Company fundamentals

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.

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.

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 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 price tends to get marked down at the open by the amount of the dividend.

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.

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.