14. Sources Of Information - Uses and Limitations Flashcards
A. Company accounts (page 2)
The purpose of company accounts is to provide investors and other interested parties with information on the performance of the company.
A1. Statutory accounting requirements (pages 2 & 3)
Under the Companies Acts, the directors of a company are legally required to prepare financial statements and make certain disclosures:
- accounts have to show the results of the company’s activities over an accounting period (usually 12 months)
- amount and format of the material depends on whether the company is small, medium or large
- accounts of PLCs must have stock market listings
- listed companies must also publish half yearly or interim accounts
A1. Statutory accounting requirements (pages 2 & 3)
Continued
STRATEGIC REPORT
- all companies must now provide a strategic report (as well as a director’s report) within their annual report
- provides a company’s shareholders with a holistic and meaningful picture of a company’s business model, strategy, development and performance
- should provide a fair review of the company’s business and a description of the risks it faces
- the review should be balanced and comprehensive
A2. Financial statements (page 3)
The standards by which financial statements are prepared and presented are laid out in the Companies Acts.
Mandatory accounting standards are set out by the UK Accounting Standards Board which is part of the Financial Reporting Council (FRC).
A2. Financial statements (page 3)
Continued
International standards are needed to make effective comparisons between companies in different countries:
- International Financial Reporting Standards (IFRS) aim to harmonise the way accounts are presented
- international standards prescribe what needs to be disclosed in financial statements but not any particular layout
A2A. Auditor’s report (pages 3 & 4)
Companies are required to appoint independent auditors unless they are classed as a small company.
Auditor’s role is to carry out an independent assessment of the company’s accounts prepared by the directors and report to shareholders on whether the accounts have been properly prepared in accordance with the Companies Acts and all accounting standards.
A2A. Auditor’s report (pages 3 & 4)
Continued
Auditor’s requirements:
- audit the accounts and report to the members of the company
- review whether the corporate governance statement reflects the company’s compliance with the provisions of the UK Corporate Governance Code and report if it does not
- review the director’s report and other information in the annual report
- ensure the information given in the strategic report for the financial accounting year is consistent with those accounts
A2A. Auditor’s report (pages 3 & 4)
Continued
Audit reports are either unqualified or qualified.
Qualified (modified) reports fall into three categories:
- Disclaimer of opinion - where the auditor is unable to form an opinion
- Adverse opinion - where the auditor disagrees with accounting treatment which the directors refuse to amend
- Qualification - where the auditor has a material disagreement with the treatment adapted by the directors
A2B. Corporate governance (page 4)
Corporate governance is concerned with the transparent disclosure of a company’s activities to it’s shareholders, director accountability and the two-way communication between the board and the company’s shareholders.
All listed companies are expected to abide by the UK Corporate Governance Code.
A3. Framework for financial statements (pages 4 & 5)
Financial Statements are based on a set of underlying assumptions:
- Accrual Basis: the effects of transactions and other events are recognised when they occur, rather than when cash or its equivalent is received or paid
- Going Concern: the financial statements presume that an entity will continue in operation for the foreseeable future
A3. Framework for financial statements (pages 4 & 5)
Continued
The International Accounting Standard (IAS): Presentation of Financial Statements sets out the overall framework for presenting financial statements.
From 1 January 2016 annual reports must contain:
- Income statement
- Consolidated statement of financial position
- Consolidated statement of cash flows
- Consolidated statement of changes in equity
Notes forming part of the consolidated financial statements - Index to notes forming part of the consolidated financial statements
A4. Statement of financial position (page 5)
- Shows the assets and liabilities of a company
- Can be seen as a list of the resources of a company and how they have been financed
- Is a reflection of a company’s position at one point in time
A4A. Assets (pages 5 & 6)
The assets in a statement of financial position are separated into:
- current assets
- non-current assets
CURRENT ASSETS
- assets purchased with the intention of resale or conversion into cash
- assets are listed in descending order of liquidity
- typically appear at the lower of cost or net realisable value
NON-CURRENT ASSETS
Fixed assets, or long-term assets of the company. Split into:
- Tangible assets (physical assets)
- Intangible assets (contracts, patents, brand names)
A4A. Assets (pages 5 & 6)
Continued
Three ways in which companies can account for their stock are:
FIRST IN FIRST OUT (FIFO):
LAST IN FIRST OUT (LIFO): Used in the USA (not UK)
WEIGHTED AVERAGE COST
A4A. Assets (pages 5 & 6)
Continued
DEPRECIATION CHARGE CALCULATION
NON-CURRENT ASSETS AND DEPRECIATION
- tangible assets depreciate over time
- a depreciation charge needs to be accounted for
- the cost of tangible assets is charged to the income statement over a number of accounting periods
DEPRECIATION CHARGE CALCULATION
(STRAIGHT-LINE METHOD):
original cost - expected residual value Depreciation p.a. = ------------------------------------------------------
expected useful life
Example:
Original cost of tractor = £10,000
Useful life = 5 years
Expected resale/residual value = £1,000
Step 1: £10,000 - £1,000 = £9,000
Step 2: £9,000 / 5 = £1,800 (Annual Depreciation charge)
A4B. Shareholder funds and liabilities (pages 7 & 8)
The bottom half of the statement shows shareholder funds and liabilities.
Its construction is underpinned by the accounting equation:
Assets = Liabilities + Equity
A4B. Shareholder funds and liabilities (pages 7 & 8)
Continued
LIABILITIES
- categorised into current non-current liabilities
CURRENT LIABILITIES
- fall due within a year of the statement date
- includes the amount a company owes to suppliers or creditors as a result of buying goods/services on credit
- includes payments received on account
- includes accruals and deferred income
NON-CURRENT LIABILITIES (LONG-TERM)
- fall due within more than a year of the statement date
- could be debentures, loan stock or longer-term borrowing
- fall into two categories:
1. issues of debentures and unsecured loan capital
2. loans from banks and other financial institutions
A4B. Shareholder funds and liabilities (pages 7 & 8)
Continued
SHAREHOLDER FUNDS
- SHARE CAPITAL and RESERVES represent the funds due to the owners of the company and are the permanent capital of the company
- when a company is created the memorandum of association states the amount of share capital with which the company is to be registered and which will be split into shares of a fixed amount
- Issued SHARE CAPITAL are what are issued at any point in time
- Capital RESERVES include the following:
1. REVALUATION RESERVE (arrises from the upward revaluation of tixed tangible and intangible assets)
2. SHARE PREMIUM RESERVE (arises from issuing shares above their normal value)
3. CAPITAL REDEMPTION RESERVE (is created when a company redeems or buys back its shares) - Capital Reserves are not distributable to the company’s shareholders (but can be converted into a bonus issue of ordinary shares)
- Retained earnings (not distributed)
- Non-controlling interest (owned by minority interests)
A5. Income statement (pages 9 & 10)
INCOME STATEMENT
- shows the performance of the company over the accounting period
- details how the company’s reported profit was arrived at
- how much profit was earned
- and how it was distributed
Key Terms from the Income Statement:
- REVENUE (represents sales generated over the accounting period regardless of whether cash has been received)
- PROFIT FROM OPERATIONS (OPERATING PROFIT)
- stated after deducting costs of sales
- as well as distribution costs
- and administration expenses (include depreciation charges)
Gross Profit Calculated:
Gross Profit = Revenue - Cost of Sales
- PROFIT BEFORE TAX (operating profit less exception items such as dividends or corporation tax estimates)
- PROFIT (the company’s total earnings or profit)
A5A. Statement of comprehensive income (page 10)
STATEMENT OF COMPREHENSIVE INCOME
- includes such things as:
- revaluation gains and losses of property
- actuarial gains and losses on pension scheme plans
- foreign exchange translation differences
A5B. State of changes in equity (pages 10 & 11)
STATEMENT OF CHANGES IN EQUITY
- summarises the movement in the shareholder funds during the year (i.e. share capital, share premium, retained earnings etc).
A6. Cash flow statement (pages 11 & 12)
CASH FLOW STATEMENTS (A STATEMENT OF CASH FLOWS)
- identify how a company’s cash has been generate over the accounting period
- and how it has been expended
CONSTRUCTION OF A STATEMENT OF CASH FLOWS:
- removing accruals from the income statement
- adjusting for balance sheet items
- adding back non-cash items
- bringing in changes in balance sheet items that impact the company’s cash position
It is important that a company generates positive cash flow at the operating level otherwise it will become dependant on non-current asset sales and borrowing facilities to finance its day-to-day operations.
A7. Consolidated accounts (pages 12 & 13)
CONSOLIDATED ACCOUNTS
- shows the financial position for a group of companies
- such as when a company ownes another company (parent company with a subsidiary)
- a consolidate account shows assets and liabilites of the parent company with that of its subsidiaries
- owning more than 50% of the shares is enough to create a subsidiary
- where more than 50% but less than 100% of shares are owned, the other party owners are known as minority interests
- the percentage of net income owned by the minority interests is shown at the foot of the group statement
A7A. Associates (page 13)
An ASSOCIATE company has a 20% to 50% shareholding.
The equity method of accounting is used in this instance.
A7B. Investments (page 13)
Where the holding is less than 20%, then this investment is shown as an asset in the statement of financial position.
Any dividends received would be taken to the income statement in arriving at profit on ordinary shares before taxation.
B. Analysing companies (pages 13 & 14)
Four potential measures can be analysed in order to estimate a company’s potential:
- PROFITABILITY (what rate of profit is being earned?)
- VOLATILITY (how sensitive are profits to changes in the markets or economy?)
- LIQUIDITY (is the company able to way its way?)
- OPERATIONAL EFFICIENCY (is the management making efficient use of the company’s resources?)
SEGMENTS
- many companies are a mixture of business
- individuals elements known as segments
- segmental analysis will highlight which parts of the business produce the best and worst returns
B1. Profitability (page 14)
PROFITABILITY
- a company’s ability to generate earnings
- can be measured in two ways
- Profit margin generated from sales
- Profit return generated from the capital or equity used by a company
B1A. Earnings compared to sales (pages 14 & 15)
OPERATING MARGIN
CALCULATION & DESCRIPTION
OPERATING MARGIN
- provides information about the profitability of a firm’s core business
- operating profit is the profit made after paying the operating costs of goods sold as well as general and administration expenses
CALCULATION:
Operating Profit Operating Margin = ---------------------------- x 100
Sales
B1A. Earnings compared to sales (pages 14 & 15)
CONTINUED
NET MARGIN
CALCULATION & DESCRIPTION
NET MARGIN
- measures the percentage of net income of an entity to its net sales
- used to compare the profit of competitors in the same industry
- net margin represents the proportion of sales that is left over after all relevant expenses have been adjusted
CALCULATION:
Net profit after taxation Net Margin = ----------------------------------- x 100
Sales
B1B. Return on equity and return on capital employed (pages 15, 16, 17 & 18)
ROE (Return On Equity)
CALCULATION & DESCRIPTION
ROE - Return on Equity
- is a measure of the profitability of the shareholder’s investment
- measures the percentage return the company is achieving on the amount of funds provided by shareholders
- with the funds provided by shareholders coming from two sources:
1. share capital and share premium (funds being paid by investors)
2. retained earnings (profits not paid out as dividends) - The higher the ROE the better
- ROE is heavily affected by differences in company capital structure
CALCULATION:
Net profit after tax ROE = ------------------------------ x 100
Total Equity
B1B. Return on equity and return on capital employed (pages 15, 16, 17 & 18)
CONTINUED
ROCE (Earnings Compared to Capital Employed)
CALCULATION & DESCRIPTION
ROCE (Earnings Compared to Capital Employed)
- determines how much the company has earned from the total of the different types of capital it has employed
- measures the percentage return achieved on the capital employed in the business
- ROCE is a better comparison between companies than ROE
- ROCE includes long-term finance and is therefore a more comprehensive test of profitability than ROE
- ROCE is limited though in that it does not account for depreciation
CALCULATION:
Profit before interest and tax ROCE = ------------------------------------------- x 100
Capital Employed
B1B. Return on equity and return on capital employed (pages 15, 16, 17 & 18)
CONTINUED
ROCE (Earnings Compared to Capital Employed)
CAN BE BROKEN DOWN INTO TWO PARTS
- Means that you can identify which element/part is responsible for a fall or rise in ROCE
CALCULATION & DESCRIPTION
PART 1: ASSET TURNOVER
- this shows how much of the return arises from good asset utilisation
Sales
CALCULATION: —————————
Capital Employed
PART 2: PROFIT MARGIN
- how much arises from profit and cost management
Profit
CALCULATION: —————————
Sales
THE FORMULA LINKING ALL THREE:
Profit before interest & tax ROCE = ------------------------------------------
Capital Employed
Sales Profit = --------------------------- x -----------------
Capital Employed Sales
B1C. Other profitability measures (pages 18 & 19)
Profits are often quoted against a particular industry-specific measurement, for example:
- Retail companies (profits per square foot)
- Distribution companies (profits per ton mile)
- Airlines (profits per passenger mile)
- Creative companies (profits per employee)
Profit analysis can help identify:
- overall level of return on equity invested
- level of return being achieved on sales and assets
B2. Profit volatility (page 19)
PROFIT VOLATILITY
- essential to an investment decision
- can be assessed using two different measures:
- FINANCIAL LEVERAGE
- ratio of debt to equity, commonly referred to as ‘gearing’
- indicates the sensitivity of a company’s profits to changes in interest rates - OPERATING LEVERAGE
- ratio of fixed costs to variable costs
- known as ‘break-even’ analysis
- indicates the sensitivity of operating profit to changes in sales volumes
B2A. Financial leverage (pages 19, 20, 21 & 22)
FINANCIAL LEVERAGE / GEARING (CALC 1)
CALCULATION & DESCRIPTION
FINANCIAL LEVERAGE
- the extent to which a company uses borrowed money
- carries a risk of bankruptcy
- but can lead to increased returns
CALCULATION:
(Long-term loans + preference shares) Gearing = ----------------------------------------------------------
(Total equity - preference shares)
- Debt to equity ratios of more than 100% are considered too high in the UK
- High gearing is usually more acceptable in the utilities sector
B2A. Financial leverage (pages 19, 20, 21 & 22)
FINANCIAL LEVERAGE / GEARING (CALC 2)
CALCULATION & DESCRIPTION
CONTINUED
ALTERNATIVE METHODS TO CALCULATE GEARING
CALCULATION:
(Long-term loans + PS + short-term loans) Gearing = ----------------------------------------------------------
(Total assets - current liabilities)
PS = Preference shares
B2A. Financial leverage (pages 19, 20, 21 & 22)
INTEREST COVER
CALCULATION & DESCRIPTION
CONTINUED
INTEREST COVER
- How many times could the interest bill be paid out of current profits?
CALCULATION:
Profit before interest and tax
Interest Cover = ——————————————-
Gross interest payable
B2A. Financial leverage (pages 19, 20, 21 & 22)
CONTINUED
EFFECT OF GEARING ON PROFITS:
- High gearing exaggerated ROE
- If revenues decline, a highly geared company is less likely to be able to raise new loans to fund corrective action needed to maintain sales and profits
- A rise in interest charges also increases costs more for highly geared, more indebted companies
B2A. Financial leverage (pages 19, 20, 21 & 22)
CONTINUED
SIGNIFICANCE FOR INVESTORS
- If interest rates go up, costs go up, reducing ROE
- If losses ensure, gearing levels deteriorate further, because equity will be reduced
- A company may find itself unable to raise funds either by borrowing or selling shares
B2B. Operating leverage (pages 22 & 23)
OPERATING LEVERAGE
- a measure of the impact of a company’s cost mix (the proportion of fixed costs to variable costs) on the rate of change in profitability
- no standard benchmark, but generally if fixed costs are above 80% of total costs, a company is likely to be considered as having a high operating leverage
B2B. Operating leverage (pages 22 & 23)
CONTINUED
INFORMATION IN THE ACCOUNTS
- some accounts will show a ‘COST OF SALES’ figure, which for general purposes can be DEEMED TO BE VARIABLE COSTS
- where this is not disclosed, the ‘notes to the accounts’ needs to be analysed and judgements made as to which costs are fixed and variable
- ALL OTHER COSTS INVOLVED BEFORE TRADING PROFIT IS CALCULATED DEEMDED TO BE FIXED COSTS
- the break-even point might be specified in the ‘notes to the accounts’ section
B2B. Operating leverage (pages 22 & 23)
CONTINUED
INDUSTRY INFORMATION
- many trade associations provide quarterly reports on capacity utilisation for the industry as a whole
- therefore the relative position of a particular company is generally known
- combined with an analysis of the company’s operating leverage and a view of the future sales prospects, this tells investors a lot about how rapidly profits (or losses) may change after they have invested in the business
SIGNIFICANCE FOR INVESTORS
- investors should not choose a company for profits in isolation:
1. they may be high-risk profits poised to fall abruptly after only modest market changes
2. even well-managed, highly respected ‘big name’ firms can suffer lower profits
B3. Liquidity management (page 23)
Liquidity is critical to a business:
- without the cash to pay bills even a company with plenty of assets could soon be in liquidation
- therefore liquidity ratios, cash flows and working capital management are watched with care by investors and analysts
B3A. Working capital (‘current’) ratio (page 24)
CALCULATION & DESCRIPTION
CURRENT RATIO
- most investors like to see a cushion to protect a company against a downturn in sales
- generally, investors prefer to see that sufficient cash will be generated from current assets in the course of a normal business day to pay off creditors
- as a generalisation, the ratio should be between 1.5 and 2
CALCULATION:
Current assets Current Ratio = --------------------------
Current liabilities
B3B. Liquidity ratio (page 24)
CALCULATION & DESCRIPTION
LIQUIDITY RATIO
- this ratio is more cautious
- only measures those assets that can be quickly and definitely turned into cash
- the liquidity ratio should be at least 1
CALCULATION:
Current assets - stock Liquidity Ratio = -----------------------------------
Current liabilities
B3B. Liquidity ratio (page 24)
CONTINUED
THE Z SCORE
- liquidity ratios are useful for indicating the ‘tightness’ of current cash flows
- but not very good at forecasting actual financial collapse
Z-Score Check
- this occurs when a promising investment is turned down because of poor liquidity ratios
- it combines a number of special ratios and is reasonably accurate at predicting collapse over one year (but less so over a longer period of time such as five years or more)
B3C. Sources and uses of cash flow statements (page 25)
CASH FLOW STATEMENT
- identifies where money is coming from
- and where it is being spent
- Increases in assets = a use of funds (purchasing)
- Decreases in assets = a source of funds (selling)
- Increase in liabilities = source of funds (new loan)
- Decrease in liabilities = use of funds (repayment)
B3D. Analysing cash flow statements (page 25)
- Cash flow statements need to be assessed in conjunction with the statement of financial position
- Key factors that the investor should focus on:
- Is the company cash-flow positive at the operating level?
- Where is the company spending its money?
- How much cash is being provided from non-operating sources?
- What changes to its financial position have occurred?
B3E. Working capital management (pages 25, 26, 27 & 28)
NET CURRENT ACCOUNT ASSETS
CALCULATION & DESCRIPTION
WORKING CAPITAL (NET CURRENT ACCOUNT ASSETS)
- represents the money that circulates through the business automatically
- i.e. money being spent on goods and services to enable production to take place and money being received as customers pay for their purchases
- when many small transactions are taking place very rapidly, working capital levels can grow unnecessarily large
CALCULATION:
Current assets - current liabilities = Net current assets
B3E. Working capital management (pages 25, 26, 27 & 28)
DEBTOR TURNOVER
CALCULATION & DESCRIPTION
DEBTOR TURNOVER
- is the ratio of a business’ net credit sales to its accounts receivable during a given period
- is an activity ratio that estimates the number of times a business collects its average accounts receivable balance during a period
- measures the efficiency of a business in collecting its credit sales
- HIGH FIGURE more favourable
- usually calculated on an annual basis
CALCULATION:
Sales Debtor Turnover = -------------
Debtors
B3E. Working capital management (pages 25, 26, 27 & 28)
DEBTOR COLLECTION PERIOD IN DAYS
CALCULATION & DESCRIPTION
DEBTOR COLLECTION PERIOD IN DAYS
- expressed in days to represent the number of days that it takes the company to collect its invoices
- benchmark to beat is 60 days
CALCULATION:
Debtors
Debtor collection period in days = ————— x 365
Sales
B3E. Working capital management (pages 25, 26, 27 & 28)
STOCK TURNOVER
CALCULATION & DESCRIPTION
STOCK TURNOVER
- is a ratio used to assess how efficiently a business is managing its inventories
- a high inventory turnover indicates efficient operations
- stock turnover is a measure of the number of times inventory is sold or used in a given time period, such as over one year
CALCULATION:
Cost of sales
Stock Turnover = ———————-
Stock
365 days / the answer gives how many days the stock is held for on average
B3E. Working capital management (pages 25, 26, 27 & 28)
CREDITOR TURNOVER
&
CREDITOR PAYMENT PERIOD IN DAYS
CALCULATIONS & DESCRIPTIONS
CREDITOR TURNOVER
- evaluates how fast a company pays off its creditors (suppliers)
- the ratio shows how many times in a given period the company pays its accounts payable
- a higher value indicates that a company was able to pay them off quickly
CALCULATION:
Cost of sales Creditor turnover = -----------------------
Trade creditors
CREDITOR PAYMENT PERIOD IN DAYS
CALCULATION:
Trade creditors
Creditor payment period in days = ———————– x 365
Cost of Sales
B4. Operational management (page 28)
Operational measures mostly involve comparing key numbers such as sales, employees and assets against other business measures.
B4A. Managing staff resources (pages 28 & 29)
SALES PER EMPLOYEE
- Divide the sales total by the number of employees
- useful to see how fewer or more staff perform
STATISTIC PER EMPLOYEE
- could be employees per square foot, per hotel room etc
WAGE COSTS AS A PERCENTAGE OF SALES
- wages/salaries divided into sales
- shows the wage costs as a percentage of sales
B4B. Managing sales overheads (page 29)
ADMINISTRATIVE COSTS AS A PERCENTAGE OF SALES
- administrative costs divided by sales
DISTRIBUTION COSTS AS A PERCENTAGE OF SALES
- distribution costs divided by sales
B4C. Managing assets (pages 29 & 30)
ASSET TURNOVER
- measures how frequently assets are used to generate sales
- shows how effectively and efficiently a company is using its fixed assets to generate revenue
- Sales divided by non-current assets
ASSETS PER EMPLOYEE
- calculated using the net assets figure from the statement of financial position
- Net assets divided by employees
B5. General limitations of ratio analysis (page 30)
Limitations of Ratio Analysis:
- changes in accounting policies can make comparisons difficult over time
- ratio analysis is based on historical data
- only as good as the information on which it is based
- individual ratios should not be considered in isolation
B6. Comparative performance assessment using ratio analysis (page 30)
A company’s performance can be compared to the:
- Economy (AS A WHOLE)
- Industry (AS A WHOLE)
- Major competitors (CROSS-SECTIONAL ANALYSIS)
- Past performance (TIME-SERIES ANALYSIS)
C. Investment valuation ratios (page 31)
C1. Investment ratios (page 31)
Various investment ratios.
C1A. Earnings per share (EPS) (page 31)
CALCULATION & DESCRIPTION
EARNINGS PER SHARE (EPS)
- is a measure of the profitability of a company or the profit available to shareholders
- expressed as an amount per share
- this is so comparisons can be made between different shares and/or companies
CALCULATION:
Net Income EPS = ------------------------------------------
Number of Shares in Issue
Net Income = may be written as ‘Profit for the year’
Number of Shares in Issue = may be written as weighted average number of shares
TWO OTHER VERSIONS OF EPS:
- EBIT - calculated before the impact of interest payments and taxation
- EBITDA - provides a way for company earnings to be compared internationally
C1B. Price-earnings ratio (PE) (page 32)
CALCULATION & DESCRIPTION
PRICE-EARNINGS RATIO
- measures how highly investors value a company in its ability to grow its income stream
- a company with a high PE ratio relative to its sector average reflects investors expectations that the company will achieve above-average growth
Reasons why a company may have a higher PE ratio:
- greater perceived ability to grow its EPS than others
- producing higher quality earnings than others
- being a potential takeover target
- experiencing a temporary fall in profits
CALCULATION:
Share Price PE = -------------------
EPS
C1C. Dividend yields and cover (pages 32 & 33)
DIVIDEND YIELD
CALCULATION & DESCRIPTION
DIVIDEND YIELDS
- give investors an indication of the expected return in a share
- can then be compared with other shares
- high dividend yield implies low dividend growth
CALCULATION:
Dividend per share
Dividend yield = —————————- x 100 = x%
Share price
C1C. Dividend yields and cover (pages 32 & 33)
DIVIDEND COVER
CALCULATION & DESCRIPTION
DIVIDEND COVER
- the ability of the company to keep paying dividends at the current level
- looks at how many times the company can pay out that level of dividend based on profit for the year
- the higher the dividend cover the less likely it is that the company will have to reduce dividends if profits fall
CALCULATION:
EPS
Dividend Cover = ——————————
Dividend per share
C1D. Price to book ratio (page 33)
CALCULATION & DESCRIPTION
PRICE TO BOOK RATIO
- measures the relationship between the company’s share price and the net book
- how much the shareholders are paying for the net assets of the company
- if the share price is lower than its book value, it can indicate that it is undervalued
- higher than book value means that it has above-average growth potential
CALCULATION:
Share price
Price to book ratio = ————————
NAV per share
C2. Equity valuation (page 33)
Equities can be valued on four bases:
- Dividend flows
- Earnings growth
- NAV
- Shareholder value added
C2A. Dividend discount models (pages 33 & 34)
Share Valuation
CALCULATION & DESCRIPTION
SHARE VALUATION
- expected return of a share based on anticipated dividends
- Gordon’s growth model is used to calculate
Drawbacks to Gordon’s growth model:
- only a few factors are considered in the valuation
- it assumes a single constant growth rate for dividends
CALCULATION:
Dividend
Share price = —————————————————–
(Return required - dividend growth)
Dividend: expected dividend one year from now
Return required: required rate of return for an equity investor
Dividend growth: growth rate of the dividends
C2B. Price-earnings ratio
See card 62.
C2C. Net asset value (NAV) (page 35)
NET ASSET VALUE (NAV)
- represents the NAV per share attributable to ordinary shareholders
Useful for assessing the following:
- minimum price at which a company’s shares should theoretically trade
- the underlying value of a property company
- the underlying value of an investment trust
CALCULATION:
(Total Assets - Liabilities - Preference Shares) NAV = ------------------------------------------------------------------
Number of Shares in Issue
C2D. Shareholder value models (pages 25 & 36)
- the approach taken by shareholder value models is to establish whether a company has the ability to add value to its ordinary shareholders by earning returns on its assets in excess of the cost of financing these assets
- Economic Value Added (EVA) is the most popular of these shareholder value approaches
POSITIVE RESULT = VALUE ADDED
NEGATIVE RESULT = VALUE DESTROYED
- To determine whether a company’s shares are correctly values, the concept of Market Value Added (MVA) needs to be employed
PRESENT VALUE OF THE COMPANY’S FUTURE ANNUAL EVA’S DISCOUNTED AT THE COMPANY’S WAVV IS GREATER THAN THAT IMPLIED BY THE MVA - IMPLIES THAT THE COMPANY’S SHARE ARE UNDERVALUED
D. Other information sources (page 36)
D1. Reporting by issuers (pages 36 & 37)
Listed companies must comply with continuing obligations which are listed in the FCA’s Listing Rules and the Disclosures and Transparency Rules Sourcebook:
- it governs the conduct of directors of listed companies
- maintains an orderly market
- ensures that investors are treated fairly
Disclosure and Transparency Rules contain over-arching requirements, which relate to the timely and accurate dissemination of inside information:
- promote prompt and fair disclosure of relevant information to the market
- set out the specific sets of circumstances in which an issuer can delay public disclosure of inside information
D1. Reporting by issuers (pages 36 & 37)
CONTINUED
Investors need to be aware of the following:
- financial statements can be calculated in a number of legitimate ways giving companies flexibility in how they report figures
- foreign companies have different disclosure requirements
- Chair’s statements look at the good and not the bad
- once a shareholder holds 3% or more of a company’s shares they must inform the company
- larger investors have access to senior management
D2. Regulatory information services (pages 37 & 38)
Regulatory News Service (RNS) operated by the LSE is the best known regulatory information service.
- Ensures that company information is distribute immediately and accurately.
D3. Reporting by collectives (page 38)
Limitations to using data on collectives:
- third party data may only include comprehensive data on managers who subscribe to the service
- Platforms may only include data on selected funds
- Performance data is historic and may not be a good indication of future performance
D4. Investment research and sales notes (pages 38 & 39)
Limitations to investment banks and brokers reports:
- analyst’s research will push for the reader to invest in their company (recommend buy notes)
- research sent to a large number of market participants so readily know and discounted by the market
- such research is not tailored to clients individual needs
D5. Newspapers/journals (page 39)
D6. Chat rooms (page 39)
Limitations include:
- this is secondary information so liable to error
- journalists are weakly regulated
Chapter 14 Key Points (page 40)
COMPANY ACCOUNTS:
- all companies listed on the EU stock exchanges are required to prepare their financial statements in conformity with international accounting standings (IAS)
- all listed companies are expected to abide by the UK Corporate Governance Code as a condition of their listing on the LSE
- construction of the statement of financial position underpinned by: assets = liabilities + equity
- two most common depreciation methods are:
1. straight-line method
2. reducing balance method
ANALYSING COMPANIES:
- gross profit revenue less the cost of goods sold
- operating profit is gross profit less distribution costs and administration expenses
- net income if the company’s total earnings or profit after tax
- ratios mean little in isolation
- ROCE is a key business measure (% return achieved on the capital employed in the business)
INVESTMENT VALUATION RATIOS:
- price-to-book ratio can indicate that it is undervalued
- shareholder value models seek to establish whether a company is able to add value for its ordinary shareholders by earning returns on its assets above the cost of financing these assets
OTHER INFORMATION SOURCES:
- Wide range of other information sources available
