The company and its business
Most ASA monitored companies, being in the top 200 ASX listed companies, are likely to have been in existence for a number of years, and so will have a recorded history of financial results, details of board members, geographic areas in which the company conducts business, and in which sector it operates (retail, health, mining etc.). All of such information will be contained in the Annual Report which is lodged as a public document and published by the ASX prior to the AGM of the company.
Plainly, being in business for a number of years does not necessarily ensure continuity, as history has shown, and delivering impressive financial results consistently can point to good management, right sector, product attractiveness, and the like, but in a fast changing world doesn’t ensure that the status quo will survive. It follows that the investor must search for sustainability in this modern world; a sustainable product in the face of an army of disruptors, sustainable financial stability, sustainable profit margins, and sustainable good management, amongst others.
Financial history and prospects
Financial health is the most common basis upon which a longer term investor would choose a company in which to invest, although we would hope that other aspects are taken into account. Various agencies make the job of studying financial history relatively easy, and up to 10 years of data can be accessed free via online broking websites such as CommSec and E*Trade. The ASX website has a multitude of financial and market price data on its website, free of charge.
Investors will have their favourite data, in the form of financial ratios, but the following ratios are favoured by ASA monitors in assessing financial health; note that these are ratios derived from financial statements, not marketplace ratios which are driven by market forces, such as Price/Earnings (P/E), Total Shareholders’ Returns (TSR), Price/Book (P/B).
ASA Monitor favoured ratios:
- Return on Equity (ROE),
- Return on Capital (ROC),
- Earnings per share (EPS) growth,
- Operating margin trends (similar to Earnings before Interest & Tax – EBIT),
- Dividend payout ratio, and consistency of payment.
There are some problems with the first two ratios in the list above (ROE & ROC) when comparing the performance of different companies, in that, to be a useful comparison, investors must avoid making the mistake of depending upon the asset values included in the balance sheets of the respective companies. The carrying value of assets will naturally impact on the company’s equity (shareholders’ equity), but, due to accounting standards, only acquired assets can be included in the balance sheet assets, whereas organically developed assets cannot be included. This means that ROE & ROC comparisons between acquisitive and organically grown companies could be misleading.
As an example, if one was to compare the ROE of Wesfarmers (WES) with that of Woolworths (WOW) for the last 10 years, which would be a popular sector comparison, an investor would be puzzled to find that WOW (26.2%) differs from WES (8.6%). Does this mean that WOW is nearly 3 times more profitable than WES? Of course not, as the difference is caused by WES, being a more acquisitive company than WOW in that period, has had to account for its buys (mostly Coles), whereas WOW, which has bought less, cannot bring its organic growth in assets to account, so its equity will be recorded at a much lower figure than is the reality.
This is further reflected in the P/B ratio for each company, WES being judged by the market to be worth 1.62 times its book value, whereas WOW has a market value 3.62 times its book value. In other words, the market has worked out the deficiencies in real values of the assets recorded and adjusted the market price accordingly.
We make this lengthy point to demonstrate the danger of indiscriminate reliance on ratios, without considering the underlying reasons behind the numbers.
The attractions of the remaining three ratios are that they do not rely on balance sheet construction methods, but are income statement dependent, which have their own separate influences (impairment of assets, normal depreciation and amortisation, provisions for contingencies), but at least are compiled from actual, and audited, income statement numbers.
EPS growth is a sought after number as it reflects true earnings growth, as distinct to a rising profit alone; the reason for this is that EPS will take into account additional shares issued, whether for capital raising, or settlement of executive incentive plans, and will demonstrate whether the issue of shares has genuinely resulted in increased earnings for every share on issue.
Operating margins, sometimes referred to as “gross profit” will reflect the ability of the company to maintain margins in a competitive environment, rather than having to reduce margins to maintain sales. With this ratio the trend, rather than a nominal number, is crucial to assessing competitive strength on sustainable sales.
Whilst growth in share value is naturally an important goal in any investment decision, there is an appetite, particularly for independent shareholders, for a regular return on investment in the form of dividends paid from profits earned by the company. It is most important to research the regularity, and sustainability, of an increasing trend in the levels of dividends paid over a number of years. The payout ratio (dividend per share as a proportion of earnings per share) becomes an important consideration in determining how sustainable the future dividends will be. The higher the ratio, the higher the likelihood of the dividend being reduced if the earnings suffer, in view of the resulting lower allocation of profits to reserves.
Businesses are financed by a mix of shareholder funds (including retained profits) and external debt. It is important to look for an appropriate balance of these stakeholders when assessing the financial health of a company, both current and into the future, so as to be able to form an opinion on its capability of surviving any difficult trading periods. Two of the most common ratios used in coming to any conclusion about these matters are the debt to equity ratio (external interest bearing debt/shareholder funds), and the interest cover (the number of times the interest charge is covered by profit before interest).
Once again, it is important to avoid using a “rule of thumb” ratio as a means of assessing the financial health of every company, as the sector in which the company operates will differ in its liquidity needs, or reliability of income streams. As an example, a company which generally doesn’t offer credit to customers, and relies on a regular stream of government subsidies (such as child care centre, or private hospital, operators) can successfully manage with a higher debt to equity ratio than other businesses. For this reason it is arguable that the more reliable indicator of financial health is the interest cover ratio, where a minimum target of 2.5 times is recommended.
It is advisable to be aware of the company’s history in capital raising, either by equity or debt, and form an opinion on whether the funds raised have been successfully employed by the company in increasing earnings per share subsequent to the funds being invested in expansion, debt reduction, or any other stated purpose of the capital raising.
Board and management
The annual report of the company will disclose full details of the members of the board, covering the experience levels of members, details of other board appointments, statements of the levels of independence, diversity of gender, skills and the like. Also it is revealing to look for details of the directors’ shareholdings, if any, and form an opinion as to whether it is considered that the directors’ interests are aligned with those of the shareholders. Look for any signs of unsuccessful service periods as a director with other companies, as well as considering the workloads of the individual directors.
Similarly, the full details of the backgrounds of the executive team will be disclosed. Look for experience levels, skill sets, service periods, together with evidence of any history of success, or otherwise, in assessing how suitable the team is in managing your investment.
In considering what makes up a “healthy” company, it seems obvious that undertaking a review of the specific risks that may be facing the particular type of business, or sector, would be advisable. The specific company financial risks have been already covered, particularly relating to debt levels, but other risks to consider would include the following:
- Product or service pricing risk (competitive forces, disruption threat),
- Regulatory risk (Government regulation, funding restrictions),
- Sovereign risk (particularly mining companies operating overseas),
- Asset impairment risk (particularly intangibles following business acquisition),
- Contractual price risk (construction companies in particular),
- Limited product/customer/geographic diversification.
It is true that past performance is no guarantee of future success, but it seems logical that a careful study of a company’s history, recent financial performance, governance culture, and capable management, will tend to lead to a better investing experience than if such matters are ignored in reaching a decision as to whether to invest or not.
An ASA monitor is favourably placed to benefit from his/her exposure to these considerations whilst carrying out the necessary research into the company’s affairs as part of the responsibilities involved in forming views about how to advise ASA members on voting recommendations.
Geoff Sherwin was a senior partner with RSM Bird Cameron until 1995, before completing an education degree and embarking on a portfolio of work, including training and development, company directorships and accounting services. Geoff joined the ASA in 2007, served on the national board from 2011 to 2014 and is currently a company monitor.
This article was first published in EQUITY May 2018