Debt ratio

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The six fundamental
indicators every investor
must use
Definition
Fundamental analysis –
the study of a
company’s capital value
(on the balance sheet)
and profit or loss (on the
income statement) to
determine its overall
viability as an
investment; to identify
financial trends; and to
decide whether the
current price is
reasonable based on
trends in revenue and
profit.
Fundamental analysis
includes the study of:
- the balance sheet, the value of assets,
liabilities and net worth as of the end of the
quarter or year.
- the income statement, a summary of
revenues, costs, expenses and profits during
a quarter or full year.
- other financial attributes including the
earnings per share, competitive position
within the industry, and dividend history.
The six indicators
An investor may use any number of
fundamental indicators, but six are essential
for everyone. These are:
1. growth in revenues
2. growth in earnings
3. price/earnings ratio (P/E)
4. dividend yield
5. dividend growth
6. debt ratio
1. growth in revenues
The nature of revenue growth
What should you expect to see?
The trend and how it changes
The tendency for trends to level out
Revenues are tied to earnings
Revenue dollar values should grow
Earnings percentage should be consistent
Problems with revenue
Revenues trend erratically
Revenues grow while earnings do not
Revenues remain level or begin to slide
2. growth in earnings
How earnings grow
Net return should remain consistent or rise
The net dollar value should grow as well
Seek consistent earnings trends
Problems with earnings
The net return declines even if dollar amount
grows
Revenues outpace the net return
Revenues grow while earnings move to negative
Revenue and earnings examples
You can only tell how a trend is evolving by
studying a long-term trend
A 10-year trend is excellent because it reveals
how trends move through time
Track revenues and earnings together to get the
full picture
General Mills
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
(In millions)
.
Revenue
Earnings
$10,506
$ 917
11,070
1,055
11,244
1,240
11,640
1,090
12,442
1,144
13,652
1,295
14,691
1,304
14,797
1,531
14,880
1,804
16,658
1,567
Caterpillar
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
(In millions)
.
Revenue
Earnings
$20,152
$ 798
22,763
1,099
30,251
2,035
36,339
2,854
41,517
3,537
44,958
3,541
51,324
3,557
32,396
895
42,588
2,700
60,138
4,928
Wal-Mart
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
(In millions)
.
Revenue
Earnings
$244,524
$ 8,039
256,329
8,861
285,222
10,267
312,427
11,231
348,650
12,178
378,799
12,884
405,607
13,254
408,214
14,414
421,849
15,355
446,950
15,766
Sears Holding
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
(In millions)
.
Revenue
Earnings
$30,762
$-3,262
17,072
248
19,701
1,106
49,124
948
53,012
1,490
50,703
826
46,770
53
44,043
235
43,326
150
41,567
-3,113
3. price/earnings ratio (P/E)
How the P/E works
The price/earnings ratio (P/E) is a summary of
the relationship between the current price per
share, and latest reported earnings per share
(EPS)
To compute, divide price per share by earnings
per share.
Problems with the P/E
The P/E compares a current technical indicator
(price) to an outdated fundamental indicator
(earnings).
The P/E multiplier is a reflection of how many
years' earnings are in the current price. The
higher the P/E, the more expensive the stock
Solutions to the P/E problem
The P/E cannot be reliably used as a singular value at the
moment.
However, volatility of the stock can be judged by a review
of the range of annual P/E and its trend.
A consistent level of P/E in a narrow range is a positive
indicator.
For example, General Mills has reported a narrow P/E
over many years.
P/E rules of thumb
Generally, a P/E between 10 and 25 is a positive
signal. However, the trend is as important as
where P/E is today.
Irregular and volatile P/E is a sign of volatility in
the stock and in the fundamentals.
For example, Caterpillar has reported very
erratic P/E range over recent years.
4. dividend yield
Definition
Dividend yield – the
percentage yield based on
dividend declared and paid
per share.
To determine, divide
dividend per share, by the
current price per share.
Example: a company
currently pays $0.44 (fortyfour cents) per share. The
price per share is $20.00.
Dividend yield is:
0.44 ÷ 20.00 = 2.2%
The meaning of dividend
yield
Price is changing constantly, but the dividend
declared per share does not change. As a
result, dividend yield changes every day.
The lower the price, the higher the yield.
Examples:
0.44 ÷ 20.00 = 2.2%
0.44 ÷ 18.00 = 2.4%
0.44 ÷ 16.00 = 2.8%
The meaning of dividend yield
To evaluate dividend yield, remember:
- Your dividend yield is always based on
the price you paid per share.
- To judge a company’s value, review
dividend yield over many years, and not just
what is paid today.
The meaning of dividend yield
Compare two companies to see how dividend yield works. Both yielded
3.43% as of December 11, 2012:
Year
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
dividend per share
Johnson
Pfizer
& Johnson
0.52
0.80
0.60
0.93
0.68
1.10
0.76
1.28
0.96
1.46
1.16
1.62
1.28
1.80
0.80
1.93
0.54
2.11
0.80
2.25
The meaning of dividend yield
In this comparison, Pfizer’s dividend over 10
years was lower than Johnson & Johnson’s.
More significantly, Pfizer reduced its dividend
per share over several year, while JNJ
increased its payment every year.
5. dividend growth
Definition
Dividend growth – the
percentage of increase
each year in dividends per
share, over payments in
the previous year.
Dividend growth may
be more revealing than
dividend yield. The rate of
growth is a significant
factor as a long-term
trend.
The meaning of dividend
growth
The change from year to year in the
dividend per share is a significant factor.
Although a company may increase its annual
dividend per share, if growth is declining,
that has to be taken into account as well.
Evaluating dividends should be a
combination of dividend yield and dividend
growth.
The meaning of dividend growth
Compare two companies to see how dividend yield works. Both yielded 3.43% as of December
11, 2012:
Year
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
dividend per share
Johnson
Pfizer
& Johnson
0.52
0.80
0.60
0.93
0.68
1.10
0.76
1.28
0.96
1.46
1.16
1.62
1.28
1.80
0.80
1.93
0.54
2.11
0.80
2.25
dividend growth
Johnson
Pfizer
& Johnson
15%
13
12
26
21
10
-38
-68
48
16%
18
16
14
11
11
7
9
7
The meaning of dividend growth
These results tell the story of dividend growth.
Although Pfizer’s yield was erratic, the growth
during positive years was impressive
In comparison, Johnson & Johnson increased its
dividend yield each year, but growth
diminished.
6. debt ratio
Debt Ratio
The debt ratio is a test of how well management
plans and controls its cash flow.
The debt ratio is the percentage of total
capitalization represented by long-term debt.
“Total capitalization” is the combination of longterm debt and stockholders’ equity.
The meaning of debt ratio
Definition
Debt ratio– the percentage of total
capitalization represented by longterm debt.
Total Capitalization – the
combination of long-term debt and
stockholders’ equity.
Example:
long-term debt = $62.7 billion
stockholders’ equity = 82.1 billion
total capitalization =
$62.7 + $82.1 = $144.8 billion
debt ratio =
$62.7 ÷ $144.8 = 43.3
Debt ratio is the percentage of total
capitalization represented by long-term
debt.
It is always expressed as a number without
percentage signs. A debt ratio of 43.3
means that long-term debt is 43.3% of total
capitalization.
When debt ratio is steady or falling, it is
positive.
When debt ratio is rising, it is negative.
The meaning of debt ratio
For example, Eastman Kodak was for many years considered
one of the strongest and best capitalized blue chip
companies in the market.
However, EK did not keep up with changing markets and when
the digital camera boom arrived, they lost market share.
In 2007, EK’s debt ratio was about 30 – but by the end of
2010, it was above 160.
When debt ratio is over 100, it means debt has entirely
absorbed equity. The company’s stock is worthless.
Conclusion
Fundamental analysis is nothing more than the
study of financial conditions and trends.
It is imperative to analyze trend direction and
strength over time.
The fundamentals identify the value of companies
and levels of competitive strength.
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