A large number of people, especially retail investors, are unfamiliar with the term DVRs. Despite the fact that it has been in existence since nearly a decade now, DVRs offer more potential in terms of returns. In fact, since they are lesser known, DVRs of some of the companies are undervalued. Unlike their perception of being a complicated product, DVRs are simple to understand as well as invest.
IMPORTANCE OF DVRS
Every ordinary equity share and its owner have equal rights in a company. If a company wants to take a decision or take over another company, it will have to seek the approval of its owners or its shareholders, who in turn, will express their decision by exercising their voting rights. If companies do not get the requisite votes from their shareholders, then it cannot pass any resolution or take decisions on matters that require the approval of the shareholders. There are practical issues too. If you ask company managements what they prefer, they would say they much rather have institutional investors as shareholders of the company, but would also prefer them not interfering in the day to day running of the company. Many companies are known to have found it difficult to convince institutional shareholders or large shareholders while seeking their votes for particular decisions. Many a times institutional investors block certain resolutions and companies are forced to rollback resolutions in the event of opposition or the inability to obtain enough votes. There are circumstances when companies want to raise funds by issuing additional shares, but they fear they would lose control as issuance of additional shares could result in the dilution of voting rights. For instance, promoters of a company have a 51% stake. And following the issuance of additional shares, the same could fall to 40%. In such a situation, the company might fear losing control and also face difficulties in seeking approval. Moreover, a higher stake dilution could create the threat of a hostile takeover of the company. All these situations, particularly for family-run businesses, could have devastating effects on companies.
SOLUTION IN ITSELF
A DVR share, as the name suggests, has solutions to all these problems or the issues that companies and investors face. These shares carry differential voting rights. This means the shares will remain the same in all respects compared to the ordinary listed equity shares, but will carry differential voting rights. In this case, say a investor who holds 100 DVR shares, might be having voting rights equivalent of 10 or one-tenth of every DVR, whereas an ordinary equity shareholder who holds 100 shares could have voting rights equivalent to 100. Through the DVR route, the company may raise funds without diluting rights because they could carry lower voting rights. This might solve the company’s problem. But what about the problems of investors? Why would they have lesser voting rights even if they really do not exercise them? It is true in the Indian context that not many, especially retail investors, exercise their voting rights.
ADVANTAGE: DISCOUNTED PRICE WITH HIGHER DIVIDEND
Why should one shareholder (DVR) be deprived and the other be given more privilege (in terms of voting rights)? In view of these valid arguments, the need to compensate DVR holders with lower voting rights arises. This is why companies offer DVR shares at a lower price compared to their counterparts - ordinary equity shares. But what will the investor do if the markets closed for the next five years? Do not worry.
DVR holders are compensated with higher dividends. This means that if ordinary shareholders are issued 10% dividend, the DVR holders get an additional dividend of 15% or 5%. Let us now take actual examples to understand this better. In India, leading automobile company, Tata Motors, was the first to offer DVR shares. Its DVR shares have one voting right for every 10 DVR shares held by its owners.
So, in this case voting rights are almost one-tenth compared to voting rights enjoyed by ordinary equity shareholders. Therefore, if you buy Tata Motors DVR today, they will have lesser voting rights. However, for the lesser voting rights you are compensated by way of price. Today ordinary equity shares of Tata Motors are trading at around `279 per share (as on 9th March) whereas DVR shares are trading at around `155 per share (as on 9th March). This is almost a 45% discount compared to ordinary shares. That apart, Tata Motors pays a 5% additional dividend. So as the company is expected to declare per share dividend of `4 next year to its ordinary shareholders, the DVR holders will get 5% higher dividend, which will total to `4.2 per share.
In the first case, one is buying DVRs at 45% discount. Secondly, if today one invests in ordinary shares at `279, then the dividend earnings will be about 1.4%. And if the same money is invested in DVRs, then the dividend earnings next year will be almost 2.8% if we include the benefit of 5% higher divided for DVR holders.
HOW MUCH DISCOUNT ?
By now it must be clear as to why DVRs trade at a discount. However, the bigger question is at how much discount should DVRs trade at and how should we value them. The quantum of discount could depend on several factors. But in India, in general, the discount is observed to be much more compared to the discount in the global markets. Globally, the concept of DVRs is quite old and well understood by investors. Many global giants like Berkshire Hathaway, Google, News Corp, etc have issued DVR shares in the past. The global price pattern suggests that most of them typically trade at about 0-15% discount compared to ordinary shares. In India the discount is as high as 40% to 50%, which many believe is not justified.
PRICE: A REFLECTION OF LOW AWARENESS
Though this looks illogical, it is largely on account of the fact that despite having four listed DVRs at present, the awareness of the product is very low. This can be gauged from the fact that most DVRs have very low volumes or liquidity. Also, only institutional investors or large investors have invested in DVRs in India. The participation of retail investors is still very low. It is possible that in the long run as a result of increased awareness, participation could increase, leading to the discovery of the logical or reasonable price of DVRs. In such a situation, the current discount on DVRs could also narrow down to the global benchmark.
SHOULD YOU BUY DVRs
Given a chance what would you buy - ordinary shares of Tata Motors or its DVR, which are trading at 45% discount and offering a far higher dividend yield? If you are an investor who is not interested in voting rights, why not invest in DVRs, which for no major reason trades at much cheaper prices. The odds are in favour of DVRs as in the long run investors will not only gain on account of structural investment story but also on account of higher dividends. Imagine you have invested in the DVR of a company which is in the growth phase and is expected to increase its dividend payouts over the long term. In such a situation, the dividend income alone could be far more rewarding. Not to forget, if in the long run, the gap between DVR prices and ordinary shares gets narrower, then there will be an additional kicker to the overall returns, which could be very high if it happens at higher prices in the future. Hence, factors like DVR discount compared to ordinary shares, dividend yield, ratio of voting rights and size of the equity capital play a critical role while determining the price of DVRs. However, simply going by the discount on DVR shares may not work always as rules of investing in equity shares do not change for DVR shares. This is nothing but one more form of equity shares albeit with lesser voting rights. Investors need to carefully understand the prospects of the company, industry in which it is operating and the company management like we do before investing in equity shares of the company.
To conclude, DVRs could be a far better instrument for long-term investors who are not very enthusiastic about voting rights. However, in the short term, the only visible risk to these instruments is that they trade with very thin volumes, which is why they tend to fall higher in falling markets as investors tend to sell them at lower prices in a bid to exit them.
However, this particular risk will largely influence short-term investors; long-term investors can still leverage on them.
DETAILS OF LISTED DVRs
Tata Motors
Tata Motors issued DVRs in the year 2008 to fund its global acquisition. In that year, the company announced rights issue, which also comprised DVR shares offered at `295 a share compared to ordinary new shares offered at `330 a share. In the case of Tata Motors’ DVR, investors have voting rights of one-tenth with the privilege to get 5% additional dividend compared to ordinary shareholders of the company.
Pantaloon Retail
Pantaloon issued its DVRs in the year 2008 through the issuance of bonus shares to existing ordinary shareholders of the company. Its DVR has voting rights of one for every 10 DVRs held by its owner. However, its DVR investors enjoy 5% additional dividends compared to ordinary shareholders of the company. Currently, Pantaloon’s DVR at the current price of `102 (as on 13th March) is trading at 37% discount to its ordinary shares which are trading at `161 per share (as on 13th March).
Gujarat NRE Coke
The private sector coking coal supplier, Gujarat NRE issued DVRs in the year 2010. Its DVR carries a voting right of one for every 100 DVRs held by its investors. Its DVR at the current price of `15.3 per share is trading at a 40% discount. However, investors should be aware that the trading volumes in the case of Gujarat NRE’s DVR is very less. The average two-week trading volumes in the counter stood at just about 7,700 shares compared to 9.31 lakh shares in the case of ordinary shares.
Jain Irrigation DVR
Jain Irrigation, which is the leading player in micro irrigation system, issued DVR shares recently in November ’11 in the form of bonus to its existing shareholders. Its 10 DVRs carry voting rights equal to voting rights of one ordinary share. Relatively, in the case of DVRs’ of Jain Irrigation, the discount is larger as currently its DVR is trading at almost 50% discount at around `52 per share (as on 13th March) compared to `108 per share price (as on 13th March) in case of the ordinary shares of Jain Irrigation.
Showing posts with label finance. investing. Show all posts
Showing posts with label finance. investing. Show all posts
Thursday, March 29, 2012
Saturday, September 10, 2011
8 Steps To Financial Analytic Intelligence
The following 8 financial ratios offer terrific insights into the financial health of a company -- and the prospects for a rise in its share price.
1. Ploughback and Reserves
After deduction of all expenses, including taxes, the net profits of a company are split into two parts -- dividends and ploughback.
Dividend is that portion of a company's profits which is distributed to its shareholders, whereas ploughback is the portion that the company retains and gets added to its reserves.
The figures for ploughback and reserves of any company can be obtained by a cursory glance at its balance sheet and profit and loss account.
Ploughback is important because it not only increases the reserves of a company but also provides the company with funds required for its growth and expansion. All growth companies maintain a high level of ploughback. So if you are looking for a growth company to invest in, you should examine its ploughback figures.
Companies that have no intention of expanding are unlikely to plough back a large portion of their profits.
Reserves constitute the accumulated retained profits of a company. It is important to compare the size of a company's reserves with the size of its equity capital. This will indicate whether the company is in a position to issue bonus shares.
As a rule-of-thumb, a company whose reserves are double that of its equity capital should be in a position to make a liberal bonus issue.
Retained profits also belong to the shareholders. This is why reserves are often referred to as shareholders' funds. Therefore, any addition to the reserves of a company will normally lead to a corresponding an increase in the price of your shares.
The higher the reserves, the greater will be the value of your shareholding. Retained profits (ploughback) may not come to you in the form of cash, but they benefit you by pushing up the price of your shares.
2. Book Value per Share
You will come across this term very often in investment discussions. Book value per share indicates what each share of a company is worth according to the company's books of accounts.
The company's books of account maintain a record of what the company owns (assets), and what it owes to its creditors (liabilities). If you subtract the total liabilities of a company from its total assets, then what is left belongs to the shareholders, called the shareholders' funds.
If you divide shareholders' funds by the total number of equity shares issued by the company, the figure that you get will be the book value per share.
Book Value per share = Shareholders' funds / Total number of equity shares issued
The figure for shareholders' funds can also be obtained by adding the equity capital and reserves of the company.
Book value is a historical record based on the original prices at which assets of the company were originally purchased. It doesn't reflect the current market value of the company's assets.
Therefore, book value per share has limited usage as a tool for evaluating the market value or price of a company's shares. It can, at best, give you a rough idea of what a company's shares should at least be worth.
The market prices of shares are generally much higher than what their book values indicate. Therefore, if you come across a share whose market price is around its book value, the chances are that it is under-priced. This is one way in which the book value per share ratio can prove useful to you while assessing whether a particular share is over- or under-priced.
3. Earnings per share (EPS)
EPS is a well-known and widely used investment ratio. It is calculated as:
Earnings Per Share (EPS) = Profit After Tax / Total number of equity shares issued
This ratio gives the earnings of a company on a per share basis. In order to get a clear idea of what this ratio signifies, let us assume that you possess 100 shares with a face value of Rs 10 each in XYZ Ltd. Suppose the earnings per share of XYZ Ltd. is Rs 6 per share and the dividend declared by it is 20 per cent, or Rs 2 per share. This means that each share of XYZ Ltd. earns Rs 6 every year, even though you receive only Rs 2 out of it as dividend.
The remaining amount, Rs 4 per share, constitutes the ploughback or retained earnings. If you had bought these shares at par, it would mean a 60 per cent return on your investment, out of which you would receive 20 per cent as dividend and 40 per cent would be the ploughback. This ploughback of 40 per cent would benefit you by pushing up the market price of your shares. Ideally speaking, your shares should appreciate by 40 per cent from Rs 10 to Rs 14 per share.
This illustration serves to drive home a basic investment lesson. You should evaluate your investment returns not on the basis of the dividend you receive, but on the basis of the earnings per share. Earnings per share is the true indicator of the returns on your share investments.
Suppose you had bought shares in XYZ Ltd at double their face value, i.e. at Rs 20 per share. Then an EPS of Rs 6 per share would mean a 30 per cent return on your investment, of which 10 per cent (Rs 2 per share) is dividend, and 20 per cent (Rs 4 per share) the ploughback.
Under ideal conditions, ploughback should push up the price of your shares by 20 per cent, i.e. from Rs 20 to 24 per share. Therefore, irrespective of what price you buy a particular company's shares at its EPS will provide you with an invaluable tool for calculating the returns on your investment.
4. Price earnings ratio (P/E)
The price earnings ratio (P/E) expresses the relationship between the market price of a company's share and its earnings per share:
Price/Earnings Ratio (P/E) = Price of the share / Earnings per share
This ratio indicates the extent to which earnings of a share are covered by its price. If P/E is 5, it means that the price of a share is 5 times its earnings. In other words, the company's EPS remaining constant, it will take you approximately five years through dividends plus capital appreciation to recover the cost of buying the share. The lower the P/E, lesser the time it will take for you to recover your investment.
P/E ratio is a reflection of the market's opinion of the earnings capacity and future business prospects of a company. Companies which enjoy the confidence of investors and have a higher market standing usually command high P/E ratios.
For example, blue chip companies often have P/E ratios that are as high as 20 to 60. However, most other companies in India [ Images ] have P/E ratios ranging between 5 and 20.
On the face of it, it would seem that companies with low P/E ratios would offer the most attractive investment opportunities. This is not always true. Companies with high current earnings but dim future prospects often have low P/E ratios.
Obviously such companies are not good investments, notwithstanding their P/E ratios. As an investor your primary concern is with the future prospects of a company and not so much with its present performance. This is the main reason why companies with low current earnings but bright future prospects usually command high P/E ratios.
To a great extent, the present price of a share, discounts, i.e. anticipates, its future earnings.
All this may seem very perplexing to you because it leaves the basic question unanswered: How does one use the P/E ratio for making sound investment decisions?
The answer lies in utilising the P/E ratio in conjunction with your assessment of the future earnings and growth prospects of a company. You have to judge the extent to which its P/E ratio reflects the company's future prospects.
If it is low compared to the future prospects of a company, then the company's shares are good for investment. Therefore, even if you come across a company with a high P/E ratio of 25 or 30 don't summarily reject it because even this level of P/E ratio may actually be low if the company is poised for meteoric future growth. On the other hand, a low P/E ratio of 4 or 5 may actually be high if your assessment of the company's future indicates sharply declining sales and large losses.
5. Dividend and yield
There are many investors who buy shares with the objective of earning a regular income from their investment. Their primary concern is with the amount that a company gives as dividends -- capital appreciation being only a secondary consideration. For such investors, dividends obviously play a crucial role in their investment calculations.
It is illogical to draw a distinction between capital appreciation and dividends. Money is money -- it doesn't really matter whether it comes from capital appreciation or from dividends.
A wise investor is primarily concerned with the total returns on his investment -- he doesn't really care whether these returns come from capital appreciation or dividends, or through varying combinations of both. In fact, investors in high tax brackets prefer to get most of their returns through long-term capital appreciation because of tax considerations.
Companies that give high dividends not only have a poor growth record but often also poor future growth prospects. If a company distributes the bulk of its earnings in the form of dividends, there will not be enough ploughback for financing future growth.
On the other hand, high growth companies generally have a poor dividend record. This is because such companies use only a relatively small proportion of their earnings to pay dividends. In the long run, however, high growth companies not only offer steep capital appreciation but also end up paying higher dividends.
On the whole, therefore, you are likely to get much higher total returns on your investment if you invest for capital appreciation rather than for dividends. In short, it all boils down to whether you are prepared to sacrifice a part of your immediate dividend income in the expectation of greater capital appreciation and higher dividends in the years to come and the whole issue is basically a trade-off between capital appreciation and income.
Investors are not really interested in dividends but in the relationship that dividends bear to the market price of the company's shares. This relationship is best expressed by the ratio called yield or dividend yield:
Yield = (Dividend per share / market price per share) x 100
Yield indicates the percentage of return that you can expect by way of dividends on your investment made at the prevailing market price. The concept of yield is best clarified by the following illustration.
Let us suppose you have invested Rs 2,000 in buying 100 shares of XYZ Ltd at Rs 20 per share with a face value of Rs 10 each.
If XYZ announces a dividend of 20 per cent (Rs 2 per share), then you stand to get a total dividend of Rs 200. Since you bought these shares at Rs 20 per share, the yield on your investment is 10 per cent (Yield = 2/20 x 100). Thus, while the dividend was 20 per cent; but your yield is actually 10 per cent.
The concept of yield is of far greater practical utility than dividends. It gives you an idea of what you are earning through dividends on the current market price of your shares.
Average yield figures in India usually vary around 2 per cent of the market value of the shares. If you have a share portfolio consisting of shares belonging to a large number of both high-growth and high-dividend companies, then on an average your dividend in-come is likely to be around 2 per cent of the total market value of your portfolio.
6. Return on Capital Employed (ROCE) and
7. Return on Net Worth (RONW)
While analysing a company, the most important thing you would like to know is whether the company is efficiently using the capital (shareholders' funds plus borrowed funds) entrusted to it.
While valuing the efficiency and worth of companies, we need to know the return that a company is able to earn on its capital, namely its equity plus debt. A company that earns a higher return on the capital it employs is more valuable than one which earns a lower return on its capital. The tools for measuring these returns are:
1. Return on Capital Employed (ROCE), and
2. Return on Net Worth (RONW).
Return on Capital Employed and Return on Net Worth (shareholders funds) are valuable financial ratios for evaluating a company's efficiency and the quality of its management. The figures for these ratios are commonly available in business magazines, annual reports and economic newspapers and financial Web sites.
Return on capital employed
Return on capital employed (ROCE) is best defined as operating profit divided by capital employed (net worth plus debt).
The figure for operating profit is arrived at after adding back taxes paid, depreciation, extraordinary one-time expenses, and deducting extraordinary one-time income and other income (income not earned through mainline operations), to the net profit figure.
The operating profit of a company is a better indicator of the profits earned by it than is the net profit.
ROCE thus reflects the overall earnings performance and operational efficiency of a company's business. It is an important basic ratio that permits an investor to make inter-company comparisons.
Return on net worth
Return on net worth (RONW) is defined as net profit divided by net worth. It is a basic ratio that tells a shareholder what he is getting out of his investment in the company.
ROCE is a better measure to get an idea of the overall profitability of the company's operations, while RONW is a better measure for judging the returns that a shareholder gets on his investment.
The use of both these ratios will give you a broad picture of a company's efficiency, financial viability and its ability to earn returns on shareholders' funds and capital employed.
8. PEG ratio
PEG is an important and widely used ratio for forming an estimate of the intrinsic value of a share. It tells you whether the share that you are interested in buying or selling is under-priced, fully priced or over-priced.
For this you need to link the P/E ratio discussed earlier to the future growth rate of the company. This is based on the assumption that the higher the expected growth rate of the company, the higher will be the P/E ratio that the company's share commands in the market.
The reverse is equally true. The P/E ratio cannot be viewed in isolation. It has to be viewed in the context of the company's future growth rate. The PEG is calculated by dividing the P/E by the forecasted growth rate in the EPS (earnings per share) of the company.
As a broad rule of the thumb, a PEG value below 0.5 indicates a very attractive buying opportunity, whereas a selling opportunity emerges when the PEG crosses 1.5, or even 2 for that matter.
The catch here is to accurately calculate the future growth rate of earnings (EPS) of the company. Wide and intensive reading of investment and business news and analysis, combined with experience will certainly help you to make more accurate forecasts of company earnings.
1. Ploughback and Reserves
After deduction of all expenses, including taxes, the net profits of a company are split into two parts -- dividends and ploughback.
Dividend is that portion of a company's profits which is distributed to its shareholders, whereas ploughback is the portion that the company retains and gets added to its reserves.
The figures for ploughback and reserves of any company can be obtained by a cursory glance at its balance sheet and profit and loss account.
Ploughback is important because it not only increases the reserves of a company but also provides the company with funds required for its growth and expansion. All growth companies maintain a high level of ploughback. So if you are looking for a growth company to invest in, you should examine its ploughback figures.
Companies that have no intention of expanding are unlikely to plough back a large portion of their profits.
Reserves constitute the accumulated retained profits of a company. It is important to compare the size of a company's reserves with the size of its equity capital. This will indicate whether the company is in a position to issue bonus shares.
As a rule-of-thumb, a company whose reserves are double that of its equity capital should be in a position to make a liberal bonus issue.
Retained profits also belong to the shareholders. This is why reserves are often referred to as shareholders' funds. Therefore, any addition to the reserves of a company will normally lead to a corresponding an increase in the price of your shares.
The higher the reserves, the greater will be the value of your shareholding. Retained profits (ploughback) may not come to you in the form of cash, but they benefit you by pushing up the price of your shares.
2. Book Value per Share
You will come across this term very often in investment discussions. Book value per share indicates what each share of a company is worth according to the company's books of accounts.
The company's books of account maintain a record of what the company owns (assets), and what it owes to its creditors (liabilities). If you subtract the total liabilities of a company from its total assets, then what is left belongs to the shareholders, called the shareholders' funds.
If you divide shareholders' funds by the total number of equity shares issued by the company, the figure that you get will be the book value per share.
Book Value per share = Shareholders' funds / Total number of equity shares issued
The figure for shareholders' funds can also be obtained by adding the equity capital and reserves of the company.
Book value is a historical record based on the original prices at which assets of the company were originally purchased. It doesn't reflect the current market value of the company's assets.
Therefore, book value per share has limited usage as a tool for evaluating the market value or price of a company's shares. It can, at best, give you a rough idea of what a company's shares should at least be worth.
The market prices of shares are generally much higher than what their book values indicate. Therefore, if you come across a share whose market price is around its book value, the chances are that it is under-priced. This is one way in which the book value per share ratio can prove useful to you while assessing whether a particular share is over- or under-priced.
3. Earnings per share (EPS)
EPS is a well-known and widely used investment ratio. It is calculated as:
Earnings Per Share (EPS) = Profit After Tax / Total number of equity shares issued
This ratio gives the earnings of a company on a per share basis. In order to get a clear idea of what this ratio signifies, let us assume that you possess 100 shares with a face value of Rs 10 each in XYZ Ltd. Suppose the earnings per share of XYZ Ltd. is Rs 6 per share and the dividend declared by it is 20 per cent, or Rs 2 per share. This means that each share of XYZ Ltd. earns Rs 6 every year, even though you receive only Rs 2 out of it as dividend.
The remaining amount, Rs 4 per share, constitutes the ploughback or retained earnings. If you had bought these shares at par, it would mean a 60 per cent return on your investment, out of which you would receive 20 per cent as dividend and 40 per cent would be the ploughback. This ploughback of 40 per cent would benefit you by pushing up the market price of your shares. Ideally speaking, your shares should appreciate by 40 per cent from Rs 10 to Rs 14 per share.
This illustration serves to drive home a basic investment lesson. You should evaluate your investment returns not on the basis of the dividend you receive, but on the basis of the earnings per share. Earnings per share is the true indicator of the returns on your share investments.
Suppose you had bought shares in XYZ Ltd at double their face value, i.e. at Rs 20 per share. Then an EPS of Rs 6 per share would mean a 30 per cent return on your investment, of which 10 per cent (Rs 2 per share) is dividend, and 20 per cent (Rs 4 per share) the ploughback.
Under ideal conditions, ploughback should push up the price of your shares by 20 per cent, i.e. from Rs 20 to 24 per share. Therefore, irrespective of what price you buy a particular company's shares at its EPS will provide you with an invaluable tool for calculating the returns on your investment.
4. Price earnings ratio (P/E)
The price earnings ratio (P/E) expresses the relationship between the market price of a company's share and its earnings per share:
Price/Earnings Ratio (P/E) = Price of the share / Earnings per share
This ratio indicates the extent to which earnings of a share are covered by its price. If P/E is 5, it means that the price of a share is 5 times its earnings. In other words, the company's EPS remaining constant, it will take you approximately five years through dividends plus capital appreciation to recover the cost of buying the share. The lower the P/E, lesser the time it will take for you to recover your investment.
P/E ratio is a reflection of the market's opinion of the earnings capacity and future business prospects of a company. Companies which enjoy the confidence of investors and have a higher market standing usually command high P/E ratios.
For example, blue chip companies often have P/E ratios that are as high as 20 to 60. However, most other companies in India [ Images ] have P/E ratios ranging between 5 and 20.
On the face of it, it would seem that companies with low P/E ratios would offer the most attractive investment opportunities. This is not always true. Companies with high current earnings but dim future prospects often have low P/E ratios.
Obviously such companies are not good investments, notwithstanding their P/E ratios. As an investor your primary concern is with the future prospects of a company and not so much with its present performance. This is the main reason why companies with low current earnings but bright future prospects usually command high P/E ratios.
To a great extent, the present price of a share, discounts, i.e. anticipates, its future earnings.
All this may seem very perplexing to you because it leaves the basic question unanswered: How does one use the P/E ratio for making sound investment decisions?
The answer lies in utilising the P/E ratio in conjunction with your assessment of the future earnings and growth prospects of a company. You have to judge the extent to which its P/E ratio reflects the company's future prospects.
If it is low compared to the future prospects of a company, then the company's shares are good for investment. Therefore, even if you come across a company with a high P/E ratio of 25 or 30 don't summarily reject it because even this level of P/E ratio may actually be low if the company is poised for meteoric future growth. On the other hand, a low P/E ratio of 4 or 5 may actually be high if your assessment of the company's future indicates sharply declining sales and large losses.
5. Dividend and yield
There are many investors who buy shares with the objective of earning a regular income from their investment. Their primary concern is with the amount that a company gives as dividends -- capital appreciation being only a secondary consideration. For such investors, dividends obviously play a crucial role in their investment calculations.
It is illogical to draw a distinction between capital appreciation and dividends. Money is money -- it doesn't really matter whether it comes from capital appreciation or from dividends.
A wise investor is primarily concerned with the total returns on his investment -- he doesn't really care whether these returns come from capital appreciation or dividends, or through varying combinations of both. In fact, investors in high tax brackets prefer to get most of their returns through long-term capital appreciation because of tax considerations.
Companies that give high dividends not only have a poor growth record but often also poor future growth prospects. If a company distributes the bulk of its earnings in the form of dividends, there will not be enough ploughback for financing future growth.
On the other hand, high growth companies generally have a poor dividend record. This is because such companies use only a relatively small proportion of their earnings to pay dividends. In the long run, however, high growth companies not only offer steep capital appreciation but also end up paying higher dividends.
On the whole, therefore, you are likely to get much higher total returns on your investment if you invest for capital appreciation rather than for dividends. In short, it all boils down to whether you are prepared to sacrifice a part of your immediate dividend income in the expectation of greater capital appreciation and higher dividends in the years to come and the whole issue is basically a trade-off between capital appreciation and income.
Investors are not really interested in dividends but in the relationship that dividends bear to the market price of the company's shares. This relationship is best expressed by the ratio called yield or dividend yield:
Yield = (Dividend per share / market price per share) x 100
Yield indicates the percentage of return that you can expect by way of dividends on your investment made at the prevailing market price. The concept of yield is best clarified by the following illustration.
Let us suppose you have invested Rs 2,000 in buying 100 shares of XYZ Ltd at Rs 20 per share with a face value of Rs 10 each.
If XYZ announces a dividend of 20 per cent (Rs 2 per share), then you stand to get a total dividend of Rs 200. Since you bought these shares at Rs 20 per share, the yield on your investment is 10 per cent (Yield = 2/20 x 100). Thus, while the dividend was 20 per cent; but your yield is actually 10 per cent.
The concept of yield is of far greater practical utility than dividends. It gives you an idea of what you are earning through dividends on the current market price of your shares.
Average yield figures in India usually vary around 2 per cent of the market value of the shares. If you have a share portfolio consisting of shares belonging to a large number of both high-growth and high-dividend companies, then on an average your dividend in-come is likely to be around 2 per cent of the total market value of your portfolio.
6. Return on Capital Employed (ROCE) and
7. Return on Net Worth (RONW)
While analysing a company, the most important thing you would like to know is whether the company is efficiently using the capital (shareholders' funds plus borrowed funds) entrusted to it.
While valuing the efficiency and worth of companies, we need to know the return that a company is able to earn on its capital, namely its equity plus debt. A company that earns a higher return on the capital it employs is more valuable than one which earns a lower return on its capital. The tools for measuring these returns are:
1. Return on Capital Employed (ROCE), and
2. Return on Net Worth (RONW).
Return on Capital Employed and Return on Net Worth (shareholders funds) are valuable financial ratios for evaluating a company's efficiency and the quality of its management. The figures for these ratios are commonly available in business magazines, annual reports and economic newspapers and financial Web sites.
Return on capital employed
Return on capital employed (ROCE) is best defined as operating profit divided by capital employed (net worth plus debt).
The figure for operating profit is arrived at after adding back taxes paid, depreciation, extraordinary one-time expenses, and deducting extraordinary one-time income and other income (income not earned through mainline operations), to the net profit figure.
The operating profit of a company is a better indicator of the profits earned by it than is the net profit.
ROCE thus reflects the overall earnings performance and operational efficiency of a company's business. It is an important basic ratio that permits an investor to make inter-company comparisons.
Return on net worth
Return on net worth (RONW) is defined as net profit divided by net worth. It is a basic ratio that tells a shareholder what he is getting out of his investment in the company.
ROCE is a better measure to get an idea of the overall profitability of the company's operations, while RONW is a better measure for judging the returns that a shareholder gets on his investment.
The use of both these ratios will give you a broad picture of a company's efficiency, financial viability and its ability to earn returns on shareholders' funds and capital employed.
8. PEG ratio
PEG is an important and widely used ratio for forming an estimate of the intrinsic value of a share. It tells you whether the share that you are interested in buying or selling is under-priced, fully priced or over-priced.
For this you need to link the P/E ratio discussed earlier to the future growth rate of the company. This is based on the assumption that the higher the expected growth rate of the company, the higher will be the P/E ratio that the company's share commands in the market.
The reverse is equally true. The P/E ratio cannot be viewed in isolation. It has to be viewed in the context of the company's future growth rate. The PEG is calculated by dividing the P/E by the forecasted growth rate in the EPS (earnings per share) of the company.
As a broad rule of the thumb, a PEG value below 0.5 indicates a very attractive buying opportunity, whereas a selling opportunity emerges when the PEG crosses 1.5, or even 2 for that matter.
The catch here is to accurately calculate the future growth rate of earnings (EPS) of the company. Wide and intensive reading of investment and business news and analysis, combined with experience will certainly help you to make more accurate forecasts of company earnings.
Monday, June 7, 2010
A Lesson In Open Offer – The ABB Example
The offer by ABB Asea Brown Boveri and ABB (
Calculation:
Is there any arbitrage available or should one buy taking open offer into consideration?
ABB current price = Rs 826 e.g. 100 shares are bought.
Currently, ABB holds 52.11% and it has offered to buy 22.89% more which would take their stake to 75% in
So if one buys 100 shares, approximately 48 would go into open offer and he will get payout @ Rs 900 a share.
Net Profit on tendered shares = (Rs 900 - Rs 826) X 48 = Rs 74 X 48 = Rs 3,552.
Net Profit = 4.3% on total capital invested, decent returns for holding period of around 2.5 months!
What History Teaches Us:
Ranbaxy shareholders were given a similar open offer which was way above its market price at that time and it was at Rs 737 a share from Daiichi Sankyo of
Why Foreign Companies Give Open Offers?
They are investing in businesses and not at all interested in small short term gains, they think of 5-10 years in advance minimum and bet on future of the economy which a common retail investor doesn`t do.
In case of ABB, the open offer price looks really stretched as the company is already trading at a P/E multiple of 62 and at Rs 900 it would go beyond 67 which is not at all cheap by any stretch of imagination.
ABB has reported an average decline of 34.5% in profits for the past four quarters ended December 2009. The performance has taken a further sharp blow in the March 2010 quarter, with profits falling by 92%. The company`s financial performance has been disappointing mainly due to its exit from a key business segment, delays in some of the projects and fluctuation in input prices.
Company imports nearly 40% of its raw material requirement and is exposed to a large foreign exchange risk; it has to follow an active hedging policy which may be lacking so far. Recent rupee appreciation may hurt financials more.
The probability of giving shares in open offer may go down also as public holding currently stands at less than 15%, which means that the company would have to convince the institutional investors, who hold a total of around 33%, to respond to the offer.
Looking at company prospects in immediate future and history of similar open offer it looks wise to take profits at current market price or have small exposure as stock may fall after the event is over. Even an 8% drop from current levels would take the investor into losses if one buys from the viewpoint of open offer now. If parent doesn`t have intentions of de-listing,profit for the investor is not guaranteed by any open offer.
Subscribe to:
Posts (Atom)