At any given point in time, share prices tend to represent the sum of expectations about its value from all investors. Visit our website for more information -> http://www.cmcmarkets.com.sg

1. Company
Fundamentals
THE CMC Markets Trading Smart Series
January 2013

2. How to evaluate company growth potential
At any given point in time, share prices tend to represent the sum of expectations about its value from all
investors. A share price represents a balance between the hopes and aspirations for profit of some and
the fear of loss from others. Generally speaking, investors tend to be willing to pay more for shares with
expectations of stable and/or growing income streams over those where income may be more variable or
where the company’s future direction is uncertain.
For investors, one of the keys to success is being able to understand
what factors influence market expectations and how these can
change over time.
A number of factors can impact sentiment toward a company, both
positive and negative.
Operating risks
There are many ways that a company’s day to day business can
face problems such as machinery breaking down, the entry of new
competitors, price wars, input cost increases, adverse economic
conditions, lost contracts/customers and more.
Growth anticipation
Political Risk
The primary driver of a company’s valuation is its ability to grow
earnings and eventually dividends. There are a number of ways that
a company can increase its earnings over time.
This varies by country but relates to the potential that a
new government could gain power and implement adverse
economic policies such as tax increases, new regulations, asset
nationalizations, and other initiatives.
Growing The Business
There are a number of ways that a company can increase sales
such as entering new markets, entering into partnerships and
joint ventures, winning new contracts/customers, developing and
launching new or improved products, improving marketing and sales
offerings and more.
Raising Prices
During positive economic times, some companies gain the ability to
charge higher prices for current products as demand increases. This
is particularly significant for resource producers during bull markets
for commodities
Cost Controls
A company can also improve its profitability by reducing expenses
although those that do run the risk of cutting corners. To measure
this, investors often look at expenses such as administrative, sales
and marketing, interest, and depreciation as a percentage of sales
to determine how efficiently management is running the business.
Looking at operating earnings as a percent of sales (margin) can also
give an indication of the profitability of the company.
Risk of disappointment
It’s important for investors to recognize that often the sky is not
the limit and that there are also numerous risks that could cause a
company to lose money or see business decline dramatically. Fear of
negative outcomes can limit the upside potential for shares or even
cause declines.
Legal Risk
This relates to the possibility that the company could be sued. This
particularly appears in sectors where there can be disputes over
patents and intellectual property which could lead to significant
damage awards or injunctions against doing business.
Currency risk
Companies operating in multiple countries run the risk that increases
and decreases in currencies relative to each other could impact the
company’s revenues or cost structure and may increase or reduce
the earnings power of foreign operations in terms of the home
currency.
Bankruptcy risk
In difficult times, companies with high debt levels can find
themselves unable to meet their obligations to have enough
financing to meet their day to day obligations. To determine the
financial strength of a company, there are a number of ratios that an
investor can analyse. This includes:
Debt to Equity = Total Debt/Total Equity – Measures how leveraged
the company is.
Times Interest Earned = Operating Income/interest payments. –
measures the ability of the company to at least service the interest
portion of its debt.
Current Ratio = Current Assets/Current Liabilities – measures the
ability of the company to meet near term obligations out of current
resources.
CMC Markets | Company fundamentals
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3. How does the market value
growth? (PE/PEG)
Another major question for investors to ask is how richly is the
market valuing the shares of a company relative to its peers? The
reason for this is that more expensive shares tend to carry higher
expectations and higher risk of disappointment, while companies
with low valuations and expectations carry the potential for upside
surprises.
The most common measure of valuation is the Price/Earnings ratio
which can be calculated as
Market capitalization / net income
or
Share price / earnings per share
This tells an investor what size premium is willing to pay for a
company’s current earnings.
The earnings/price ratio would tell you how many years it would take
for the company to make its current share price at the current rate
of earnings, the payback period in a sense. Therefore, a higher P/E,
indicates higher expectations for earnings growth.
With valuation tied to growth, another key measure for investors
to consider is the Price/Earnings Growth ratio, or PEG for short,
calculated as.
Current P/E ratio / current rate of earnings growth
So a company with a 30% growth rate and a 30x P/E would have a
PEG of 1.0, which is widely considered to be the benchmark level.
A PEG greater than one means that the markets is pricing in even
faster growth for the company, which raises the prospect of
disappointment, while a PEG of less than one suggests that there
may be room for valuation to increase.
The only problem with using P/E ratios to compare valuation is that
the market tends to put a premium
Dividends
Dividends can also have a significant impact on market sentiment.
While earnings can be dependent on accounting estimates,
dividends represent a payment of actual cash to shareholders. With
equity markets stagnating over the last decade, dividends have
become a significant component of shareholders’ income and return
expectations.
Because some shareholders rely on dividends for income, companies
that cut their dividends tend to see their shares punished severely
by the marketplace, and those that eliminate them entirely tend to
lose institutional shareholders restricted by policies of only owning
dividend paying shares. Because of this, companies tend to only
raise dividends to levels that they feel confident that they can
maintain over the longer term.
This suggests that changes to dividends can give a strong indication
of management’s expectations of future results. A dividend increase
is indicative of confidence, while a dividend cut generally indicates
that a company has encountered major difficulties.
- The dividend yield is calculated as
- Dividend per share / price per share
- The higher the yield, the higher the current return on your
capital from dividends.
Sometimes, a high dividend yield can indicate undervaluation, but
sometimes it may indicate concerns that the dividend rate may be
cut.
To measure the riskiness of the current dividend level, investors can
look at the dividend coverage ratio = earnings per share / dividends
per share. This measures the company’s ability to earn its current
dividend. The higher the level the stronger the potential for dividends
to at their current level or increase, while a level below 1 suggests
the potential for a cut.
One final key note on dividends for investors. Once a dividend is
declared, there is a cut-off date for owning the shares to receive the
dividend. On the first day of trading where a buyer would not get
the dividend, known as the ex-dividend date, the priced tends to get
marked down at the open by the amount of the dividend.
Investing around earnings reports
Corporate earnings reports tend to attract a lot of attention
and trading activity for a couple of reasons. First, while some
developments may come as a surprise, earnings reports and the
accompanying conference calls tend to be scheduled and publicised
well in advance, so that investors and media are watching for the
results. Second, analysts tend to publish estimates for earnings in
advance, so the consensus of expectations tends to be priced into
shares ahead of time.
Because of this, investing around earnings reports tends to be less
influenced by the actual level of earnings and more by how reported
earnings turned out relative to market expectations. Management’s
estimates for future quarters, widely known as guidance, can also
have a big impact on investor sentiment.
Share investing ahead of a report can also be important. A rally
heading into earnings news may suggest growing expectations
and a higher risk of disappointment, while a selloff before the news
suggests a lack of confidence and the potential for a positive
surprise.
With so many investors and media focused on the earnings and
guidance numbers there can be significant volatility following the
release of earnings data which is why many companies, particularly
in the US, tend to report outside of market hours. These reports can
have an impact on trends as well and thus can create significant
opportunities and turning points for investors.
CMC Markets | Company fundamentals
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4. Investing around takeover bids
Takeover bids can create a lot of excitement and volatility in the
marketplace, which can create opportunities for investing. There
are a number of factors that can influence how shares respond to
takeover bids.
Target Company
Since buyers usually pay a premium to take over a company, shares
of the target company tend to rally on the news. Sometimes they
rally on rumours before hand, but rumours can be difficult to trade as
many turn out to be false.
How much the target rallies depends on the nature of the bid and the
potential for other bidders. In a friendly takeover the target usually
trades just below the bid price. In a hostile or contested takeover (ie
multiple bidders) the target tends to trade higher than the bid price
on speculation that a higher offer may emerge.
Purchaser
Shares of the purchaser tend to decline on the announcement of a
takeover bid, which tends to create risks for the buyer, such as
Overpayment Risk – the potential that they may overpay for the
acquisition or get dragged into a bidding war which could cause the
buyer to underperform in future years.
Transaction Risk – the risk that the transaction may fail. Also that
the transaction may distract management from running the day to
day business and cause its performance to falter.
Integration Risk – the synergies that corporate cultures may not
merge smoothly or that projected synergies may not be achieved.
If a transaction subsequently fails, these effects can reverse
themselves.
Finally, a takeover bid can cause other companies in the same
industry group to also rally as speculation grows that other
transactions in the group may occur.
CMC Markets | Company fundamentals
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