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Can we compare EBITDA with CFO to assess quality of profits, Using historical PE ratio to assess current valuation level, Interpreting related party transactions, Trading members as shareholders of companies

Modified on September 10, 2019

We have a section dedicated to answering queries from readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. We have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to the following queries:

  1. Can we compare cumulative EBITDA (instead of cumulative PAT) with cumulative CFO to decide whether a company is converting its profits into cash?
  2. Can we use the historical PE ratio of a company to determine whether it is currently, cheaply or richly valued?
  3. How to interpret related party transactions?
  4. Why do trading members hold shares on behalf of beneficial owners?

 

Can we compare cumulative EBITDA (instead of cumulative PAT) with cumulative CFO to decide whether a company is converting its profits into cash?

 

Dear Vijay,

I have one question related to comparing cumulative cash flow from operations (cCFO) to cumulative net profit after tax (cPAT). Consider a small company that operates in cash only and has only one asset, which is depreciating every year. Then, in this case, cPAT will always remain lower than cCFO. I believe that it will misguide the comparison. Because there are few other non-operating expenses that would always keep this difference. Here the company did not require any cash as its dealing in cash only.

My question is how can you remove this variance in order to compare cCFO to cPAT?

Below is a snapshot of an example I am talking about. Here, the company’s cash is increasing and does not require any loans to fund its growth. However, if we go through the comparison of cPAT vs cCFO, then we could conclude that the company is bad at converting their profit into cash. However, it is 100% converting its PAT into cash.

Sample P&L, Balance Sheet And Cash Flow Statement

One correction in the above pic is for year 2 the CFO is 5 and not 10 and cCFO will be 15 and even net profit is -15 for year 1 and cPAT will be -25.

This is a simple example. Here, I have assumed that the company does the same-day purchase and sales. Therefore, there is no credit purchase or credit sales. Hence, the company is accumulating cash as it can be seen from the year-to-year comparison. However, the depreciation is higher and hence resulting in net loss. This is all that I have assumed.

Therefore, my query is how to avoid such situations as there could be multiple scenarios where this could happen like finance expenses etc. I hope you got my query.

Well, my point here is simply that comparing cPAT with cCFO will not yield any conclusive evidence whether the company has been able to convert its profit into cash. An investor needs to deep dive into it.

Secondly, I have also assumed in my example that the plant was purchased and in the same year, operations were started. Therefore, on an overall basis, this company would never match cPAT with cCFO.

Therefore, can we instead compare cumulative earnings before interest, tax, depreciation & amortization (cEBITDA) to cCFO as this would be a better view I believe.

If you apply this concept in my example, then you will come to know that the company has been converting its profit fully into cash.

Let me know if you agree with me.

 

Author’s Response:

Hi,

Thanks for writing to us and elaborating on your query with clarifications.

In the case cited by you, the cumulative cash flow from operations (cCFO) will be higher than the cumulative net profit after tax (cPAT). The reason for the same is high depreciation, which has resulted in net losses. You may read further about the factors that may lead to CFO higher than PAT and the factors that may lead to CFO lower than PAT in the following article, which shows step-by-step calculation of CFO from PAT: Understanding Cash Flow from Operations (CFO)

We believe that an investor should always keep in mind that an investment decision is a result of a comprehensive analysis that includes assessment of PAT as well as CFO. An investor should not be biased by good performance on either PAT or CFO alone. A company should have good performance on PAT and the PAT should have been converted into CFO.

Regarding PAT being negative due to depreciation, an investor should remember that the depreciation is nothing but the deferred recognition of expenses done by the company on plant & machinery. The company spent money on plant & machinery in the past but it did not deduct these expenses in the profit & loss statement (P&L) as an expense when it constructed the plant.

Therefore, in a manner, in the past, when the company was spending to construct the plant, its profits were overstated because the money spent was not deducted as expense. Whereas now, when the plant is complete, the profits are understated because the prior expense of plant creation is being deducted as depreciation even though there is no current cash outflow due to plant creation.

However, this is how the concept of capitalization operates. You may read more about how investors should understand capitalization in the following article: Understand Capitalization of Interest and Other Expenses

As mentioned earlier, we do not attempt to take our final investment decision by looking at CFO alone and therefore, we would request investors to look at PAT, CFO as well as all other parameters of the following checklist before making any final investment decision about any company. Final Checklist for Buying Stocks

Moreover, investing & finance allows investors to use their preferred ratios and even tweak them to make their own custom ratios. We advise investors to keep experimenting with different ratios and use the ones, which they find to give good results. At end of the day, none of these ratios is an end in themselves.

As mentioned earlier in the case of PAT and CFO, in case of EBITDA vs CFO as well there are challenges like those that EBITDA is pre-tax number and CFO is post-tax number.

Therefore, we advise readers to use the ratios that they feel comfortable about and more importantly do not overly focus on any one ratio. A comprehensive analysis of all the aspects is important before taking a final investment decision.

Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

All the best for your investing journey!

Dr. Vijay Malik

 

Can we use the historical PE ratio of a company to determine whether it is currently, undervalued or overvalued?

 

Dear Sir,

You say that the industry-specific PE ratio is not relevant for investors. (Is Industry P/E Ratio Relevant to Investors?). However, what about the company-specific PE ratio for large established companies?

If a company like Infosys Limited, which has a median PE ratio around 18 for 8 years/5 years, if we are able to buy it for say 13 or 15 PE ratio, then we can say that we have bought it cheap relative to historic valuations and then sell it when it goes above the median PE ratio.

The investor needs to analyse though the reason why the PE ratio fell down before buying the stock.

This is something like the Nifty PE ratio. When the Nifty PE ratio crosses certain threshold, we say the market is overvalued and when it falls below a certain threshold, then we say the market is undervalued.

 

Author’s response:

Hi,

Thanks for writing to us!

We do not give a lot of weight to the historical PE ratio. This is because, if the company is doing well and as a result, its PE ratio rises, then the PE ratio may not go down in future. Similarly, if the company is doing badly and as a result, its PE ratio comes down, then the PE ratio may not go up in future.

Therefore, we advise the investors to look at the current business position and the current PE ratio of the company and then make their decision.

3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

How to interpret related party transactions?

 

Sir,

I have one question related to Shri Jagdamba Polymers Ltd (SJPL). (Analysis: Shri Jagdamba Polymers Ltd)

From the amount outstanding to the associate companies in the related party transaction section of the annual report (AR), we notice that SJPL has to collect some money from Shakti Polyweave Private Ltd (SPPL). However, how do we know whether SJPL has given debt to SPPL or it has sold products or job work to SPPL from this data?

Shri Jagdamba Polymers Ltd Related Party Transactions

In addition, the promoter or key management personnel (KMP) have received interest on their loan given to SJPL. However, the rate of interest is never shown in any AR from 2010 to 2018. Moreover, the loan from the promoter is never shown in the credit rating reports except in the 2017 credit rating report stating that:

“there were unsecured loans from promoters of Rs.11.90 crore of which Rs.8 crore were subordinated to bank loans and hence considered as quasi capital till FY16. However, the promoters have withdrawn the unsecured loans of Rs.6.25 crore during FY17. Hence, from FY17 onwards the unsecured loans have been considered as debt.”

 

Author’s response:

Hi,

Thanks for writing to us!

The amount outstanding at the end of the year is the result of transactions with the related party during the year. An investor has to analyse each of the items in the related party transactions table to understand all the transactions during the year. It might be a result of loans given/repaid, interest accrued but not paid, job work, rent, remuneration, dividends etc.

Shri Jagdamba Polymers Ltd Related Party Transactions 2

An investor may determine the ease of interpretation of such transactions as a measure of disclosure standards of the company. If something is difficult to interpret, then it might be a deliberate attempt to make it so.

Read: Why Management Assessment is the Most Critical Factor in Stock Investing?

Most of the time, companies do not disclose the interest rate being paid to promoters on their loans. However, investors may ascertain the approximate level of interest rate from the amount of loan given by any related party and the amount of interest paid by the company to the related party during the year. For illustration, an investor may refer to the following article in which we have calculated the interest rate on the loans granted by promoters to KNR Constructions Ltd:

Analysis: KNR Constructions Ltd

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Why do trading members hold shares on behalf of beneficial owners?

 

Hi Sir,

One doubt –In shareholding pattern in BSE they show something as “Details of disclosure made by the Trading Members holding 1% or more of the Total No. of shares of the company.” below it

Details Of Holding By Trading Members

Sl. No.–Name of the Trading Member –Name of the Beneficial Owner—No. of shares held— % of total no. of shares–Date of reporting by the Trading Member

Here, I wanted to know what the trading members do by holding the shares of the beneficial owner. Do they regularly trade with those stocks & maintain liquidity in the market? Or they trade on behalf of Promoters & earn profit?

Thank you.

 

Author’s response:

Hi,

Thanks for writing to us!

Let us take the example of a sample case where a trading member may hold shares on behalf of the beneficial owner.

If an investor buys shares of a company through a stockbroker (i.e. trading member), then the stock exchange/clearing corporation sends the shares to the stockbroker (also called as a trading member). These stocks usually remain in a common pool account with the stockbroker unless the investor gives instructions to the stockbroker to shift these shares to the investor’s Demat account (CDSL or NSDL).

These shares lying in the common pool account of the stockbroker, which are not transferred by the investor to her Demat account, is one example of the trading member holding shares on behalf of beneficial owner (the investor).

Investors (beneficial owners) may leave the shares in the common pool account for many purposes:

  1. To take financing (margin funding) from the broker
  2. Allow the broker to trade on behalf of the investor etc. or any other reason.

Read: How to Safeguard Stocks with Discount Brokers?

All the best for your investing journey!

Regards

Dr. Vijay Malik

P.S.

 

DISCLAIMER

Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of any of the companies discussed above.

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