Previously, we talked about how well CapitaLand and CityDev performed in terms of financial ratios from financial statements. There are however, four more categories of these financial ratios, namely; profitability, liquidity, solvency, and valuation. This week, we focus on the analysis and interpretation of these four categories to evaluate which is our ultimate pick. Have you already made up your mind based on previous results? If not, let’s proceed ahead to examine the financial health of two of the largest property developers in Singapore.
Profitability ratios reveal how lightly it is for a company to turn into profit. Two important profitability ratios investors always look at will no doubt be the Return on Asset (ROA) and the Return on Equity (ROE). As the name sounds, the ROA and ROE is used to evaluate how well a company is turning into profits relative to their assets and equity.
Return on Asset (ROA) = Net Income / Average total assets *100%
Return on Equity (ROE) = Net Income / Average shareholder’s equity *100%
As both CapitaLand and CityDev are property developers, it is not surprising that they would usually have low ROA ratios as they require huge investment in assets as compared to other industries. Even then, CityDev seem to have a relatively higher performance of managing their assets to generate income as compared to CapitaLand over the past two years. CityDev has yet again proven its worth when its ROE ratio shows their capability and efficiency to utilize shareholders’ capital to generate profits. ROE is another important ratio that value investors look at because it measures a company’s profitability by revealing how much profit a company makes with the money that shareholders have invested. As both ROE ratios decreased over the past two years, the below graph shows the resultant lower share prices of both CapitaLand and CityDev, leading to a fall in the net worth of both companies during this period.
Liquidity ratios measure how quickly assets can turn into cash to buy assets or repay creditors. We use the PDACL ratio because it is a powerful ratio as it depicts a company’s margin of safety to meet its short-term obligations using cash flow generated from operating activities.
PDACL = Profit before Depreciation & Amortization / Current Liabilities *100%
Although both companies are able to lower their short term debt obligations over the past two years, it was due to lower profits. This is especially so for CapitaLand as a higher drop in its PDACL ratio may indicate a compromise in its margin of safety to generate operating cash flows to repay their short-term debt obligations.
OCFCL = Operating Cash Flow / Current Liabilities *100%
The OCFCL ratio shows that our worries that CapitaLand is unable to generate enough operating cash flows is unfounded as they had a significant increase in its operating cash flows causing OCFCL ratio to rise considerably. CityDev, on the other hand, had a drastic fall in its operating cash flow. A lower OCFCL ratio indicates higher risks and CityDev may not be able to generate sufficient cash quick enough to meet their current debt obligations. If prolonged, this may cripple its ability to service its debts, increasing the chances of bankruptcy when it becomes severely undercapitalized. Operating cash flow is a more accurate measure of a company’s profitability than net income because it deducts actual cash expenses and demonstrates the strength of a company’s operations. Here, it indicates that CapitaLand is significantly stronger than CityDev.
Asset Turnover Ratio (aka Efficiency Ratio) = Sale Revenue / Average Total Assets
The asset turnover ratio shows an entity’s overall efficiency in generating income per dollar of investments in assets. Here, we can see that despite a drop in efficiency, CityDev still remains relatively more efficient at generating income per dollar of investments in assets as compared to CapitaLand. While we are unable to determine whether CapitaLand would improve further in 2016, nor can we judge that CityDev may continue to decline in their efficiency, we decided to take a look at 2013 results. Upon having better continual efficiency as CapitaLand over the past three years, we have decided to award it to CityDev.
A company without a lot of debt is a better investment than one that is weighed down by it. Investors use solvency ratios to see how well a company can cope with long-term financial obligations.
Debt Coverage Ratio = Non-current liabilities / Cash from operating activities
The debt coverage ratio shows the ability of the companies’ operating cash flows to service its long-term debts. While the long-term debt obligations of CityDev may seem little as compared to CapitaLand, the amount of operating cash flows generated by CityDev seem to severely undermine its capability of supporting its future investments. A comparison made with the OCFCL liquidity ratio provides that CityDev indeed face a higher risk of insolvency as compared to CapitaLand. CapitaLand on the other hand, has proven its worth again by having a substantial amount of operating cash flows to support even longer-term debt obligations.
Interest Cover = EBIT / Interest
The interest coverage ratio measures the ability of a company to pay the interest on its outstanding debt. This is usually a measurement used by creditors, lenders, and investors to determine the risk of lending funds to a company. Of course, a high ratio indicates that a company can pay for its interest expense several times over. Nonetheless, a ratio of 2 is regarded as a healthy position to cover interest. Since both CapitaLand and CityDev appears to be in a healthy position, we decided to award points to both.
Valuations ratios analyse an investment’s attractiveness, revealing how cheap or expensive a company’s current stock price is. Of course, the less expensive a company is, the more attractive the investment usually is. We use the PE ratio to assess both company’s value and interprets how much an investor pays for every $1 the company earns.
Price-to-Earnings (PE) ratio = Share Price / Earnings per share (EPS)
Since the PE ratio represents how much an investor is willing to pay for every $1 of the company’s earnings, a stock with lower PE ratio definitely costs less as compared to one that has a higher PE. From the above, it looks like CityDev is still the more favourable stock to buy.
If the PE ratio is a good indicator of what investors are willing to pay for every dollar the company makes, then the PB ratio would be an equally good indication of what investors are willing to pay for each dollar of the company’s assets. It compares a stock’s market capitalization value to its book value. Value investors prefer to see a PB ratio between 1.0 to 1.5 or lower, and more importantly, significantly below the average PB ratio of their industry peers. The PB ratio must be used with caution because, while a relatively low PB ratio may indicate a stock is undervalued, it can also indicate a company is just fundamentally unsound.
Price-to-Book ratio = Share Price / Net assets
Taking out the intangibles is an important element in the price-to-book ratio as it shows that investors are really paying for the real world tangible assets. Here, CityDev has also proven its capability by being more efficient at using either its assets or shareholders’ capital to generate returns for the Company, resulting in ideal PE and PB ratios. Right from the start, exhibiting a higher current ratio does seem to indicate that CityDev may be more financially capable of repaying their short-term debts. However, current assets are ultimately not the same and is even more illiquid as compared to having cash at hand. As CityDev have massive sums of expenses with decreasing operating cash flows, they do face higher risks of bankruptcy if they are not able to generate sufficient cash quick enough. This severely undermines their capability of supporting any future investments. Of course, at the moment, CityDev is still able to pay for its interest several times over which puts it in a healthy position to cover interest. A relatively low debt-to-equity ratio over the past two years indicates that CityDev does poses less investment risks and offers financial stability as well.
As for CapitaLand, although the ratios seem to exhibit its weakness in repaying its short-term debts, having high cash flows despite paying high dividends shows that CapitaLand has more than twice the capability of reinvesting in operations. Having a higher net profit margin is even more ideal because that means being able to translate revenue into profits which is ideal for shareholders. Nonetheless, a PB ratio of less than one indicates that its shares are selling for less than the value of the company’s assets. While the low PB ratio may reveal that CapitaLand is an undervalue stock, we need to also ask ourselves that if it is obvious that CapitaLand is trading for less than its book value, why then did others not notice and push the price back to book value or even higher? Could it be that the market believes that there is a chance its asset value will drop even further if there is a downward correction? After all, the market fluctuates based on consumers’ expectations.
Of course, both companies are equally capable of managing their assets/shareholders’ capital to generate returns. It does not mean that the purchase of these shares have to be mutually exclusive. In view of the above, CityDev appears to be an investment for investors who are more risk-loving and do not mind the fact that they have low cash flows in the short run. While fundamentals may change in the long-term, all is still in the unknown future and it is best to closely monitor any actions taken that could jeopardize their cash flows further. On the other hand, CapitaLand seemed to be a better investment for investors who are more risk averse considering that the company has been able to generate high cash flows to cover its liabilities yet capable of paying dividends consistently. Of course, if CapitaLand turns out to be an undervalued stock, it spells good news to investors. Otherwise, if bought, investors should also take note of any market correction since CapitaLand seem to be more susceptible to fluctuations in the market. The purchase of these shares and whichever shares ultimately depends on the risk appetite and funds of each and every individual.
Disclosure: I do not have any positions in any CapitaLand and CityDev stocks at time of writing and have no plans to initiate any positions within the next 72 hours. I wrote this article myself and the calculations made are my own and are not intended as investment advice. I am not receiving any paid compensation for it and I have also no business relations with any company whose stock is mentioned in this article.
CapitaLand Limited Annual Report 2015.
City Developments Limited Annual Report 2015.
Lincoln Indicators Pty Ltd. 2010. “The Top 15 Financial Ratios.” Australia Shareholders Association.