Behind Organizational Management Efficiency:
Every quarter or year, periodically we see that these amounts keep changing.
1) Assets can increase. This results in expenditure. Assets bought will decrease net profits and assets sold could add to net profits. If there are any captial gains or captial losses on the assets sold they should be filed/claimed in taxes.
2) Debt: A company may borrow money or reduce the debt. This change in amount of outstanding debt results in changes in interest amount paid hence reflecting changes in net income.
3) Equity: A = E + L. Assets by itslef does not reflect the wealth of the company. Equity removes liaility from asset to give the true worth. A company can increase equity by reducing debt or by increasing assets. A company should strive to increase the net equity. A company when goes to raise the additional money via shares, then it is diluting the equity. If the raised money is used to reduce the debt, then the equity is increased. Companies can benefit from this from time to time during high interest periods. They can reduce the interest paid amount.
How depreciation helps for a company:
1) tax incentive
2) Most important: Depreciation reduces equity in the book. And at the same time company can defer tax, and use it for expenses. Now assuming that there is no real depreciation for the asset, a company can give a perception that the return on equity is more even though it is not.
3) Company can show increase in net income through this tax deferral. At first look it might sound correct. But it will catch the analysts eye. They will remove this tax deferral amount, to calculate the net income. If the net income does benefit from tax deferral only, then the stock will be down graded.
Most companies can choose to charge high depreciation in early years and reduce it during subsequent years. They deduct this depreciation amount from earned income, to publish net income. The trick here is that by deducting higher depreciation in the beginning and reducing depreciation amounts later on, the company can show improved net earnings,save tax money. This may skew investors perceptions if he looks only for net earnings. More problems when the depreciation amount deducted reduces significantly, because investors feel happy that there is nothing more depreciating and it may also give a feeling that the returns on equity are more during later years.
What would a company do with the earnings, borrowed money or raised income ?
The efficiency of the management of a company lies with what they do with the profits.
A company can do any of the following things in case it thinks it can expand:
a) Invest in cutting edge technology to remain competetive. This does not necessarily improve margins. Atleast management do not foresee that.
b) Invest in better technologies to increase productivity and improve margins.
c) Become a minority iinterest holder in some other company.
d) Buy a company to diversify the business and hedge against unfavorable economic and tax legislations.
e) Buy a competitor (Merger, consolidation, acquisitions) to improve the market share. HP and Compaq marriage.
f) Buy a complementary product manufacturer to become a turn key solution provider. Eg: Cisco bought Scientific Atlanta to enhance the suite of Triple Play products. Arris Networks bought Tandem TV to compete against Cisco.
g) Increase revenues by advertising.
h) Attract and retain highly talented people.
i) Settle litigations. This will improve the company's focus on current operations than on past litigations.
j) Invest in R&D or buy patents or pay royalties.
k) Clear short term, higher interest debt.
For a growing company, it can invest the profits. If additional money is required then it can raise it by
k) by issuing secondary shares.
l) by issuing bonds.
m) by raising short term debt. The short term debt will be cleared with the subsequent profits.
If a company thinks that it cannot better the share holders value or if it considers that growth is significantly achieved with reducing progress, it can do the following:
a) Reduce the outstanding number of shares floated. This increases the per share equity of a share, and hence per share earnings, finally increasing the share price.
b) Reduce the outstanding debt, in a growing economy to reduce the interest expenses.
c) Giving a dividend.
Understanding Earnings and Interpreting Management efficacy:
Gross Margins: Gross Margins are calculated by removing cost of production from total sales. This cost of production is often skewed because, it only calculates direct costs. It does not account indirect costs, such as operating expenses which include Administration costs required to run the business such as compensation to CEO, President, marketing and advertising expenses. If a company has many cost centers then the administration expenses to organize these cost centers is not accounted in Costs.
Gross margins are nevertheless useful in comparing apples to apples, that is companies with in the same domain. A company with better gross margins generally means that it has an edge over its competitors.
Operating margins: Operating margins include both direct and indirect costs. This reflect the true value of a business for an investor. It shows how much an enterprise is able to generate. One quick look at comparing gross to operating margins can show whether the administration is very expensive... If gross margins are high but operating margins are less, it would mean little value for the investor. It could either mean that operating costs are too high or administration at higher levels are excessively paid (CEO compensations).
Gross Margins and Operating margins show the competetiveness of a business. Different industries will have different operating and gross margin ratios. For software companies gross margins will be high (70 %), but operating margins will not be that high (30%). There is significant difference between gross margins and operating margins. This reflects that it costs more to market and sale the product than it costs to manufacture the product. For an airline industry gross margins will be less (5%), because the cost for airlines (renting fleet, crew wages, fuel expenses, ticketing costs), but difference between gross margins and operating margins will be less, unless CEO's are paid hefty pay checks (American Airlines).
A company can improve operating margins by reducing compensations and hence decreasing operational expenses at higher executive positions. A nice example is Cisco during 2001 down turn. The company slashed executive compensations by 10% and company made economy travel as business policy by going frugal. This resulted in better operating margins and also corresponding increase in gross margins. This helped Cisco to remain competitive during the dot com bubble burst.
Gross Margins and Operating margins show the competetiveness of a business. What they do not show is the underlying health of a business by it self. Because they are not accounting: Interest from short term debt and Interest from Long term debt, Taxes, Depreciation. To get a true picture of a business as itself rather than in comparison to its peers, other expenses such as interest expenses, depreciation and taxes need to be looked at.
Companies have to reinvest the earnings to remain competetive. This expenditure could be either in the form of increasing assets or by increased advertising. Advertising may result in increased revenues and could correspondingly increase net income if advertising expenditures are lesser than increased gain in net income. On the other hand if a company tries to increase productivity by investing in cutting edge technology, it may improve on increasing gross margins. This improvement in gross margin can trickle down to operating margins if there is no significant increase in wages/compensation/advertising, Or if the ratio of increase in wages is lesser compared to increase in sales.
When an economy is booming it can result in increased sales. If this increase in gross margins is negated by increase in operating margins, by the way of increased expenditure on wages and compensation then it is not good for the future business. In a downward economy gross margins will come under pressure as more and more consumers will be cutting down on their expenses. But operating margins are not directly dependent on economy, but they are either inherent to the business or show operational inefficiency of the business. So, in a downward economy net margins will suffer.
If taxes are high then it means that a business is operating in a higher taxing areas of the world and business areas. So, when comparing business with in same sector, it is better to look for a business that is having lesser taxes, as in a long run that business can save more... Or if taxes are significant portion of the net income, then it could mean that the health of the business unit is dependent upon the tax rate, which can change... If the current taxing is the highest, then the only direction is for ease of tax rates, which could mean that the business could be more efficient in future. But if current taxing is to encourage businesses, by temporary reduction of taxes. then when the taxes are restored then the business may not sustain these profits...
Taxes should be compared with net profits.. If they are insignificant, then well and good. But if they are significant, then check whether the reported taxes have any temporary tax benefits. If there are, then the business may not sustain the profits when the taxes are restored... If a company is exposed to higher taxing states like CA then their net profits will not be good even though their EBITDA margins, Operating margins and Gross margins are good.
Debt: A company can secure long term debt by issuing senior notes, bonds, by issuing secondary shares etc.. and Short term debt from financial institutions or money lenders. The interest expenses on short term debt are higher, but they can be cleared in a short term from the profits.... if there are any. If the company cannot reduce its short term debt, then it may go for longer term debt. A company may seek long term lending to eliminate short term finances... example: Sun Microsystems recently borrowed money from KPR.. And some companies will issue additional company shares to raise the money for clearing debt both long term and short term. This is not actually reducing the existing share holders equity, as it might look though at the first instance. That debt is already part of the existing share holders equity.
In general, a company which has a significant debt, is not attractive. Unless they earn a lot more money on money borrowed, i.e., if the return on money borrowed is significant to the interest paid. It is important to see how it is using the earnings. Are they investing profits earned to result in increased equity, and further increasing share holders equity. Then if it is so, over a period of time, the companies equity should be more than the debt. If the debt to equity ratio is decreasing at a good rate that means the company is doing good, but if it is increasing, (if it increases or does not improve consistently, then it shows that there are periods where the borrowed money is more expensive than the returns on that money... not good. Because, if it decreases in one quarter, it effectively erases gains from the earlier quarter.)
The more the debt, the more are interest expenses in comparision to gross profits. When the economy is sinking, fed will lower the interest rate to boost the economy and increasing money flow by making money look very attractive to borrow. During these low interest rate periods these companies can do better. But when the economy is good, fed will obviously hike the interest rates to reduce the inflation, Then these companies net profits will suffer. The axiom is that the interest will never remain steady. They need to be tuned to keep economy afloat. For more information on why should fed tinker with interest rate, please google and get a grasp on concepts of increasing inflation, decreasing inflation, deflation, unemployment rate, cpi, cci fed rate cut/hike, manufacturing index, retail sales index etc.
The other two margins of interest are Net Margins and EBITDA margins(Earnings before interest, tax, depreciation and amortization) . Net earnings are also called GAAP (Generally agreed accounting principles) earnings. All analysts will be concerned more about EBITDA margins as they are less skewed and do not benefit from interest rates, tax rates and tax deferrals.
Assessing growth and core competency:
A company can compete in several different areas. But there will be core competency areas that a company is graded against. For example Apple computers, competes in both computers (PC, laptop) and also consumer goods (iPod, iPhone, iTv...). But investor would like Apple to compete in the Computers area more than the consumer goods. Investors are happy that a company is doing well in other areas, but what finally counts is its competency in its core competency. If apple cannot increase its penetration from 1% of the existing computers towards 100%, then its vast revenue potential will be at stake. Because, the amount of revenues that can be earned in computers area are much more multiples than the consumer products. These other non core competency areas have less barrier for existing and new competitors. This is precisely the reason why Apple was downgraded after its blowout revenues in Jan 2007. The strategy for Apple should be to reduce margins on its computers a little or become efficient in reducing manufacturing costs and compete against others such as Microsoft in Personal computers area.
Assessing a fair stock value:
This is where the main problem with a stock. In evaluating a price of a stock, the historical net income growth of a company need to be considered. Unlike a traditional fixed CD, earnings for a company keep growing at a compounded rate. So one dollar in earning now could result in 3 dollar in earnings at the end of 10 years. Or the company could be no longer in existence. If the interest rates are attractive then fixed CD's will be attractive. So, stocks are attractive to enter into when interest rates are higher as more and more money will get into banks. When the interest rates are low, stocks look more attractive and their prices will be high.
The best way to earn money through stocks is to buy low sell high. Every novice investor will do a mistake of being attracted to a blown up stock. The stock looks very attractive as does a blown balloon. It looks irresistable. But the inevitable thing is for a stock price correction. An experienced investor will look for a dip in stock price to get into a company's stock.
To understand what a fair value for a stock, look at Market cap for a company. It is the total of number of shares floating and price of the share. See the net income for the Trailing Tweleve Months (TTM). If you divide the Net Income with Market Cap, we get the amount of earnings per dollar invested. This is not where it ends. We should consider the growth of the company. Let us say for last three years the annual compounded growth rate is 30 %. This could statistically suggest that for next three years this enterprise could sustain that growth rate (when coming to such conclusions we should check gross margins and see whether the enterprise is a monopoly)
Market cap of Apple Inc is 76 B. The net income for the Trailing Tweleve Months (TTM) is 2.2 B. That means that for every 76 dollars of investors amount the return is 2 dollars. It is approximately 2.89 % return. But if the company sustains that growth for next 10 years at a compounded rate of 30% then the returns on 100 $ invested 10 years later would be 2.89 * (1.3 to the power of 10). I guess it must be $24. So $100 invested now would return $24 at the end of 10 years. So thats the reason why stocks trade a higher premium than their current returns, because markets will pay the corresponding premium to enter the stock.
This return of $2.8 per $100 looks attractive when interest rates are low. But in a booming economy this rate would not interest investor as bonds and cd's will be attractive. So, an average joe like you and me should buy stocks when interest rates are high and wait for interest rates to come down significantly. Its just that simple.
We will take a hypothetical examples of growth rates for Apple Inc, and analyze the future possbile price of Apple next.......
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