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.
