Ratio Analysis A) the Price-Earnings Ratio Reflects

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. 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 on Capital 55.73% Return on Equity 3.44% 2.78% Sales/employees Profit/employee 1.96 1.52 The performance ratios indicate that the company has improved performance slightly over the past year, especially with respect to margins and returns. Profit/employee has increased as a result Working Capital, Liquidity, Solvency 2013 2012 Inventory Days 63 61 Debtor Days 42 39 Creditor Days 55 46 Current ratio 1.74 1.73 Acid test 0.72 0.80 Interest cover 6.17 4.31 Gearing 35.64% 34.52% These ratios test the financial robustness of the company.

Overall, there has not been a significant change at HRG, though it has stretched its payables out, perhaps to free up more cash flow. The company's liquidity is fine with a current ratio well over 1.0, and its interest cover has improved despite a slight increase in gearing. Its overall gearing remains at a healthy level for a company of its type. Jenny wants to compare HRG's performance with Kingfisher's to see if the current stock prices make sense.

In terms of profitability, Kingfisher has the better gross margin and by far the better net margin. Kingfisher also has the better asset turnover and lower gearing. HRG has the better inventory days, turning it over a little bit more frequently, but Kingfisher's performance on debtor days is impeccable, at a mere 1.35. Both firms like to delay creditor payments as long as possible.

It should be noted that HRG has better liquidity by far, to the increase in creditor days is not a symptom of solvency issues but perhaps one of improved bargaining power. While HRG has better liquidity overall, there is nothing wrong with Kingfisher's liquidity, and Kingfisher has a much lower rate of gearing. Still, as far as past performance is concerned, Kingfisher should not differ much in terms of its stock price from HRG.

The biggest difference seems to be that HRG is coming off of a turnaround project and is expected to grow more rapidly than Kingfisher going forward, the result of better underlying business conditions and an aggressive e-commerce strategy that has moved HRG into a more growth-oriented segment of the market. Both firms have exhibited modest performance over the past couple of years, declining as the result of the tough economy.

The key differentiating factor as far as the market is concerned appears to be forward-looking, in particular HRG having an aggressive growth strategy and Kingfisher not. Jenny should also be aware that this case exhibits the difference between past performance and the future-orientation of the market. The market looks at past performance mainly in relation to expectations of future performance. Thus, Kingfisher's stock is priced in relation to its recent run of performance because the company has offered no indication that it will turn around that performance.

It has struggled in all of its geographic markets and yet has persisted with its same strategies. The market is right not to get too hopeful. It is also a bit of a fallacy for Jenny to suggest that there is strict equivalency between these two companies. They operate in slightly different industries, and more important Kingfisher has not wildly outperformed HRG as Jenny seems to believe.

With specific respect to market expectations of HRG's future performance, these appear to be fairly optimistic, and that is why many analysts are urging caution. Market efficiency is a trend towards the intrinsic value of the company, not instantaneous achievement of that, especially considering that the stock price reflects the expected present value of future cash flows. If the market only priced on past information, there would be no need for a rational investor to trade.

It is only in the interpretation of the future earnings for the company that investors will differ. In this case, the market has placed a growth value on HRG because of its strategy to build sales in a growth market through investment in technology and a strategic alliance with eBay, not because its past performance has been particularly rousing. Question 2. The first thing that needs to be clarified is that there is a difference between a credit rating agency and an auditor.

An auditor examines the financial statements in order to ensure that those statements accurately reflect the financial condition of the company. Auditors are a necessary safeguard because management does have temptations with respect to the financial statements. One temptation is that managers are often compensated in part with equity, so misrepresenting something on the statements to give the impression of higher earnings can lead to higher personal gains for the managers. Further, managers can be tempted simply because of the pressure to produce ever-higher earnings.

The auditor, therefore, is a necessary safeguard against such temptations ever coming to fruition. It is worth remembering that financial statements are becoming increasingly complex. There are more areas of judgment, and more qualitative disclosures, and these are things that even sophisticated investors can have trouble understanding (Schilder, 2013). Auditors have access to the information that goes into the financial statement, not just access to the statement like the public has.

So the auditor plays an important role as an independent entity who can verify the statement's accuracy, providing a safeguard in case management is attempting to misrepresent the company's financial standing. The role of the credit rating agency is similar but a little bit different. The rating agency also acts as an intermediary between the company and the investor -- usually the creditor. The agency then reports on the strength of the company's financials (S&P, 2013).

The credit rating agency therefore reports on the strength of the company's financials, where the auditor simply reports on the accuracy of the financials, without passing any judgment on the company's strength. Lastly, there is no evidence at all that the auditing system does not work. That sort of assertion is not wise coming from somebody who invests. Auditors perform an important function, in that they ensure that the information you use to analyze the company is accurate.

This role, because it does not involve making a subjective evaluation of the company, can be performed competently by the same firm for many years. Indeed, it is better to use the same firm because they are more familiar with the company's business and are therefore in a better position to note changes that could be evidence of an attempted fraud. The use of judgment creates a moral hazard for the credit rating agency in that they need to maintain a healthy relationship with the company but yet be honest.

This creates more risk of improper behavior than exists for the auditors, so it is perfectly reasonable that companies would need to change credit rating agencies more.