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Young Investors

Fundamental Analysis – Understand The Numbers & Ratios

Thursday, 3 April 2014

In previous article, we looked at the structure of different financial reports. I believe you should have a basic concept on how to do analysis. In this article, we will teach you how to analyze financial reports further.

The easiest way to do analysis is to look at "substantial figures", which are significantly greater than the numbers and hence have a larger impact on the company's financial performance. These pivotal substantial figures will have great influence on the overall performance; analysis on this figure should also be more diligent.

We also have to look at the company's historical financial performance and analyse which items increase or decrease significantly. Next is to look for the factors which led to these changes by checking the “Notes” below financial report. Whether there is any unusual market movement affecting the financial performance, or whether the company has a new plan or project, and does these changes consistent with the plan and project? If the change is caused by external factors, then you should next check major newspapers or other reliable sources for economists’ and experts’ opinion.

Let’s start at the very beginning.

Firstly we like to compute the lowest value of the company, which is usually the minimum cash that the shareholder will receive back in the event of insolvency. To get this minimum value, we could use Net Tangible Assets Value per share or NTA. This is because when the company went into insolvency, company will dispose all of its assets and firstly used the cash generated to pay back all its creditors. The remaining cash will be given back to shareholders. Do note that company's assets often have an item called intangible assets. These are items such as registered trademark, copyright, patents, and logo. Intangible assets usually cannot dispose to get back cash, so we need to deduct this item from the assets of the company. Next are the preference shares, holder of these shares are not considered as shareholder, but rather creditors of the company. So that has to be deducted. The company may also have subsidiaries, and these subsidiaries may not be 100% owned by the company which mean it is not easy to sell the stake interest in subsidiary in short period of time, unless the subsidiary is a Public Listed Company. So, Net tangible Assets (NTA) per share =

In theoretical, although this is minimum value of a particular stock, but it does not mean this is a “reasonable value”, we still need look into company's historical financial performance. If the company is making money every year, so NTA will gradually grow, by then only you can use NTA to determine is it undervalued or overvalued. Otherwise if company is making loss over the year, NTA will decline year by year, then NTA cannot be used as benchmark.

If the company's business is growing, earnings are increasing, assets also increased year by year, and then we will proceed to the next step to find additional value of the company. Using progressive approach, we can start with analyzing the company's Fixed Assets.

One example is the value of the property. The value of the property change every year and is, applied to company’s property. In the Balance Sheet, under Non-Current assets part, some company does report the fixed asset value based on their purchase price. This will affect the company's share intrinsic value because the property value may have risen up several times. To check the market value, we can contact property agent to check the current value. After get this “Additional Fixed Asset Value”, we can then divide it by the total number of outstanding shares. Then add this “additional value” with NTA, you will be able to find a more accurate "Share value".

The next step is to assess the company's historical financial performance. In financial report, we need to look at Revenue, Gross Profit, and Net Profit. Check to see whether these numbers are increasing, if any is declining, next check for factors lead to the decline. The easiest way is look at "Substantial Figure", or which item shows "the most significant rise or fall" and therefore affect the earnings. Next search for economic analyst reports to understand if the particular industry being affecting by any external factors, and how long this is expected to last. Another useful method is to analyze the company's financial performance during financial crisis. During the year 1997-1999 as well as 2008-2009 financial crisis, if the company’s financial performance is still outstanding, that proves the company's business is not adversely affected by the bad economic environment. If competitors companies are all affected and only this company is not affected, it is a strong indication that the company has a very strong management team.

We now move on to look at the company's Net Earnings growth, as well as Earnings Per Share (EPS) growth. We can use "average" approach to forecast future financial performance. Next we can add this forecast value into the “share value” to derive “more accurate share value”. But before adding this forecasted EPS into “share value”, we need to discount this forecasted EPS, because inflation will affect the value of "money". The value of money you receive in the future is different from the money you received today. You can use 5%, 10%, or other percentage to discount. However we would suggest the minimum discount to be equal or higher than the inflation rate.

Next step is analyzing Balance Sheets. One of the most important figures is Debt. Compare the company's debt and its assets, to see whether the company has the ability to repay debt. Is the ratio too high? Then also look for "substantial figure", which impact a large proportion of the entire balance sheet and understand what the nature of the figure is. An example is intangible assets. Intangible assets are sometimes considering worthless asset because it is not something that will generate money. Hence this item should not occupy a large proportion of the company's assets. For other items, you should refer to the “Note Part” after Financial Report section and understand what these items are and what their impacts on the overall assets are.

The last we will look into is Cash Flow Statement. This statement is divided into three parts: Operating, Investing and Financing. The main source of income should come from operation activities or the company’s core business. If the company's main source of income is generated through investments, then we will need to see what type of investment are these. Some companies are even involved in Foreign Exchange investment which is very risky. If the company is not an investment firm but is starting to focus on revenue sources from investment income, it means the company's core business is getting into difficulties.

Next we will explore Ratio Analysis, we will provide some important and commonly use ratio for your reference.

This ratio is easy to understand. Clearly, we would like to see a positive growth.

 

This too, we like to see it grow, but we need analyse this together with revenue. Example, if revenue increased by 20%, while net profit increased by only 10%, what does this mean? Obviously the lower increment is due to increasing costs or expenses.

If Revenue rose by only 10%, the net profit has increased by 30%, what does this mean? It means the costs and expenses has reduced. However, costs and expenses have a bottom line (minimum value), such as staff wages and office rental. Both of these expenses cannot reduce, no matter how efficient the company is, cost and expenses can only reduce to certain level. Hence, cost and expenses reduce is not a last long solution to increase net profit.

This is the net profit attributable to each share, the higher the better.

The common interpretation for this ratio is: The higher the ratio, the more optimistic is the market on this stock. Conversely, if this ratio is low, the market is not optimistic about the stock.

However, we would prefer low PE and provided that earnings are growing. If PE declining and earnings are growing, while the share price did not move, what does this mean? It means the stock is undervalued! If you choose a stock with high PE, it means the market is optimistic on this stock and everyone is buying, do you think you still able pick it up with cheap price?

But PE declining does not necessary mean profit is growing, it might be decline in profit, but just the price decline in a higher degree than earnings, so PE will drop.

If you found a company's profits maintained within a range with no substantial fluctuations. Then the interpretation of the ratio becomes "how many years the company needs to earn back the money you invested". For example, if the company's annual EPS maintained at 5 cents and you purchase the stock with 50 cents. It means the company would take 10 years to earn back the money you have invested.

This ratio is used to measure the company's ability to repay its debt, because current liabilities must be repaid within one year, if the company does not have sufficient liquid assets to repay the debt, the company will being sued, or even go into bankruptcy. The standard number for this ratio is at least 1.5 (healthy), the higher the better.

Cash Ratio is similar to current ratio, to Measure Company’s ability to repay its debt. The different is because some current assets are not easily converted into cash and some of the assets are even "bad assets". So this ratio emerges and only cash item will take into calculation of the ratio. Same as Current Ratio, the higher the better.

Well, it is good to stop here. This is just a small part of "Financial Statement Analysis", and does not represent the entire Fundamental Analysis, because fundamental analysis will study every factor that will affect the Share Value. But don’t feel stress because as long as you read more Annual Report and financial news, accumulate more experience, then you will be able to do it.

If you have any question or enquiries, feel free to send us an email by clicking the "contact" tab. :)

** In next article, we will teach you further in fundamental analysis (Management Team, Business Analysis, Insider Trades, Economic Analysis, etc.). **

By the Young Investors Team