Some financial terms explained
The three terms described below are Hybrid securities, Price/Earnings Ratio and Dividend imputation.
What does it mean?
Hybrids are products that combine the characteristics of shares and fixed interest products..
Hybrid securities are “higher yielding” investments, generally paying regular income to investors a couple of basis points above the bank bill rate. Such investments are popular with retirees seeking higher yields than they’d normally receive from a cash account.
As with most investments, riskier hybrids pay a higher interest payment (otherwise called a coupon or preferred dividend) to compensate investors for the added risk.
When buying a hybrid security you are typically lending money to a bank, insurance company or large corporation, known as the issuer. In return for the loan, the issuer pays a given interest rate (called the coupon) for the life of the security, repaying the principal at maturity (more on this later).
As the name suggests, hybrid securities are a mix between a debt and equity instrument. Before changes to the International Accounting Standards, most hybrid securities issued were reset preference shares (RPS).
RPSs act like traditional bonds to begin with – paying investors a fixed or floating interest rate (often franked) – but at maturity, or the reset date, can be converted to ordinary shares, cashed in, or rolled over into a new security.
This means that investors in hybrids get it both ways; they receive regular coupons for a set period (usually five years), but also receive the equity twist. In the event of bankruptcy, investors in hybrids rank after bondholders but before shareholders in the carve-up of the company’s assets.
All things considered, perpetual step-ups are not as attractive as the old reset preference share. Investors in the new step-ups no longer retain the right to convert their securities to shares, or redeem them for cash. Instead, this right will lie at the feet of the issuer. Basically, the step-up clause means that, in the event that the securities are not converted or redeemed for cash, interest payments are increased (stepped-up) after a specific date. Steps-ups are regarded as marginally inferior to the old reset preference shares since investors are no longer guaranteed the right to cash out at maturity in order to receive their money back.
What does it mean?
The Price/Earnings ratio is how much money you are paying for $1 of the company's earnings. So if a company is reporting a profit of $2 per share, and the stock is selling for $20 per share, the P/E is 10. In other words you are paying ten-times earnings.
P/E Ratio = Price Per Share / Annual Earnings per Share
A favourite tool of the contrarian is the price/earnings ratio (P/E), which is calculated by dividing the current share price in cents by the company’s earnings per share, or EPS. Thankfully, the historic P/E on stocks is readily available, so you don't have to manually do this calculation yourself.
The P/E ratio is rather useless on its own, but is a handy comparison tool. You can use it to compare one company against its peers, to the overall market, or sector, as well as to track historic performance.
Let's say that one company (Company A) has a P/E of 12 and another company in the same industry (Company B) sports a P/E of 20. For every $1 of current earnings, the investor is effectively paying $12 a share for Company A and $20 a share for Company B.
It's clear that Company A is cheaper than Company B because for every $1 of earnings, you're paying $12 a share instead of $20.
Contrarian investors use this as a guide for finding stocks that are going cheap. They particularly like stocks that are trading on a low P/E relative to their peers and the overall market.
But does that mean that Company A is a better buy than Company B?
As we all know, earnings are the basic ingredients of share price growth, and the best stocks to buy are those exhibiting a trend of increasing earnings (we like to see earnings growth for five years or longer). Remember, earnings refer to “net profits” and not revenue.
When investors spot a company with a trend of increasing earnings, they get excited and buy shares. As more shares are purchased, the share price is bid up, and so is the P/E ratio (since the current share price is the numerator in the ratio). The more popular the stock, the higher its P/E.
So Company B could in fact be a better buy than Company A if its earnings are growing at a faster pace.
There are times however when markets get out of wack. External shocks such as the recent financial crisis send share prices into a spin, and stocks that were once expensive (on a P/E) basis can be suddenly looking pretty darn cheap.
It's times like these that contrarian or value investors come to the fore. With their toolkit in hand, bargain hunters set to work.
A bargain means that you are getting something that should cost $10, for $5. You buy a leather couch on special for $2,000 that a week prior was holding a price tag of $4,000. This is what most of us call a true bargain without thinking too much about it.
But just because the coach was priced at $4,000 the week prior, doesn’t necessarily mean that it's a bargain at $2,000. (It could be old stock, its design could be going out of fashion).
Likewise, just because your favourite stock was trading at a P/E of 10 many months ago, doesn't necessarily mean that it's a steal at 6 today. Basically you have to consider whether the fundamentals have changed.
For example, as consumers tighten their purse strings, will the company struggle to sell its goods and services? If the company has a lot of debt on its books, will it battle to get funding? If it's an importing company, will the fall in the AUD/USD impact its sales?
Sometimes a fall in the P/E can be justified, sometimes not. And getting this right is the true test of whether a contrarian investor spots a bargain or not. .
What does it mean?
Dividend imputation is a company tax term in which some or all of the tax paid by a company may be attributed to shareholders in the form of a tax credit to reduce income tax payable on the income distribution (dividend).
Before 1 July 1987 corporate profits were subject to two lots of tax. Firstly, companies paid company tax on their earnings. Only the "after tax" earnings were then available for dividend declarations. Secondly, individual shareholders paid personal income tax on any dividends received by them, despite the fact that the companies paying them had already paid tax on the underlying profits. This unfair approach has now been replaced.
Under the current system, which is called "dividend imputation", companies still pay tax on their earnings and then declare dividends, if they wish, out of their "after tax" incomes. However, these transactions no longer involve double taxation.
Such dividends are known as "franked" dividends. The company tax which was paid by the company on the portion of the gross profit relating to the dividend is called the "imputation credit".
With a company tax rate of 30 per cent each $100 gross profit becomes $30 tax and $70 net profit. Each dollar of net profit thus has associated with it 30/70 dollars of imputation credits.
Individuals receiving a franked dividend are then treated, for tax purposes, as having received as assessable income both the dividend and the associated imputation credit, and as having already pre-paid as tax a sum equal to the imputation credit.
Individuals on marginal tax rates which are less than the company rate of tax thus become entitled to a refund of the amount overpaid. If not required as an offset to tax this refund is now available in the form of cash.
Some dividends are unfranked - for example, when the relevant company profits were earned overseas and did not result in tax payments to the Australian government.
Some dividends are only partly franked. The franked portion divided by the whole is known as the "franking ratio".