AF4 Asset Classes Part 3: Shares

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Maud Ford
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1 AF4 Asset Classes Part 3: Shares The milestones for this part are to understand: The main types of share. The difference between technical and fundamental analysis How to calculate and interpret Price/Earnings ratio, Dividend Yield and Dividend Cover. How to calculate and interpret the main ratios from a Balance Sheet and Profit and Loss Account How rights issues work How share save and share incentive plans work. Shares are issued by companies to raise capital. Both AF4 and J10 will focus on testing your ability to assess whether a share represents good value rather than the technicalities and properties of different share classes. This should have been covered in R02 but to refresh your memory here is a short summary. The bulk of a company's share capital will be in ordinary shares. These entitle the owner to 1 vote for each share held. In the past family companies would often split their shares into voting and non voting shares, usually termed A & B shares. This practice is not now encouraged Preference shares have priority over ordinary shares in terms of dividend payment. The dividend is normally fixed and they have no voting rights Cumulative preference shares give the holder the right to receive a dividend in a later year if not made in an earlier one. Non cumulative preference shares don't have this right Participating Preference shares get an additional dividend in addition to the fixed one Redeemable means that the preference share will be purchased by the company at some point in the future Convertible preference means that they can be converted into ordinary shares at some point in the future Warrants are issued by the company and are not classed as shares but give the right to buy ordinary shares at a fixed price at some future date For 18/19 everyone has a dividend allowance of 2,000 which is effectively a 0% rate. Dividends in excess of this are taxed at 7.5% in basic rate, 32.5% in higher rate and 38.1% in additional rate. Whether a share represents good value can be done by two methods: Share analysis (Technical analysis) Company analysis (fundamental analysis) 1

2 Share Analysis The price of a share is set by supply and demand in the market. Share analysis looks at data around the share itself to see if it represents good value. There are two key figures from which, together with the share price, we can derive useful data. These are: Earnings per share (EPS) Dividend. A company exists to make profits and as the shareholders are the owners they expect to be rewarded by receiving part of the profits as a dividend. EPS represents the profits or earnings that are attributable to the ordinary shareholders. It is not necessarily the same as the gross profits. For example, if a company makes 10m in profits but has to pay the Bondholders 2m in interest then the profit attributable to shareholders is 8m. If there are 40m shares in issue then the EPS is 8m/40m = 20p. In other words each share has got 20p of profits behind it. Let s look at this in practice. Here are three companies all in the same sector. A B C Share Price 321p 340p 236p EPS From this we can calculate an important figure the price earnings ratio (p/e) The formula is share price/eps so in this case it will be: A B C Share Price 321p 340p 236p EPS p/e Calculation is one thing, interpreting the figures is another! All assets other than cash will fluctuate in price. If they produce an income one way in which we can assess their value is to compare its price with the income it produces. For example, an investment property might produce 26,000 in income. If it is bought for 260,000 the price would have been 10 times its income. If it was sold for 520,000, it would have been sold for 20 times its income. The p/e of A is which means the market is prepared to pay a multiple of of its EPS for the shares. With company C it is only prepared to pay 9.5 times its EPS. What can be deduced from this? 2

3 The usual answer is that a high p/e indicates a greater confidence in the future profits of the company whereas a lower p/e tends to indicate less confidence. Just by looking at the p/e it would seem to indicate that the prospects for A are better than C. Alternatively another analyst might conclude that A is overvalued and C is undervalued! P/E is useful but it needs to be treated with caution. The EPS of a company reflects its latest profits which are by definition historic. The share price is a current figure that changes minute by minute. Let s say that company B issued a profits warning and its share price slumped to 240p. The EPS would stay the same until the next profit figures were calculated but its p/e would have reduced to 240/32.73 or P/E can also be calculated on a forward basis. This uses an estimate of the future earnings. Another formula is the Cyclically Adjusted Price Earnings (CAPE) This is the price divided by the average of the past 10 years earnings adjusted for inflation. A variation on the P/E ratio is the Price Earnings Growth or PEG ratio. The formula is: PE/anticipated growth so if the PE is 14 and growth is 7% the PEG is 2. The case for PEG is that P/e is too simplistic. Two shares, A & B could have a P/e of 24 which implies they both have high growth potential. If the anticipated growth is 12% and 6% respectively then it can be seen that the P/e of A seems more justified than B because of its greater growth. The PEG for A will be 2 and 4 for B. In general the lower the PEG the better as you are paying less for each unit of potential growth. A high PEG may indicate that the share is overvalued. Companies could pay out all the EPS as dividend but in practice they will only pay out a part of it and retain the remainder to invest in the business. A B C Share Price 321p 340p 236p EPS p/e Dividend 14.76p 16.9p 12.15p The next thing we can calculate is the dividend yield which is the dividend/share price expressed as a percentage A B C Share Price 321p 340p 236p EPS p/e Dividend 14.76p 16.9p 12.15p Yield 4.6% 4.97% 5.15% 3

4 This tells us what return the dividend is paying and naturally we would like to see this as high as possible. It also gives us a comparison with other investments. As with p/e it needs to be treated with caution since dividend is historic and share price is current. A fall in the share price would increase the yield but one reason for the fall could be a profits warning and this would probably lead to a cut in the dividend at the next payment date. The ability to sustain dividend is a key factor in identifying share value and can be measured by dividend cover. This is EPS/dividend. A B C Share Price 321p 340p 236p EPS p/e Dividend 14.76p 16.9p 12.15p Yield 4.6% 4.97% 5.15% Cover In this case A is paying almost all its profits out as dividend and this may not be sustainable. B and C would appear to have a cushion so it is more likely that dividends will be maintained. In assessing dividend cover the higher the number the better. Share analysis can only take as so far. The above figures were compiled in March This is the data for the same companies, together with their names in January 2018 Tesco J Sainsbury W Morrison March 14 Jan 18 March Jan 18 Jan 18 Jan 18 Share Price 321p 211p 340p 261p 236p p EPS p p p p/e Dividend 14.76p 1p 16.9p 9.7p 12.15p 5.51p Yield 4.6% 0.47% 4.97% 3.72% 5.15% 2.44% Cover Tesco shareholders have been on something on a rollercoaster with the shares at one point dropping to 107p. Due to internal problems and losses it suspended its dividend. It has now resumed dividends. Its p/e is extremely high which could indicate that investors believe the management has eradicated all its problems and that future prospects are much better. UK supermarkets have been under immense pressure in recent years and all three major players have seen this reflected in their share price. These measures are in the main snapshots in that they reflect that day s statistics. Technical analysts will also be concerned with the way in which the share price moves over a period of time> 4

5 One key measure used by technical analysts is moving day averages. This measures the closing level of an index or the price of a security and averaged over a set period. The idea is to identify trends without it being influenced by short term fluctuations. The most common ones are 50 and 200 days with the former being used to pick out immediate trends and the latter for long term trends. When the moving trend is rising the trend is bullish, if it is falling it is bearish and when moving sideways there is no trend. Significant trend changes occur when the short term average crosses above the longer term average. If the shorter term average crosses above the longer term average it signifies a new bullish trend. If the short term crosses below the long term it indicates a strong bearish trend. Another measure is the Relative Strength Indicator. This is a mathematical formula that measures the average of the number of days an index or security rose or fell over a period of time.. It is a figure ranging from 0 to 100. If it is approaching 30 it may indicate it is undervalued and if over 70 it may be overvalued. It can though give false signals as large surges or fall in price will affect the RSI. Fundamental analysis focuses on the company s performance by looking at the accounts. Company accounts The good news is that you don t need to be an accountant to pass either exam but you must have a basic knowledge. First let s identify what accounts record. The Profit and Loss Account records the income and expenditure over a given period although the published accounts will usually be over its trading year. The Balance Sheet is a snapshot of the company s assets and liabilities on a given day, usually the last day of its trading year. In addition there is the Cash flow statement that gives a clearer indication of where and how cash is being earned and spent. Whilst these are essential to take a view of the company, analysts will look at many more indictors. For example, with supermarkets the sales per square foot will be studied, the percentage of rooms sold each night would be a key indicator for a hotel chain. Please note that some of the terms and formulas used in the following may not be the same as you would find in an accountancy text book. They are based on the definitions in past exams Profit and Loss Statement The old accountancy joke is that if you ask an accountant how much profit a company has made you will be asked how much do you want the profits to be! In other words profits can be managed by deducting different levels of costs. 5

6 At its simplest the gross profit will be Turnover (sales) less cost of sales. The latter would include costs of buying stock, wages, heating lighting etc. An accountant will then deduct other costs such as depreciation but in the exam these will be omitted so gross profit is likely to be the same as Profits before Interest and Tax (PBIT). They would then deduct interest and tax to find the net profit. In practice an analyst would be comparing this year s figures with the previous ones. Balance Sheet This records the company s assets (what it owns) and its liabilities (what it owes) A balance sheet will typically look like this: Long term assets Assets Liabilities Long term Liabilities Building Machinery Current Assets 1,000, ,000 Mortgage on premises 800,000 Current Liabilities Stock Outstanding sales Cash in Bank 200, ,000 30,000 Money owing to suppliers 150,000 Shareholder s funds 880,000 Total 1,830,000 1,830,000 The difference between assets and liabilities is the equity in the company which belongs to the shareholders as the owners of the company. In practice it will be made up of three elements: Issued share capital, that is the number of shares in issue at their par value Share Premium Account, that is the difference between par value and the amount the company received when the shares were issued. Retained profits, that is profits that aren t reinvested in the company or paid to investors If liabilities exceed assets the business is insolvent and it would be a criminal offence for it to continue to trade. Using both P&L and the Balance Sheet there are some basic calculations that can be made. 6

7 Profit ratio. This is a percentage derived solely from the P&L account. It is: Profits before Interest and Tax x 100 Sales For example, a restaurant making a profit of 80,000 on sales of 400,000 would have profit ratio of 20%. ( 80,000/ 400,000 x 100) How well is the company using its capital? But let s suppose that the owner has invested 4,000,000 to buy this restaurant then the return on the investment is 80,000/ 4,000,000 = 2%. This is known as Return on Capital The basic formula for ROE is: Profit AFTER Interest and Tax X 100 Shareholder s funds In a previous exam when this was asked the answer included preference shares dividend on the top line. ROE is used to compare the return on investment against other assets. In the case above the investor is only making a 2% return and other investments might offer a higher figure. To assess how well a company is doing we need to calculate the Return on Capital Employed (ROCE) Return on Capital Employed A business has two main source of funds, its equity and borrowings. ROCE is expressed as a percentage and identifies how well it is using that capital. The formula is: Profit BEFORE Interest and Tax x 100 Debt + Equity In general a company will make its profits by good asset turnover, sales/capital employed OR by good profit margin, profit/sales. ROCE can therefore also be expressed by the formula Sales x Profit Capital employed Sales The higher the ROCE the better use the company is making of its capital. 7

8 Borrowing tests Most companies will borrow to expand but this carries risks and two key ratios can be used to assess its vulnerability. These are the Gearing Ratio and the Debt to Equity Ratio. Gearing ratio This is usually expressed as a figure. The formula is: Total Loans + Preference shares Shareholder s funds This is sometimes called the leveraged ratio. A company may have a high gearing ratio but can service this debt. A rise in interest rates could undermine its position and that can be measured by the interest cover. Interest Cover A company services its debts from its profits. The formula is therefore: Profit before Interest and Tax Gross interest payable The higher the number the better the company will be able to cope with a rise in interest rates. Have we got enough cash? Most companies fail because they run out of cash. The cash flow statement will give a lot of information as to how this is generated but the balance sheet also gives two key ratios as to a company s liquidity, Working Capital and the Acid Test. Working Capital A balance sheet splits assets into long term and current assets. The former are not considered to be liquid in that they could be sold but it would not normally be practical if the company had to raise cash to meet its obligations. Similarly any long term debt is not likely to be called in for payment at short notice. Working capital can be expressed either as a figure or a ratio. For the figure, it is: Current Assets less Current Liabilities The ratio is: Current Assets Current Liabilities 8

9 Otherwise we can just subtract current liabilities from current assets to get the monetary amount. A business should have more assets than liabilities so we would expect to see a positive figure or a ratio of at least 1. Anything less means the company is vulnerable to being squeezed by its creditors. However current assets will include stock which may be difficult to dispose of so a more stringent test known as the acid test. Acid Test This can also be expressed as a figure or ratio. The figure is: (Current Assets less stock) minus Current Liabilities. The formula is: Current assets less stock Current liabilities In the worst case a business s creditors may demand their money all at once so this measures how easy it would be to cope with that situation Finally we will look at rights issues and employee share schemes. Rights issues A company will sometimes seek to raise capital by issuing new shares. This is called a rights issue. It offers existing shareholders the right to buy new shares at a discount. For example a company's shares may be trading at 120p and they offer each shareholder the right to buy one share for every four they hold for 60p. When a rights issue is complete the share price will always be lower than it was pre-rights because the number of shares has been increased. On the above basis if someone with 1,000 shares, exercising the rights issue would increase the number of shares to 1,250 The share price prior to the rights was 120p so their holding was worth 1,200. The 250 new shares would have cost, at 60p, 150. At the end there would be 1,250 shares with a value of 1,350. The theoretical value of the shares would therefore be 1,350/1250 = 108p The shareholder can do one of three things with a rights issue. They can exercise the right to buy the shares They can decide not to exercise the right They can sell the rights By exercising the right, a shareholder maintains the value of their holding. 9

10 Brian decides not to exercise the right. Because more shares have been issued his holding has been diluted. He owns less of the business than he did before. If he held 2000 shares before the rights issue his holding at 120p a share would have been worth 2,400. After the rights issue, assuming the price was 108p, the total value would have been worth 2,160. Carol decides that she doesn't want to exercise the right but decides to sell her rights on the open market. This compensates her to some extent for the dilution Rights issues are normally underwritten. There is a risk that existing shareholders will not take up the offer so for a fee the company will get other financial institutions to agree to buy up any of the new shares that aren't taken up by the existing shareholders. A fee is charged for this. Employee shares schemes There are two main types. Share Incentive Plans Share save Share Incentive Plans These can be free shares where the employer can give up to 3,600 of shares in anyone year. There is no income tax on NI on this although they must be kept for five years to keep this tax free status. They can be withdrawn early in the case of retirement or redundancy without penalty. Employees can buy partnership shares buying shares out of gross income before tax and NI. The maximum is the lower of 10% of gross salary and 1,800. Again you must keep them for five years to be exempt from income tax and national insurance. A company may give matching shares which is limited to two shares for every one partnership shares. Dividends from partnership and free shares may be reinvested in Dividend shares. If the shares are sold whilst held in the SIP there is no Capital Gains Tax no matter how large the gain 10

11 Sharesave schemes The employer will launch a scheme that gives employees the right to buy shares at a fixed price in the future. The employee can save up to 500 a month out of net salary for a period of three or five years. This is placed into a Save as You Earn (SAYE) deposit account. Interest is paid with no tax deduction. At maturity date the employee can exercise the option if the option price is below the current share price. Put another way the shares are bought at a substantial discount. They can then be sold for a profit or kept for future growth If the share price is below the option price it will not be exercised and the employee can take the value of the fund in the SAYE account When the shares are sold they are subject to Capital Gains Tax, the acquisition price being the option price that you paid. CGT can be avoided if they are transferred into an ISA or Pension within 90 days of the shares being taken out of the scheme. The amount transferred into the ISA will count towards the annual subscription for that year. That concludes this part so you should now understand The main types of share. The difference between technical and fundamental analysis How to calculate and interpret Price/Earnings ratio, Dividend Yield and Dividend Cover. How to calculate and interpret the main ratios from a Balance Sheet and Profit and Loss Account How rights issues work How share save and share incentive plans work. 11

R02: The main asset classes

R02: The main asset classes These are: Cash (deposits) Fixed Rate (Gilts & Corporate Bonds) Equities (shares) Property Commodities Alternatives Cash Notes and Coins sitting in a wallet or in a box don't