27 March 2012

Fundamental Analysis - ROE, PE, DY, CAGR

ROE, PE and DY are few of the good Fundamental Analysis indicators for me to filter out good stocks from the stock market. You normally can find PE and DY from newspapers, and need to derive ROE from the annual report / financial report.

ROE (Return On Equity)

In short, it is EPS dividend by average Equity. In layman term, it means that how efficient a management can generate income from the current equity holding. As you know, normally industry/commodities stock would require more properties & equipment (in short, it is Non Current Asset) to generate more inventories to sell it to the customers to generate more income.  Different industry has different Capital Expenditures needs and even different company in the same industry can have different business model too.

We can further divide ROE to 3 main factors, Net Profit Margin, Asset Turnover and Equity Multiplier.

Net Profit Margin - The higher the better. If the company can beat its peers on net profit margin, it could be due to its targeted market is niche market, or due to technology advances or due to Economy of Scales. we can then determine whether the higher net profit margin can be sustainable or not.

Asset Turnover - The higher the better compared within the same sector. It means that a company can generate more revenue given same asset level. The company may adopt aggressive strategy to allow longer credit period for the customers to pay for the goods, and hence increase more revenue from there. Or the company could have a better technology so that they can employ lesser machines/equipment to generate same revenue as compared to its peers.

Equity Multiplier - In corporate finance theory, if the company have optimal capital structure (debt to equity ratio), then the company can perform better ROE (means the company require lesser equity to generate same income level). However please note that the company may suffer higher losses during recession as they still require to pay debt despite they generate lesser income. So it is a leveraging effect that must be taken good care of.

In general, I would prefer a long term ROE of >15% (more than 5 years), and higher ROE among its peers.

PE (Price/EPS Ratio)

PE in layman term, is the period that we can get our capital back provided the EPS stay constant. For example, a PE of 10 means that the investor needs to take 10 years to 'get the invested capital' back. Normally PE of a company tends to stay at high range when recessions starts and stay at low range when recession is going to end.

I would prefer a PE of less than 10 for large capital stock and PE of less than 7 for small capital stock.

DY (Dividend/Price Ratio - Dividend Yield)

DY in short, give you some guidance on % of return in form of dividend to you from the past 1 year. Normally Dividend Yield is trailing ratio, as we can only get the dividend from past year records. Another use of dividend is some company may provide dividend policy as they may distribute constant dividend payout to shareholders, or they based on economy/business capital allocation strategy. Some institutional investors prefer constant dividend payout ratio policy, as they prefer to receive dividend as a form of return from long term investment, as they hope that the longer the investment period, the higher the earnings level can be.

2 comments:

  1. In fact, ROE can be further split up to 8 portions by splitting Profit margin into 5 parts, Asset Turnover into 2 parts and lastly equity multiplier. This is why I like ROE so much, it can encompass nearly all the financial ratio and states of a company other than inventory, receivables turnover as well as free cash flow.

    Another good ratio to use will be (ROIC - WACC) it is similar to ROE but its main role is to help measure value-creation.

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  2. I like the comments on PE ratio. In this environment, a low PE gives you a margin of safety so to speak. Plus, by definition, it should also mean dividends are higher (I think?). For example, take a stock like Telefonica of Spain, due to crisis, it now has very low PE and pays a dividend of 13%!!

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