This post is entirely contributed by our veteran community member, Tam Ging Wien, author of REITs to Riches: Everything You Need to Know About Investing Profitably in REITs
We decided contribute to the InvestingNote community with an educational piece to demystify the 3 financial statements.
When we read we begin with A…B…C…, when we sing we begin with Do… Re…Me…
That at least how the song lyrics go.
But when we want to understand and assess the financials of a stock, we need to begin with the 3 financial statements, namely:
- Balance Sheet (or Statement of Financial Position)
- Income Statement (or Profit/Loss Statement)
- Cash Flow Statement
In our last “The Beginner’s Guide to…” series, we covered the The Beginner’s Guide to Understanding The 3 Financial Statements.
After having an understand of the 3 financial statements, we continue the series with analysing these financial statements in order to understand the financial health of a company. In this post, we will be learning how to analyse the Income Statement.
Do read the previous articles first before continuing as it will give you a firm foundation of the 3 core financial statements.
Cash Flow Statement
Free Cash Flow
Free cash flow is simply the difference between the operating cash flow and the capital expenditure. This gives us a good measure of how much cash is generated by the business on a periodic basis. Another way to think of the Free Cash Flow is the amount of cash generated by the business after spending money required to maintain or increase its assets.
It is possible for companies to sometimes have their earnings impacted by non-cash profits or losses. For example, when a property owned by the company appreciates in value, the increased value can be recorded as a profit to the company. However, this gain is only on paper since the value is not actually realised as the property is not sold. Similarly, a company could record deprecation of their assets as losses and this will reduce the overall profit of the company.
Such non-cash effects on the profits sometimes may not paint an accurate picture of the actual cash flow generated by the business. Therefore, the Free Cash Flow provides a complimentary picture of the business’ cash flow. If the Free Cash Flow is consistently close to the Net Income of the business, we can conclude that the majority of the business profits are collected in cash.
As an investor, the cash flow of the business is akin to the life line to a human. Cash flow is what sustains the business. Businesses could make large profits but if they run into cash flow problems, they may end up becoming insolvent. Insolvency is a state where the business may still have enough asset value, but does not have the appropriate form (ie cash) to continue operation.
It would be desirable for a company to maintain a high free cash flow as that means that the company probably requires a low capital expenditure to maintain it’s business. However, on-off low or negative free cash flow may not necessarily be bad as the company could be incurring a higher capital expense in that period as an investment for future business growth.
Putting the Analysis of the 3 Financial Statement All Together
We have come a long way in our analysis of the business’ 3 financial statements. Using a combination of these matrices and ratios, we could easily determine if a particular company is a suitable investment. Ideally, we should search for a stocks that consistently exhibits the following characteristics:-
- Current ratio above 2.00
- Quick ratio above 1.25
- Cash ratio above 1.00
- Gearing ratio below 0.5
- Debt-to-Equity ratio below 0.75
- Gross income margins above 25%
- Operating income margins above 10%
- Pre-tax income margins above 10%
- Net income margins above 10%
- ROA above 10%
- ROE above 15%
- Free cash flow close or exceeding it’s net profit consistently
Such companies are rare and few, but when they are found, they make excellent investments. In the majority of cases, an investor may find good quality companies but 2 or 3 of the above criteria will not be met. In such cases, investors should weight the risks of those criteria that are not being met and consider if the investment is worthwhile compared to the risk they are going to take.
While it is important to use the criteria above to determine what stocks to buy, it is just as important to determine what price to pay for the stock. To do so, you need 2 important ratios, the P/E Ratio and the P/B Ratio.
Price-to-Earnings (P/E) Ratio
The P/E Ratio is one of the most commonly used metric for valuing a stock price. This is the ratio of the stock price at a specific point of time to the Earnings Per Share (EPS). The earnings used are typically the annualised figures which are the sum of all the earnings in the last 4 quarters. This is known as the 12-month trailing P/E Ratio. If the earnings used are based on forecasted or projected earnings in the next 12-months, then it will be known as the forward or leading P/E Ratio.
The P/E Ratio can be thought of as the amount of years it will take for the company to earn back the amount paid for the stock. This means that if an investor paid $0.635 for a stock, the company would take 8.56 years to earn back the amount invested.
The P/E Ratio could be plotted over a series of quarters of years to determine which was the lowest P/E ratio the stock transacted at historically. If the stock price is trading close to this historical low, it could signal a good entry price.
Another way the P/E Ratio could be used is by comparing similar companies in the same industry. For example, in the case of The Hour Glass, the P/E Ratio can be compared to Cortina Watches to get a sense of which stock is trading at a better value.
This method of evaluating a stock price is useful for an investor to decide what the optimal entry price is considering the potential downside risk vs the upside rewards. This will help the investor avoid overpaying for a stock.
The problem with the P/E Ratio is that it would become meaningless if the EPS is negative for the period. In other words, if the company made a loss instead of a profit, the P/E Ratio cannot be used for valuation.
Price-to-Book (P/B) Ratio
The P/B Ratio is another commonly used metric for valuing a stock price. It is the ratio of the stock price at a specific point of time to the Book Value or the Net Asset Value (NAV) Per Share. The earnings used are typically the annualised figures which are the sum of all the earnings in the last 4 quarters. Similar to P/E Ratio, both the 12-month trailing or 12-month forward P/B Ratio can be used.
The conventional wisdom is that businesses should be constantly earning for the investor. Therefore, if the business is trading as a stock price below the NAV Per Share, then the company is worth more “dead than alive”. NAV Per Share is the total amount left over after all the assets have been sold and all debts repaid. Therefore, with an P/B Ratio below 1, an investor would be sitting on an instant investment gain.
It would therefore be wise for an investor to hunt for good quality stocks which are trading close to if not below the NAV Per Share. This can easily be compared to the NAV.
The P/B Ratio can be thought of as, the amount an investor is paying for every dollar worth of assets in the business.
We have come a long way in our analysis of the business’ 3 financial statements. Using a combination of these matrices and ratios, we can easily determine if a particular company is a suitable investment.
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