a GUIDE TO ANALYSING COMPANY FUNDAMENTALS

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1 SHARE THIS E-BOOK a GUIDE TO ANALYSING COMPANY FUNDAMENTALS How to use the PEG Ratio and avoid common pitfalls using P/E and dividend yield ratios By Cadence Capital Limited January 2016 PERFORMANCE YIELD COMMITTED

2 CONTENTS CHAPTER 1 5 Traps in Using the Price to Earnings (PE) Ratio / CHAPTER 2 5 Traps in Using the Dividend Yield / CHAPTER 3 Understanding the Price to Earnings Growth (PEG) Ratio / CHAPTER 4 Financial Ratios in Action - Gilead Sciences Inc (GILD US) / CHAPTER 5 About Cadence Capital Limited / 11

3 CHAPTER 1 5 TRAPS IN USING THE PRICE TO EARNINGS (P/E) RATIO The Price to Earnings ratio (P/E) is widely quoted within the investment community, however often misunderstood. To calculate the P/E of a company, we divide the price of a share by the earnings per share (EPS) or the market capitalisation of a company by the net profit after tax. For example, a $2.00 share price divided by EPS of say 20 cents represents a P/E ratio of 10. Early on we are taught that, theoretically, this means that if we were to buy this company today it would take 10 years to earn back our investment. Of course, with all theories the reality is quite different. Perhaps the most troubling part of this theory is that when you buy a share you have to pay with cash or a version of cash. The earnings that you receive in return for your cash are not necessarily cash. The biggest and by far the most dangerous component of the P/E ratio is that the earnings are the accounting earnings as defined by the accounting standards for a particular country. These earnings are not the cash earnings of the business. In fact, many companies listed on the Australian Securities Exchange (ASX) earn no cash despite reporting profits. A second problem with the P/E assumption is that future earnings will be at least what they are currently. In the case of a company trading on a 10 times P/E ratio, we as investors are taking a chance that earnings will be at least what they are today for the next 10 years! 01 5 TRAPS IN USING THE PRICE TO EARNINGS (P/E) RATIO

4 Working as an investor in the industry, it is quite clear that estimating the earnings of a company listed on the ASX for a year or two into the future is extremely difficult, let alone 10 years into the future. A third problem with the P/E ratio is the idea that 10 times earnings is cheaper than 15 times earnings. The assumption that a company will earn its current earnings for the next 10 years and an investor will get their money back is of course theoretical. A company s earnings may well go up significantly or down significantly over the next 10 years. It would follow that we as investors should prefer to own a company whose earnings go up significantly over the next 10 years rather down significantly. The P/E ratio has no way of telling us what will happen! A fourth problem with the P/E ratio is that it tells the investor nothing about a company s balance sheet. It may be that a company trading on a 2 times P/E multiple is actually incredibly expensive since the company has a very large amount of current debt that it has no way of repaying, and as a consequence, the company will be declared bankrupt in the current financial year. We need only look back to the recent global financial crisis to find many examples of companies in exactly that situation. A fifth problem with the P/E ratio is that it tells us nothing about the quality of a company s earnings. We may look at one company trading on 8 times earnings and declare it cheaper than a company trading on 16 times earnings. We often hear conversations along these lines. However, upon closer inspection we discover that the company trading on 8 times earnings has just had a one-off profit never to be repeated and that the company on 16 times earnings has displayed 20 percent per annum earnings growth for the past 15 years. It may well be that once these factors are taken into account, the company on a 16 times P/E multiple is actually a better investment than the company on 8 times. The list of problems associated with the P/E ratio goes on and on. For the time being, let s restrict our discussion to what may be the top five problems associated with the P/E ratio and promise ourselves that we will never look at the P/E multiple in isolation as a serious tool for fundamental analysis TRAPS IN USING THE PRICE TO EARNINGS (P/E) RATIO

5 CHAPTER 2 5 TRAPS IN USING THE DIVIDEND YIELD Following our last chapter, 5 traps in using the P/E ratio, we believe that the dividend yield is possibly the second most misused ratio within the equities investment community. Dividend yield is calculated by dividing the dividends paid by a company in one financial year by the market capitalisation of that company, for example, a $10-million dividend divided by a $200 million market capitalisation company equals a 5 percent yield per annum. To the extent the company has paid tax before paying the dividend out, the dividend will often be fully franked, which means tax has been paid on that dividend at a 30 percent tax rate. More recently, the investment community has become fixated on dividend yield, and in particular, the self-managed superannuation fund (SMSF) investor. There are many reasons for this. SMSF retirees use these dividends to live on and the higher they are, in principle, the higher their standard of living. SMSF investors actually pay much lower than 30 percent tax so that the excess amount of tax paid is, in effect, refunded to SMSF investors. Interest rates globally have been falling steadily and are now at historically low levels so that fully franked dividend yields look significantly more attractive than interest on cash in the bank or term deposits TRAPS IN USING THE DIVIDEND YIELD

6 The risk with fixations, fads and trends in the market is that they can eventually lead to abnormal behaviour. The desire to provide a strong fully franked yield or strong perceived yield can result in less-than-ideal business practices. The first less-than-ideal business practice is taking excessive risk to deliver greater dividend yield, by significantly ramping up the level of debt within a business. As company structures increase debt, an inevitable tipping point emerges at which too much risk has been taken to deliver yield and the underlying share price, assets or capital of the company, collapse. We witnessed this phenomenon in great detail in the GFC with the collapse of real estate investment trusts (REITs), infrastructure trusts and many other financially engineered companies with excessive debt. As the hunt for dividend yield heats up again, the risks of a repeat collapse in underlying capital can occur. The risk with dividends is paying out non-cash earnings. This was another common practice before the GFC. A property trust would, for example, revalue a series of buildings as non-cash profits, raise money in the capital markets via a capital raising and then pay those funds out as dividends. The property trusts engaging in this activity would present as having high and, to the uninitiated, sustainable dividend yields. Again, this practice continued until there was a massive property market correction. Unrealised gains previously booked as non-cash earnings would have to be reversed and the property trust went from high, sustainable yield to no yield, with a massive hit to the asset value of the company s balance sheet. The most extreme example involved companies paying dividends on unrealised gains while also having excessive levels of debt. Another common phenomenon with dividend yields is the special dividend. From time to time, companies pay out special dividends when they have had an extraordinarily good period of profitability. These dividends fall outside the scope of the normal half-year or full-year result TRAPS IN USING THE DIVIDEND YIELD

7 The market has a tendency to take normal and extraordinary dividends, combine them and impute these dividends into the future. This tendency is wrong since the special dividend is just that and won t necessarily be declared again in the future. Another tendency of the market is to impute dividend yield for a particular company into the future, or indefinitely. While this idea is appealing it is equivalent to saying a company s profitability will continue to grow indefinitely. This again is not the case for almost all listed equities. We need only look at yesterday s blue chips Kodak, Sony, Gowings and WC Penfolds to realise that profitability, and hence underlying dividend yield, changes over time. One final check that we tend to employ as a rule of thumb is to look at the cash-flow statements released annually by a company and to determine how much free cash flow a company has produced in the year just gone. The key question is whether or not the free cash flow is greater than the dividends declared. A dividend paid out that is greater than free cash flow is essentially unsustainable over time and runs the risk of future disappointment. There can be timing differences between when free cash flow is earned and when it is paid out, but ultimately a company cannot pay out more than it is earning. The only way this is possible is by increasing debt or raising additional funds from the market. The equivalent at an individual level is living beyond your means and borrowing money on credit cards to fund your lifestyle, or borrowing against your assets to fund your lifestyle. As we all know, these practices are ultimately unsustainable although some would argue you can have a lot of fun along the way. We try and have fun identifying those companies employing these practices! 05 5 TRAPS IN USING THE DIVIDEND YIELD

8 CHAPTER 3 UNDERSTANDING THE PRICE TO EARNINGS GROWTH (PEG) RATIO After having discussed the dangers of relying on a P/E ratio and Dividend Yield, let s turn to a ratio we do use frequently and pay more attention to, the Price to Earnings Growth ratio (PEG). The PEG ratio is a measure of the Price Earnings Multiple divided by the Earnings Per share growth rate of a particular share (P/E divided by EPSG). In practice, the lower the PEG ratio the better or cheaper a company s particular shares are. For example, a company growing its earnings per share by 20% per annum trading on a Price Earnings multiple of 10 times would have a PEG of 0.5. Conversely a company growing at 10% per annum trading on a price earnings multiple of 20 times would have a PEG of 2.0. In this example, on the face of it the company on a PEG of 0.5 would be significantly cheaper than a company on a PEG of 2.0. Another way of thinking about this ratio is that it measures the price you are paying for a particular level of growth. What is really good about the PEG ratio is alone it puts the P/E multiple in a context of earnings growth rather than just earnings and forces the investor to think about the quality, security and consistency of earnings growth. Just as we are getting comfortable with the science and the maths of valuation methodologies, we are once again being asked to form a qualitative or subjective assessment about earnings growth..and ultimately earnings growth relative to a stock s current earnings multiple. 06 UNDERSTANDING THE PRICE TO EARNINGS GROWTH (PEG) RATIO

9 It can be proven time and time again, and we can accept it almost as law, that should a company consistently fail to realise future expected earnings it will ultimately be worth less, and conversely, should a company consistently deliver strong earnings per share growth then it will be worth more. What the PEG ratio does is allow the investor to evaluate a potential investment based on its earnings growth relative to its current P/E valuation. The old adage is that it is all about earnings growth and in the long run this tends to be true.along with cash is king..but let s not get ahead of ourselves..using operating and free cash flow for valuation purposes will be the topic of a future e-book. For the moment, let s focus in on the fact that knowing a company s valuation (or basic P/E) relative to a company s earnings growth is far more valuable than just knowing the P/E of a stock. The PEG ratio gives the P/E some context and a basic ability to evaluate companies with different levels of earnings growth against each other. For example, two stocks could have a PEG of 0.5. One could have EPSG of 20% per annum and a P/E of 10, and another could have EPSG of 10% per annum and a P/E of 5. Suddenly the assumption that a stock on a P/E of 5 is cheaper than a stock on a P/E of 10 is no longer true.from a PEG valuation perspective they have the same valuation. To determine which stock is ultimately worth more we would need to estimate how long the EPSG rates would last, and create a more detailed model of future year s earnings. This is why analysts and portfolio managers, and investors in general, spend so much time trying to work out future earnings and future earnings growth for stocks. It is the future earnings and future earnings growth of a particular stock that ultimately determines whether the stock price will go up or down. At Cadence, we have to confess that we ve spent our first few years in the investment industry looking for cheap stocks.on a P/E basis..only to discover that just because a stock was cheap on a P/E basis did not mean it wasn t going to fall in price.especially if earnings growth was nonexistent or negative! At Cadence, we remain quite sentimentally attached to the PEG ratio. Once we fully understood the concept of being able to evaluate different types of companies relative to each other, the investment task became a lot easier. 07 UNDERSTANDING THE PRICE TO EARNINGS GROWTH (PEG) RATIO

10 The PEG ratio allows you to compare a high growth company with a low growth company and still find value in both, if it exists. The PEG ratio does not, for example, eliminate high growth or low growth companies in the way that the P/E ratio sometimes does. The PEG ratio combined with detailed cash flow analysis and cash flow valuation, has the capacity to keep most investors out of a lot of trouble, and avoid many companies that display poor investment characteristics. At Cadence, this forms the basis of most of our Fundamental Analysis. Cadence Fundamental Analysis GLOBAL 47,500 stocks Around 14,250 made a profit last year AUSTRALIA 2,000 stocks Around 700 made a profit last year BAD STOCKS AVERAGE STOCKS GOOD STOCKS , BAD STOCKS AVERAGE STOCKS GOOD STOCKS Bad Fundamentals (For current year and two years estimates) Good Fundamentals (For current year and two years estimates) PEG 2+ PEG <1 OCF yield -ve% to 8% OCF yield 12% 15% FCF yield -ve% to 3% FCF yield 8% 10% Cash No Cash Yes Debt Yes Debt No 08 UNDERSTANDING THE PRICE TO EARNINGS GROWTH (PEG) RATIO

11 CHAPTER 4 FINANCIAL RATIOS IN ACTION Gilead Sciences Inc. (GILD US) Gilead Sciences (NASDAQ: GILD) is an international stock currently in the Cadence portfolio and was the first international listed position in the fund, initiated in mid Gilead is a large US biotech stock specialising in antiviral drugs to treat patients suffering from HIV, hepatitis C, influenza and other health conditions. In 2014 it generated approximately US$25bn in revenue and had a market capitalisation of US$150 billion (this is larger than any company listed on the ASX). As the world s leading anti-viral company, Gilead holds strong market positions in some very lucrative markets. Prior to investing in a stock, in terms of fundamental research we analyse the company from both a qualitative and quantitative perspective. The focus of this article is to examine some of the financial metrics we use for our fundamental analysis. These financial metrics are contained in the table below: Gilead Sciences Financial Metrics at initial investment (mid 2014) Price to Earnings Multiple Earnings Per Share Growth PEG Ratio GILD 12x 25% FINANCIAL RATIOS IN ACTION

12 Price to Earnings Multiple (P/E) If we look at the P/E of Gilead at the time of our initial investment, it was 12x forward earnings. This was very cheap, especially for a large cap stock with a leading market position for its particular drug products. The market was implying that future earnings growth for Gilead will be hard to come by. We disagreed and foresaw the company growing its earnings at a reasonable rate both organically and via acquisition. Therefore we saw the low valuation applied by the market to Gilead as an opportunity. PEG Ratio (PEG) For Gilead in mid 2014, the PEG Ratio of 0.5 was calculated by dividing its P/E ratio of 12.0 by its forward growth rate of 25% (i.e. 12 divided by 25 = 0.5). A PEG ratio under 1.0 is considered to be excellent. The PEG ratio is also useful for benchmarking companies across a particular sector because it takes into account both the valuation (P/E) and earnings growth rate in the one ratio. Often a high P/E for a company can be justified by a high earnings growth rate and the PEG ratio will account for this. 10 FINANCIAL RATIOS IN ACTION

13 CHAPTER 5 ABOUT CADENCE CAPITAL LIMITED Cadence Capital Limited (ASX Code: CDM) is a Listed Investment Company that invests in Australian and international equities with the aim of producing above market riskadjusted returns over time. CDM listed on the ASX in December 2006 and currently has funds under management of $400m and over 7,400 shareholders (over 65% of our shareholders are Self Managed Super Funds). The team at Cadence are the largest investors in the fund, creating a strong alignment of interest with shareholders. By employing a combination of Fundamental and Technical research and following a disciplined Entry & Exit strategy, the fund has produced gross returns of 17.60% p.a, since inception outperforming the All Ordinaries Accumulation Index by 3.2 times, while also producing a historic fully franked dividend yield of between 6% - 8% pa. To find out more visit our website 11 ABOUT CADENCE CAPITAL LIMITED