Diluted earnings per share

[viciam]

We all have a personal style, for me it hinges on things like the quality of earnings (a subjective measure), consistency of earnings, quality of management (you would be surprised at how inept some senior executives are), financial strength (capital structure/leverage), sensitivity to macro themes, industry themes and strategic position within an industry. Only after you understand each of these can you begin to get comfortable with putting a price on the EPS or NTA you calculate from financial statements.

If you are just starting out, the best free advice IMO is found right here:
http://www.berkshirehathaway.com/letters/letters.html

A few weekends rattling through those and you should be ahead of the average punter!

I don't want to be an average punter, I want to be an excellent investor. Thanks for the link I will continue reading through those.

I'm reading about ratios at the moment and I have a question. Few different websites will give a slightly different formula for the same ratio. I understand that some analysts will personalize a formula by adding or leaving certain numbers from the balance sheet or income statement out. Is this something only experience can teach? Knowing what could possibly be left out or added to give a more accurate answer?

I'm looking at Return on Capital Invested and there are examples of EBIT / Capital Employed or Net Income / Capital Employed. Then even Capital Employed is defined differently, some say Capital Employed is Total Assets - Current Liabilities whilst another will say Capital Employed is Average Debt Liabilities + Average Shareholders Equity.

Is the variations in formulas just a personal preference? How can one know the preferences of top investors? I suppose its down to being flexible and adaptable to the variation of the formula one should use under certain circumstances? Knowing when to use which comes with experience, am I right or am I off the mark?

Thanks again

 

[yonobarn]

Yep, as you gain experience you will become better at knowing implicitly which figures to use.

Ask yourself what a particular ratio is trying to tell you about a company. A "return on capital invested" figure can tell you a couple of different things. You need to understand a company's balance sheet, and how they got it to where it is to understand this figure properly.

For an example, in Australia we have a financial institution called Suncorp (ASX:SUN) that purchased a large general insurance business just before the GFC. It paid a peak multiple on peak cyclical earnings, issuing a significant amount of new equity at the time to do it. The value of this acquisition sits at its historical cost in Suncorp's balance sheet (unless they ever write it down), and given earnings have fallen, detracts from its "return on capital invested".

At the other end of the spectrum, you may have a conservative IT company like Technology One (ASX:TNE) that has essentially been run as a private company (ie - minimise tax by expensing as many costs as possible rather than capitalising them). This keeps the balance sheet small, and "returns on capital invested" high. If TNE ever goes and acquires a peer, your calculation for ROCI would likely fall.

To further complicate things (!), you need to understand what returns a company can be expected to generate on a marginal dollar of capital invested (this figure is arguably of more value than the vanilla stat, but difficult to quantify). Sometimes companies don't 'need' as much capital as they have, so they would be best served returning it to shareholders.

The point I am trying to get across is you shouldn't get too hung up on ratios like these, rather you should understand what they tell you, and their inherent limitations. There is usually limited value in making your ratios 'more accurate', ie - it is unlikely to help you make more money.

May I suggest a good one to start with is EV/EBIT.

The numerator EV is Enterprise Value, and is calculated as market capitalisation (number of shares on issue x current share price) + net debt (long term debt + short term debt - cash). This reflects the price you as a minority shareholder will have to pay for the "capital employed" and also gets rid of the nuances surrounding a firm's equity figure as reported on its balance sheet.

The denominator EBIT is usually quite easy to calculate (pretax profit plus net interest expense if it is not reported explicitly).

The value in an EV/EBIT multiple is it normalises out the impact of a firm's capital structure. That is, it is total earnings before any money is distributed to debt or equity holders. I would argue that the inverse of your EV/EBIT multiple is probably a more useful proxy for return on capital invested than the others you mentioned.

As always, there is always a few ifs and buts. In the case of an EV/EBIT multiple, banks do not have them (a lot of their earnings come from net interest received, so you are better served using a PE ratio). Also, do you want to know average EV for a financial period, the EV at the balance date, etc, etc. For some businesses an EBITDA figure is of more use, especially those that have big depreciation bills and little capital expenditure requirements. You may see a theme emerging?

The biggest limitation is that by looking at these figures, you are investing by looking in the rear view mirror, that is, watching stuff that has already happened. The 'top investors' you refer to are probably more interested in all the factors that will affect the EV/EBIT multiple investors will be willing to pay 3 years from now, and what that implies for the price being paid for shares today!

 

[viciam]

That's just the problem you see. I shouldn't get hung up on ratios but rather understand what they tell me and their limitations. But I feel I need to master calculating ratios because if I don't then my calculations will be way of the mark, then when I do try to understand what they are telling me, I will be seeing a picture that isn't accurate.

I'm feeling the emotions of buying stocks though for the first time today since my 2 month history. All of my stocks went down today because of a news that Spain might need sovereign bailout. But I'm trying to keep calm and emotionless because I read somewhere that don't let daily news and plunges in the stock market make you lose your logical thinking to emotional thinking.

To me it seems things are just going to get worse. The way the worlds economies are shaped up to be and the way the financial structure appears to be showing cracks and China and US at each others throats. You know history tells us that when tension rises too much, a war needs to happen and blood needs to be split in order for things to calm down again, to settle the greed, to get rid of bad feeling. With all the armed conflicts around the world, this euro zone crisis really makes me think I bought these stocks too early because things are going to get worse. The Eurozone countries can't come out of the mess they are in, more loans is not going to solve the problem because it just brings more debt. I get the feeling Eurozone will break up, Its not possible to manage so many different countries under one. I wish I had a crystal ball!

 

[viciam]

I'm very confused

 

[craft]

I'm very confused

Viciam

Reading your posts in this thread, I feel that you might be placing the cart before the horse. The accounting will not provide you the answers until you know the questions you are trying to answer.

For example if you want to know the level of profitability of a business it is much easier to drop out the financial structure and look at EBIT/Funds employed then muck around with diluted earnings/debt levels etc to get a meaningful ROE at the per share level.

Get yourself an investing frame work (ie competitive/economic advantage, how durable, how much capital can be applied to it? etc) and you will know what you want the books to tell you and you’ll find it easier to narrow down the areas you need to concentrate on.

 

[viciam]

Viciam

Reading your posts in this thread, I feel that you might be placing the cart before the horse. The accounting will not provide you the answers until you know the questions you are trying to answer.

For example if you want to know the level of profitability of a business it is much easier to drop out the financial structure and look at EBIT/Funds employed then muck around with diluted earnings/debt levels etc to get a meaningful ROE at the per share level.

Get yourself an investing frame work (ie competitive/economic advantage, how durable, how much capital can be applied to it? etc) and you will know what you want the books to tell you and you’ll find it easier to narrow down the areas you need to concentrate on.

Hi Craft, that's good advice especially the last paragraph, please elaborate I'd like to hear more

Thanks

 

[viciam]

I think electric cars are the future

Just taking a stroll around my neighbourhood and I can't help but notice electric cars in run down neighbourhoods meaning its taken the interest of the working class ( largest group of people in any country ). Then large supermarkets and stores like Tesco, Sainsburys and IKEA and NCP car parks are setting up electric charging points in their car parks. Plus there's government incentives for buying electric cars, even the world famous Ford Transit van is coming in an electric version.

Most of the batteries used in electric cars are lithium and so I am now turning my attention to Lithium producing or mining companies. Bolivia has the largest reserves of Lithium with no production as of yet whilst Chile has the 2nd largest reserve with the highest production.

And even if the world economy and Eurozone keeps going down and all hell breaks loose on a global scale, I think lithium will either be steady or grow because of its varied use in military, everyday tech from Iphones to laptops to a growing electric car industry, and if there is all hell and the world doest take a step back because everyone just blows the **** out of each other, as humans we still strive for technology and electricity is always going to remain and lithium is the ultimate electricity storage material on earth. And if all hell doesn't break lose and things improve then that's even better, so that's got my confusion solved a little I think. Not being able to predict the future of the financial collapse or war ( War really can't be dis regarded because its a very real threat, just take a step back and think about it for a second and you may get a feeling that everything is set up for some kind of major conflict, The eurozone collapse, the power shift from US to China, the US isn't going to give up power that easily, infact I remember reading a while back that some official US military doctrine mentioned something along the lines of how the US will do everything in its power to stop another nation rising beyond America. And an economical war is already under way as seen by the trade wars with import tarrifs etc being put into place by US on Chinese goods ) Anyway not being able to predict the outcome of the future I think I'll stick with certain energy and natural resources, in case of hell breaking loose or a gradual economic recovery they will be the winners

 

[viciam]

but saying all that I don't even know where to begin to put a value on a company

I wish I was einstein, newton, buffett, templeton, aristotle, plato rolled into one then I'd be able to make a good decision

 

[burglar]

...
If the share price rises dramatically, do you sell or hold?
If it falls, do you buy more?
...!!

Do you have a plan?

 

[viciam]

Just re-read this thread, so helpful.

At the time I started the thread, most of the things mentioned were complete jargon to me. Now having spent time learning and teaching myself, looking back and reading this thread makes a lot more sense.

Some great advice in here!

Thanks guys