Introduction

As discussed in previous “iVSA Article 10 - Recognise your Risk” (http://klse.i3investor.com/blogs/ivsatradingtipsandplans/98184.jsp), it is a common understanding whereby for companies with good financial performance, its stock price will always move up in the long run. Therefore, to be a winning trader or investor, one of the important skills to acquire is the ability to analyse a companies’ performance through its financial numbers, percentages and ratios in order to differentiate the good versus bad companies as well as associated risks in taking position on these shares. The skill of analysing company performance is also the back bone of fundamental analysis, used by fundamental investors or value investors like Warrant Buffet to pick companies of great value to invest in.

People often regard analysing company performance as a painful process and frown upon reading financial reports as they are overwhelmed with numbers and confusing accounting terms. This article aims to provide a simple and yet effective way to analyse company performance, especially useful for beginners.

In other words, you don’t need to be a rocket scientist or gain a CFA (Certified Financial Analyst) certificate to analyse company performance in relation to Fundamental Analysis. Hence, you can expand your mindset and horizon to complement FA with Technical Analysis (TA) methodology, namely adopting a confluence strategy on your journey to become a successful trader and investor.

Below are selected key parameters to be considered as part of FA, especially for newbies as a quick start guide and the complete list of parameters will depend on individual’s preference and experience in analysing company performance.

Is it making money?

Generally, before spending time making further analysis, the straight forward way to differentiate between good and bad companies is by looking at its profitability, whether it is making money or losses. Besides looking through the company’s financial report income statement section, another quick way to know whether the company profitable or otherwise, is through its PE ratio (Price to Earnings Ratio). A zero or “N/A” PE value means the company is making losses. Value investors and traders who prefer companies with good fundamental are advised to stay away from loss making companies as their stock prices will go down in the long run and upward movements are usually for short-term only.

Absolute Values

The absolute values that needs to be assessed are the company’s Revenue and Net Profit. However, by looking at the values itself will only be able to tell you the size of the company in terms of turnover or profit per year. What is more meaningful is to analyse the company’s 3 to 5 years’ revenue and net profit trends. A company which posted an increasing revenue and profit trends reflects the company’s ability and proven track record to grow and increase market share consistently, resulting in long term share price growth and stronger financial position. In contrast, company with an inconsistent, fluctuating or declining revenue and profit trends, will result in a declining or unpredictable long term share price.

Percentages

There are 2 important percentages that should be studied when analysing company performance.

1. Dividend Yield is often express in the form of percentage whereby the dividend amount per year is divided by its share price. Generally, a performing and dividend paying company typically has a dividend yield of around 2% to 5%. One must take note that dividend yield is not necessarily the higher the better, the other two factors that one must look into is the dividend yield consistency and its dividend payout ratio. The more consistent is the company in paying out dividend with dividend yield being maintained when its share price move up over the years, the better is the company’s financial strength as it has no problem in rewarding its shareholders with their earnings over the years.

When a high paying dividend company is encountered, one should look into its dividend payout ratio. Dividend payout ratio is the ratio of the company's net earnings that is being paid out to the shareholders as dividend. Company which has dividend payout ratio higher than 0.75 (75% of net earnings being pay out to shareholders as dividend) indicates that the company is likely not utilising its earnings effectively for business growth and expansion. Hence these high dividend paying companies usually does not grow much in revenue or profit hence affecting its share price growth over the long term.

As such, these high dividend paying stocks may appeal to investors who prefer dividend payment, but it may not be as attractive to those traders/investors who look for companies that have good potential to grow with reasonable dividend yield, as their share prices will provide much better return % or capital gain over a relative period (while the growth phase of these companies is still intact).

2. Net Profit Margin is expressed in percentage of revenue which turns into net earnings after minus off all expenses, depreciation and tax. In this case, the higher the net profit margin, the better is the company’s product in demanding a premium from the market or the better is the company in controlling operation expenses.

A typical net profit margin value ranges from 3% to 50% depending on the industry that they belong and different economic cycles. However, when an ultra-high net profit margin of more than 50% is encountered, one should take notice as these exceptional earnings may come from one off gains which are usually not regarded as operational revenues as these not repeatable incomes. Example will be earnings from disposal of assets, earnings from affiliates etc. Traders or investors should investigate further when coming across company with financial performance of exceptional high net profit margin, through their annual reports to make sure that such high net profit margins are repeatable and consistent.

Ratios

As companies varies in scale and sizes, ratios are derived from a company’s financial performance in order for these financial figures to be comparable among each other. Often companies within the same industry have similar range of values of these financial ratios, therefore companies with ratio which falls outside of the industrial norm will be either undervalued or overvalued. The followings are selected key ratios that should be considered when analyzing company performance.

1. Total Debt to Equity Ratio is a ratio between a company’s total liability value (long term plus short term) vs. its shareholder equity value. Typically, a good figure will be less than 0.5 (the lower the better), as this signifies that the company has little or no debt. Company with little or no debt will be less affected when the economy turns bad. However, some industries are common in having relatively higher debt to equity ratio, such as telcos, banks, insurance, etc. as it is an industrial nature for these industries to have high loans.

2. Current Ratio is the ratio between current assets (cash or assets that can be converted to cash within a year) vs. current liabilities (value of debt to creditors and suppliers plus short term debts within a year). A good value will be more than 1 (the higher the better) as this signifies that the company can totally pay off their current liabilities with their current asset at any point of time. Therefore, risk of company getting into financial difficulties will be relatively low.

3. Cash Ratio is the ratio between the company’s cash and cash equivalent vs. current liabilities. A good value will be more than 0.5 (the higher the better) as this signifies that the company have at least half of their current liability value being held in the form of cash. Do note that Cash Ratio will always be lower than Current Ratio as cash is part of the current asset of the company.

4. PE Ratio refers to the ratio between share price and the company’s earnings per share. The layman explanation of PE ratio is the amount of money that you are willing to pay to own a company for every dollar of earnings. Example, Company A with PE ratio of 5 shows that investors are willing to pay 5 dollars for every dollar the company earns whereas Company B with PE ratio of 3 shows that investor are willing to pay only 3 dollars for every dollar the company earns. For this simple example, Company B is regarded as being “cheaper” than Company A.

The average market PE ratio is around 20 to 25, but PE ratio often varies greatly between industries, for example companies in the real estate sector will generally have a low PE ratio of less than 10 while health care companies generally have higher PE ratio of more than 50.

Therefore, it is only meaningful when PE ratios are compared among companies within the same sector or industry. Company with low PE ratio when compared to its peers in the same industry can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends or yet to be unearthed by traders/investors. However, company with high PE ratios when compared to its peers may point towards that traders/investors are anticipating higher growth in the future or it is overvalued.

In essence, low PE ratio (lower than 20) often gives the first impression that the stock is of fair or undervalue, but PE ratio must not be view in isolation and shall be compared to its peers in the same industry as well as analysed together with other financial figures before determining that the share is over, fair or undervalued.

Conclusion

Analysing company performance is part of fundamental analysis approach in investing and trading. It is crucial for traders and investors alike to acquire this skill as taking position in companies with good fundamental and consistent performance comes with much lower risk over the long term. A winning trader or investor should always analyse the company’s financial performance before investing your hard earned money to minimise the risk of buying into companies that are in financial distress which may go bust.

As discussed in previous “iVSA Article 3: What are the differences between Fundamental Analysis and Technical Analysis?” (http://klse.i3investor.com/blogs/ivsatradingtipsandplans/95311.jsp), successful trader and investor can use FA to determine WHAT stock to buy, and use TA methodology such as Volume Spread Analysis to determine WHEN to enter and exit. This confluence strategy of complementing FA with TA can help trader and investor to beat the market with above average returns consistently by focusing on quality stocks selection couple with timing their entry/exit.

Watch out for next article in this series of education articles brought to you by iVSAChart, “Article 16 – Importance of Market Structure & how to identify them?” under Series C: A Winning Strategy.

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This article only serves as reference information and does not constitute a buy or sell call. Conduct your own research and assessment before deciding to buy or sell any stock. If you decide to buy or sell any stock, you are responsible for your own decision and associated risks.