CompanyFundamentalsTHE CMC MarkETs Trading sMarT sEriEsJanuary 2013

CMC Markets | Company fundamentals 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.

Growth anticipation 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.

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.

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.

Political Risk

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.

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.

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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.

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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.

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