Company and Stock?

Have you thought of these questions of what are the differences between a growth company and a growth stock? How about a defensive company and a defensive stock? Do they equate one another? What are their differences? Below is a summary of what do they actually meant.

Growth companies are ones that consistently earn higher returns than required by their risk. A growth stock is one that earns higher returns than other stocks of equivalent risk. Typically growth stocks have P/E ratios higher than that of the market average P/E as well.

A defensive company is a company that has earnings that are relatively insensitive to downturns in the economy. A utility company is a good example. These types of firms typically have low business risk and moderate financial risk. A defensive stock is a stock that will not decline as much as the market when the overall market declines. The returns of defensive stocks have a low correlation with the returns of the market. Defensive stocks are characterized by having low beta values.

A cyclical company is a company with earnings that tend to follow the business cycle. An automobile company is a good example. Cyclical companies often have high levels of fixed costs (business risk) and/or leverage (financial risk). A cyclical stock is a stock with rates of return that will change more than changes in the return on the overall market. These are stocks with betas greater than one, indicating more than a one-to-one reaction to changes in the return on the market.

A speculative company is a company that has assets that are very risky, but have the potential to generate very large earnings. An oil exploration company is a good example. A speculative stock is a stock that is highly likely to have very low or negative returns, because they are almost always overpriced. These stocks have a low probability of a return near that of the market, but a slight probability of an enormous return.

Individual Income Tax (Salaried Employee)

This is the most dreaded thing by most people I guess where every year you have to pay a certain amount of your hard-earned money to the government. This is one aspect most people seldom take into consideration as their monthly expenses simply because it only occurs once a year. For Singaporean, you can easily compute your taxable income by using the spreadsheet provided by Inland Revenue Authority of Singapore (IRAS) to estimate your annual taxable income so you can set aside a sum of money for that month to your income tax. You can find more information for income tax for individual salaried employee and download the spreadsheet here.

Plain-vanilla interest rate swap

Have you ever flip through the newspapers and see this term known as the "Plain-vanilla interest rate swap"? When I first heard of this, I thought it was kind of cute and interesting. I was asking myself, why plain vanilla? Why not chocolate or strawberry? Hmm.., anyone know why?

Anyway, what is a plain-vanilla interest rate swap then? A plain-vanilla interest rate swap is an exchange of a series of fixed interest payments for a series of floating interest payments, fluctuating with LIBOR (London interbank offer rate). The fixed rate of interest is often quoted as a spread over the current US Treasury security of the desired maturity and is called the swap rate. Normally, the floating rate paid at the end of each period is based on LIBOR at the beginning of the period. The times at which the floating rates are established are called the “reset dates.” The two sides of the swap are called the “fixed leg” and “floating leg”; and the life of a swap is called its tenor. In this case, only the cash flows, not the principals, of the two types of debt are exchanged. So the size of the swap is measured by its notional principal.

For example, for five years, one counterparty (“the buyer”) agrees to pay a fixed rate of interest, say the coupons that would be received on $1,000,000 of principal of the current five-year Treasury note plus 65 basis points (.65%) in exchange (from “the seller”) for five years of semiannual floating rate payments equal to $1,000,000 paying LIBOR with six-month resets. Here, the notional principal is $1,000,000 and the tenor of the swap is five years. The spread over treasuries allows the swap to be quoted “flat”, similar to a forward contract, so that no money need change hands at inception.

Swap financing is normally adopted by companies which operate globally and can be used as a hedge against foreign rate exchange risk.

Rates & Bonds

For those who wish to know the different rates in the market now, for e.g. the 3-Month LIBOR rate, US Treasuries bill rate etc., you can find good information by clicking this link here: http://www.bloomberg.com/markets/rates

The difference between options and warrants

Have you ever wonder what is the difference between options and warrants? They seem to be almost identical in some aspects. However, they are not truely similar.

Warrants are options to buy or sell shares that are listed on a stock exchange. The warrants themselves are listed on that stock exchange, rather than on the futures market.

The underlying asset of a warrant is always a share or a basket of shares, while the underlying product of an option could be anything from wheat to gold to shares.

Warrants are usually more accessible to the small investor, because the size of the contract, called the cover ratio, is smaller.

The cover ratio of an option or warrant is the number of options or warrants you need to buy one unit of the underlying asset. Warrants may, for example, only entitle you to buy a quarter or a half of a share, rather than one share or even 100 shares.

Warrants have no set time to maturity as this depends on the warrant issuer, but typically they are issued with an expiry date of four to 18 months. Options on the futures exchange usually have expiry terms – generally three months – that are set by the futures exchange.

How is STI index being computed?

For those who observe closely on the indexes such as the S&P500, the DJIA, the STI etc., have you ever wonder how these indexes are constructed? There are 3 basic ways to compute these indexes. They are

1. Price-weighted
2. Market value-weighted
3. Unweighted

The returns on a price-weighted index could be matched by purchasing an equal number of shares of each stock represented in the index. Since the index is price-weighted, a
percentage change in a high-priced stock will have a relatively greater effect on the index than the same percentage change in a low priced stock.

A value-weighted index assumes you make a proportionate market value investment in each company in the index. The major problem with a value-weighted index is that firms with greater market capitalization have a greater impact on the index than do firms with lower market capitalization.

An unweighted index places an equal weight on the returns of all index stocks, regardless of their prices or market values. The procedure used to compute an unweighted index value assumes that the index portfolio makes and maintains an equal dollar investment in each stock in the index.

So how is the STI index computed? The STI index like most of the major US index are computed using the value-weighted approach and covers all sectors. As it is value-weighted, the influence of the large capitalisation constituent stocks on the index is moderated by weighting them by their free float percentages.

You can find more information on the STI index by clicking here and other information about other indexes such as the Nikkei 225 Index, MSCI Taiwan Index etc., by clicking here.

How to calculate Earning Per Share?

If you are investor and you have read the analyst report, have you ever wonder how did the analyst compute the Earnings per share (EPS)?

EPS is one of the most commonly used corporate profitability performance measures for publicly traded firms. A company may have either a simple or complex capital structure. A simple capital structure is one that contains no potentially dilutive securities. A simple capital structure contains only common stock, nonconvertible debt, and preferred stock. On the other hand, a complex capital structure contains potentially dilutive securities such as options, warrants, or convertible securities.

All firms with complex capital structures must report both basic and diluted EPS. Firms with simple capital structures report only basic EPS.

The basic EPS calculation does not consider the effects of any dilutive securities in the computation of EPS.

• Basic EPS = (Net Income - Preferred Dividends) / weighted average number of common shares outstanding.

The current year's preferred dividends are subtracted from net income because EPS refers to the per-share earnings available to common shareholders. Net income minus preferred dividends is the income available to common stockholders. Common stock dividends are not subtracted from net income because they are a part of the net income available to common shareholders.

Before computing the dilutive EPS, you need to understand the following terms:

• Dilutive securities are stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock.
• Antidilutive securities are securities that would increase EPS if exercised or converted to common stock.

The numerator of the basic EPS equation contains income available to common shareholders (net income less preferred dividends). In the case of dilutive EPS , if there are dilutive securities (e.g., convertible preferred stock, convertible bonds, or warrants) that will cause the weighted average common shares to change, then the numerator must be adjusted for the following:

• If convertible preferred stock is dilutive (meaning EPS will fall if stock is converted), the convertible preferred dividends must be added back to the previously calculated income from continuing operations less preferred dividends.
• If convertible bonds are dilutive, then the bonds' after-tax interest expense would not be considered as an interest expense for diluted EPS. Hence, interest expense multiplied by (1-tax rate) must be added back to the numerator.

The diluted EPS equation (assuming convertible securities are dilutive) is:

• diluted EPS = adjusted income available for common shares/weighted-average common and potential common shares outstanding

where adjusted income available for common shares is:

• Net income - preferred dividends + Dividends on convertible preferred stock + After-tax interest on convertible debt

Remember, each potentially dilutive security must be examined separately to determine if it is actually dilutive (would reduce EPS if converted to common stock). The effect of conversion to common is only included in the calculation of diluted EPS for a given security if it is in fact dilutive.

At the end of the day, we just used these figures taken for granted. With the understanding of how the computation is done, it will give you more insight into a company capital structure. Hence for a complex capital structure company, the dilutive EPS will give a better estimation of the earning per share. Cheers.

Rationales for the usage of price multiples in equity valuation

If you are investor and you read the analyst report, you may wonder why they used price multiples such as P/E, P/BV, P/S and P/CF ratios in equity valuation. Well, I have consolidated the rationales and their drawbacks here. Hope you find them useful.

Rationales for using price-to-earnings (P/E) ratios in valuation:

• Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
• The P/E ratio is popular in the investment community.
• Empirical research shows that P/E differences are significantly related to long-run average stock returns.

The drawbacks of using the P/E ratio are:

• Earnings can be negative, which produces a useless P/E ratio.
• The volatile, transitory portion of earnings makes the interpretation of P/E difficult for analysts.
• Management discretion within allowed accounting practices can distort reported earnings and thereby lessen the comparability of P/E ratios across firms.

Advantages of using the price-to-book value ratio (P/BV) include:

• Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, P/BV can typically be used when P/E cannot.
• Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile.
• Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples include finance, investment , insurance, and banking firms.
• P/BV can be useful in valuing companies that are expected to go out of business.
• Empirical research shows that P/BV ratios help explain differences in long-run average returns.

Disadvantages of using P/BV include:

• P/BV ratios do not recognize the value of nonphysical assets such as human capital.
• P/BV ratios can be misleading when there are significant differences in the asset intensity of production methods among the firms under consideration.
• Different accounting conventions can obscure the true investment in the firm made by shareholders, which reduces the comparability of P/BV ratios across firms and countries. For example, research and development costs (R&D) are expensed in the U.S., which can understate investment and overstate income over time.
• Inflation and technological change can cause the book and market value of assets to differ significantly, so book value is not an accurate measure of the value of the shareholders' investment. This makes it more difficult to compare P/BV ratios across firms.

The rationales for using the price to sales (P/S) ratio include:

• P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and P/BV ratios, which can be negative.
• Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly affected by accounting conventions.
• P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis.
• P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and for start-up companies with no record of earnings.
• Like P/E and P/BV ratios, empirical research finds that differences in P/S are significantly related to differences in long-term average stock returns.

The disadvantages of using P/S ratios are:

• High growth in sales does not necessarily indicate operating profits as measured by earnings and cashflow.
• P/S ratios do not capture differences in cost structures across companies.
• While less subject to distortion than earnings or cashflows, revenue recognition practices can still distort sales forecasts. For example , analysts should look for company practices that speed up revenue recognition. An example is sales on a bill-and-hold basis, which involves selling products and delivering them at a later date. This practice accelerates sales into an earlier reporting period and distorts the P/S ratio.

Rationales for using the price to cashflow (P/CF) ratio include:

• Cash flow is harder for managers to manipulate than earnings.
• Price to cashflow is more stable than price to earnings.
• Reliance on cashflow rather than earnings addresses the problem of differences in the quality of reported earnings, (a problem when using P/Es).
• Empirical evidence indicates that differences in P/CF ratios are significantly related to differences in longrun average stock returns.

Drawbacks to the P/CF ratio:

• Some items affecting actual cashflow from operations are ignored when the EPS plus noncash charges estimate is used. For example, noncash revenue and net changes in working capital are ignored.
• From a theoretical perspective, free cash flow to equity (FCFE) is probably preferable to cash flow. However, FCFE is more volatile than straight cashflow.

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