This article was first published in the latest issue of the Moneyweb Investor. To read the magazine click here.
There are hundreds of companies listed on the JSE and few people have the time to go through them all. The guide below provides a relatively simple way to scan the results before deciding whether to look at them more closely. In the coming months we will drill into some of the individual components, for instance understanding ROE, in more detail.
- Read the previous result’s management guidance: Most company management teams write about their expectations for the next reporting period within a set of results. Begin by reading the previous set of results to see whether things turned out the way they predicted. If not, why not? This sets the scene for the current results, and lends credibility to management’s guidance within the current
- Check if revenue is up by more than inflation: If revenue is not up by at least inflation, then it probably means that the company’s volumes dropped. At a basic level, this means that the company is actually shrinking. Also consider the effect of acquisitions made in the current and previous reporting period that can distort revenue figures. Try to strip these acquisitive distortions out and then consider if revenues are up by at least If not, then despite what the company may be acquiring, the operations on the ground could well be contracting.
- Check if margins are up or stable: A company’s Gross Profit Margin indicates its product and/or service’s pricing power, while its Operating Profit Margin indicates its operation’s efficiency. All things being equal, if a volume-dependent company’s revenue analysis indicates that volumes are going backwards, then you should expect that its Operating Profit Margin should be slipping. However, keep an eye on whether a company can keep lifting (or at the least maintaining) its Gross Profit Margin, which is less volume dependent and far more powerful. The combination of these checks will indicate how much pricing power a company has, its ability to pass on inflation to its customers, as well as its ability to leverage Returns to Scale. If these are all moving in the right direction, it is a good sign. If they are moving in a contrary manner to revenues, it may indicate that the company is chasing sales at the expense of profits or is building inefficiencies within the group (often trapped within the operating expenses line item and often a symptom of management’s ego), among other things.
- Check Headline Earnings Per Share (HEPS): HEPS theoretically strips out once-offs and non-operational profits and losses, thus consider whether HEPS has risen, fallen or remained flat. Obviously a rising HEPS is better than a falling one. If the profits of the company have risen, but its HEPS has not risen by as much (or even fallen), find the “Weighted Average Number of Ordinary Shares” balance and see if this has risen dramatically over the period. This could be the case when a company has issued a lot of shares for an acquisition or something similar, thus bulking up its profits, but diluting its existing shareholders. If nothing else, this gives you a bit of context on the HEPS movement in relation to the move in profits.
- Check the Cash Conversion Ratio (CCR): This is calculated as the percentage of EBITDA (or even operating profit) which is turning in cash flow from operations. Compare this against the last reporting period and see if this is a high percentage and/or is rising. If this is the case, then the company is nicely cash generative. If the CCR is dropping, the company could be chasing sales at the expense of cash flows (exposing it to growing credit risk in its debtors) and/or its inventory could be building up (exposing it to growing inventory obsolescence risk). In that case, check debtors and inventory balances on the Statement of Financial Position, as you will likely see them growing by more than revenue has grown. Only a high and rising CCR is good, all other possibilities point to a low quality or deteriorating company.
- Read the commentary as background to the numbers: For now ignore the rest of the results and jump straight into management’s commentary thereon. Understand that this commentary will likely be biased as management paints a positive picture, but it should still give you some context in which to understand the rest of the results. If your analysis of (1) to (5) was done properly, you should already have an idea of what management will be touching on in the commentary. Beware if you see negatives in (1) to (5) that management does not comment on. It suggests that management is hiding the negatives and makes further commentary less reliable. Good and honest management will write about the negatives as well as the positives in their commentary.
- Where are the once-offs? Once-offs can seriously distort results, so you should try to identify as many as possible and do your own sums to strip them out of the results. HEPS should capture some of these, but it won’t capture all of them. Consider any unusual transactions that management comment on in #6 above, as they may relate to once-offs and unrepeatable business that you should strip out for a more honest reflection of the underlying business. What you are going after is a true operational reflection of the underlying company, not an IFRS-dictated distortion of reality.
- What happened to debt, finance charges and tax? Consider if the company’s capex is at least matching its depreciation. If not, then surely the company is running its assets into the ground (or its depreciation is overstated and its profits understated)? If the company is spending lots of cash on expanding, where is this cash coming from: cash reserves, debt or otherwise? Take Finance Charges and divide it by the average debt for the period to work out a rough implied interest rate on the company’s debt. If this implied interest rate is very high, then questions have to be asked – if bankers are not comfortable lending to the company, should you be investing in it? Take tax and divide it by Profit Before Tax to get an effective tax rate. Is this close to the relevant statutory tax rate (in SA its 28%)? If not, why not? Low effective tax rates can be great competitive advantages, albeit not always structurally sustainable.
- What is the Return on Equity(ROE)? Calculate the ROE of this period (annualised) and compare it the last period (annualised). Is this rising or falling? Is the ROE above the Cost of Equity (if you are unsure of the company’s nominal Cost of Equity, take 15% as a rule of thumb for a small South African listed company. These all point to either a good quality (and improving) company or a bad quality (and declining) company.
- Dividend and Dividend Cover: Is the company paying dividends? And does it pay them consistently? If so, this is a good sign. Go a step further and see if the company is paying out more or less of its profits from period to period as dividends (Dividend Cover or Dividend Payout Ratio trends). While paying out more profits as dividends is good, it may indicate that the company is going ex-growth. Paying out less profit as dividends is almost always a warning sign.
- Prospects: Finally, taking all of the above into account, consider whether management sound optimistic or pessimistic about the future in the prospects section. Is the tone appropriate to the results? If the results are a disaster, but management is massively optimistic, then questions just have to be asked. Often management try to strike a balance between how tough the environment is (any downside is not their fault) and how the company is well positioned to capitalise on opportunities. Ignore the clichés and focus on anything specific, quantifiable and/or event-based. For example, in the prospects section of a coal mining company, I would ignore all comments on how tough mining is in South Africa and the softness in the coal price (we know this), and focus on any specific comments regarding new mines coming on stream, old mines shutting down, possible acquisitions or any more focused, company-specific commentary. These directly impact on your feeling for the company’s results over the short-term.
And there we have a short list to work through while scanning a company’s results.
Notice that only one of these steps actually looks directly at profits (HEPS). The rest work through commentary, cash flow and context, because a company and its performance is more than just accounting profits, which can be manipulated.
In closing, this is far from a comprehensive list and it does not include any valuation metrics, but hopefully it is helpful as a quick start to re