OLD ARTICLE – Original posted on September 23, 2014
Here is a (brief) list on how to read a listed company’s results on the JSE like an analyst. I’m going to list a couple key things to work through with the intention that in a matter of minutes you’ll be able to work out if the results are good or bad.
The reality is that there are hundreds of companies listed on the JSE. Keeping up with the news flow, especially in “Reporting Season”, can be quite a time consuming task. So, as an analyst-come-fund-manager, I’ve developed a relatively quick manner of scanning the results (see below) before deciding whether to dedicate more time to working through them in detail, updating (or building) valuation models and so on.
Once you get the hang of this glorified checklist, it shouldn’t take you more than ten or twenty minutes to apply:
- Read the previous result’s management guidance: Most company’s management write about their expectations for the next reporting period within a set of results. Begin by checking if the last time management did this (i.e. in the previous set of results) whether or not things turned out the way they expected. If not, why not? This doesn’t just set the scene for the current results, but it also adds or detraction from the value of management’s guidance within these results, depending on whether their previous guidance was correct or not.
- 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 inflation or not? 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 (see #1 above) indicates that volumes are going backwards, then you should expect that its Operating Profit Margin should be slipping. Less volume dependent and far more powerful, see if a company is able to keep lifting its Gross Profit Margin (or at least be maintaining it). 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, that is a good sign. If these 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. One can always work out Price Earnings (PE) and so on about now, but that is relating more to valuing the company, while this article is focused on purely scanning and interpreting the results of the company.
- Check the Cash Conversion Ratio: The Cash Conversion Ratio is calculated as what percentage of EBITDA (or even Operating Profit, where a company does not disclose its EBITDA) is turning in Cash Flow from Operations. Compare this against the last reporting period and see if this is a high percentage and/or rising. If this is the case, then the company is nicely cash generative. If this isn’t the case or the Cash Conversion Ratio 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, go and 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 Cash Conversion Ratio 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 bias as management want to show what a great job they are doing, but it should still give you some context in which to understand the rest of the results numbers. 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 do not comment on… This means that management is hiding the results’ negatives. In this case, you should instantly distrust all further positive commentary that management make and consider the fact that they may be hiding less obvious negatives elsewhere. 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 question has to be asked; if bankers are not comfortable to lend to the company, should you be investing in it at all? Take tax and divide it by Profit Before Tax to get an “effective tax rate”. Is this close to the South African statutory tax rate of 28% (or whatever statutory tax rate exists in the dominant geography that the company operates). If not, why not? Low effective tax rates can be great competitive advantages, albeit not always structurally sustainable as Government tend close tax loopholes over time.
- What is the Return on Equity (ROE)? Calculate the ROE of this period (annualized) and compare it the last period (annualized). Is this rising or falling? Is the ROE above the Cost of Equity (if you are unsure of what the (nominal) Cost of Equity of the company is, 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. The ROE’s interaction with the COE almost dictates the share’s Price-to-Book multiple in the market, which directly influences its Price Earnings ratio… But, once again, this article is about interpreting results, not building valuations.
- Dividend and Dividend Cover: Is the company paying dividends? Has it always and has it always maintained them? If so, this is always a good sign. Take it a step further and see if a 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 profits as dividends is almost always a warning sign…
- Prospects: Finally, taking all of the above into account, consider if management sound optimistic or pessimistic about the future in the prospects section. Consider if management’s tone is appropriate to the results or not? 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 (because any downside is then not their fault) and how the company is well-positioned to capitalize on opportunities (because shareholders are so lucky to have them as management). Ignore those cliche “balanced” remarks, but 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 all know this already), but focus on any specific comments regarding new mines coming on stream, old mine shutting down, acquisitions in the pipeline and/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. When you get good at doing this, you should be able to do so within ten to twenty minutes.
Notice that only one of these steps actually looks directly at profits (i.e. HEPS)? The rest work through commentary, cash flow and context, because a company and its performance is far more than just manipulable accounting profits. 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 reading results like an analyst.