type of security that might be used. For example, common shares are suitable for a company with a heavy debt load. In analyzing capital structure, you should consider the following issues: A large debt issue approaching maturity may have to be refinanced by a new securities issue or by other means. Retractable securities may also have to be refinanced if investors choose to retract. A similar possibility exists for extendible bonds. Convertible securities represent a potential decrease in earnings per common share (EPS) through dilution. Any outstanding warrants or stock options represent a potential increase in the number of common shares outstanding. THE EFFECT OF LEVERAGE The earnings of a company are said to be leveraged if the capital structure contains debt or preferred shares. The presence of these securities accelerates any cyclical rise or fall in earnings. In comparison to companies without leverage, earnings increase faster during an upswing in the business cycle and collapse more quickly as economic conditions deteriorate. The leverage effect of preferred shares on common share earnings is similar to what occurs in a company that uses debt to finance its operations. In either case, a relatively small increase in revenue can produce a magnified increase in EPS. The reverse is true when revenue declines. The market action of shares in leveraged companies shows considerable volatility. Table 14.1 illustrates the leverage effect of preferred shares on common share earnings at one company in comparison to another company that is unleveraged. Table 14.1 | The Effect of Leverage on per Share Earnings Year One Year Two Year Three Company A (No Leverage) Earnings available for dividends $50,000 $100,000 $25,000 Preferred dividends Nil Nil Nil Available for common $50,000 $100,000 $25,000 Per common share $0.50 $1.00 $0.25 Percentage of return earned on common shares 5% 10% 2.5% © CANADIAN SECURITIES INSTITUTE 14 6 CANADIAN SECURITIES COURSE      VOLUME 2 Table 14.1 | The Effect of Leverage on per Share Earnings Year One Year Two Year Three Company B (50% Leverage) Earnings available for dividends $50,000 $100,000 $25,000 Preferred dividends $25,000 $25,000 $25,000 Available for common $25,000 $75,000 Nil Per common share $0.50 $ 1.50 Nil Percentage of return earned on common shares 5% 15% 0% Using the figures outlined in Table 14.1 above, you can calculate the percentage return on common shares for both Company A and Company B. EXAMPLE Assume that two companies, Company A and Company B, each have a total capitalization of $1 million and each have earned the following profit: Year One: $50,000 Year Two: $100,000 Year Three: $25,000 Company A’s capitalization consists of 100,000 common shares of no par value. Company A’s common share capitalization is equal to its total capitalization of $1 million. Company B’s capitalization consists of 50,000 5% preferred shares of $10 par value and 50,000 common shares of no par value. Company B’s preferred share capitalization is $500,000 (calculated as 50,000 preferred shares multiplied by $10 par value). Its common share capitalization is also $500,000. In Table 14.1, consider the effect of the variation in earnings on the EPS for the two companies. To calculate the percentage return on common shares in Year One for Company A, divide the $50,000 available for common shares by the $1,000,000 common share capitalization to arrive at 5%, in percentage terms. To calculate the percentage return on common shares in Year One for Company B, divide the $25,000 available for common shares by the $500,000 common share capitalization to arrive at 5%, in percentage terms. The stock of Company A is less risky than the stock of Company B, which must pay out interest on senior preferred capital before it can pay dividends to common shareholders. Stock A also has more stable earnings, because it is less vulnerable to shrinkage in earnings, though it is also less sensitive to any increase in earnings. OTHER FEATURES OF COMPANY ANALYSIS Other features of company analysis include qualitative analysis, liquidity of common shares, and continuous monitoring. Qualitative analysis Qualitative analysis is used to assess management effectiveness and other intangibles that cannot be measured with concrete data. The quality of a company’s management is unquestionably a key factor in its success. However, it is not a topic that we can cover in this course. The ability to evaluate the quality of management comes with years of contact with industry and company executives, experience, judgment, and even intuition. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 7 Liquidity of common Liquidity is a measure of how easy it is to sell or buy a security on a stock exchange shares without causing significant movement in its price. Trading should be sufficient to absorb transactions without undue distortion in the market price. Institutional investors dealing in large blocks of shares require a high degree of liquidity. Information on trading volume is readily available from most financial news and stock exchange publications. Continuous Company analysis involves monitoring the operations of the company for changes that monitoring might affect the price of its shares and the dividends it pays. Quarterly financial reports to shareholders are an especially important source of information, which you should scrutinize in detail. You can also glean useful material from prospectuses, trade journals, and financial publications. INTERPRETING FINANCIAL STATEMENTS 2 | Explain how to analyze a company’s financial statements using trend analysis and external comparisons. You must use caution when analyzing and interpreting financial statements. Companies must adhere to a number of disclosure requirements and accounting rules; however, International Financial Reporting Standards allow flexibility. To attract investors, management sometimes selects accounting practices that show the company’s finances in the best possible light. It is also important to look over the statements in general and read the notes to the financial statements very carefully before delving into ratio analysis. You can often find clues that the financial health of the company may be deteriorating before financial ratios relay the same information. FOR INFORMATION ONLY Warning Signs Found in the Notes to the Financial Statements CHANGES IN ACCOUNTING PRACTICES OR AUDITORS Look for changes in accounting practices that increase revenue or decrease expenses when the actual operation of the company did not change. The company may be trying to appear more prosperous than it really is. Look also for changes in accounting practices that decrease revenue or increase expenses when the actual operation of the company did not change. The company may be trying to deflate its current profit level so that it can appear to be growing in profitability in the next few years. A change in the company’s auditors may signal a fundamental disagreement between the auditors and company management concerning how certain transactions should be treated. A SERIES OF MERGERS AND TAKEOVERS Companies have been known to acquire a series of smaller companies to manipulate the consolidated statement of financial position in their favour. A series of mergers or takeovers may also be an attempt to hide the unprofitability of the parent company. If any of the above notes are present, it does not necessarily mean that the company is a bad investment. For example, companies often change accounting practices simply in response to new situations, changes in industry practice, or directives from accounting boards. The point is to be aware of these issues when you find them and research further for explanations. © CANADIAN SECURITIES INSTITUTE 14 8 CANADIAN SECURITIES COURSE      VOLUME 2 TREND ANALYSIS Ratios calculated from a company’s financial statements for only one year have limited value on their own. They only become meaningful when compared with other ratios. Internally, they can be compared with the same ratios collected from the same company in different years. Externally, they can be compared with the same ratios collected from similar companies or with industry averages. Analysts identify trends by selecting a base period, treating the figure or ratio for that period as 100, and then dividing it into the comparable ratios for subsequent periods. Table 14.2 shows this calculation for a typical pulp and paper company. Table 14.2 | Pulp and Paper Company A—Earnings per Share Year Year 1 Year 2 Year 3 Year 4 Year 5 EPS $1.18 $1.32 $1.73 $1.76 $1.99 1.18 1.32 1.73 1.76 1.99 1.18 1.18 1.18 1.18 1.18 Trend 100 112 147 149 169 Table 14.2 uses Year 1 as the base period. The EPS for that year, which is $1.18, is treated as equivalent to 100. The trend ratios for subsequent years are easily calculated by dividing 1.18 into the EPS for each subsequent year. A similar trend line over the same period for Pulp and Paper Company B is shown in Table 14.3. Table 14.3 | Pulp and Paper Company B—Earnings per Share Year Year 1 Year 2 Year 3 Year 4 Year 5 EPS $0.71 $0.80 $0.90 $0.84 $0.78 0.71 0.80 0.90 0.84 0.78 0.71 0.71 0.71 0.71 0.71 Trend 100 113 127 118 110 The trend line of each of these two companies shows the characteristic fluctuations of pulp and paper company earnings. For example, adding new machinery often causes temporary over-capacity and reduces earnings until demand catches up with supply. The trend line for Company B suggests some over-capacity in recent years, as earnings show a decline. Trend ratio calculations are useful because they clearly show changes. They are also simple to do and easier to interpret than the alternative, which is a two-step method of calculating percentage changes from year to year. DID YOU KNOW? A trend line is misleading when the base period is not truly representative. It is also impossible to apply the method if the base period figure is negative, which happens when a loss was sustained in the base year. EXTERNAL COMPARISONS Ratios are most useful for comparing financial results of companies in the same or similar industries, for example, when a distiller is compared with a brewer. Differences shown by the trend lines help to put the EPS of each © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 9 company in historical perspective. They also show how each company has fared in relation to others. Different industries may have different standards for the same ratio, and they often employ a range rather than a specific target number. Industry standards are different from industry ratios in that the ratios change each year, whereas the standards are relatively static. Ratios show the industry average, which changes depending on the performance of the industry in a particular year. Standards provide a longer-term view and remain the same regardless of the performance of the industry or the economy. For your analysis to be fair and thorough, you must compare the company to both the current average of the industry and the historical industry standard. EXAMPLE Assume the current ratio standard for hotels is 1.10 (current assets / current liabilities = 1.10). In the past six months, Granite Hotel Group has an average current ratio of 0.91, which is above all other hotel chains in the industry. Since all companies in the hotel industry are below the current ratio standard, Granite would be considered a top performer in an industry that is underperforming. ANALYZING FINANCIAL RATIOS 3 | Assess company performance using financial ratios. Having learned what the financial statements reveal about the financial condition of a company, the next step is to put that knowledge to work by testing the investment merits of the company’s bonds and stocks. The tool most commonly used to analyze financial statements is called a ratio, which shows the relationship between two numbers. Four types of ratios are commonly used to analyze a company’s financial statements: Liquidity ratios Liquidity ratios are used to judge the company’s ability to meet its short-term commitments. An example is the working capital ratio, which shows the relationship between current assets and current liabilities. Risk analysis ratios Risk analysis ratios show how well the company can deal with its debt obligations. For example, the debt-to-equity ratio shows the relationship between the company’s borrowing and the capital invested in it by shareholders. Operating Operating performance ratios illustrate how well management is making use of the performance ratios company’s resources. For example, the net profit margin ratio indicates how efficient the company is managed after taking both expenses and taxes into account. These ratios include profitability and efficiency measures. Value ratios Value ratios show the investor what the company’s shares are worth, or the return on owning them. An example is the price-to-earnings ratio (P/E ratio), which links the market price of a common share to EPS, and thus allows investors to rate the shares of companies within the same industry. Ratios must be used in context. One ratio alone does not tell an investor very much. Ratios are not proof of present or future profitability, only clues. An analyst who spots an unsatisfactory ratio may suspect unfavourable conditions. Conversely, analysts may conclude that a company is financially strong after compiling a series of ratios. © CANADIAN SECURITIES INSTITUTE 14 10 CANADIAN SECURITIES COURSE      VOLUME 2 The significance of any ratio is not the same for all companies. In analyzing a manufacturing company, for example, analysts pay particular attention to the working capital ratio, which is a measure of the use of current assets. In an electric utility company, however, the working capital ratio is not as important, because electric power is not stored in inventory, but produced at the same time that it is used. In the sections that follow, we show how to calculate and use the various financial ratios. To make it easier for you to follow and understand the method, we have numbered the items to correspond to the related items in sample financial statements. You can find these statements at the end of this chapter in Appendix A: Financial Statements of Trans-Canada Retail Stores Ltd. DID YOU KNOW? For the Canadian Securities Course exam 2, you will not be required to calculate ratios. However, you may be asked to interpret ratio results, compare results between similar companies, and determine how a ratio might be affected by changes in a key ratio component. LIQUIDITY RATIOS Liquidity ratios help investors evaluate the ability of a company to turn assets into cash to meet its short-term obligations. If a company is to remain solvent, it must be able to meet its current liabilities, and therefore it must have an adequate amount of working capital (also called net current assets). Frequent causes of business failure are the lack of sufficient working capital and the inability to liquidate current assets readily. You can find a company’s working capital by subtracting its total current liabilities from its total current assets. EXAMPLE The working capital for Trans-Canada Retail Stores Ltd. is calculated as follows: Current Assets (Item 9) $12,238,000 Less:  Current Liabilities (Item 22) $4,313,000 Equals:  Working Capital $7,925,000 WORKING CAPITAL RATIO The working capital ratio, sometimes expressed as the working capital position (and also called the current ratio), is calculated as follows: Current Assets Current Liabilities The ability of a company to meet its obligations, expand its volume of business, and take advantage of financial opportunities as they arise is, to a large extent, determined by this ratio position. EXAMPLE The working capital ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 9 12,238,000 = = 2.84 1 Item 22 4,313,000 The working capital ratio of 2.84 to 1 means Trans-Canada Retail has $2.84 of cash and equivalents to pay for every $1 of its current liabilities. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 11 CURRENT ASSETS Current assets are cash and other company possessions that can be readily turned into cash (and normally would be) within one year. Current liabilities are liabilities of the company that must be paid within the year. How you interpret the ratio depends on the type of business, composition of current assets, inventory turnover rate, and credit terms. A current ratio of 2 to 1 is good but not exceptional, because it means that the company has $2 cash and equivalents to pay for each $1 of its debt. However, suppose 50% of Company A’s current assets are cash, whereas 90% of Company B’s current assets are in inventory. If each company has a current ratio of 2 to 1, Company A is more liquid than B because it can pay its current debts more easily and quickly. The current ratio does not easily translate into multiples. For example, although a current ratio of 2 to 1 is good, it doesn’t follow that a ratio of 20 to 1 is 10 times as good. A company that consistently maintains a current ratio that exceeds 5 to 1 may have an unnecessary accumulation of funds. This situation can arise from sales problems in the form of too much inventory or from financial mismanagement. Different businesses have different working capital requirements. In a business such as a distillery, for example, several years may elapse before the raw materials are processed and sold as finished products. Consequently, these businesses require a large amount of working capital to finance operations until they receive cash from sales. In a business such as meat packing, the manufacturing process is much shorter, and cash from sales is available to pay current debts sooner. Such a business can safely operate with less working capital. QUICK RATIO (THE ACID TEST) The second of the two most common corporate liquidity ratios—the quick ratio (also called the acid test) — is shown below: Current Assets - Inventories Current Liabilities This ratio is a more stringent test than the current ratio. Current assets generally include inventories that can be difficult to convert into cash. For the quick ratio, inventories are subtracted from current assets. The quick ratio, therefore, offers a more conservative test of a company’s ability to meet its current obligations. It shows how well current liabilities are covered by cash and by items with a ready cash value. EXAMPLE The quick ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 9 - Item 5 or Item 22 12,238,000 - 9,035,000 3,203,000 = = 0.74 1 4,313,000 4,313,000 The ratio of 0.74 to 1 means that Trans-Canada Retail has 74 cents of current assets, exclusive of inventories, to meet each $1 of current liabilities. There is no absolute standard for the quick ratio, but 1 to 1 or better suggests a good liquid position. However, companies with a quick ratio of less than 1 to 1 may be in equally good shape if they have a high rate of inventory turnover. Inventory that is turned over quickly is the equivalent of cash. In our example, a quick ratio of 0.74 to 1 is probably satisfactory because the company we are looking at is a retail store chain. This industry is characterized by large inventories and a high turnover rate. © CANADIAN SECURITIES INSTITUTE 14 12 CANADIAN SECURITIES COURSE      VOLUME 2 RISK ANALYSIS RATIOS The analysis of a company’s capital structure enables investors to judge how well the company can meet its financial obligations. Excessive borrowing increases the company’s costs because it must service its debt by paying interest on outstanding bank loans, notes payable, bonds, or debentures. If a company cannot generate enough cash to pay the interest on its outstanding debt, then its creditors could force it into bankruptcy. If the company must sell off its assets to meet its obligations, then investors who have purchased bonds, debentures, or stock in the company could lose some or all of their investment. ASSET COVERAGE The asset coverage ratio shows a company’s ability to cover its debt obligations with its assets after all non-debt liabilities have been satisfied. This ratio typically shows the net tangible assets (NTA) of the company for each $1,000 of total debt outstanding. It enables the debtholder to measure the protection provided by the company’s tangible assets after all liabilities have been met. The asset coverage ratio is calculated as follows: Tangible Assets - (Current Liabilities - Short Term Debt ) Total Debt Outstanding In this ratio, tangible assets are the company’s total assets less goodwill and other intangible assets. Current liabilities do not include short-term debt such as short-term borrowings and the current portion of long-term debt when calculating asset coverage. Total debt outstanding includes all short-term and long-term debt. EXAMPLE The asset coverage ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 10 - Item 2 - éêëItem 22 - (Item 18 + Item 21)ùúû or Item 18 + Item 21 + Item 15 19,454,000 - 150,000 - éêë4,313,000 - (120,000 + 1,630,000)ùúû 16,741,000 = = 5.4 1 120,000 + 1,630,000 + 1,350,000 3,100,000 The ratio of 5.4 to 1 means that Trans-Canada Retail has, for example, $5,400 in NTA for each $1,000 of total debt outstanding. The asset value behind each $1,000 of total debt outstanding is important information for debtholders. Normally, they have a claim against all of the company’s assets after providing for liability items, which rank ahead of their claims. To be conservative, goodwill and other intangible assets are first deducted from the total asset figure. In our example, Trans-Canada Retail Stores Ltd. has $5,400 of assets backing each $1,000 of total debt outstanding after providing for current liabilities. (Short-term borrowings and the current portion of long-term debt are excluded from current liabilities, but they are included in total debt outstanding.) If the industry standard for this ratio is that retail companies should have at least $2,000 of NTA for each $1,000 of total debt outstanding, this company meets—in fact, exceeds—this standard. Industry standards for this ratio vary, due in part to the stability of income provided by the company. Utilities, for example, have a fairly stable source of income and greater assurance of income continuity compared to retail stores. They are characterized by heavy investment in permanent property, which accounts for a large part of their total assets. They are also subject to regulation, which ensures the utility a fair return on its investment. Trans-Canada Retail Stores Ltd. has only one issue of long-term debt outstanding (item 15). The calculation of NTA for each $1,000 of total debt outstanding is, accordingly, relatively straightforward. If more than one issue were © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 13 outstanding, the NTA coverage calculation would include that debt figure as well. Of course, the senior issue would be better covered than a junior issue because of its higher priority in interest and liquidation proceeds. DEBT-TO-EQUITY RATIO The debt-to-equity ratio shows the proportion of borrowed funds used relative to the investments made by shareholders in the company, as follows: Total Debt Outstanding Equity If the ratio is too high, it may indicate that the company has borrowed excessively, which increases its financial risk. If the debt burden is too large, it reduces the margin of safety protecting the debtholder’s capital, increases the company’s fixed charges, and reduces earnings available for dividends. In times of recession or high interest rates, a high debt burden could cause a financial crisis for the company. EXAMPLE The debt-to-equity ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 21 + Item 18 + Item 15 or Item 14 1,630,000 + 120,000 + 1,350,000 3,100,000 = = 0.233 1 or 23.30% 13,306,000 13,306,000 The debt-to-equity ratio is often expressed as a percentage of debt to equity. In the example above, the total amount of debt represents 23.3% of the size of the total amount of equity. The ratio of 0.233 to 1 is acceptable for Trans-Canada Retail, if it does not exceed the industry standard for retail stores. Sometimes, analysts make adjustments to the debt-to-equity ratio by including total liabilities in the calculation. We have excluded other liabilities to focus the ratio on the company’s financial risk, based on leverage through the use of debt. CASH FLOW-TO-TOTAL DEBT OUTSTANDING RATIO Cash flow from operating activities is a measure of a company’s ability to generate funds internally. Other things being equal, a company with a large and increasing cash flow is better able to finance expansion using its own funds, without the need to issue new securities. The increased interest or dividend costs of new securities issues may reduce cash flow and earnings, and issues of convertibles or warrants may dilute the value of common stock. The cash flow-to-total debt outstanding ratio gauges a company’s ability to repay the funds it has borrowed. Short-term borrowings must normally be repaid or rolled over within a year. Corporate debt issues commonly have sinking funds requiring annual cash outlays. A company’s cash flow from operating activities should therefore be adequate to meet these commitments. Before calculating this ratio, it is important to recall, from Chapter 11 of this course, the concept of cash flow from operating activities and consider its significance: Company profits + All deductions not requiring a cash outlay, such as amortization − All additions not received in cash + The change in net working capital = Cash flow from operations © CANADIAN SECURITIES INSTITUTE 14 14 CANADIAN SECURITIES COURSE      VOLUME 2 DID YOU KNOW? Non-cash items are items that do not involve an actual outlay or receipt of funds, such as share of profit of associates. Because of the substantial size of non-cash items on a statement of comprehensive income, cash flow from operating activities frequently provides a broader picture of a company’s earning power than profit alone. Consequently, cash flow from operating activities is considered by some analysts to be a better indicator of the ability to pay dividends and finance expansion. It is particularly useful in comparing companies within the same industry. It can reveal whether a company can meet its debts, even one that shows little or no profit after depreciation. To properly analyze cash flow, you must consider it in relation to a company’s total financial requirements. In financial statements, the cash flow statement puts cash flow from operating activities into perspective as a source of funds available to meet financial requirements. A relatively high ratio of cash flow to total debt outstanding is considered positive, whereas a low ratio is negative. Analysts use minimum standards to assess debt repayment capacity and provide another perspective on debt evaluation. For example, the industry standard for cash flow-to-total debt ratio for retail stores might be 0.2 to 1 over five years, meaning that annual cash flow in each of the last five fiscal years was at least 20% of total debt outstanding. The ratio is expressed as follows: Cash Flow from Operating Activities Total Debt Outstanding EXAMPLE The ratio of cash flow to total debt outstanding for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 34 + Item 36 - Item 32 + Item 37 or Item 21 + Item 18 + Item 15 1,298,000 = 0.4187 1 or 41.87% 3,100,000 The ratio of 0.418 to 1 is acceptable for Trans-Canada Retail because it exceeds the 0.2 to 1 or 20% industry standard for retail stores. Analysts usually calculate the cash flow-to-total debt outstanding ratio for each of the last five fiscal years. An improving trend is desirable. A declining trend may indicate weakening financial strength unless the individual ratios for each year are well above the minimum standards. For example, if the latest year’s ratio was 0.61 (Year 5) and preceding years’ ratios were 0.60 (Year 4), 0.63 (Year 3), 0.65 (Year 2), and 0.70 (Year 1), there would seem to be no cause for concern because each year’s ratio is strong. INTEREST COVERAGE The interest coverage ratio reveals the ability of a company to pay the interest charges on its debt based on profit that it has available to pay the interest. The ratio also indicates whether there is a margin of safety for interest coverage. Having such a margin is important because a company’s inability to meet its interest charges could result in bankruptcy. When calculating the interest coverage ratio, you must consider all interest charges. Default on any one debt may lead to default on other debts. Interest coverage is generally considered to be the most important quantitative test of risk when considering a debt security. A level of profit well in excess of interest requirements is deemed necessary as a form of protection against possible adverse conditions in future years. Overall, the greater the coverage, the greater the margin of safety. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 15 A common practice is to set criteria to assess the adequacy of interest coverage. For example, you may decide that an industrial company’s annual interest requirements in each of the last five years should be covered at least three times by profit available for interest payment in each year. At this level you would consider its debt securities to be of acceptable investment quality. Interest coverage standards indicate only the likelihood that a company will be able to meet its interest obligations. A company may fail to meet the coverage standards while still meeting its debt obligations. However, its securities would be considered a much higher risk because the company lacks an acceptable margin of safety. It is important that you study the year-to-year trend in the interest coverage calculation. Ideally, a company’s coverage will increase year by year to exceed the standard. A stable trend where the company meets the minimum standard is also considered acceptable. However, a deteriorating trend suggests that further analysis is required to determine whether the company’s financial position has seriously weakened. Aberrations in the trend may occur as the result of events such as a prolonged strike. Such abnormalities may cause earnings to drop within a single year but will probably not impair the company’s basic financial soundness in succeeding years. However, a steep decline in earnings should prompt a revaluation of the investment quality of a debt issue. Particularly if the decline is prolonged, it may indicate a fundamental deterioration in the company’s financial position. A sudden reversal from a profit to a loss also merits close scrutiny. Other changes, such as a rapid build-up in short-term borrowings, could also reduce the investment quality of a company’s debt securities. The formula used to calculate the interest coverage ratio is as follows: Profit Before Interest Charges and Taxes Interest Charges In general, the lower the ratio, the more a company is burdened by interest charges to cover its debt. EXAMPLE The interest coverage ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 34 + Item 31 + Item 33 - Item 32 or Item 31 1,208,000 + 289,000 + 880,000 - 5,000 2,372,000 = = 8.21 1 289,000 289,000 The calculation shows that Trans-Canada Retail’s interest charges for the year were covered 8.21 times by profit available to pay them. Stated another way, it shows that the company had $8.21 of profit out of which to pay every $1.00 of interest owing. Again, standards vary from industry to industry, not only for companies in different industries, but even for those in the same industry. Standards can depend on past earnings records and future prospects. The record of a company’s interest coverage is particularly important because the company must meet its fixed charges in both good and bad times. Unless it has already demonstrated its ability to do so, it cannot be said to have passed the test. A high interest coverage ratio is not required for utility companies. They have a licence to operate in specific areas with little or no competition, and rate boards establish rates that enable them to earn a fair return on their capital investment. By contrast, the profits of retail companies are likely to be more volatile, so a higher coverage ratio is necessary to provide a greater margin of safety. © CANADIAN SECURITIES INSTITUTE 14 16 CANADIAN SECURITIES COURSE      VOLUME 2 OPERATING PERFORMANCE RATIOS The analysis of a company’s profitability and efficiency tells the investor how well management is making use of the company’s resources. DID YOU KNOW? Profit or return calculations are typically expressed as a percentage. GROSS PROFIT MARGIN The gross profit margin ratio, which is useful both for calculating internal trend lines and for making comparisons with other companies, is calculated as follows: Revenue - Cost of Sales Revenue This ratio is especially useful in industries such as food products and cosmetics, where both the turnover rate and competition level are high. The gross margin is an indication of the efficiency of management in turning over the company’s goods at a profit. In other words, it shows the company’s rate of profit after allowing for the cost of sales. EXAMPLE The gross profit margin ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 24 - Item 25 or Item 24 43,800,000 - 28,250,000 15,550,000 = = 0.355 1 or 35.50% 43,800,000 43,800,000 Trans-Canada Retail’s rate of profit after allowing for cost of sales is 35.50% of revenue. NET PROFIT MARGIN The net profit margin ratio, which is an important indicator of the efficiency of a company’s management after taking both expenses and taxes into account, is calculated as follows: Profit - Share of Profit of Associates Revenue Because this ratio is the result of the company’s operations for the period, it effectively sums up in a single figure management’s ability to run the business. EXAMPLE The net profit margin ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 34 - Item 32 or Item 24 1,208,000 - 5,000 1,203,000 = = 0.0275 1 or 2.75% 43,800,000 43,800,000 The calculation shows how much of the money the company collected as revenue remains as its profit. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 17 Not all companies have made investments in associates. Therefore, for comparisons between companies or from one year to another, the profit must be shown before the share of profit of associates is added in. RETURN ON COMMON EQUITY The net (or after tax) return on common equity ratio, which shows the dollar amount of earnings that were produced for each dollar invested by the company’s common shareholders, is as follows: Profit Total Equity The trend in the return on common equity indicates management’s effectiveness in maintaining or increasing profitability in relation to the common equity capital of the company. A declining trend suggests that operating efficiency is waning. Further quantitative analysis is needed to pinpoint the causes. For shareholders, a declining ratio shows that their investment is being used less productively. This ratio is very important for common shareholders because it reflects the profitability of their capital in the business. EXAMPLE The net return on common equity ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 34 or Item 14 1,208,000 = 0.0908 1 or 9.08% 13,306,000 The calculation shows that Trans-Canada Retail earned $0.09 for each dollar invested. INVENTORY TURNOVER RATIO The inventory turnover ratio, which measures the number of times that a company’s inventory is turned over in a year, is calculated as follows: Cost of Sales Inventory It may also be expressed as a number of days required to achieve turnover, as shown in the example that follows. A high turnover ratio is considered good because the company requires a smaller investment in inventory than one producing the same revenue with a low turnover. EXAMPLE The inventory turnover ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 25 or Item 5 28,250,000 = 3.13 1 9,035,000 To calculate inventory turnover in days, divide 365 (days) by the inventory turnover ratio, as follows: 365 = 116.61 3.13 The calculation shows that Trans-Canada Retail turns over its inventory 3.13 times over the span of a year, or every 116.61 days. © CANADIAN SECURITIES INSTITUTE 14 18 CANADIAN SECURITIES COURSE      VOLUME 2 The inventory turnover ratio can be used to compare one company’s efficiency in turning over inventory with others in the same field. It also provides an indication of the adequacy of a company’s inventory for the volume of business being handled. Inventory turnover rates vary from industry to industry. For example, companies in the food industry turn over their inventory more rapidly than aircraft manufacturers because the process of making and selling planes takes longer. EXAMPLE Examples of high-turnover industries include those involved in baked goods, cosmetics, dairy products, groceries, and meat packing—in other words, industries dealing in perishable goods and quick-consumption, low-cost items. Examples of low-turnover industries include distillers, producers of fur goods, heavy machinery manufacturers, steel plants, and wineries. If a company has an above-average inventory turnover rate for its industry, it generally indicates a better balance between inventory and sales volume. The company is unlikely to be caught with too much inventory if the price of raw materials drops or the market demand for its products falls. There should also be less wastage due to deterioration in quality or marketability. On the other hand, if inventory turnover is too high in relation to industry norms, the company may have problems with shortages resulting in lost sales. DID YOU KNOW? A company may have a low inventory turnover rate for any of the following reasons: The inventory contains an unusually large portion of unsaleable goods. The company has over-bought inventory. The value of the inventory has been overstated. Because a large part of a company’s working capital is usually tied up in inventory, the way in which the inventory position is managed directly affects the company’s earnings and the rate of return earned on the company’s common equity. VALUE RATIOS Value ratios (sometimes called market ratios) measure the way the stock market rates a company by comparing the market price of its shares to information in its financial statements. Price alone does not tell analysts much about a company unless there is a common way to relate the price to dividends and earnings. Value ratios do this. PERCENTAGE DIVIDEND PAYOUT RATIOS The dividend payout ratio, which indicates the percentage of the company’s profit that is paid out to shareholders in the form of dividends, is calculated as follows: Common Share Dividends ´ 100 Profit Deducting the percentage of earnings being paid out as dividends from 100 gives the percentage of earnings remaining in the business to finance future operations. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 19 EXAMPLE The dividend payout ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 41 ´ 100 or Item 34 387,500 ´ 100 = 32.08% 1,208,000 The calculation shows that Trans-Canada Retail paid out 32.08% of available earnings as dividends in the year; therefore, 67.92% was reinvested in the business. Dividend payout ratios are generally unstable because they are tied directly to the earnings of the company, which change from year to year. The directors of some companies try to maintain a steady dividend rate through good and poor times to preserve the credit rating and investment standing of the company’s securities. If dividends are greater than earnings for the year, the payout ratio will exceed 100%. Dividends are then taken out of retained earnings, which erodes the value of the shareholders’ equity. EARNINGS PER COMMON SHARE The EPS ratio, which shows the earnings available to each common share, is calculated as follows: Profit Weighted Average Number of Common Shares Outstanding The ratio is an important element in judging an appropriate market price for buying or selling common stock. A rising trend in EPS has favourable implications for the price of a stock. In practice, a common stock’s market price reflects the anticipated trend in EPS for the next 12 to 24 months, rather than the current EPS. Thus, it is common practice to estimate EPS for the next year or two. Accurate estimates for longer periods are difficult because of the many variables involved. EXAMPLE Assume that the notes to the financial statements for Trans-Canada Retail Stores Ltd. indicate that the weighted- average number of common shares outstanding is 387,500. The EPS ratio for Trans-Canada Retail is therefore calculated as follows: Item 34 or 387,500 shares $1,208,000 = $3.12 per share 387,500 The calculation shows that Trans-Canada Retail has earned $3.12 for each common share. Because of the importance of EPS, analysts pay close attention to possible dilution of the stock’s value. Dilution occurs when the number of shares outstanding increases, which results in each existing shareholder owning a smaller percentage of the company. It may be caused by changes such as the conversion of outstanding convertible securities, the exercise of warrants, or shares issued under employee stock options. Fully diluted EPS can be calculated on common stock outstanding plus common stock equivalents such as convertible preferred stock, convertible debentures, stock options (under employee stock-option plans), and warrants. This figure shows the dilution in EPS that would occur if all equivalent securities were converted into common shares. © CANADIAN SECURITIES INSTITUTE 14 20 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE Because Trans-Canada Retail Stores Ltd. has no convertible securities, let us consider the statements of Company ABC, which show the following information: 300,000 warrants can be converted on a 1-for-1 basis into common shares. The weighted-average number of common shares is 2,800,000 common shares. The company had a profit of $10,455,000. Profit or Weighted Average Number of Common Shares Outstanding $10,455,000 = $3.73 per share 2,800,000 To calculate fully diluted EPS, you would have to increase the number of common shares by 300,000 because 300,000 warrants would be converted on the basis of 1 to 1. The formula is therefore adjusted as follows: Adjusted Profit or Adjusted Weighted Average Number of Common Shares Outstanding $10,455,000 $10,455,000 = = $3.37 per share 2,800,000 + 300,000 3,100,000 The calculation shows that Company ABC has $3.37 in fully diluted earnings for each common share. Profit, after all prior claims have been met, belongs to the common shareholders. The shareholders will therefore want to know how much has been earned on their shares. If profit is high, directors may declare and pay out a good portion as dividends. Even in growth companies, directors may decide to make at least a small dividend payment because they realize that shareholders like to receive income. On the other hand, if profit is low or the company has suffered a loss, they may not pay dividends on the common shares. Describing earnings in terms of common shares shows shareholders the profitability of their ownership interest in the company and whether dividends are likely to be paid. In the Trans-Canada Retail Stores example, earnings are $3.12 for each common share. Because regular dividends of $1.00 per share per year are being paid on common shares, the calculation also indicates that the dividend is well protected by earnings. In other words, the EPS is $2.12 more than regular dividend payments. Because common share dividends are declared and paid at the discretion of a company’s board of directors, no rules govern the amount likely to be paid out at a given level of profit. Dividend policy varies from industry to industry and from company to company. Before a company can pay a dividend, it must have sufficient earnings and working capital. It is up to the directors to consider pertinent factors and decide whether to pay a dividend; and if so, how large the payment should be. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 21 DID YOU KNOW? When estimating the dividend possibilities of a stock, you should consider the following factors: The amount of profit for the current fiscal year The stability of profit over a period of years The amount of retained earnings and the rate of return on those earnings The company’s working capital The policy of the board of directors Plans for expanding (or contracting) operations Government dividend restraints (if any) DIVIDEND YIELD The dividend yield on common stock is the annual dividend rate expressed as a percentage of the current market price of the stock. It represents the investor’s return on the investment, as follows: Indicated Annual Dividend per Share ´ 100 Current Market Price EXAMPLE Assuming a current market price of $26.25 for the common shares of Trans-Canada Retail Stores Ltd., the yield is calculated as follows: 1.00 ´ 100 = 3.81% 26.25 The calculation shows that the dividend yield on Trans-Canada Retail’s common stock is 3.81% of the current market price. Dividend yields allow analysts to make a quick comparison between the shares of different companies. However, to make a thorough comparison, you must also consider the following factors: The differences in the quality and record of each company’s management The proportion of earnings reinvested in each company The equity behind each share Consider all these factors during a company analysis, in addition to yield, and preferably over several years. Only then can you make an informed evaluation. EQUITY VALUE PER COMMON SHARE The equity value per common share ratio, also called book value per common share, measures the net asset coverage for each common share if all assets were sold and all liabilities were paid, as follows: Equity Number of Common Shares Outstanding © CANADIAN SECURITIES INSTITUTE 14 22 CANADIAN SECURITIES COURSE      VOLUME 2 DID YOU KNOW? Note from the calculations that the number of common shares outstanding is not the same number as the weighted-average number of common shares outstanding. The weighted-average number of common shares outstanding is calculated by taking the number of shares outstanding and multiplying it by the proportion of the reporting period for which the shares were outstanding, and then summing the total of each portion. This calculation allows a company to incorporate any changes in the number of outstanding shares over a reporting period. As a simplified example, if the number of outstanding shares in the first six months is 1.2 million, and in the second six months is 1.45 million, the weighted average of these two periods would be 1.325 million shares (1.2 million × 0.50 + 1.45 million × 0.50). EXAMPLE Assume that the notes to the Trans-Canada Stores Ltd.’s financial statements report that the company has 400,000 common shares outstanding as of December 31, 20XX, as follows: Item 14 or 400,000 13,306,000 = $33.27 per Common Share 400,000 The calculation shows that equity for each of Trans-Canada Retail’s common share is $33.27. There is no simple answer as to what constitutes an adequate level of equity value per common share. A per-share equity (or book) value figure is sometimes used in appraising common shares. However, in actual practice the equity value per common share may be very different from the market value per common share. Equity per share is only one of many factors to be considered in appraising a given stock. Many shares sell for considerably less than their equity value, whereas others sell for far in excess of their equity value. This disparity between equity and market values is usually accounted for by the actual or potential earning power of the company. The shares of a company with a high earning power command a better price in the market than the shares of a company with little or no earning power, even when the shares of both companies may have the same equity value. Thus, we cannot quote a meaningful standard for an adequate equity value per common share. PRICE-TO-EARNINGS RATIO The P/E ratio is probably the most widely used of all financial ratios because it combines all the other ratios into one figure. It represents the ultimate evaluation of a company and its shares by the investing public. The P/E ratio is calculated only for common stocks, as follows: Current Market Price of Common Shares Earnings per Share Note: The EPS figure shown is for the latest 12-month period. EXAMPLE Assuming that the current market price of Trans-Canada Retail’s common stock is $26.25, and that the company’s EPS is $3.12, the P/E ratio is calculated as follows: 26.25 = 8.41 1 3.12 The calculation shows that the current market price of Trans-Canada Retail’s common stock is 8.41 times the EPS value. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 23 The main reason for calculating EPS, apart from determining dividend protection, is to compare it to the share’s market price. The P/E ratio expresses this comparison in one convenient figure, showing that a share is selling at so many times its actual or anticipated annual earnings. This figure allows you to compare the shares of one company with those of another. Consider Table 14.4, which shows the earnings per share, current market price, and P/E ratio of two companies: Company A and Company B. Table 14.4 | Earnings per Share, Current Market Price, and P/E Ratio Earnings per Share Current Market Price P/E Ratio Company A $2.00 $20.00 10:1 Company B $1.00 $10.00 10:1 Although the EPS of Company A ($2) is double that of Company B ($1), the shares of each company represent equivalent value because A’s shares cost twice as much as B’s. In other words, both companies are selling at 10 times earnings. Two types of elements determine the quality of an issue and are therefore represented in the P/E ratio: Tangible elements contained in financial data, which can be expressed in ratios relating to liquidity, earnings trends, profitability, dividend payout, and financial strength Intangible elements, such as quality of management, nature and prospects for the industry in which the issuing company operates, its competitive position, and its individual prospects All these factors are taken into account when investors and speculators collectively decide what price a share is worth. DID YOU KNOW? To compare the P/E ratio for one company’s common shares with that of other companies, the companies should usually be in the same industry. Analysts also consider individual company P/Es in relation to the relevant market index or average. They compare that number with an average relative P/E over some period of time, such as three years or five years. In the Trans-Canada Retail Stores example, we calculated the price-earnings ratio on the earnings of the company’s latest fiscal year. In practice, however, most investment analysts and firms make their own projections of a company’s earnings for the next twelve-month period. They then calculate P/E ratios on these projected figures in relation to the stock’s current market price. Because of the many variables involved in forecasting earnings, you should use estimates in calculations with great caution. The P/E ratio helps analysts determine a reasonable value for a common stock at any time in a market cycle. By calculating a company’s P/E ratio over a number of years, you will find considerable fluctuation, with high and low points. If the highs and lows of a particular stock’s P/E ratio remain constant over several stock market cycles, they indicate selling and buying points for the stock. A study of the P/E ratios of competitor companies and that of the relevant market subgroup index also provides a perspective. The P/E ratio comparison assists in the selection process. For example, if two companies of equal stature in the same industry both have similar prospects but different P/E ratios, the company with the lower P/E ratio is usually the better buy. As a rule, P/E ratios increase in a rising stock market or with rising earnings. Earnings that increase over time are a favourable sign; the company’s stock price should also rise over time. Investors see rising earnings as a positive © CANADIAN SECURITIES INSTITUTE 14 24 CANADIAN SECURITIES COURSE      VOLUME 2 development and are willing to pay a higher price for the stock. The increase in the stock price is usually greater than the increase in earnings; therefore, the P/E ratio increases. The reverse is true in a declining market or when earnings decline. EXAMPLE At the start of the bull market, the P/E ratio for DEF Corp. was 10:1 based on their stock trading at $10 per share and an earnings per share of $1. As the bull market continued and DEF Corp. reported a higher EPS of $2.50 in their next quarterly earnings report, investor confidence drove the price of DEF Corp. higher to $43 per share, resulting in a P/E ratio of 17.2:1 Generally, it is assumed that when investor confidence is high, P/E ratios are also high, and when confidence is low, P/E ratios are low. Because the P/E ratio is an indicator of investor confidence, its highs and lows may vary from market cycle to market cycle. Much depends on changes in investor enthusiasm for a company or an industry over several years. The P/E ratios of individual stocks are also affected by many factors specific to individual companies, such as comparative growth rates, earnings quality, and risk due to leverage or stock liquidity. DIVIDEND DISCOUNT MODEL The widely used dividend discount model (DDM) illustrates, in a simple way, how companies with stable growth are priced, at least in theory. The model relates a stock’s current price to the present value of all expected future dividends into the indefinite future. The DDM assumes that there will be an indefinite stream of dividend payments, whose present values can be calculated. It also assumes that these dividends will grow at a constant rate (represented as g the growth rate in the formula). In fact, this version of the DDM is more accurately known as the constant or Gordon growth model. For our purposes in the CSC, we continue with reference to the DDM. The discount rate used is the market’s required or expected rate of return for that type of investment. We can think of the required rate of return as the return that compensates investors for investing in that stock, given its perceived risk. The formula and definitions of the relevant variables for calculating the DDM are shown in Figure 14.1. Figure 14.1 | Dividend Discount Model Div 0 (1 + g) Div 1 Price = = r-g r-g Where: Price = The current intrinsic value of the stock in question Div0 = The dividend paid out in the current year Div1 = The expected dividend paid out by the company in one year r = The required rate of return on the stock g = The assumed constant growth rate for dividends EXAMPLE ABC Company will pay a dividend of $0.94 this year. If the company reports a constant long-term growth rate (g) of 6%, ABC will pay out an expected dividend in one year’s time of $0.996 or $1.00 ($0.94 × 1.06). It is technically incorrect to assume that “r” in the denominator is equal to the general level of interest rates or that “g” is simply equal to growth in corporate profits. However, these simplifying assumptions make it possible to © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 25 illustrate how changes in interest rates and corporate profits affect stock price valuation during a business cycle. Other, more complex formulas are used to accommodate changing dividends and changing growth rates. DID YOU KNOW? Although the DDM has many practical limitations, it is a useful way to think of stock valuation. EXAMPLE ABC Company is expected to pay a $1 dividend next year. It has a constant long-term growth rate (g) of 6% and a required return (r) of 9%. Based on these inputs, the DDM is calculated as follows: Div 1 1.00 Price = = = 33.33 r-g 0.09 - 0.06 The DDM tells us that, based on the expected dividend, the required return and the growth rate of dividends, the stock has an intrinsic value of $33.33. Thus, if ABC is selling for $25 in the market, the stock would be considered undervalued because it is selling below its intrinsic value. Conversely, if ABC is selling for $40, the stock would be considered overvalued because it is selling above its intrinsic value. NFR INC. COMPANY ANALYSIS In this activity, you will practice company analysis on the fictitious Canadian company NFR. Can you apply the formulas you learned to calculate this company’s key ratios? Complete the online learning activity to assess your knowledge. COMPARING PERFORMANCE In this activity, you will review and compare the ratios of the fictitious Canadian company NFR Inc. against another company in the same industry. Can you determine which company offers the better investment? Complete the online learning activity to assess your knowledge. ASSESSING PREFERRED SHARE INVESTMENT QUALITY 4 | Distinguish among the criteria used in assessing the investment quality of preferred shares. As we discussed in Chapter 8 of the course, preferred shares have characteristics that differ from those of common shares. For example, preferred shareholders are entitled to a fixed dividend and they do not have the right to vote. In addition, the prices of preferred shares act more like bonds than common stocks. For these reasons, preferred shares are evaluated differently than common shares. INVESTMENT QUALITY ASSESSMENT The investment quality assessment of preferred shares hinges on three critical questions: Do the company’s earnings provide ample coverage for preferred dividends? For how many years has the company paid dividends without interruption? Is there an adequate cushion of equity behind each preferred share? © CANADIAN SECURITIES INSTITUTE 14 26 CANADIAN SECURITIES COURSE      VOLUME 2 Analysts used four key tests to answer these questions: 1. Preferred dividend Like interest coverage, the preferred dividend coverage ratio indicates the margin coverage ratio of safety for preferred dividends. It measures the amount of money a firm has to pay dividends to preferred shareholders. The higher the ratio the better, as it indicates the company has little difficulty in paying its preferred dividend requirements. Typically, preferred dividend coverage is calculated for the last five years, and a trend is plotted. Ideally, a rising or stable trend is revealed. 2. Equity Preferred shares rank before common shares in any liquidation, winding up, or (or book value) distribution of assets. When the preferred shareholders’ claims have been met, the per preferred holders of common shares are entitled to what is left. Analysts like to see that the share minimum equity value per preferred share in each of the last five fiscal years is at least two times the dollar value of assets that each preferred share would be entitled to receive in the event of liquidation. 3. Dividend As an analyst, you should ask whether the company has established a record of payments continuous dividend payments to its preferred shareholders. You can obtain this information from individual company annual reports. 4. Credit assessment Just as with bonds, a company’s preferred shares may be rated by one of the recognized securities rating services. During your analysis, you should ask what the rating is and is it high enough to merit investment. An unexpected change in the rating of a preferred share issue usually affects the shares’ market price. An unexpected downgrade to a lower rating has negative implications, whereas an upgrade is a favourable development. SELECTING PREFERRED SHARES Other factors to consider when investigating equity securities include marketability, volume of trading, and research coverage by investment firms. The following questions are specific to preferred shares, whether they are straight or convertible: What features (such as cumulative dividends or sinking funds) and what protective provisions have been built into the issue? Is the yield from the preferred acceptable compared to yields from other, similar investments? If the preferred are convertible, you should ask additional questions: Is the outlook for the common stock positive? A conversion privilege is valuable only if the market price of the common rises above the conversion price during the life of the conversion privilege. Is the life of the conversion privilege long enough? The longer the life of the conversion privilege, the greater the opportunity for the market price of the common and preferred to respond to favourable developments. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 27 SUMMARY In this chapter, we discussed the following key aspects of company analysis: Company earnings reveal how well management makes use of company resources. The statement of financial position reveals important aspects of company operations and factors that may affect earnings. Financial ratios are meaningful only when compared with other ratios over a period. Ratios are most useful when comparing financial results of companies in the same or similar industries. Liquidity ratios measure a company’s ability to meet its short-term commitments. The working capital ratio shows the ability of a company to meet its obligations, expand its volume of business, and take advantage of financial opportunities as they arise. The quick ratio, or acid test, offers a more conservative test of a company’s ability to meet its current obligations. It shows how well current liabilities are covered by cash and by items with a ready cash value. Risk analysis ratios show how well the company can deal with its debt obligations. The asset coverage ratio shows a company’s ability to cover its debt obligations with its assets after all non- debt liabilities have been satisfied. The debt-to-equity ratio shows the proportion of borrowed funds used relative to the investments made by shareholders in the company. If the ratio is too high, it may indicate that the company has borrowed excessively, which increases its financial risk. The cash flow-to-total debt outstanding ratio gauges a company’s ability to repay the funds it has borrowed. Short-term borrowings must normally be repaid or rolled over within a year. The interest coverage ratio reveals the ability of a company to pay the interest charges on its debt based on profit that it has available to pay the interest. Operating performance ratios illustrate how well management makes use of the company’s resources. The gross profit margin ratio is an indication of the efficiency of management in turning over the company’s goods at a profit. The net profit margin ratio is an important indicator of the efficiency of a company’s management after taking both expenses and taxes into account. The trend in the return on common equity indicates management’s effectiveness in maintaining or increasing profitability in relation to the common equity capital of the company. The inventory turnover ratio can be used to compare one company’s efficiency in turning over inventory with others in the same field. It also provides an indication of the adequacy of a company’s inventory for the volume of business being handled. Value ratios reveal what the company’s shares are worth in comparison to the shares of companies in the same industry. The dividend payout ratio indicates the percentage of the company’s profit that is paid out to shareholders in the form of dividends. The earnings per share ratio is an important element in judging an appropriate market price for buying or selling common stock. A rising trend in EPS has favourable implications for the price of a stock. The dividend yield allows analysts to make a quick comparison between the shares of different companies. The equity value per common share ratio, also called book value per common share, measures the net asset coverage for each common share if all assets were sold and all liabilities were paid. The P/E ratio expresses the comparison of the company’s share market price to the company’s earnings. This figure allows you to compare the shares of one company with those of another. © CANADIAN SECURITIES INSTITUTE 14 28 CANADIAN SECURITIES COURSE      VOLUME 2 The investment quality of a company’s preferred shares is based on the following three factors: The company’s ability to generate enough earnings to cover its preferred dividend obligations. Whether the company has consistently paid dividends without interruption. The amount of equity behind each preferred share. The investment quality of a company’s preferred shares is evaluated based on the preferred dividend coverage ratio, the equity per preferred share, the record of continuous dividend payments, and independent credit assessments. The rating services assign ratings to a number of Canadian preferred shares. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 14 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 14 FAQs. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 29 APPENDIX A: FINANCIAL STATEMENTS OF TRANS-CANADA RETAIL STORES LTD. The examples in this chapter are based on the financial statements on the following pages. The statements are simplified for ease of use. They differ from real financial statements in the following three ways: Comparative figures from the previous year are not shown. Notes to financial statements are not included. The consecutive numbers on the left side of the statements do not appear in real reports; they are provided here for reference. Note: It is assumed that Trans-Canada Retail Stores Ltd. is a non-food retail chain. Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF FINANCIAL POSITION as at December 31, 20XX ASSETS 1. Property, plant and equipment $ 6,149,000 2. Goodwill 150,000 3. Investments in associates 917,000 4. Total Non-current assets 7,216,000 5. Inventories 9,035,000 6. Prepaid expenses 59,000 7. Trade receivables 975,000 8. Cash and cash equivalents 2,169,000 9. Total Current Assets 12,238,000 10. TOTAL ASSETS $ 19,454,000 EQUITY AND LIABILITIES 11. Share capital $ 2,314,000 12. Retained earnings 10,835,000 13,149,000 13. Non-controlling interest 157,000 14. TOTAL EQUITY $ 13,306,000 15. Long-term debt 1,350,000 16. Deferred tax liabilities 485,000 17. TOTAL NON-CURRENT LIABILITIES $ 1,835,000 18. Current portion of long-term debt 120,000 19. Taxes payable 398,000 20. Trade payables 2,165,000 21. Short-term borrowings 1,630,000 22. TOTAL CURRENT LIABILITIES $ 4,313,000 23. TOTAL EQUITY AND LIABILITIES $ 19,454,000 Approved on behalf of the Board: [Signature], Director [Signature], Director © CANADIAN SECURITIES INSTITUTE 14 30 CANADIAN SECURITIES COURSE      VOLUME 2 Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME For the year ended December 31, 20XX OPERATING SECTION 24. Revenue $ 43,800,000 25. Cost of sales (28,250,000) 26. Gross Profit 15,550,000 27. Other income 130,000 28. Distribution costs (7,984,800) 29. Administration expenses (4,657,800) 30. Other expenses (665,400) 31. Finance costs (289,000) 32. Share of profit of associates 5,000 33. Income tax expense (880,000) 34. Profit 1,208,000 Other comprehensive income 0 35. Total comprehensive income $ 1,208,000 Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF CHANGES IN EQUITY For the year ended December 31, 20XX Share Retained Non-controlling Total Capital Earnings Total interests Equity Balance at January 1, 20XX 1,564,000 10,026,500 11,590,500 145,000 11,735,500 Changes in equity for 20XX Issue of share capital 750,000 750,000 750,000 Dividends (387,500) (387,500) (387,500) Total comprehensive income 1,196,000 1,196,000 12,000 1,208,000 Balance at December 31, 20XX 2,314,000 10,835,000 13,149,000 157,000 13,306,000 Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF CASH FLOWS For the year ended December 31, 20XX OPERATING ACTIVITIES 34. Profit $ 1,208,000 Add or (subtract) items not involving cash 36. Depreciation 496,000 32. Share of profit of associates (5,000) 37. Change in net working capital (401,000) NET CASH FLOW PROVIDED BY OPERATING ACTIVITIES $ 1,298,000 © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 31 Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF CASH FLOWS For the year ended December 31, 20XX FINANCING ACTIVITIES 38. Proceeds from issue of share capital $ 750,000 39. Repayment of long-term debt (400,000) 40. Proceeds from new long-term debt 50,000 41. Dividends paid (387,500) NET CASH PROVIDED BY FINANCING ACTIVITIES $ 12,500 INVESTING ACTIVITIES 42. Acquisitions of capital assets $ (900,000) 43. Proceeds from disposal of capital assets 75,000 44. Dividends received from associates 2,000 NET CASH FLOW USED IN INVESTING ACTIVITIES $ (823,000) 45. INCREASE IN CASH AND CASH EQUIVALENTS 487,500 46. CASH AND CASH EQUIVALENTS—YEAR END 2,169,000 AUDITORS’ REPORT To the Shareholders of Trans-Canada Retail Stores Ltd. We have audited the statement of financial position of Trans-Canada Retail Stores Ltd. as at December 31, 20XX and the