Company Analysis -- Procter & Gamble

P&G’s performance is mediocre in recent years; part of the reasons is because the acquired Gillette business in year 2005 has been a drag on P&G’s top line, not a boost.  ROE dropped from 40% before the acquisition to around 19% after 2005 till now. 

I studied the most recent 10-Q report, and there is literally nothing to be excited about. The stock’s price hovered at $63 range for quite some time.

However, on 02/23, Procter & Gamble Co announced that it plans to cut a total of 5,700 nonmanufacturing jobs as part of a new plan to reduce costs by $10 billion by the end of fiscal 2016.  P&G had already said it would cut 1,600 positions in the current fiscal year. On Thursday, it said it would cut another 4,100 jobs during fiscal 2013, which begins in July.  This news brought excitement to the market, since people believe this plan will help P&G make another leap forward.  The stock has been upgraded twice, and the current market price is $67.

I strongly believe that this stock is a solid one that worth being held forever (both for capital growth and for dividend earnings).  However, at current market surge, I tend to believe that the price is too high for me to go in.  I’d rather wait till it cools down a little bit.  I believe P&G’s performance in this fiscal year won’t be very good.  When the next quarter result comes out, the market might be leak out a chance for patient buyers to go in. I still think $63 or lower is a good entry point.

Disclosure: None.

PEG Ratio

The calculation

Price/Earnings to Growth ratio (PEG ratio) = (Price/earnings ratio) / Annual EPS growth

PEG ratio is widely used as an indicator of a stock's potential value.  It is favored by many over the PE ratio because it also accounts for growth.  Similar to the P/E ratio, a lower PEG means that the stock is more undervalued. Most will use 12-month trailing earnings for the bottom part of this formula.

What PEG ratio tells us

PEG ratio results greater than 1 suggest one of the following:-

• Market expectation of growth is higher than consensus estimates.
•  Stock is currently overvalued due to heightened demand for shares.

PEG ratio results lower than 1 suggest one of the following:-

• Market expectation of growth is lower than consensus estimates.
•  Stock is currently undervalued due to markets underestimating growth.

Best use for PEG


The PEG ratio is best suited to stocks with little or no dividend yield.  Because the PEG ratio doesn't incorporate income received y the investor in its presentation of valuation, the metric may give unfairly inaccurate results for a stock that pays a high dividend.  For companies paying out dividend, the PEG ratio calculation should be revised as following:-

PEG = (P/E) / (Growth estimate + dividend yield)

Formulas and calculations for Balance Sheet

• Tests of a Company's Financial Strength and Liquidity:

 Working Capital: Current Assets - Current Liabilities 

Working capital per share = working capital / total shares outstanding

If you could buy a stock at working capital per share, you would be getting all of the company's fixed assets (real estate, computers, long term investments, etc.) plus its earnings / profit each year from now until eternity for free! The company will probably never trade that low; but you should always keep this in mind when analyzing a business. Sometimes, especially during serious economic downturns, you will find companies selling close to working capital.

Working Capital per Dollar of Sales: Working Capital ÷ Total Sales

Manufacturers of heavy machinery require the most working capital and range from 20-25%.

Current Ratio: Current Assets ÷ Current Liabilities 

The current ratio should be at least 1.5 but probably not over 3 or 4.

Too low current ratio means the company may have difficulty to pay off its current debts.  Too high current ratio means the management isn’t utilizing the money efficiently.

Quick / Acid Test / Current Ratio: Current Assets minus inventory (called "Quick Assets) ÷ Current Liabilities 

 Inventory is what causes the biggest difference between the current and quick ratio. The quick ratio was designed to measure the immediate resources of a company against its current liabilities.

Debt to Equity Ratio: Total Liabilities ÷ Shareholders' Equity

Generally, any company that has a debt to equity ratio of over 40% to 50% should be looked at more carefully to make sure there are no liquidity problems.

• Tests of a Company's Efficiency:

Receivable Turnover: Net Credit Sales ÷ Average Net Receivables for the Period 

Average Age of Receivables: Numbers of days in period ÷ Receivable Turnover 

Inventory Turnover: Cost of Goods Sold ÷ Average Inventory for the Period 

Number of Days for Inventory to Turn: Number of days in Period ÷ Inventory Turnover

Inventory turns and working capital

When analyzing the balance sheet, you want to look at the percentage of current assets inventory represents.  If 70% of a company's current assets are tied up in inventory and the business does not have a relatively low turn rate (less than 30 days), it may be a signal that something is seriously wrong and an inventory write-down is unavoidable.

Inventory turnover = cost of goods sold / average inventory for the period.

Working capital is to calculate the difference between current assets and current liabilities.

Working capital = current assets - current liabilities

Usually speaking, working capital should be positive, and the higher, the better.  However, there is an exception: negative working capital can be a good thing for high turn businesses thanks to the effect of leverage.

Companies that have high inventory turns and do business on a cash basis (such as a grocery store) need very little working capital. These types of businesses raise money every time they open their doors, then turn around and plow that money back into inventory to increase sales. Since cash is generated so quickly, managements can simply stockpile the proceeds from their daily sales for a short period of time if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available. 

Account receivable turns

Receivable turns calculation:

Account receivable turns = credit sales (or total sales shown in income statement) / average account receivables

An example of account receivable:-

H.F. Beverages Financial Statement Excerpt
	2009	2008
Accounts Receivable	$1,183,363	$1,178,423
Credit Sales	$15,608,300

average account receivable = (1,183,363+1,178,423)/2 = 1,180,893

account receivable turns = 15,608,300 / 1,180,893 = 13.217

The average number of days that customers pay = 365 / 13.217 = 27.62.

If the collection deadline policy is 30 days term, then the company is doing good because customers pay within 30 days.  Had the answer been greater than 30, you would have been wise to try to find out why there were so many late payments, which could be a sign of trouble. (Keep in mind you will need to read through the company's reports to find out what its collection deadline is.  Not all companies require their customers to pay within 30 days).

Asset intensive businesses

Return on Assets as a Measure of Asset Intensity (or How "Good" a Business Is) 
The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets.

As a general rule, anything below 5% is very asset-heavy (manufacturing, railroads), anything above 20% is asset-light (advertising firms, software companies).

Option 1: Net Profit Margin x Asset Turnover = Return on Assets

Option 2: Net Income ÷ Average Assets for the Period = Return on Assets

As always, you should be interested in non-asset intensive businesses with high returns on equity, little or no debt, operating in non-commodity type industries without fixed cost structures. You should also attempt to look for under valuation in larger rather than smaller companies. In the event of a retail recovery, for example, Wal-Mart is more likely to recover sooner than a small specialty retailer such as Tuesday Morning. The owner of smaller issues may find himself waiting considerably longer for his shares to realize their full value in the market.

In most cases, investors would best be served by avoiding commodity industries entirely unless prices are so low that the respective companies are being given away (even then, the holdings should be sold once a more reasonable valuation has returned. These are not the kind of stocks you want to pass on to your grandchildren).

Return on Equity -- the Dupont Model

Original article is here.

ROE formula is very simple and easy understanding.

ROE = Net Profit / Average shareholder equity for period

However, in the above article, there are three components in the calculation using the traditional DuPont model: the net profit margin, asset turnover, and the equity multiplier.  By examining each input individually, we can discover sources of a company's return on equity and compare it to its competitors.

ROE calculation using DuPont model:

ROE = Net profit margin x Asset turnover x equity multiplier
=(Net income / Revenue) x (Revenue / Assets) x (Assets / Shareholder's equity)

Asset turnover tends to be inversely related to the net profit margin: the higher the net profit margin, the lower the asset turnover.  The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business.

The equity multiplier is a measure of financial leverage that allows the investor to see what portion of the return on equity is the result of debt.  If you found a company at a comparable valuation with the same return on equity yet a higher percentage arose from internally-generated sales, not from equity multiplier, it would be more attractive.  We can assume equity multiplier = 1, and calculate the ROE without leverage effect from debt.

Corporate Tax Rate Reference Table

Corporate Income Tax Rates - 1998-2012
Taxable income over	Not over	Tax rate
$0	$50,000	15%
$50,000	$75,000	25%
$100,000	$335,000	39%
$335,000	$10,000,000	34%
$10,000,000	$15,000,000	35%
$15,000,000	$18,333,333	38%
$18,333,333	........	35%

Reading: The 400% Man

Link is here: The 400% Man

Over a 12-year stretch, through the end of year 2011, Allan Mecham, now a mere 34 years old, has earned an astounding cumulative return of more than 400 percent by investing in the US companies.  Reading through the article, what Allan Mecham does is what a disciplined value investor should do when he or she is in the market.  The summary in the article is kind of guideline for value investor:-

• Ignore the economy. The idea to ignore the economy scared me at the first glance.  For me, before analyzing a stock, the first step is to see the economy which determines whether I should step in the market or not.  To totally ignore the economy is like a blind man feels the elephant. However, in this article, this sentence touched me: to “look for stable, defensive businesses that can thrive whenever bad times come.” This single statement makes the whole sense.

• Don't diversify. Most mutual funds own dozens or even hundreds of stocks (regulations usually require them to own at least 15). I totally agree with this point. One of the main reasons of diversifying is, in the positive term, not to put all the eggs in one basket, while in the true but negative term, to avoid thorough study for each of the stocks.  I am determined to maintain my portfolio within 10 stocks.

• Don't sweat the spreadsheets. Although I do think spreadsheet analysis is essential. But “it's more productive to use that time trying to understand a company and its industry -- the management, the competition, and the customers and so on.”

• Think decades, not quarters. “Shareholders and managers tend to focus on companies' announcements of quarterly or annual earnings, and whether they beat or miss analysts' estimates. But some managers -- including one Warren Buffett -- say it's more useful to try to figure out where a company will be in a decade or more.”  The confidence of long-term thinking is based on the true understanding of the company and business, which needs much dirty work.

• Don't just do something. Stand there! “One of the toughest things for investors to do is to sit still and do nothing -- especially when nervous clients demand that they respond to short-term fluctuations in the market. But most of the time, say a few contrarians, inactivity is the right longer-term move. It's about "keeping emotions from corroding the decision process," says Mecham.”