Financial Development Partners
Exploration - Development - Production
INPAC
Integrated Pan-African Energy Co., Ltd
Equity
The investor interested in equity securities should first have a firm understanding of what equity is. Equity can be defined
as ownership of, or investment in, property. Property may include such things as art, race horses, computer chips,
lumber, automobiles or just about anything to which legal ownership may be demonstrated.
There are three basic types of equity: common shares, preferred shares and warrants.
Equity is viewed by the market as an ownership "share" in the revenue stream of a corporation's income once all prior
obligations and debts have been satisfied. The "share" price is the relative value given to the corporations earning
potential based on a number of factors. These include general economic conditions, both in the industry and in the
overall economy, earnings projection, projected corporate growth, corporate stage of development, and financial ratio
analysis. The overall analysis of a firm's future earning potential must be done through both fundamental and technical
analysis, including charting and other indicators.
Generally, the structure of equity is that a "share" of the corporation represents the current market value of the firm,
secondary to this is the potential for dividend income. There are various classes of equity for the individual investor to
consider. The primary three groups into which equity may be subdivided are common stock, preferred shares, and
warrants.
Common Stock
Common stockholders participate in the earnings stream of the corporation through dividends paid and capital gains
made on a per share basis. Owners of common stock are responsible for the election of the Board of Directors,
appointment of Senior Officers, the selection of an auditor for the corporate financial statements, dividend policy and
other matters of corporate governance. This may also be done on a proxy basis, whereby a third party may be ceded the
shareholders right to vote by the shareholder.
The responsibilities associated with common stock mean the investor participates to a greater extent in the fortunes of
the firm. Capital gains, through the increase in market price of the firm's stock, accrue to a greater extent to the holder of
common stock than to the holder of preferred stock.
Common stockholders also have a couple of significant rights should the business invested in be wound down: limited
liability to the creditors of the firm and a residual claim on any assets or income derived once all prior claims
(mortgages, bondholders, creditors, etc.) have been satisfied.
Preferred Stock
Preferred shares are stock in a company which have a defined dividend, and a prior claim on income to the common
stock holder.
Should the company wind up operations, preferred shareholders are paid any obligations owed to them. Should a
dividend be suspended by the Board of Directors, for what ever reason, the preferred share usually has a cumulative
clause in it allowing that any unpaid dividends must be paid fully before any dividends may be declared and paid to
holders of common stock. This means that the preferred share is a relatively more secure investment. The corporate
issuing preferred shares may add differing features to the share in order to make it more attractive. These features are
similar to those used in the fixed income market and include convertibility into common shares, call provisions, etc. Many
have equated preferred shares with a form of fixed income security due to its defined dividend stream.
However, with the added security offered by the guaranteed dividend stream, the holder of preferred shares gives up the
right to vote on issues related to corporate governance. Therefore, the preferred holder has little input into corporate
policy.
Warrants
Warrants are a form of option which is usually added to a corporate bond issue or preferred stock in order to sweeten the
deal.
A warrant is a long dated option which allows the owner to participate in the capital gains (losses) of a firm without
buying the common stock. In effect, the holder of a warrant has a leveraged play on the corporate common stock.
As a form of option, a warrant has an exercise price and an expiry date. The exercise price is the price at which the holder
may convert the warrant into common shares of the issuer. The expiry date is the last date on which the warrant may be
converted into common shares. Given that a warrant is generally issued to reduce the cost of a debt issuer, the expiry
date is usually more than two years from issuance. This allows warrants to trade separately from the bond with which
they were issued. Thereby providing the investor with a long dated option on a firm's common stock.
There is a draw back to warrants for those investors concerned with income. As an option, a warrant does not pay a
dividend, and is subject to a certain amount of price compression as the underlying stock approaches or surpasses the
exercise price. This is only a factor if the investor is purchasing the warrants when the common stock is trading near the
exercise price.
Warrant holders have no voting rights until the warrants are converted into common shares. Upon conversion an active
role may be taken in corporate governance. If the warrants provide for conversion into preferred shares, it is unlikely the
holder will gain any influence into corporate governance upon conversion.
Financial Ratio Analysis
Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a
company's financial statements. The level and historical trends of these ratios can be used to make inferences about a
company's financial condition, its operations and attractiveness as an investment.
Financial ratios are calculated from one or more pieces of information from a company's financial statements. For
example, the "gross margin" is the gross profit from operations divided by the total sales or revenues of a company,
expressed in percentage terms. In isolation, a financial ratio is a useless piece of information. In context, however, a
financial ratio can give a financial analyst an excellent picture of a company's situation and the trends that are developing.
A ratio gains utility by comparison to other data and standards. Taking our example, a gross profit margin for a company
of 25% is meaningless by itself. If we know that this company's competitors have profit margins of 10%, we know that it
is more profitable than its industry peers which is quite favourable. If we also know that the historical trend is upwards,
for example has been increasing steadily for the last few years, this would also be a favourable sign that management is
implementing effective business policies and strategies.
Financial ratio analysis groups the ratios into categories which tell us about different facets of a company's finances and
operations. An overview of some of the categories of ratios is given below.
It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio
is governed by the GIGO law of "Garbage In...Garbage Out!" A cross industry comparison of the leverage of stable utility
companies and cyclical mining companies would be worse than useless. Examining a cyclical company's profitability
ratios over less than a full commodity or business cycle would fail to give an accurate long-term measure of profitability.
Using historical data independent of fundamental changes in a company's situation or prospects would predict very little
about future trends. For example, the historical ratios of a company that has undergone a merger or had a substantive
change in its technology or market position would tell very little about the prospects for this company.
Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the "downside" risk since
they gain none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios
to ascertain a company's financial risk. Equity analysts look more to the operational and profitability ratios, to determine
the future profits that will accrue to the shareholder.
Although financial ratio analysis is well-developed and the actual ratios are well-known, practicing financial analysts
often develop their own measures for particular industries and even individual companies. Analysts will often differ
drastically in their conclusions from the same ratio analysis.
As in all things financial, beauty is often in the eye of the beholder. It pays to do your own work!
Stock Valuations
Valuing stocks involves four basic issues: 1) the characteristics of the stock as a financial security, 2) the financial and
business prospects of the issuer of the stock, 3) the relative valuation of the particular stock versus other stocks, and 4)
the valuation of financial securities in general and the stock market in particular.
"Stock pickers" focus on the characteristics of the particular stock as a financial security and the financial and business
prospects of the particular issuer. They believe that they should value the stock and analyze the prospects for the issuer
independent of market and economic changes. With their focus on individual securities, they believe that they are "buying
companies" that will prosper over a longer period of time and reward investors because of their success. Value investors
try to buy "good companies at cheap prices" when these companies are out of favour with other less disciplined and
more faddish investors. Growth investors strive to find companies with business strategies and products that will allow
them to achieve high levels of growth. Both value and growth investors try to ignore the future path of the market or
economy. They are confident that the prospects for the individual securities they are buying will overwhelm over factors
and do not try to "time the market". If they cannot find individual stocks that are attractive, they might leave some monies
in cash. This really reflects their ability to find attractive investment ideas rather than a call on the market.
"Sector rotators" focus on the relative valuation of a stock compared to other stocks and the overall prospects for the
stock market in general. They assess the relative valuation of individual stocks and move between stocks and industry
groups when they are cheap by comparison using historical standards. They also assess the the overall valuation of the
market using aggregate data on earnings, price and other historical accounting measures and compare these to
historical norms. Another valuation yardstick is a comparison to other financial assets, such as bonds and money
market securities. Much emphasis is given to the relative levels of bond and money market yields and the market
dividend yield. The stage of the economic cycle is important, as stock industry groups have differential performance over
the course of a market and economic cycle. If their valuation measures suggest that the market is expensive, they sell
stocks and raise cash to defend their portfolios from a potential market setback.
The average investment manager combines stock picking and sector rotation, maintaining her portfolio reasonably
similar to her index benchmark and other managers. This type of manager will make industry and security "bets" in their
portfolio weightings, moving into defensive stocks and cash in overvalued markets and weighting stocks and industries
that are relatively attractive.
FUNDAMENTAL VALUATION TECHNIQUES
Fundamental valuation of equity securities relies on financial analysis of historical financial data and an assessment of
the business prospects of an issuer. The historical data demonstrates the "track record" of the company and its
management. The assessment of the business prospects of an issuer involves a study of the conditions and
environment under which a company operates.
The financial analysis of the company examines trends in its profitably, efficiency in employing capital, financial capability
and other factors that the analyst considers important. These are assessed by calculating the applicable financial ratios
and patterns of sales and profit growth. Important ratios would include: gross and net margin, sales and inventory
turnover, financial and operating leverage, interest coverage, current and quick ratios. Valuation yardsticks would include
price/earnings, book value per share, earnings yield, dividend yield and return on equity.
A basic assessment of a company's business prospects includes a review of all public information available on a
company and third party research reports.
A more "in depth" review would include interviews of senior management of the company, both telephone and in person,
and even discussions of the company's prospects with suppliers, regulators (where applicable) and even competitors'
personnel.
Types of Equity Securities
1. Shares Generally
Let’s look at equity capital under the Model Business Corporation Act. You divide up the ownership interest in a
corporation into shares. You can have different classes of shares. Each class must have something that makes it
different from the other classes, and all the shares within one class must have the same rights. If there is only one class
of shares issued, they may be called “common shares”, “capital shares”, or just “shares” or “stock”.
When you own a share of stock, you can vote for the directors of the corporation and you are entitled to a share of the
corporation’s net assets when dividends or other distributions are paid out. Not every class of shares needs to have
these powers, but at least one class must have both.
2. Common and Preferred Shares
Common shares have the two rights described above. Preferred shares have some rights that are preferential to
common shares, but they are also limited. The preferred shares may have the right to a certain amount of money before
the common shares get any money, but at the same time these shares are non-voting. If the company screws up in
certain ways, though, the preferred shares can get voting power. Preferred shares basically are higher in the pecking
order in terms of who gets dividends or distributions first. Dividends are paid out of earnings to shareholders.
Distributions, on the other hand, are paid out of capital. There are special rules for distributions, but not necessarily for
dividends. Shareholders have other, non-financial rights too.
3. Special Rights of Publicly Traded Preferred Shares
These shares get cumulative dividend rights, which basically means that if you don’t pay out dividends to preferred
shareholders for a few years, you have to sort of make back payments of dividends to them before you can make any
dividend payments to the common shareholders. These shares usually don’t have voting rights except under certain
special circumstances like when preferred dividends haven’t been paid for a certain amount of time. If the corporation
dissolves, the preferred shareholders will have a shot at the proceeds from selling the company’s assets before the
common shareholders get it.
Preferred shares can be made redeemable by the corporation, meaning the corporation can buy back the shares at a
fixed price and the shareholder must accept. The redemption price is typically made higher than the specified amount of
money the preferred shareholder is entitled to if the corporation dissolves. Preferred shares can sometimes be made
convertible into regular old common shares at the option of the shareholder. The conversion ratio is set such that it’s not
worthwhile to convert the preferred shares unless the common shares appreciate in value quite a lot.
4. Classes of Common Shares
There can also be different classes of common shares! There can be non-voting shares, for example. There can be
classes that get more dividends.
The investor interested in equity securities should first have a firm understanding of what equity is. Equity can be defined
as ownership of, or investment in, property. Property may include such things as art, race horses, computer chips,
lumber, automobiles or just about anything to which legal ownership may be demonstrated.
There are three basic types of equity: common shares, preferred shares and warrants.
Equity is viewed by the market as an ownership "share" in the revenue stream of a corporation's income once all prior
obligations and debts have been satisfied. The "share" price is the relative value given to the corporations earning
potential based on a number of factors. These include general economic conditions, both in the industry and in the
overall economy, earnings projection, projected corporate growth, corporate stage of development, and financial ratio
analysis. The overall analysis of a firm's future earning potential must be done through both fundamental and technical
analysis, including charting and other indicators.
Generally, the structure of equity is that a "share" of the corporation represents the current market value of the firm,
secondary to this is the potential for dividend income. There are various classes of equity for the individual investor to
consider. The primary three groups into which equity may be subdivided are common stock, preferred shares, and
warrants.
Common Stock
Common stockholders participate in the earnings stream of the corporation through dividends paid and capital gains
made on a per share basis. Owners of common stock are responsible for the election of the Board of Directors,
appointment of Senior Officers, the selection of an auditor for the corporate financial statements, dividend policy and
other matters of corporate governance. This may also be done on a proxy basis, whereby a third party may be ceded the
shareholders right to vote by the shareholder.
The responsibilities associated with common stock mean the investor participates to a greater extent in the fortunes of
the firm. Capital gains, through the increase in market price of the firm's stock, accrue to a greater extent to the holder of
common stock than to the holder of preferred stock.
Common stockholders also have a couple of significant rights should the business invested in be wound down: limited
liability to the creditors of the firm and a residual claim on any assets or income derived once all prior claims
(mortgages, bondholders, creditors, etc.) have been satisfied.
Preferred Stock
Preferred shares are stock in a company which have a defined dividend, and a prior claim on income to the common
stock holder.
Should the company wind up operations, preferred shareholders are paid any obligations owed to them. Should a
dividend be suspended by the Board of Directors, for what ever reason, the preferred share usually has a cumulative
clause in it allowing that any unpaid dividends must be paid fully before any dividends may be declared and paid to
holders of common stock. This means that the preferred share is a relatively more secure investment. The corporate
issuing preferred shares may add differing features to the share in order to make it more attractive. These features are
similar to those used in the fixed income market and include convertibility into common shares, call provisions, etc. Many
have equated preferred shares with a form of fixed income security due to its defined dividend stream.
However, with the added security offered by the guaranteed dividend stream, the holder of preferred shares gives up the
right to vote on issues related to corporate governance. Therefore, the preferred holder has little input into corporate
policy.
Warrants
Warrants are a form of option which is usually added to a corporate bond issue or preferred stock in order to sweeten the
deal.
A warrant is a long dated option which allows the owner to participate in the capital gains (losses) of a firm without
buying the common stock. In effect, the holder of a warrant has a leveraged play on the corporate common stock.
As a form of option, a warrant has an exercise price and an expiry date. The exercise price is the price at which the holder
may convert the warrant into common shares of the issuer. The expiry date is the last date on which the warrant may be
converted into common shares. Given that a warrant is generally issued to reduce the cost of a debt issuer, the expiry
date is usually more than two years from issuance. This allows warrants to trade separately from the bond with which
they were issued. Thereby providing the investor with a long dated option on a firm's common stock.
There is a draw back to warrants for those investors concerned with income. As an option, a warrant does not pay a
dividend, and is subject to a certain amount of price compression as the underlying stock approaches or surpasses the
exercise price. This is only a factor if the investor is purchasing the warrants when the common stock is trading near the
exercise price.
Warrant holders have no voting rights until the warrants are converted into common shares. Upon conversion an active
role may be taken in corporate governance. If the warrants provide for conversion into preferred shares, it is unlikely the
holder will gain any influence into corporate governance upon conversion.
Financial Ratio Analysis
Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a
company's financial statements. The level and historical trends of these ratios can be used to make inferences about a
company's financial condition, its operations and attractiveness as an investment.
Financial ratios are calculated from one or more pieces of information from a company's financial statements. For
example, the "gross margin" is the gross profit from operations divided by the total sales or revenues of a company,
expressed in percentage terms. In isolation, a financial ratio is a useless piece of information. In context, however, a
financial ratio can give a financial analyst an excellent picture of a company's situation and the trends that are developing.
A ratio gains utility by comparison to other data and standards. Taking our example, a gross profit margin for a company
of 25% is meaningless by itself. If we know that this company's competitors have profit margins of 10%, we know that it
is more profitable than its industry peers which is quite favourable. If we also know that the historical trend is upwards,
for example has been increasing steadily for the last few years, this would also be a favourable sign that management is
implementing effective business policies and strategies.
Financial ratio analysis groups the ratios into categories which tell us about different facets of a company's finances and
operations. An overview of some of the categories of ratios is given below.
- Leverage Ratios which show the extent that debt is used in a company's capital structure.
- Liquidity Ratios which give a picture of a company's short term financial situation or solvency.
- Operational Ratios which use turnover measures to show how efficient a company is in its operations and use of
assets. - Profitability Ratios which use margin analysis and show the return on sales and capital employed.
- Solvency Ratios which give a picture of a company's ability to generate cashflow and pay it financial obligations.
It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio
is governed by the GIGO law of "Garbage In...Garbage Out!" A cross industry comparison of the leverage of stable utility
companies and cyclical mining companies would be worse than useless. Examining a cyclical company's profitability
ratios over less than a full commodity or business cycle would fail to give an accurate long-term measure of profitability.
Using historical data independent of fundamental changes in a company's situation or prospects would predict very little
about future trends. For example, the historical ratios of a company that has undergone a merger or had a substantive
change in its technology or market position would tell very little about the prospects for this company.
Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the "downside" risk since
they gain none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios
to ascertain a company's financial risk. Equity analysts look more to the operational and profitability ratios, to determine
the future profits that will accrue to the shareholder.
Although financial ratio analysis is well-developed and the actual ratios are well-known, practicing financial analysts
often develop their own measures for particular industries and even individual companies. Analysts will often differ
drastically in their conclusions from the same ratio analysis.
As in all things financial, beauty is often in the eye of the beholder. It pays to do your own work!
Stock Valuations
Valuing stocks involves four basic issues: 1) the characteristics of the stock as a financial security, 2) the financial and
business prospects of the issuer of the stock, 3) the relative valuation of the particular stock versus other stocks, and 4)
the valuation of financial securities in general and the stock market in particular.
"Stock pickers" focus on the characteristics of the particular stock as a financial security and the financial and business
prospects of the particular issuer. They believe that they should value the stock and analyze the prospects for the issuer
independent of market and economic changes. With their focus on individual securities, they believe that they are "buying
companies" that will prosper over a longer period of time and reward investors because of their success. Value investors
try to buy "good companies at cheap prices" when these companies are out of favour with other less disciplined and
more faddish investors. Growth investors strive to find companies with business strategies and products that will allow
them to achieve high levels of growth. Both value and growth investors try to ignore the future path of the market or
economy. They are confident that the prospects for the individual securities they are buying will overwhelm over factors
and do not try to "time the market". If they cannot find individual stocks that are attractive, they might leave some monies
in cash. This really reflects their ability to find attractive investment ideas rather than a call on the market.
"Sector rotators" focus on the relative valuation of a stock compared to other stocks and the overall prospects for the
stock market in general. They assess the relative valuation of individual stocks and move between stocks and industry
groups when they are cheap by comparison using historical standards. They also assess the the overall valuation of the
market using aggregate data on earnings, price and other historical accounting measures and compare these to
historical norms. Another valuation yardstick is a comparison to other financial assets, such as bonds and money
market securities. Much emphasis is given to the relative levels of bond and money market yields and the market
dividend yield. The stage of the economic cycle is important, as stock industry groups have differential performance over
the course of a market and economic cycle. If their valuation measures suggest that the market is expensive, they sell
stocks and raise cash to defend their portfolios from a potential market setback.
The average investment manager combines stock picking and sector rotation, maintaining her portfolio reasonably
similar to her index benchmark and other managers. This type of manager will make industry and security "bets" in their
portfolio weightings, moving into defensive stocks and cash in overvalued markets and weighting stocks and industries
that are relatively attractive.
FUNDAMENTAL VALUATION TECHNIQUES
Fundamental valuation of equity securities relies on financial analysis of historical financial data and an assessment of
the business prospects of an issuer. The historical data demonstrates the "track record" of the company and its
management. The assessment of the business prospects of an issuer involves a study of the conditions and
environment under which a company operates.
The financial analysis of the company examines trends in its profitably, efficiency in employing capital, financial capability
and other factors that the analyst considers important. These are assessed by calculating the applicable financial ratios
and patterns of sales and profit growth. Important ratios would include: gross and net margin, sales and inventory
turnover, financial and operating leverage, interest coverage, current and quick ratios. Valuation yardsticks would include
price/earnings, book value per share, earnings yield, dividend yield and return on equity.
A basic assessment of a company's business prospects includes a review of all public information available on a
company and third party research reports.
A more "in depth" review would include interviews of senior management of the company, both telephone and in person,
and even discussions of the company's prospects with suppliers, regulators (where applicable) and even competitors'
personnel.
Types of Equity Securities
1. Shares Generally
Let’s look at equity capital under the Model Business Corporation Act. You divide up the ownership interest in a
corporation into shares. You can have different classes of shares. Each class must have something that makes it
different from the other classes, and all the shares within one class must have the same rights. If there is only one class
of shares issued, they may be called “common shares”, “capital shares”, or just “shares” or “stock”.
When you own a share of stock, you can vote for the directors of the corporation and you are entitled to a share of the
corporation’s net assets when dividends or other distributions are paid out. Not every class of shares needs to have
these powers, but at least one class must have both.
2. Common and Preferred Shares
Common shares have the two rights described above. Preferred shares have some rights that are preferential to
common shares, but they are also limited. The preferred shares may have the right to a certain amount of money before
the common shares get any money, but at the same time these shares are non-voting. If the company screws up in
certain ways, though, the preferred shares can get voting power. Preferred shares basically are higher in the pecking
order in terms of who gets dividends or distributions first. Dividends are paid out of earnings to shareholders.
Distributions, on the other hand, are paid out of capital. There are special rules for distributions, but not necessarily for
dividends. Shareholders have other, non-financial rights too.
3. Special Rights of Publicly Traded Preferred Shares
These shares get cumulative dividend rights, which basically means that if you don’t pay out dividends to preferred
shareholders for a few years, you have to sort of make back payments of dividends to them before you can make any
dividend payments to the common shareholders. These shares usually don’t have voting rights except under certain
special circumstances like when preferred dividends haven’t been paid for a certain amount of time. If the corporation
dissolves, the preferred shareholders will have a shot at the proceeds from selling the company’s assets before the
common shareholders get it.
Preferred shares can be made redeemable by the corporation, meaning the corporation can buy back the shares at a
fixed price and the shareholder must accept. The redemption price is typically made higher than the specified amount of
money the preferred shareholder is entitled to if the corporation dissolves. Preferred shares can sometimes be made
convertible into regular old common shares at the option of the shareholder. The conversion ratio is set such that it’s not
worthwhile to convert the preferred shares unless the common shares appreciate in value quite a lot.
4. Classes of Common Shares
There can also be different classes of common shares! There can be non-voting shares, for example. There can be
classes that get more dividends.