Value Investing – Business Ratios (Lesson 12)
Without the ability to compare potential investments, how does an investor know what is good and what is not so good when reviewing financial information? There must be some tool or set of tools to compare similar companies?
There is. Business ratios are used to compare similar companies within the same industry. RULE #1: DO NOT USE BUSINESS RATIOS TO COMPARE COMPANIES AGAINST EACH OTHER IF THEY ARE IN DIFFERENT INDUSTRIES.
Business ratios are not perfect, they have their respective flaws and it is important for value investors to understand the algorithms used with business ratios. It is also important to note that business ratios can be easily manipulated and result in misleading outcomes. More importantly, business ratios only reflect current information and not long-term trends. Think of business ratios as comparable to a doctor acquiring your vitals upon your medical visit. The vitals only reflect the ‘then and now’ status of your medical condition. They do not reflect your lifetime nor trending condition.
In effect, business ratios have a purpose, albeit limited. They are the best tools to compare similar companies within the same industry and typically the same market capitalization tier. Thus, a second rule to use with rule number one above; RULE #2: USE BUSINESS RATIOS TO COMPARE SIMILAR MARKET CAPITALIZATION COMPANIES WITHIN THE SAME INDUSTRY.
Because business ratios can be easily manipulated, it is important that users of business ratios have a full understanding of their respective formulas. RULE #3: BUSINESS RATIOS ARE NOT AN ABSOLUTE RESULT. They are merely indicators and that is all they are good for when interpreting their results.
Even with the above limitations, business ratios are beneficial to investors as they are the best method of comparing existing or potential investments. Their results are not perfect, but they can indeed provide adequate confidence when making pertinent decisions about a companies current financial status.
As illustrated in the prior lesson, it is a good idea to set the standard first. Again, the standards to use will come from the best company within your pool of similar investments. With a known value for each business ratio used, the investor can then evaluate the other members of that pool of investments.
This lesson introduces business ratios by explaining that there are five basic groups of ratios. Each group has a purpose and it is important to acknowledge what that purpose is and how to interpret the results. For those of you that are members of this site’s Investment Club, your initial e-mail came with an e-book ‘Value Investing with Business Ratios‘. Please refer to the e-book for each ratio’s formulas, nuances, illustrations and drawbacks. This lesson will not go into that level of detail.
The five groups of commonly used business ratios are:
The following sections introduce each group of ratios and goes into some common ratios used and their proper application.
Of all the business ratios, this group is not an internally pure business ratio. All the ratios within this group derive their results as a function of the market price per share at a single moment in time. In effect, every single ratio in this group fluctuates every single moment the stock market is open. The outcome can swing wildly in a single day. HOWEVER, this group of ratios is the most commonly cited ratios when discussing shares. There are four commonly used ratios in this group. The first two exist on every broker’s dashboard for every stock.
- Price to Earnings (P/E)
- Price to Book
- Price to Operating Cash Flow or Price to Free Cash Flow
- Price to Sales
The last one in this group is rarely used because it is an outdated ratio and was more commonly used pre-1930’s. Since then, it has lost favor with investors due to its easy manipulation and of course its irrelevancy towards profit. This ratio is more appropriate for small business valuations, especially those in the service industry.
Since price is dictated by the market, valuation ratios are considered an externally driven ratio and therefore, they are used as a quick tool to compare the investment against other similar industry stocks. Many less sophisticated investors will use the ratio to compare dissimilar industry investments because they perceive the ratio as a barometer of a return on investment. For example, an investor will purchase an investment with a 12:1 P/E ratio over a 25:1 P/E ratio as the return on the investment initially appears superior.
Value investors are not fooled by the casual use of these ratios. They are only indicators of the market’s perceived value at this moment in time and are often distorted by psychological intemperance. Smart and sophisticated investors use average values from historical results to derive value. The key to wealth accumulation is to know the value of a stock whether tied to earnings, book or cash based on average results against the current market’s interpretation of value. If there is a distinct discrepancy (> 9%), an opportunity to buy or sell may exist warranting action by a value investor.
As stated multiple times in these lessons, value investors think long-term; the market is short-term driven as conveyed by valuation ratios.
To truly understand a company, value investors turn towards internally driven ratios. The best group of internally driven ratios are performance ratios.
Performance ratios are oriented toward profitability, i.e. the various profit points along the income statement’s organizational presentation. In addition, it takes the net profit and compares this net profit as function of assets and shareholder’s equity. Think of it as ‘return on investment’ indicator.
In general, a business has three goals. The primary goal is to earn a profit. The other two address long-term security for the company.
Performance ratios measure the ability of the company to achieve the primary goal of earning a profit. Performance ratios consist of:
The first three measure the income statement relationships for the three basic sections. If you look at a basic income statement (profit and loss), you will find the layout as follows:
Revenue (Sales) $ZZ,ZZZ,ZZZ
Cost of Sales ZZ,ZZZ,ZZZ
Gross Profit Z,ZZZ,ZZZ
Operational Profit Z,ZZZ,ZZZ
Deprec./Amort. & Taxes Z,ZZZ,ZZZ
Net Profit $Z,ZZZ,ZZZ
All three profit points reflect the first three performance ratios. The ratios are a percentage of revenue. Gross profit should have a higher percentage than operational and operational is customarily higher than the net profit margin. These relationships tell the investor how well the company is performing financially related to actual operations. At anytime, if the profit point in the report is negative, it is a sign to the reader to investigate further to determine the contributing factors. But the traditional outcome is always a stepping down of percentages, whereby the bottom line is a positive percentage of revenue. Of course, the greater the net profit percentage the greater the performance of the company.
The last two performance ratios tell the investor how well the company is doing utilizing the existing equity and total assets. The ratio formulas are the net profit earned during the period divided by the respective average balance of either equity or total assets (more conservative investors use the beginning balances). Since equity is a function of total assets less total liabilities, its ratio outcome will always be greater than the return on assets result.
In the overall ratio hierarchy, performance ratios carry greater weight than the other ratio groups. Why? Well, performance ratios measure what the company actually does, not how the market perceives the company (valuation ratios). The other ratio groups measure the relationships between the income statement and the balance sheet. Performance ratios focus on what the company does as a business. As an investor, you want to know the value of how well the company performs financially selling its product and/or services.
In Lesson 8 of this series, there are five identified essential financial points of information every investor must know about a company. Two of those points are tied directly to performance ratios. The most important one is gross profit as a percentage of sales. This is referred to as gross profit margin stated as a percentage of sales. The higher this percentage, the more efficient corporate operations. Each industry will have its own average gross profit margin.
As a sidebar, some industries refer to the reverse of gross profit margin and disclose their gross profit margin by disclosing the cost of sales as a function of sales using the term ‘operating ratio’. Operating ratio is the cost of sales in percentage format.
Performance ratios are given the greatest weighted value when using business ratios to evaluate a company’s overall value. Performance ratios reflect the power of earnings for a company. Not only do value investors want to understand financial performance, they want to know if the management team is a good steward of the assets of the company. Activity ratios address management’s ability to maximize value with existing assets.
Activity ratios are easy to spot because they always relate a balance sheet group of accounts against either its average balance or against sales. In addition, activity ratios use the word ‘turnover’ in their title. There are six common activity ratios. Five of them are the different groups or accounts with the assets half of the balance sheet.
Recall, assets are the upper half or one side of the balance sheet. It’s formatted as follows:
ASSETS (in thousands of $)
. Cash $ZZZ,ZZZ
. Inventory ZZ,ZZZ
. Prepaids Z,ZZZ
Sub-Total Current Assets $ZZZ,ZZZ
Fixed Assets Z,ZZZ,ZZZ
Other Assets ZZ,ZZZ
TOTAL ASSETS $Z,ZZZ,ZZZ
The five ratios are used to compare the asset’s ending balance against its average balance or sales. The five are:
- Inventory Turnover Rate
- Receivables Turnover Rate
- Working Capital Turnover
- Fixed Assets Turnover Rate
- Total Assets Turnover Rate
The sixth activity ratio mimics the receivables turnover rate by evaluating accounts payable in the liabilities section of the balance sheet – Accounts Payable Turnover Rate.
The key to proper application of activity ratios is understanding what type of asset is most utilized by the respective company. Greater credence is given to the inventory turnover rate for retail based operations. Those entities involved in production of inventory (manufacturing & mining), emphasis shifts towards fixed assets turnover rate. For those organizations where inventory and equipment combined are essential to success, the total assets turnover rate is given more weight. Service based companies have greater reliance on receivables turnover rate.
When working with high quality top 2,000 companies, only the fixed assets and total assets turnover rates gained prominence in the decision model. The other turnover rates tend towards lesser value as they become standardized perfunctory values from year to year with little deviation.
Of the six activity ratios, four are production based and two are performance tools. Production activity ratios are 1) Inventory Turnover Rate, 2) Working Capital Turnover, 3) Fixed Assets Turnover Rate and 4) Total Assets Turnover Rate. The Accounts Receivable and Payable Turnover Rates are used to evaluate the quality of the customer base and the ability of operations to timely pay the bills.
Notice how activity ratios are oriented towards the upper half of the balance sheet. The next group of ratios are similar, but they are designed to evaluate the bottom half of the balance sheet.
Leverage refers to the ability to lift a heavier load using a fulcrum, a lever and a second lighter weight. The common image is a board on a triangular pivot point with a heavy weight (M1) on one end and a lighter weight (M2) on the other. As the lever shifts towards the lighter load it starts to lift the heavier weight.
In effect, as the distance ‘b’ gets longer, it becomes easier to lift M1.
This principle works with finances too. How so?
Well, in finance, leverage is the use of borrowed funds (M2) to increase the profits (M1) of the company. Simply put, the money is borrowed to purchase assets and then these assets are sold or utilized to generate profit. The core accepted principle is that the cost of the borrowed funds is less than the profits generated before the interest is paid. An example is appropriate here.
Airlines use leverage to increase their profits. They identify that there is indeed a consistent demand for additional flights to and from a particular destination. After some analysis, the airline determines that the revenue less the marginal costs of operating a plane will exceed the interest cost to buy that plane. Thus, sales less operating costs (including depreciation for the plane) will exceed the cost of interest on the debt to buy that plane. The result is additional profit to the bottom line. The airline is using financial leverage (borrowing money) to increase net profits.
Leverage ratios evaluate proper financing of a company especially those companies that are dominated by fixed assets on their balance sheets.
There are three commonly used leverage ratios.
The debt ratio is a simple comparison of total debt to total assets. It is common for certain industries to have higher debt than other industries. For example, a real estate investment trust will carry debt of more than 70% of total assets. This makes sense, real estate is a long term investment, bonds are issued to buy the apartment complexes or commercial locations. Rents cover operating costs and the remaining amounts pay interest and debt service for the real estate.
Interest Coverage Ratio
Interest is customarily paid from the earnings of the company, referred to as operational income. The interest coverage ratio evaluates the ability of the company to make its interest payments on its debt.
There is no universal interest coverage ratio that is acceptable. This is because each industry has its own set of dynamics. The more elastic the industry, the higher the ratio necessary to protect against economic volatility. As an example, retail industries require very high interest coverage ratios to reduce risk exposure related to consumer confidence. Walmart’s interest coverage ratio is:
EBITDA (2018 Fiscal Year Ending 01/31/18) = $30,966 Million = 14.22:1
Net Interest Paid $2,178 Million
Whereas inelastic industries can have significantly lower ratios. A perfect example is real estate (relatively inelastic). It is customary to have high debt ratios thus interest payments are greater than other industries. Also, inelastic industries tend to have lower operational profits as a percentage of sales. Thus the EBITDA is lower per dollar of revenue and so when the numerator decreases, and the denominator increases, you end up with a significantly lower ratio than retail.
Simon Property Group is the 2nd largest market capitalization REIT in the world. It owns malls and premium outlet centers. Its earnings before interest, depreciation, amortization and income taxes (REIT’s are technically income tax free under the Internal Revenue Code) in 2018 was $5,009,464,000; its interest expense was $1,282,454,000. Simon Property’s interest coverage ratio was 3.91:1. As an interesting side note, Simon Property Group’s debt ratio is 87%!
Notice the vast difference between a retail entity and a real estate company. This is a perfect example of why business ratios are not universal across all industries. As a user of ratios, be respectful of the industry standards and not some universally assumed norm.
Debt to Equity
Debt to equity ratio measures how much shareholders have in the game against debt holders. The lower the ratio, the more favorable for debt holders. A high number like 4:1 means that shareholders have only posted 20% of the risk that the company will go out of business. Debt holders frown on risk even though they are legally preferred for payment in bankruptcy. Typically, good companies have less than a 2:1 debt to equity ratio. This means that it is uncommon for debt to exceed 67% of the total assets value of the company. Debt is relatively protected at that level. However, this common value is adjusted for more fixed asset intensive operations such as REITs, utilities and raw resource extractors (oil, mining, natural gas). It is also common to have high debt to equity ratios for lending institutions.
The last group of ratios measures the ability of a company to meets its short-term obligations. With large-cap and DOW companies, these ratios are not emphasized due to the volume of sales and ability to access cash from their lines of credit. In effect, liquidity ratios are given little weight in decision models. However, it is still important to know them and understand their formulas. It is often here that value investors discover safety with their investment.
Liquidity refers to the ability to turn current assets into cash. In effect, at the large-cap and DOW level, all current assets are similar to cash as all of the current assets will soon become cash (typically in less than 60 days). Thus, when looking at the assets section of the balance sheet, a strong current assets position as a percentage of the entire assets position provides greater assurance of the company’s ability to continue operations for an extended period of time. The stronger the cash position, the less riskier the respective investment. There have been recorded instances whereby the cash position alone was more than total debt and the remaining balance exceeded the market capitalization position of the shares of stock. This means the price in the market for the stock is less than leftover cash! This is a value investor’s dream come true. If you had enough money, you would buy every share, shut down the company and take the left over cash and make your profit.
There are four liquidity ratios:
Most value investors use a variance of the operating cash ratio to evaluate a company’s ability to pay all its commitments throughout the year. This is explained in more detail in Phase Two of this program. Liquidity ratios should not have a lot of weight with a business decision model.
Summary – Business Ratios
When using business ratios to evaluate a business remember the three rules:
RULE #1: DO NOT USE BUSINESS RATIOS TO COMPARE COMPANIES AGAINST EACH OTHER IF THEY ARE IN DIFFERENT INDUSTRIES.
RULE #2: USE BUSINESS RATIOS TO COMPARE SIMILAR MARKET CAPITALIZATION COMPANIES WITHIN THE SAME INDUSTRY.
RULE #3: BUSINESS RATIOS ARE NOT AN ABSOLUTE RESULT.
The author also wants to emphasize the importance of not relying on one or two business ratios when making buy or sell selections. It is best to use at least a dozen business ratios to assist in ranking companies, not for the buy/sell decision itself. Ranking of potential investments is one step in creating a good buy/sell model. Sophisticated investors think holistically when buying and selling stock. It is about buying low with the least risk possible and selling at or near the market’s price tolerance for the stock. Act on Knowledge.