Stock Picking: Some thoughts on figures and ratio’s

Trusting that you have completed the chapters concerned with figures and ratio’s within our course materials, we thought we’d add some more tips and tricks to working with these wonderful decision making tools!

Earnings vs Earnings per share: Lets demonstrate how deceptive figures can be! Earnings growth could be a good indicator of whether a company has grown or not. A company with such growth would surely have added value to it’s shareholders? Not necessarily true!

Company XYZ may have increased its earnings by expansion that was fueled by the issue of more shares. Lets say a company had 100000 shares in issue and was making R100000 net profit per year. This means for each share, R1.00 of earnings was made for the shareholders.

The next year, company XYZ publishes that earnings growth was 25% which implies R125000 net profit for the new year. It sounds great. But as you look at how this growth came about, you realize that the company issued another 50000 shares with which it funded an extra manufacturing plant. This means it now has 150000 shares in issue.

A quick calculation shows that it is actually making less profits per share: R125000 earnings divided by 150000 shares, gives you earnings per share of on R0.83! This effect of dilution: If the number of shares in any company increases, the percentage of the total shares you currently own becomes less.

This example illustrates why it is important to look at growth in earnings per share and not only in earnings growth. If the number of shares remained constant, you could have simply looked at earnings growth for a real reflection of what value was added over the period.

Some proactive companies use the extra cash they have in hand to buy back shares. In the example of Company XYZ, this would mean that they use some of their cash profit, to buy back lets say 10000 shares. The total shares in issue would now be 90000. With earnings growth of 25% to R125000, the earnings per share now stands at 38.9%! This example shows how share buy back’s can add value to the shareholders - quite the opposite effect of share dilution!

You will be wise to read up about the companies you’re interested in: Do they plan issuing more shares, or buying back shares with the cash they have. Just keep in mind, if more shares are offered, the shareholders get offered a right to buy them first. You can usually get them at a discount price, and, if you don’t want to take up the offer, you can even sell your right to buy them before you actually own the shares.

Retained Earnings: In most years in most companies, a part of the profits are paid out as dividends, and a part is retained to fund expansion or new acquisitions. There is a simple way to evaluate whether the directors’ decision to retain earnings was the correct one. Suppose a company elects to retain earnings of R1000000.

The question the investor should be asking is whether the R1000000 is working for him within this company, or whether it could have worked for him harder elsewhere.

The calculation to be done is this: Determine the growth in earnings the extra R1000000 will afford the shareholders: Support it will improve growth from 14% per annum to 25%. This means that the retained earnings improved earnings by 11%. Suppose the R1000000 could have been deposited in a bank account giving 6% interest, then retaining the earnings obviously adds more value.

If the retained earnings makes no contribution to earnings-per-share growth, the investor would have fared better taking it as dividend and putting it in the bank.