Ratio Analysis A) the Price-Earnings Ratio Reflects Research Paper

Open, View, and/or
Download this Document

Total Length: 3219 words ( 11 double-spaced pages)

Total Sources: 7

Page 1 of 11

Ratio Analysis

a) The price-earnings ratio reflects two things -- the company's earnings and the market price. By no means is there a law that says one firm's P/E ratio should be in line with either the market or the competitors. First, an explanation of the earnings. The earnings component of the P/E is past-looking. The profit margin for HRG is fairly low -- 1.7% - reflecting that its earnings are quite low. With low earnings as the denominator, HRG will have a much higher P/E even with the same stock price. So in part, HRG benefits from having a weak denominator.

The other aspect of the P/E ratio is the price. The price reflects the expected future cash flow of the company. The market therefore expects higher growth in the future from HRG than what Kingfisher offers (Investopedia, 2013). So part of the misunderstanding is that the P/E ratio only partially reflects past performance; taken a whole it reflects the expected future performance compared with past performance, which is to say its expected growth. If the market expects growth from HRG. Arguably, there is no real reason to expect higher rates of growth of HRG based on its financials. The company's revenues are not growing, nor are its profits.

However, cutting back on dividends does make a difference. When a company reduces its dividend, Jenny is right in that is usually a bad sign, but it is not always. If the company has cut back on its dividend because it has experienced a strategic shift and is aiming for a high growth business model in the future, then the market might be responding to that. Again, however, it does not look like HRG is aiming for growth since it has not made any acquisitions, decreased its capital expenditures and has not added fixed assets. If anything, the market might be pricing in the possibility of an acquisition of HRG. The dividend cut was dramatic but it should be noted that in 2012 the dividend rate of 14.70p was higher than the EPS of 9.1p. So the dividend cover was unsustainable and HRG had to reduce it. Under the old dividend rate, if the share value was the same last year as this, the discount rate would have been 13.1% but now the discount rate is 64.3%. This implies that either the market has failed to adjust for the change in dividend policy or that HRG is now being viewed as significantly riskier than it was before.

Thus, while there is no evidence in the financial data that HRG is set to grow, a spike in the stock price either via acquisition or via a period of rapid growth has been priced in by the market, while Kingfisher remains priced at a modest level of growth as befits its actual level of growth.

It is worth remembering what the concept of market efficiency means. It reflects that the market has priced public knowledge into the stock price. The strong form of market efficiency holds that everything is priced in. This could be the case with HRG -- Jenny cannot simply assume that because she has the financial statements that she knows as much about this company as the market does. Furthermore, there is not much logic in benchmarking against just one other company. Kingfisher can reasonably benchmark against the industry averages or its own past performance, but against just one other competitor it is simply not a statistically significant sample size, especially if there is some mitigating piece of information she does not know about, like a potential takeover bid that has driven the price up. The trend in the price is important here. For what it's worth, 11 of 24 analysts have a sell rating on the company's stock, with a further 9 having a hold rating -- many observers feel this company's stock is overvalued (Byrd, 2013). Remember that efficient markets are not necessarily instantaneous, reactions can be slow, and different figures will be interpreted differently by the various market actor and participants.

b)

To further analyze this situation, it is necessary to examine the financial statements of both of these companies. We only have the figures for HRG with which to work. The analysis is as follows. First, the context.

Kingfisher and HRG are in slightly different, albeit related, industries. Kingfisher sells home improvement goods while HRG sells home furnishings.

Stuck Writing Your "Ratio Analysis A) the Price-Earnings Ratio Reflects" Research Paper?

View All Our Example Ratio Analysis A) the Price-Earnings Ratio Reflects Research Paper

Have A Custom Example Essay Written

Both should have some correlation with the housing market, but more so for Kingfisher than for HRG. So part of the differences in the expected growth of these two companies relates to differences in their industries. Kingfisher is the larger of the two, and has operations in 8 countries. HRG is only in the UK and Ireland, which inhibits its growth potential. However, it is possible that consumer spending is increasing at a more rapid rate than housing growth, which would imply a faster rate of growth for HRG going forward. While Kingfisher's management is focused on incremental growth (Kingfisher 2013 Annual Report), other firms in the industry, especially smaller firms, may have set themselves on a faster growth trajectory. At HRG, Argos recorded 5.9% sales growth, and the company has plugged its cash into updating the stores, improving its e-commerce and entering into partnerships with firms like eBay, all of which point to a stronger growth pattern in the future. Past performance, in the case of HRG, might not be indicative of future performance as it moves to an integrated e-commerce platform (BBC, 2013).

Overview

The market seems to be pricing in much stronger growth than past performance indicates for HRG because of the renovations the company has done to modernize its stores, and because of its burgeoning e-commerce business. The emergence of a forward-looking e-commerce strategy, complete with powerful strategic partners, represents a strategic shift for the company. The result is that the market is not pricing in past growth but expected future growth as the new strategies take hold at HRG. Many analysts are less optimistic than the markets, largely based on their overview of the company's financial situation. The dividend decline should also be taken into consideration here -- as noted this could represent a shift and indeed that is the case with HRG, where cutting the dividend frees up capital for the e-commerce venture at Argos and repositions the company in the market as a growth company rather than a dividend company.

Perhaps less important is the external situations of these two companies, but it is worth taking a quick look at these. First, Kingfisher seems to be flatlining in terms of its growth potential. It needs new markets but has been slow to pursue these. It has no hope of accomplishing anything against the strong competition in North America so unless Kingfisher can grow elsewhere it can expect an underwhelming response from the stock market. The company has seen its continental, European and Asian markets all decline in the past year. Other international saw a steep decline in profit as well, and thus there are no reasons in the income statement to believe that Kingfisher is going to grow at a faster rate than HRG going forward. HRG may not have performed well over the past five years, but it has a plan to improve and that plan is starting to bear fruit.

Financial Ratio Analysis

Overview HRG

2013

2012

Turnover

% change

-1.93%

Operating Profit

99

% change

38.38%

Earnings

94

73

% change

28.77%

Operating Cash Flow

% change

43.00%

Capital Expenditure

78

% change

-40.46%

Total Debt

% change

9.32%

These figures paint the picture of a company that is on a downward trend. Turnover has declined, though there have been some improvements in operating profit and net earnings. That points to improved cost control at the company, in order to gain increased profit despite ongoing reductions in turnover. An examination of the income statement reveals the gains were incremental, but that was enough to squeeze out an extra £38 million in operating profit. Slightly better margins combined with a slightly lower selling costs/sale are responsible for the improvements, rather than any major shift. As a result of these minor changes, however, the company shows as being much more profitable this year than last. Furthermore, cash flow improved as the result of the company reducing its capital expenditures. This occurred despite the program to modernize the stores -- it would appear that the company has been more selective in the projects it is taking on. There was a slight increase in gearing, but by no means anything over which to get alarmed. The next set of ratios will illuminate further trends with HRG's business.

Performance Ratios

2013

2012

Gross Margin

32.55%

32.04%

Expenses/Sales

29.70%

29.91%

Net Margin

1.72%

1.31%

Asset Turnover

1.29

1.39

Return.....

Show More ⇣

     Open the full completed essay and source list


OR

     Order a one-of-a-kind custom essay on this topic


sample essay writing service

Cite This Resource:

Latest APA Format (6th edition)

Copy Reference
"Ratio Analysis A The Price-Earnings Ratio Reflects" (2013, December 04) Retrieved May 17, 2024, from
https://www.aceyourpaper.com/essays/ratio-analysis-price-earnings-ratio-reflects-178923

Latest MLA Format (8th edition)

Copy Reference
"Ratio Analysis A The Price-Earnings Ratio Reflects" 04 December 2013. Web.17 May. 2024. <
https://www.aceyourpaper.com/essays/ratio-analysis-price-earnings-ratio-reflects-178923>

Latest Chicago Format (16th edition)

Copy Reference
"Ratio Analysis A The Price-Earnings Ratio Reflects", 04 December 2013, Accessed.17 May. 2024,
https://www.aceyourpaper.com/essays/ratio-analysis-price-earnings-ratio-reflects-178923
   

Open, View, and/or
Download this Document
order custom essay example