FIN343 6 Discussion Question Responses
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R1
When purchasing shares of a company I would want to know all of the information talked about in the lecture. If I had to limit this to just 2 out of the 5 though I would choose revenue growth and debt. These are two solid indicators of the health of the company right now, and where it is forecasted to go. Revenue growth can be a great indicator as to how much the company will increase its sales which is imperative for a growing company. I like to invest in growing companies as I am more of a growth investor, but I do partake in value and income investing as well. Projected revenue growth can help tell me what the stock will be worth in the future, and how much upside my investment will have.
I chose debt as my other important factor to look at. I would want to make sure that the company has a lower debt than their assets Both total debt and current debt compared to assets can help me determine if a company is in a healthy spot, or if they have too much debt that they will struggle to pay in the future. Obviously, I do not want to invest in a company that has too much debt because of the risk involved. All companies have some level of debt and it is not always a bad thing, but the debt should be manageable for the company to keep making payments on in the future. Too much debt is a good sign the company will not be around for very long and is a poor investment.
Hayes, A. (2020, September 16). Debt Ratio. Investopedia. https://www.investopedia.com/terms/d/debtratio.asp.
R2
I personally believe that the debt of a company is important to analyze. Most companies have a debt of some sort, whether it be to fund inventory or accounts receivable, machinery and equipment purchases, or real estate, it is nearly impossible to avoid. However, at some point, too much debt becomes too much to handle. Usually, when companies take on debt, there needs to be something on the income statement that adjusts in order to compensate for this additional debt payment that will now be required. For that reason, when looking at potential companies to invest in, a few years of financials should be analyzed. If debts increased on the balance sheet, did the income statement show a positive effect of that increased debt? For example, did revenues increase in year three after debt increased in year two, did repairs expense decrease, etc. Scherreik (n.d.) warns that when companies take on debt for reasons other than building a business is when it becomes an issue. She noted that an increase in debt to finance stock repurchases in the 1990s eventually hurt companies because even though their share prices increased, they now had additional debt payments to make.
I don’t think that a company should be considered by investors based strictly on its revenue growth. If the company is unable to manage expenses, this revenue growth may not turn into additional earnings for the company. Furthermore, is the revenue increase sustainable or was it a one-time event? If the increase is non-recurring, any increase in earnings will also diminish after revenues steady back out.
References
Susan Scherreik. (n.d.). Reprinted with special permission from Business Week — by The McGraw-Hill Companies, Inc.
R3
Among the lecture items that are considered key criteria for companies with outstanding growth prospects, I think the most important is revenue growth. The lecture explains that revenue growth is so important because companies cannot move numbers around to plump up profits very well, so they cannot mislead investors as much in this area. The examples of Johnston & Johnston that has had 69 years of consecutive years of sales increases and Wal-Mart that is able to show revenue growth year after year, showing some examples of companies that are truly being some of the most influential companies that show their success through their revenue growth. Looking for a revenue growth that is above that of the overall economy is something to look for-such as above 3% sales growth rate would be above the economy’s GDP average annual rate prediction. Also looking to avoid revenue that is almost entirely just tied to acquisitions, which could be making the revenue numbers look better than they are is a key for investors tied to the revenue growth. (Sherreik)
It is also discussed in the lecture how sales are something that investors like to focus on instead of earnings, since sales cannot be manipulated as easily as earnings figures. Sales and inventories should be growing at similar rates to provide proof that the sales numbers are not manipulated. All of this type of information can be found on companies’ 10K annual financial statements. (Sherreik)
Sources:
Sherreik, Susan. (no date). Business Week. Mcgraw Hill Companies Inc. Retrieved from: https://upperiowa.brightspace.com/d2l/le/content/95918/viewContent/1168104/View
R4
The P/E ratio is a very popular gauge that investors look at before purchasing a stock. The P in the ratio stands for price. This is the current price of 1 share of the stock. The E in the ratio stands for earnings. This represents the earnings for the company or its bottom line. The ratio gives us a good look at how much you are paying for the company relative to how efficient they are at making money have had a profit.
The pros of this ratio are that it is a quick way to get a pulse at if the stock is on sale or you are paying a premium for potential. Investors may look at hundreds of stocks a day and this simple ratio can be one way to go quickly through a bunch by eliminating ones with too high of a ratio. Another pro of this ratio is simply the general effectiveness of the numbers involved. Investors want to make sure they are purchasing the share at a good price relative to how the company is performing and the P/E ratio can do this effectively.
One con of the P/E ratio is that companies can use some shady techniques to make their earnings look better than they actually were. This will make the P/E ratio lower, in turn being more attractive to investors without actually being as valuable as it shows. Another con of the P/E ratio is that companies that are newer with lots of potential have really high ratios because they do not have much if any, earnings. This makes it difficult for investors to decipher between a bad deal or a company with lots of upsides that is just new. The P/E ratio is not effective for new companies that have not had time to build up earnings.
Fernando, J. (2021, January 28). Price-to-Earnings Ratio – P/E Ratio. Investopedia. https://www.investopedia.com/terms/p/price-earningsratio.asp.
R5
A price-to-earnings ratio is a tool for valuing a company. You take a company’s share price divided by the earnings per share. The pros to the P/E ratio are that it helps us determine if a company’s stock is overvalued or undervalued. We have learned that when choosing companies to invest in, it’s important to see if we’re purchasing shares at a fair value. Other benefits of the P/E ratio are that it’s easy enough to compute and it is widely used across the financial spectrum. It is also a great tool for comparing a business to its industry averages. A con to using the P/E ratio is that it cannot be used on businesses that have no profits. If there are no earnings then the formula cannot be used. Another limitation of this tool is that it does not accurately compare companies across different sectors. Different industries have a variety of ways in which they earn money and the time frame in which they earn that money. These differences make comparing the P/E ratio of companies in different industries less beneficial. One other drawback of using this ratio is that it doesn’t take debt into consideration. Two similar companies, one with little debt and one with much debt, would have different price-to-earnings ratios. The company with more debt would have a lower P/E ratio but it could also see higher earnings because of this (Fernando, Jason).
Reference
Fernando, Jason. (February 8, 2021). “Price-to-Earnings Ratio – P/E Ratio”. https://www.investopedia.com/terms/p/price-earningsratio.asp.
R6
The price-to-earnings ratio, or P/E ratio for short, helps investors evaluate the stock price of a company in relation to its earnings per share (EPS). You calculate the P/E ratio by dividing the company’s stock price by the EPS. Many investors look for stocks that are undervalued, this way, they have the potential to grow in value over time. If a company has a low P/E ratio, this means they are utilizing their resources to produce the maximum amount of profits. This benefits investors. “The average P/E ratio for stocks hangs around the 20-25 mark. This means that investors are willing to pay $20-$25 per $1 of company earnings.” (McClanahan, n.d.)
Pros – Easy to calculate, readily available, can quickly estimate the value of a stock, helps investors compare a stock among other stocks.
Cons – Does not provide a thorough or complete analysis of a company’s stock, the ratio can be manipulated, not updated in real-time, based on earnings from the past, does not take into account a company’s debt or cash.
Overall, the P/E ratio can be a quick way to figure out the value of a stock, but it doesn’t necessarily show the full story of a stock or a company.
Reference
McClanahan, A. (n.d.) Price-Earnings Ratio (P/E) Guide: Explanation, Uses & Examples. Retrieved from https://www.wealthsimple.com/en-us/learn/price-earnings-ratio
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