Figuring out a good investment
Scrutinise the key financials before picking a company
WHEN it comes to investing, many people tend to use a company’s profit as a guide to whether they should put money into it.
While profit is an important factor, the way financial reporting can be manipulated means it’s not the most reliable number to base your decisions on.
This means you need to look at an array of figures that might give you a clearer picture of the company’s performance.
Diving into financial results might leave you rather confused, but there are key figures you can look at to get a snapshot view of the company’s performance.
Dividends: look at the company’s dividend payout and frequency. Is it consistent? Has it gone up or down compared to the previous year’s reporting period?
One-off costs: look out for them and understand their nature — are they initial investment costs or fines? If most of these one-off costs are fines, you might want to find out why they are a recurring problem for the company. It could be an indicator of corporate governance problems.
Headline earnings per share: this number should be viewed in relation to one-off costs. It gives you the company’s earnings, but strips out income that may arise from cuts to operational costs, such as retrenchments, in an effort to trim expenditure.
Revenue: how well has the company done when compared to the rate of inflation? Compare the revenue figure to the previous year’s growth — but then don’t forget to strip it down to real growth.
The figures above cannot be considered in isolation. We need to dig a little deeper to get a clearer view of the health of the business.
The gross profit margin: this figure will give you an idea of the viability of the company’s business model. Gross profit margin shows the difference between the cost of the goods or product sold and proceeds from sales.
Operating profit margin: this combines the cost of goods sold and operating expenses in relation to revenue. It’s important that the business keeps manufacturing, service and operational costs below revenue.
The cash conversion ratio: remember that cash flow is a very important consideration when you’re looking at the health of the business. This is why it’s a good idea to keep a close eye on the company’s cash conversion ratio.
This means taking a look at the company’s earnings before interest, tax, depreciation and amortisation. Dividing the company’s operating cash flow by this ebitda figure will give you the cash conversion ratio. If the ratio is too low, the company might be having problems managing its working capital — it’s worth keeping a close eye on.
When looking at the company’s results, do not look at them in isolation.
Compare the performance of the company to that of other companies in the same industry.
If the company is lagging behind its peers, investigate why this is the case. Look at the numbers but also pay attention to what’s in the news. Don’t rely solely on management commentary to red-flag issues.
If possible, try to attend results presentations and annual general meetings that you can ask questions and get a clearer understanding of any concerns or questions you might have.
You can follow Tsamela on Twitter @DineoTsamela