How to do homework: EPS, Market Price, Profit Margin, Acid Ratio, Cash Flow, Dividend

In this post, I am going to list out five important indicators which I often use to assess whether a particular company is worth for invest or not. These five indicators consist of safety margin (PE), business profitability (Profit Margin), financial condition (Acid Ratio or Quick Ratio), cash management (Cash flow), and shareholders' return (Dividend).

1. PE = Market Price / EPS
Before making any investment decision, what I am interested in is how many money a particular business or company can earn in terms of Earning per Share (EPS). This is because the market price of the business is in terms of price for one Share. For example, the market price of XZY company is $5.00 with EPS of $0.50. This means that if we acquire the whole business of this company with the market price of $5.00, and if this company can maintain its earning with EPS of $0.50 annually, we can breakeven by 10 years (10 years X $0.50) (with the assumption that the profit will be maintained). If we expect that the profit will grow, of course, we will break even within shorter period of time (faster). Therefore, we need to ask ourselves: Is it a good deal to break even for ten years? or five years? Is the assumption logic, reasonable and achieveable in the future? In fact, the ratio of market price to EPS is the so-called PE. In other words, PE of 10 shows us that our investment is possible to be breakeven by 10 years if the assumptions are true. Therefore, we can use PE as a reference to determine whether the market price of a particular company is over-valued or not. Personally, I prefer PE less than 10. However, some exception is possible. For example, if we expect the growing rate of EPS is 30% annually, with purchasing price of RM1.20 for EPS of 10sen or PE of 12 (1.2/0.1), actually, we are going to breakeven by six year as stated below:

Year 1: 10sen

Year 2: 13sen

Year 3: 16.9sen

Year 4: 21.97sen
Year 5: 28.561sen

Year 6: 37.1293sen

Total: 127.56sen

2. Profit Margin
After we identify few potential under-valued companies (based on PE, for instance), we need to further assess whether the profit margins of them are attractive. For example, the revenue of XYZ business is 100 million with cost of 50 million, the gross profit margin equals to 50 million. In other words, XYZ business generates $0.50 profit from $1.00 revenue (gross profit margin of 50%). Is it a good business? I think so. However, it is a good idea to compare the profit margin of a company within the same industry and among its competitors, if possible. In addition, we need to be very careful about its expenses (fixed cost and variable cost) such as administration fees, marketing fees, distribution fees, etc. So, we should look at net profit margin as well to determine whether the management team control expenses wisely or not. Lastly, we should pay attention on "huge" one-off profit and find out what is the core business of the company, and is the profit stable or volatile? Some examples of one-off profit are disposing investments, disposing assets, assets re-value etc.

3. Acid Ratio
When we have list of under-valued (low PE) and competitive (high profit margin among its peers) companies, we should evaluate the financial condition of the company now. Based on balance sheet, we can calculate acid ratio, which equals to liquidity asset divided by liquidity debt. If the ratio is smaller than one, then we should be very careful because the company may not able to pay back its debt in a short period of time and has potential facing financial crisis. Normally, I more prefer to invest a company which have very small amount of borrowing (zero borrowing is the best, of course) and big amount of cash (this cash must be generated from its operating activities previously, instead of fund raising or borrowing) in the balance sheet. In order to know whether a company is capable to convert its goods and services into CASH, we should proceed to next step to study its cash flow to determine where the money comes from and where the money flows to.

4. Cash flow

In cash flow statement, we must identity how many cash is generated from a particular business, then how many cash is required to re-invest to the business to maintain its competitive and even grow its business in the future. There are three parts in a cash flow statement:

• 4.1 Cash flow from operation
• Flow In:
• Cash generated by operation are cash received from customers and other cash receipts.
• Flow Out:
• Cash used for inventory, insurance, rent and lease, advertising, payroll, other payments, interest paid and taxes.
• 4.2 Cash flow from investments
• Flow In:
• Cash generated from sale of property or investments or other activities.
• Flow Out:
• Cash used for investments like Capital expenditures (CAPEX), purchases and other use.
• 4.3 Cash flow from Financing
• Flow In:
•  Cash generated from new borrowing, stock issuing and capital contributions.
• Flow Out:
• Cash used for loan repayments, dividends paid and other distributions.

Basically, what I expect a good company did in its cash flow statement is:

• a) Lots of cash generated from its operating activities (Cash flow from operation)
• b) Using less than 60% of the generated cash for CAPEX. (Cash flow from investments)
• c) Reasonable distribution of dividends for its shareholders. (Cash flow from Financing)

5. Dividend

Generally, the profits investors will receive from a particular investment are capital gain and dividend. For divided perspective, it will generate cash flow for investors. A good company will provide attractive dividend to its shareholders (more than 5 percent annually) and retain sufficient cash to expand its business. Bad company, on the other hand, may or may not give dividend to its shareholders, and does not use the cash wisely which willcause investors lose their capital ultimately . Therefore, as value investor, I only put my money in good company even though its trading volume is very low. This low trading volumn may due to the fact that most of its shareholders want to have long investment on it. Capital gain, on the other hand, is a "bonus" for investors because the trend of market price is unpredictable. Therefore, normally I will only sell my investment if and only if its market price is over-valued.

That's all for today. More investing and financial management articles can be found at our archive.

Written by: Xaivier Chia

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Updated: 2/8/2011
Reasons: Adding more explanation of cash flow and organize the content.
Updated: 11/8/2011
Reasons: Adding an introduction and organize the content.
Updated: 25/10/2011
Reasons: Adding an example for PE explanation.

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