The industry analysis enables us to shortlist industries for the purpose of equity investments. The next step is to identify superior performers in this industry. Sometimes even though an industry might be doing well, some companies in the industry may not perform well. For example, with the support of the eighth five year plan, telephone cable industry is performing extremely well. But the performance of Tamilnadu Telecommunications Limited is not up to the expectations.
Performance of a company can be assessed on
1. Quantitative analysis, based on financial data
2. Qualitative analysis, based on non-financial parameters
The two broad categories of information available for analysis are internal and external. Internal information consists of data and events in respect of the operations of the firm made public by them. The principal information sources generated internally by a firm are its financial statements. External sources of information are those generated independently outside the company. They provide a supplement to internal sources by (1) overcoming some of the bias inherent in company generated information, and (2) providing information simply not found in the materials made available by the companies themselves.
Quantitative analysis is usually based on the traditional financial statements, viz., income statement and balance sheet. A company publishes the balance sheet and the income statement every year. An investor, before evaluating the company based on the traditional statements has to confirm that the information provided is correct complete consistent and comparable. The word consistent refers to the accounting procedures and policies of the firm. Comparable refers to the information provided which can be compared between one firm and another.
Factors to be observed before analyzing the financial statements are:
1. Any changes in accounting policies
2. Manipulation of bottom line by manipulating inventories, depreciation, loans and advances etc
Ratios express the mathematical relationship between one quantity and another of a financial statement.
Quantitative analysis based on financial data consists of two steps:
Step 1: Forming ratios between various financial variables of the financial statement.
Step 2: making inter-firm comparison or comparison with industry performance.
Industry Average: It is a summary measure of the performance of all the companies in an industry.
Inter-firm comparison consists of comparing ratios of one company with another of the same industry. Comparison wit the industry performance refers to the comparison of company ratios with the industry averages.
Operating Profit Margin: When investor compares the industry average 9.54 with the ratio values of the companies in the industry, only Hindustan Motors and Mahindra and Mahindra look to be performing well. Sipani auto, Premier Auto, Standard Motors show poor performance as the ratio values of these companies are lower than the industry average value. When the investor considers inter-firm comparison, Hindustan Motors has high ratio value compared to other companies in the industry. But an investor cannot judge the performance of the company based on a single ratio.
Gross Profit Margin: industry average of gross profit margin is 6.88. When this value is compared with the ratio values of companies, Mahindra and Mahindra (8.00) alone is showing good performances. Even when inter-firm comparison is made Mahindra and Mahindra is showing better performance over the remaining companies of industry. Readers can observe that based on the operating profit margin, Hindustan Motors (14.33) shows good performance over Mahindra and Mahindra (11.40). But based on gross profit margin Mahindra and Mahindra (8.00) is showing better performance than Hindustan Motors (5.70). Thus, an investor is not to judge the performance of company based on single ratio.
Net Profit Margin: Industry average of net profit margin is 3.87. When this is compared with the ration values of the companies in the industry, Mahindra and Mahindra (5.00) shows performance above the industry average. When inter-firm comparison is made it can be observed that many companies are making losses indicated by negative value of ratio.
Return on Networth: The industry average of Return on Networth is equivalent to Return on networth of Mahindra and Mahindra (16.42) (as the ratio value of Hindustan Motors is negligible and the remaining companies in industry are making losses).
Earnings Per share (EPS) and Cash Earnings Per Share (CEPS): By observing ratios of EPS and CEPS of all the companies, only Mahindra and Mahindra and Hindustan Motors have ratio values. As remaining companies are making losses the values of ratio is considered as zero. By making inter-firm comparison Mahindra and Mahindra with EPS (16.82) and CEPS (23.80) shows performance well ahead of Hindustan Motors whose ratio values are EPS (1.63), CEPS (3.44).
Price – earnings Ratio (P/E Ratio): P / E ratio is the ratio of market Price to the earnings per share industry. The industry average of P/E ratio is 27.52 whereas Hindustan Motors P/E ratio value is 29.47 and Mahindra and Mahindra P/E ratio value is 25.57. As the ratio value of Hindustan Motors is higher, the investor has greater expectations about the performance of the Hindustan Motors than Mahindra and Mahindra.
What we have discussed here are a few ratios. An investor can frame ratios between any two values of financial statement, and can interpret the ratio value in order to evaluate the performance of a company.
The reader can observe the following things from the above example:
1. Even though the performance of the industry is good, there will be companies facing losses and companies making profits.
2. Investor cannot judge the performance of a company based on any single ratio.
3. Performance of any company can be evaluated only by comparison, against benchmark or ratio values of another company of the same industry or with the industry averages.