Bottom up analysis and executing a warrant trade – PBL

The changes to media laws passed through parliament earlier last month had an immediate impact on media stocks. Already we have seen News Corp (NWS) take a 7.5% stake in Fairfax (FXJ) and Channel Seven (SEV) a 14.9% strategic stake in the Western Australian Newspaper (WAN). This has contributed to a flurry of trading activity in media stocks with most of them rising in anticipation of consolidation in the sector.

The recent activity has also created a fresh interest in the media sector by traders and analysts alike. One media stock attracting significant attention of late is Publishing & Broadcasting Limited (PBL). With a market capitalisation of $13 billion, and a diverse set of holdings including Crown Casino in Melbourne, Foxtel, ninemsn and other media outlets, it’s a timely stock to review as a case study for bottom-up analysis for warrant trades.

Before buying warrants over any stock it is important that a company stacks up fundamentally. There are a few different ways of looking at a stock and one of them is bottom-up analysis. This is the art of looking at a stock’s micro-environment while only applying the macro-environment as a final filter. The analysis will focus almost exclusively on the financial reports and announcements of a company as well as its management to determine if its earnings are capable of growing.

Although there are many things to look for and consider, in this report the focus will be on two indicators that deal with a company’s level of debt and their ability to generate profit. So back to our company in review, PBL, we will look at their Debt/Equity ratio and Profit Margin indicators and use this information to formulate a warrant play.

Debt/equity ratio

This ratio helps to determine the aggressiveness of a company when using debt to grow earnings and is calculated by dividing the company’s total liability by the shareholders equity.

A high number indicates a greater proportion of debt and potentially greater financial risk. A lower the number indicates potentially lower financial risk and this is pleasing for the ‘value seekers’.

Generally, a rule of thumb is a debt/equity ratio 10% below industry average and one which has improved from prior periods is preferable. The definition of what is high and low varies across industries. It is calculated by dividing the company’s total liability with the shareholders equity.

PBL has a current debt/equity ratio of 15.7% compared to 25% for FY05. This means PBL has reduced its debt from last year which makes it less financially risky. PBL could have raised more debt to potentially boost earnings but at the expense of becoming a higher risk stock. At times this is no problem, so long as the additional cash flows earned as a result of the debt cover the higher interest charges. If these earnings are not sustainable, this may create problems in the future.

Profit margin

The profit margin will tell us how much profit, in cents, is earned from every dollar of sales, or the percentage of operating revenue that results in profit. A higher number is obviously desirable, with the indicator calculated by dividing the net profit by the operating revenue.

PBL managed a profit margin of 17.1% for FY06 which is above the prior year’s profit margin of 16.3%. Thus PBL has managed to increase profits while containing costs.

All in all these are bullish results from PBL and we would be looking at trading the long side on any chart breakouts. For this practical case study, we have pinpointed 27/09/06 as a good long entry on a breakout and chosen 09/10/06 as an exit as the stock seemed to consolidate. Most often warrant traders would be looking at a short term trade to capitalize on the volatility in these leveraged products. Instalment warrants, which entitle the holder to dividends paid, may be held longer.

Publishing & Broadcasting daily share price

Publishing & Broadcasting daily share price

 

 The warrant trade 

Trading the share and warrant were both profitable however the warrant gave a higher profit due to its leverage. The warrant provided a total return on 115% compared to a 6.2% return on the stock.

Share Warrants (PBLWMG) 
Capital $10,000 $10,000
Purchase Price (27/09/06) $18.45 $0.135
Shares/warrants 542 74,074 (ratio 4:1)
Sell Price (09/10/06) $19.60 $0.29
Profit per share/warrant $1.15 $0.155
Total profit $623.2 $11,481.46
% return 6.2% 115%

Traders beware: leverage is a two edged sword.

Of course, with leverage, you should always consider the higher risks involved. The gearing of warrants can result in magnified losses. Fortunately there is a lot we can do to minimise this risk. This is why all wise-owl.com trades use risk management to reduce a trader’s exposure to these potential losses should a trade turn pear shaped. The benefits of thorough research and careful risk management are clear. They will not only improve the success of your trading, but also your confidence and peace of mind.

 

Wise-owl.com is a leading Australian independent research house that publishes a range of Equity and Derivative Reports spanning the scope of the Australian market. Learn more about our unique approach with a free two-week trial to our Derivative Report, published every Sunday with Instalment & Trading warrants, CFD and Options strategies.