Analysing company fundamentals

How to evaluate company growth potential

At any given point in time, share prices tend to represent the sum of expectations from all investors about a company's value . A share price represents a balance between the hopes and aspirations for profit of some and the fear of loss from others. Generally speaking, investors tend to be willing to pay more for shares with expectations of stable and/or growing income streams over those where income may be more variable or where the company's future direction is uncertain.

For investors, one of the keys to success when it comes to trading shares is being able to understand what factors influence market expectations and how these can change over time. A number of factors can impact  both positive and negative sentiment towards a company.

Growth anticipation 

The primary driver of a company's valuation is its ability to grow earnings and eventually dividends. There are a number of ways that a company can increase its earnings over time:

Growing the business 
Companies can increase sales by entering new markets, entering into partnerships and joint ventures, winning new contracts or customers, developing and launching new or improved products, improving marketing and sales offerings and more.

Raising prices 
​During positive economic times, some companies gain the ability to charge higher prices for their products as demand increases. This is particularly significant for resource producers during bull markets for commodities.

Cost controls 
A company can also improve its profitability by reducing expenses, although those that do run the risk of cutting corners. To measure this, investors often look at expenses such as administrative, sales and marketing, interest and depreciation as a percentage of sales to determine how efficiently management is running the business. Looking at operating earnings as a percent of sales (margin) can also give an indication of the profitability of the company.

Risk of disappointment 

It's important for investors to recognise that while companies can enjoy great success, there are also numerous risks that could cause them to lose money or see business decline dramatically. Fear of negative outcomes can limit the upside potential for shares, or even cause declines.

Operating risks 
​There are many possible problems that a company may face as a part of normal business, including  machinery breaking down, the entry of new competitors, price wars, input cost increases, adverse economic conditions, lost contracts or customers and more.

Political risk 
​This varies by country but relates to the potential that a new government could gain power and implement adverse economic policies such as tax increases, new regulations, asset nationalisations, and other initiatives.

Currency risk 
​Companies operating in multiple countries run the risk that increases and decreases in currencies relative to each other could impact the company's revenues or cost structure and may increase or reduce the earnings power of foreign operations in terms of the home currency.

Legal risk 
​This relates to the possibility that the company could be sued. This particularly appears in sectors where there can be disputes over patents and intellectual property which could lead to significant damage awards or injunctions against doing business.

Insolvency risk 
​In difficult times, companies with high debt levels can find themselves unable to meet their obligations to have enough financing to meet their day to day obligations. To determine the financial strength of a company, there are a number of ratios that an investor can analyse. These include:

  • Debt to equity = total debt/total equity  (This measures how leveraged the company is.)
  • ​Times interest earned = operating income/interest payments (This measures the ability of the company to at least service the interest portion of its debt.)
  • ​Current ratio = current assets/current liabilities (This measures the ability of the company to meet near-term obligations with current resources.)

How does the market value growth? (P/E & PEG ratios) 

Another useful question for investors to ask is how the market is valuing the shares of a company relative to its peers. The reason for this is that more expensive shares tend to carry higher expectations and higher risk of disappointment, while companies with low valuations and expectations carry the potential for upside surprises.

The most common measure of valuation is the price-to-earnings (P/E) ratio, which can be calculated as:

​P/E ratio = market capitalisation / net income

​or

​P/E ratio = share price / earnings per share

​This tells an investor what additional premium is likely to be applied to justify the company's current earnings.

​The earnings/price ratio would tell you how many years it would take for the company to make its current share price at the current rate of earnings, the payback period in a sense. Therefore, a higher P/E ratio, indicates higher expectations for earnings growth. 

​​​With valuation tied to growth, another key measure for investors to consider is the price/earnings-to-growth (PEG) ratio, calculated as:

PEG ratio = current P/E ratio / current rate of earnings growth

​​So a company with a 30% growth rate and a 30x P/E would have a PEG of 1.0, which is widely considered to be the benchmark level. ​A PEG greater than 1.0 means that the market is pricing in even faster growth for the company, which raises the prospect of disappointment, while a PEG of less than 1.0 suggests that there may be room for valuation to increase.

​The only problem with using P/E ratios to compare valuations is that the market tends to put a premium on certain sectors, making peer group comparisons easier than comparisons across a wider range of stocks.

Dividends 

Dividends can also have a significant impact on market sentiment. While earnings can be dependent on accounting estimates, dividends represent a payment of actual cash to shareholders. Dividends have become an important component of shareholders' income and return expectations.

​​Because some shareholders rely on dividends for income, companies that cut their dividends tend to see their shares punished severely by the marketplace, and those that eliminate them entirely tend to lose institutional shareholders who are restricted by policies that dicatate they can only own dividend-paying shares. Because of this, companies tend to only raise dividends to levels that they feel confident they can maintain over the longer term.

​​This suggests that changes to dividends can give a strong indication of management's expectations of future results. A dividend increase is indicative of confidence, while a dividend cut generally indicates that a company has encountered major difficulties.

  • The dividend yield is calculated as: dividend per share / price per share
  • The higher the yield, the higher the current return on your capital from dividends.

Sometimes, a high dividend yield can indicate undervaluation, but sometimes it may indicate concerns that the dividend rate may be cut.

​​To measure the riskiness of the current dividend level, investors can look at the ​dividend coverage ratio:

Dividend coverage ratio​ = earnings per share / dividends per share


​​This measures the company's ability to earn its current dividend. The higher the level, the stronger the potential for dividends to remain at their current level or increase, while a level below 1 suggests the potential for a cut.

Another thing for share traders to consider is that once a dividend is declared, there is a cut-off date by which you must own the shares to receive the dividend. On the first day of trading where a buyer would not get the dividend, known as the ex-dividend date, the price tends to get marked down at the open by the amount of the dividend.​

Investing around earnings reports 

Corporate earnings reports tend to attract a lot of attention and trading activity for a couple of reasons. First, while some developments may come as a surprise, earnings reports and the accompanying conference calls tend to be scheduled and publicised well in advance, so that investors and media are watching for the results. Second, analysts tend to publish estimates for earnings in advance, so the consensus of expectations tends to be priced into shares ahead of time.

​​Because of this, investing around earnings reports tends to be less influenced by the actual level of earnings and more by how reported earnings turned out relative to market expectations. Management's estimates for future quarters, widely known as guidance, can also have a big impact on investor sentiment.

​​Share investing ahead of a report can also be important. A rally heading into earnings news may suggest growing expectations and a higher risk of disappointment, while a sell-off before the news suggests a lack of confidence and the potential for a positive surprise.

​​With so many investors and the media focused on the earnings and guidance numbers, there can be significant volatility following the release of earnings data which is why many companies, particularly in the US, tend to report outside of market hours. These reports can have an impact on trends as well and therefore can create significant opportunities and turning points for investors.

Investing around takeover bids

Takeover bids can create a lot of excitement and volatility in the marketplace, which can create opportunities for investing. There are a number of factors that can influence how shares respond to takeover bids.

Target company 
​Since buyers usually pay a premium to take over a company, shares of the target company tend to rally on the news. Sometimes they rally on rumours beforehand, but rumours can be difficult to trade as many turn out to be false.

​​How much the target company rallies depends on the nature of the bid and the potential for other bidders. In a friendly takeover the target usually trades just below the bid price. In a hostile or contested takeover (with multiple bidders) the target tends to trade higher than the bid price on speculation that a higher offer may emerge.

Purchaser 
​Traditonally, shares of the purchaser tend to decline on the announcement of a takeover bid, which tends to create risks for the buyer, such as:

  • Overpayment risk – the potential that they may overpay for the acquisition or get dragged into a bidding war which could cause the buyer to underperform in future years.
  • Transaction risk – the risk that the transaction may fail. Also the risk that the transaction may distract management from the day-to-day running of the business, causing its performance to falter.
  • Integration risk – the risk that corporate cultures may not merge smoothly or that projected synergies may not be achieved. 

​​If a transaction subsequently fails, these effects can reverse themselves. Finally, a takeover bid can cause other companies in the same industry group to also rally as speculation grows that other transactions in the group may occur. 

Client sentiment on our platform

The client sentiment tool on our trading platform allows you to see the percentage of clients that are long versus short on a particular share, plus the monetary value of these positions as a percentage.

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