POOR COMPANIES RICH MULTIPLES

Author: Preetam Mittal

               PGDM RM 2011-2013

               Welingkar Institute of Managament

The document is about common mistakes made by investors while analyzing the financial ratios and how companies manipulate their stock prices.

A premium earning multiple is hard to come to a company and even harder to maintain.

In the recent times when everybody seems to be in a hurry, investors too have discovered a quick short hand for their investment – P/E ratio.

Countless investors - individuals and professionals alike spend their time seeking out cheap stocks with very low P/E ratios. Sometimes the stocks are cheap for some reasons, they are not in favorable industries or have poor fundamentals hidden within. And as a result, the stock prices stay stagnant... sometimes for years.

But investors don’t understand this fact and companies take their advantage and modify the P/E ratio by various means – the most common been -inclusions of debt in the capital structure. When companies are financially leveraged then the one with higher debt in the capital structure has lower P/E ratio and is more preferable among its peers.

Exhibit 1

Leverage distorts the P/E ratio (Hypothetical case)

Exhibit1clearly shows that though both the company has same EV value, their P/E ratios have substantially changed due to inclusion of debt. Taking the example of two companies Apache Corp and Anadarko Petroleum, each of these energy firms in the year 2010 had an EV/EBITDA multiple of just over 5 (source: investing answers.com) the average EV/EBITDA multiple in their peer group was just under 7. That seems to indicate APA and APC were relatively undervalued.

But if you looked at Anadarko strictly on a P/E basis, you'd wonder why shares hold any appeal, trading at nearly 30 times of its net income.

Why PEG is better than P/E ratio?

There are more detailed valuation models available in the market which seldom makes the headline. These are generally the cause of concern for the senior executives as they claim that their company has great growth prospects and many investments projects in hand. Actually, they are not necessarily wrong. Even financial theories suggest that companies which have higher growth prospects should have higher earnings ratios and hence better market value.

But the problem with the P/E ratio is that it's a retroactive metric. It pits a company's current market cap against its trailing-12-month profit. But when you buy shares of a company, you're not purchasing its history - you're purchasing its future cash flows. What matters is what the company is going to do and not what it has done.

So what's the solution?

The solution is to account for the growth rate of the company or expected growth rate if it can be estimated. Thus, it gives birth to a new and better ratio - PEG ratio, the calculation is as follows:

PEG Ratio = Price-to-Earnings (P/E) Ratio / Annual Earnings per Share Growth

In fact, if one goes back a decade ago then one may find that Apple's P/E ratio at that time was as high as 297. So, anyone making investment on the basis of P/E ratios would not have considered it a very profitable investment but had you bought shares of the company then, you'd be up over 7,300% today.

But, if someone calculated the PEG ratio it would be something closer to 1. A crude analysis suggests that companies with PEG values between 0 to1 may provide higher returns (the closer to 0 the more undervalued).

Common manipulation techniques used by the management

There is another very common form of manipulation used by companies called the "big bath," and this can cause these stocks to seem undervalued to investors. This happens when the company incurs a big loss to their bottom line. This method involves the company taking the complete loss in one single period, instead of spreading these losses over years. This will cause the earnings per share to drop significantly for the time period involved, due to the large losses posted. The intention of the company is to foster the idea among investors that this charge is a once only deal, and that the stock will rise considerably after the loss has been absorbed. This will cause investors to see the stock as one of the undervalued stocks, or as an attractive investment and thus will cause the demand and price for the stock to jump up.

One must always keep in mind that using P/E ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. After all, there will be periods when entire industries will become overvalued. In 2000, an Internet stock with a P/E of 75 might have looked cheap when the rest of its peers had an average P/E of 200. In hindsight, neither the price of the stock nor the benchmark made sense. Just remember that being less expensive than a benchmark does not mean something is cheap, because the benchmark itself may be vastly overpriced.

These ratios are completely ineffective for cyclical firms that go through boom and bust cycles--semiconductor companies and auto manufacturers are good examples and these requires a bit more investigation. Although one would typically think of a firm with a very low trailing P/E as cheap, but that would precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon.

In a similar way, when you're looking at a P/E ratio, also make sure that the "E" part of the equation makes sense. A few things can distort the P/E ratio. First, firms that have recently sold off a business can have an artificially inflated "E" and a lower P/E as a result. The denominator of the ratio can be easily manipulated by changing the revenue recognition, depreciation and capitalizing cost methods the company have been following.

The company generally projects “pro forma” earnings, which shows the profit the company would have made in case some bad/extraordinary event didn’t happen. Consider the case of the attack on hotel T­­aj few months back. It would have surely affected its current earnings, but long term scenario remaining the same. Using Pro forma in those cases makes absolute sense to get an overall long term picture. But there are companies which excludes preferred stock dividends, taxes paid, bad investments, etc., and shows a very attractive pro forma earnings. Hence in general, it’s always better to forget about the pro forma earnings as more companies have come to misuse it, than guiding the stock holders.

Sometimes, companies may show an attractive figure as per-share earnings, but in the foot note it may take away a major part of it as special charges. In such cases investors usually do not pay attention or are ignorant about these facts but this ultimately affects the total earnings of the company and reduces the per-share earnings. Sometimes the special charges may not be really so special and it may show all its operating expenses and even losses as special charges.

Another common mistake made by investors in calculating the EPS is calculating it based on the number of shares currently available in the market and neglecting the convertible debentures available in the market. Companies generally issue fully convertible debentures in the market which the debenture holder converts into equity share when he/she finds the market lucrative. Here at any condition, one should only take the diluted earnings and also check if the company has any plans to dilute further, as it may take away another piece from your pie.

Why management manipulates financial statements?

There are three primary reasons why management manipulates financial statements. First, in many cases the compensation of corporate executives is directly tied to the financial performance of the company. As a result, management has a direct incentive to paint a rosy picture of the company's financial condition in order to meet established performance expectations and bolster their personal compensation.

Second, it is relatively easy to manipulate corporate financial statements because GAAP standards afford a significant amount of flexibility, making it very easy for corporate management to paint a favorable picture of the financial condition of the company.

Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the corporate client. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are compensated by the very companies that they audit. As a result, the auditors could be tempted to bend the accounting rules to portray the financial condition of the company in a manner that will keep their client happy. Moreover, auditors typically receive a significant amount of money from the companies that they audit. Therefore, there is implicit pressure to certify the financial statements of the company in order to retain their business.

Conclusion

Are these ratios the “be all to end all” for pricing a share of stock for a company? Of course they aren’t. There are a lot of factors that go into pricing shares of stock and so it's important to continually sharpen one's skills and put new tools in the toolbox. It makes sense to go through and calculate different multiples such as EV multiple (EV/EBITDA, EV/EBIT), PEG and Dividend yield ratio etc. for all current holdings and for future investments.

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All About Commodities Market

By: Shipra Jha , NMIMS , MBA Capital Markets

WHAT ARE COMMODITIES?

Commodities are one of the most volatile asset classes available to investors .They are interchangeable products which, as a consequence, share a common price. Examples for commodities are goods such as grains, livestock, oil, cotton, or even financial products like currencies, bonds, and stock market indices.

ABOUT COMMODITIES MARKET:

The commodities market has emerged during the modern era as an important player in the way people invest and speculate. The two most-watched commodities by far are crude oil and gold: oil because it is the primary form of energy commodities market use to power international transportation and trade ,  and gold because it is viewed by financial markets as a hedge against rising inflation. Daily price swings in commodities of all kinds can be violent and due to the use of leverage, investors can lose more than their initial investment.

PROCESS :

Prices in the commodities market are determined by the motives of the buyers and sellers, who together make up the market.

TYPES OF COMMODITY MARKET :

A commodities market can be a : Cash market or futures market.

 In the case of a cash market, again it could be either a spot or forward market. In case of a spot market, you get immediate physical delivery of a commodity, whereas in the forward market, you tend to get your commodity delivered at a specific date in future. Both spot markets and forward markets are together known as actuals since actual delivery has to be made in either of the types.

A futures contract is a special type of forward contract. They are designed to reduce risks and increase flexibility of forward contracts. The contract, for instance, may specify delivery points and price variations for discrepancies in the quality of the commodity being shipped.

HOW  VULNERABLE ARE COMMODITY PRICES ?

The recent decline in commodity prices attests to the possibility that commodity prices are vulnerable to a deterioration of the global outlook.

HOW BENEFICIAL HAS QE3 BEEN TO COMMODITIES ?

As the Fed embarked on a third round of quantitative easing, risky assets are rallying hard. Commodities were among the biggest gainers of any asset class following the announcement of QE2.Are commodities poised for similar gains this time round?

Conditions in the macro economy are much less supportive, commodity prices are higher and the impact of successive waves of QE is reduced each time. China’s big build is maturing as capacity catches up with demand and that is beginning to backfire through parts of the global commodities supply chain that has fed China for the past decade. Markets are concerned that with business confidence low, growth faltering and export demand poor, weakness in China’s commodity imports will become more pervasive, especially with high inventories overhanging sectors such as copper and steel. With the dollar weakening and the debate over fiat currency debasement now likely to retake centre stage, QE3 is likely to unleash enough physical and futures market buying to bring to an end to gold’s position as one of the weakest commodity markets in 2012 so far. In terms of current market positioning, base metals look likely to benefit most from better sentiment in the short term, as hedge funds look severely underweight, especially in copper.

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Informed Investor – an asset to the company

Author : Charchit Joshi, NMIMS, MBA Capital Markets

In the past few years the relationship between the corporate managers and investors has gone for a beating. Investors lost money in the turbulent markets. Their disinterest in the scribes brought down the stock prices. And this added to the woes of decision makers and top management of the public companies. Many corporate houses started believing that managers should not take care of the capital market. Managers should do their business, do well and investors will follow the success story. They have forgotten that it is a mutually beneficial relationship which if respected in an honest and transparent way can prove to be a win-win situation for both the involved parties.

Giving true and relevant information to the investors is generally a good business. But doing it in a detailed and unambiguous way is rather more important. Providing investors with something more than just quarterly and annual results can help in maintaining this mutually beneficial relationship between the two.

As per the economic theory of information asymmetry – When one party in a transaction knows more than the other, someone suffers – and it is not whom you might think of. If the seller has more information than the buyer, the sellers are the primary losers, as a suspicious buyer can bring down prices or can quit the market altogether (George Akerlof won Nobel Prize for this). No one would buy a car without inspecting it. Same theory applies to share market as well. By providing the necessary information about the company’s plans and estimates in future a manager can avoid falling share prices, weakening demand, high volatility, higher cost of capital, etc. Such practice if followed by a company eliminates suspicion in investor’s mind. It further helps a company to hold an investor with the company’s stocks for longer period of time and to attract new investors to invest in the company.

To make this practice of information sharing, working, companies should know their investors well. They should dig deep to know what investors want from them. According to a misconception, very prevalent amongst the corporate managers today, those who buy and sell stocks are jumpy and myopic in nature. But it is the other way around. Market is usually dominated by the investors who are more concerned about long term investments rather than short term or intraday investments. Though short term news, fluctuates the market. But the impact of long term forecast revisions and financial reports of the companies have much stronger impact on companies’ share prices. Actually investors suffer from what organizational researchers call, limited attention. It is the inability or rather restricted ability of human brain to process and analyze vast information. Hence investors react to the news that captures the headlines of the News Papers. This causes knee jerk reactions, even from the long term investors, who would have never paid much heed to such news ahead of the forecasted financials of the company.

Hence companies should not only provide its investors with the information about the present financials, but also a detailed report of the future projects, estimated financials , possible threats , opportunities, etc. They should highlight the key points of such detailed information. This will not only help investors to be well informed about the main features of the company’s current and future operations but also help company in safeguarding against the knee jerk reactions to the short term news.

As I said earlier the company investor relationship is a two way bond where interacting with the investor does not always mean giving information. The movements in share prices speak a lot. Capital Market’s response after the announcement of financial results reveals the investors’ expectations and faith on the current management. Knee jerk reactions and sudden short sales often signal some serious trouble with operations of the company that needs to be fixed.

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