In company analysis analysts consider the basic financial variables for the estimation of the intrinsic value of the company. These variables contain sales, profit margin, tax rate, depreciation, asset utilization, sources of financing and other factors. The conduction of further analysis of company include the competitive position of the company in the industry, technological changes, management, labor relations, foreign competition and so on.
How to do the Company Analysis
Company analysis actually provides the indication of the estimated value & potential of the company along with the comprehension of its financial variables. Common stock can be valued by the investors by using dividend discount model. Similarly earnings multiplier model can be used for estimation of intrinsic value for a short run. Intrinsic value (or estimated value) is the product of expected multiplier or P/E ratio and the estimated earnings per share (EPS).
Estimated Value of Stock = Vo = Estimated EPS x Expected P/E Ratio
Relative valuation techniques are used by many investors in which comparison of P/E ratio, P/S ratio and P/B ratio of the company is made with many benchmarks in order to ascertain the relative value of the company. Another effective way adopted by investors is to find out whether the stock is properly valued, undervalued or overvalued without being much exact about the absolute amount.
Majority of investors considers the P/E ratio and the Earning Per Share while accessing the value of the stocks of company.
The Financial Statements
Major financial data about company is obtained from its financial statements while doing the process of company analysis. Following are included in the category of financial statements.
- Balance Sheet
- Income Statement
- Cash Flow Statement
The Balance Sheet
The balance sheet represents the Portfolio of assets and liabilities & owner’s equity of a company at particular point of time. The accounting conventions dictate the amounts at which items are carried on the balance sheets. Cash is the real dollar amount while marketable securities can be at market value or cost. Assets and stockholders equity are based on the book value. The careful analysis of the balance sheet of a company is important for the investors. The investors want to know those companies which are really profitable and are different from the ones which pump up their performance by taking too much debt whose recovery is a big issue. Balance sheet is really important to analyze while doing company analysis for making investment.
In Company analysis process Investors frequently use income statement to evaluate the current performance of management and forecasting of the future profitability of the company. The flows for certain period (one year) are represented by the income statement.
The investors are more interested for the After-tax net income item of the income statement which is divided by the number of common shares outstanding to ascertain the earnings per share. The success of the company is viewed from the earnings from its continuing operations and these earnings are mostly reported as earnings in the financial press. Nonrecurring income is kept separate from the continuing income.
The Cash Flow Statement
The cash flow statement is the third financial statement of the company which includes the items of the balance sheet and income statement as well as other ones. It provides the picture of the travelling of the cash in and out of the company. There are three part of cash flow statement which are
- Cash from operating activities
- Cash from investing activities
- Cash from financing activities
The quality of earnings is examined by the investors with the help of cash flow statement. For example if inventories are increasing more quickly than sales this indicate serious problem by likely softening of the demand. Similarly cutting back of capital expenditures by a company indicate problem. Moreover it is also problematic if the accounts receivables increase more quickly than the sales which shows the poor recovery of the debts by the company.
Certifying the Statements
The Generally Accepted Accounting Principles (GAAP) provides the basis to derive earnings from the balance sheet. Accounting professionals developed certain rules on the basis of historical costs which are followed by the company. The earnings in the financial statements are certified by an auditor from an independent accounting firm.
There are certain foot notes at the end of the financial statements that should be considered by the investors which mostly gives the information on the accounting methods being used and how income is reorganized etc. These footnotes may easily put the company analysis process in the right direction.
Analyzing Profitability of a Company
There are many factors that collectively provide basis for the culmination of the EPS in the company. Key financial ratios are considered to examine these determining factors. The increasing or decreasing profitability of a company is ascertained by examining the components of the EPS.
EPS = ROE x Book Value per Share
Where book value per share is the accounting value of equity of shareholders on the basis of per share and ROE is the return on equity. Book value changes slowly so ROE is the main variable that should be focused. These ratios are calculated as follow.
EPS = Net Income after Taxes / Outstanding Shares
Book Value per Share = Shareholder’s Equity / Outstanding Shares
ROE = Net Income after Taxes / Stockholder’s Equity
ROE reflects the accounting rate of return that stockholders are in on their part of the entire capital employed to finance the company. The accounting value of the stockholder’s equity is measured by the book value per share.
The earnings growth and dividend growth is determined by the ROE which is the key component. Many important variables collectively provide basis of ROE. The investors and analysts try to split the ROE into its important components for the identification of the severe effects on the ROE and forecasting of the future trends in ROE.
Analyzing Return on Equity (ROE)
ROE = ROA x Leverage
ROA is an important complement of return on investment (ROE) and is used to measure the profitability of a company. ROE measures the return to stockholders while ROA measures the return on assets. The effects of leverage must be considered by going from ROA to ROE. The measure of how a company fiancé its assets, is referred to as leverage ratio. The company can either takes debt or utilizes only equity for financing its assets. The debt is although cheaper but more risky due to the associated regular interest payments which must be paid consistently from preventing bankruptcy. The returns to shareholders are either magnified with leverage or diminish with it. By the judicious use of debt financing, certain ROA can be magnified into higher ROE. On the other hand ROE is lowered than ROA by the injudicious use of Debt.
Leverage = Total Assets / Stockholder’s Equity
Analyzing Return on Assets (ROA)
One of significant measure of the profitability of the company is the ROA. ROA is product of two factors
ROA = Net Income Margin x Turnover
Net Income Margin = Net Income / Sales
Turnover = Sales / Total Assets
The net income margin which affects the ROA measures earning power of a company on its sales. Efficiency is measured by the asset turnover. The ROA measures the profitability of a company by showing how efficiently & effectively the assets of a company are used. It is clear that the return is better when there is higher net income for a certain amount of assets.
The estimated EPS is used by the investor to value the stock. Current stock price is a function of the price earnings ratio (P/E) and the future earnings estimate. The investor required following three things when conducting fundamental security analysis using EPS.
- Ascertaining of how to get an earnings estimate
- Viewing the accuracy of any earning estimate acquired
- Comprehending the role of earnings surprises in influencing stock prices
The price earnings ratio is very important consideration in doing company analysis. The P/E ratio shows how much of per dollar earnings investors presently are volitionally to pay for a stock. The market’s summary evaluation of the prospects of the company is reflected by P/E ratio.
Determinants of P/E Ratio
Conceptually the price earnings ratio (P/E) is a function of three factors
P/E = D1/E1
k – g
Where k = required rate of return for stock
g = Expected growth rate in dividends
D1/E1 = expected dividend payout ratio
These three factors and their likely changes should be considered by the investors who are trying to determine the P/E ratio that will prevail for certain stock.
- The higher expected payout ratio indicates the higher the P/E ratio provided other things being equal. In fact the others are rarely equal. The expected growth rate in earnings & dividends (g) will likely decline if the payout ratio rises. This will severely affect P/E ratio. The reason for this decline is the availability of the lesser funds for the purpose of reinvestment in the company.
- There is inverse relationship between k and P/E ratio. The increase k will reduce the P/E ratio and similarly decrease in the k will enhance the P/E ratio provided other things being equal. The reason behind this is that required rate of return is the discount rate. Discount rates and P/E ratio moves inversely to each other.
- g and P/E are directly related. The increase in the g will enhance the P/E ratio provided other things being equal.
Company analysis is also known as the fundamental analysis of a company in which we analyze the company profile, securities, profitability, goals, values and objectives, etc.
Hello everyone! This is Richard Daniels, a full-time passionate researcher & blogger. He holds a Ph.D. degree in Economics. He loves to write about economics, e-commerce, and business-related topics for students to assist them in their studies. That's the sole purpose of Business Study Notes.
Love my efforts? Don't forget to share this blog.