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# Chapter 7.18: Understanding Ratio Analysis with Various Financial Ratios

In the previous section, we looked at equity valuation using present value models. Another approach to equity valuation is the relative value approach. Under this approach, investors decide whether or not to buy a company’s stock by comparing it with stocks of other companies on the basis of certain financial ratios. In this section we will explore this approach.

• #### Valuations through financial ratios: Introduction

If you wanted to buy something and had two differently priced alternatives to choose from, will you simply go ahead and pick the cheaper one? You would probably like to compare their prices vis-à-vis their benefits before selecting one. You would then pick the one that provides the greatest value for the given price. A similar cost-benefit analysis is performed when shopping for stocks. Investors like to know what benefits they will receive for the price they are paying for them. Fortunately, the benefits of owning stocks are quantifiable, unlike the features of other products you might buy. These benefits are in the form of a share in the future income, cash flows or dividends of the company; as well as in the form of a share in its assets or book value. To calculate the cost-benefit trade-off, the price of the stock is divided by these values. The ratios thus calculated are called price multiples. These multiples are then compared across similar companies to discover which of them offers the greatest value. Since this approach is based on a comparison between different companies, it is called the relative value approach. The idea here is that in an efficient market, share prices reflect company fundamentals perfectly. If there is inconsistency between the two, investors will spot them quickly and prices will soon appreciate to reflect what fundamentals warrant.

• #### What are PE, PB ratios

Traditionally, many price multiples are used for stock-picking. They include: price-to-sales (PS), price-to-cash flows (PCF) and price-to-dividends. However, the ones used the most are price-to-earnings (PE) and price-to-book value (PB). Let’s look at these individually.

• Price-to-earnings (PE): The PE ratio is calculated by dividing the market price per share of a company with its earnings per share (EPS). EPS is the proportion of net income that can be theoretically allocated equally to each individual share. It is calculated by dividing net income by the number of shares outstanding. As such, EPS is essentially net income per share. It may be historical or forward, based on whether it is calculated using previous period’s earnings or the next one’s. Since current prices are a function of expected future earnings, investors prefer calculating forward PEs. In case a company’s forward earnings are unpredictable for some reason, historical PEs are used.

#### How to Calculate PE Ratio

Forward PE calculates the price an investor effectively has to pay for each rupee of future earnings of the company. Net income belongs to shareholders of the company, whether it pays it out as dividend or retains and reinvests it in the future, thereby leading to an increase in future dividends. This is why investors want to know exactly how much they are paying for each unit of earnings. Smaller the price, the better it is for investors.

• Price-to-book value (PB): One limitation of price multiples based on flow variables, such as net income and cash flows, is that they are volatile. It is possible for these variables to be very high in one period and negative in the next. A volatile or negative denominator doesn’t make a meaningful multiple. To cope with this, investors sometimes use balance sheet figures as they are more stable and predictable. The figure used most commonly is the book value. As discussed in the section on the balance sheet, book value is the total value of the company’s equity. It includes the face value of its shares, retained earnings, certain reserves and comprehensive incomes that escape the income statement and go directly to the balance sheet. As in the case of EPS, book value too is converted into a per share form by dividing it by the number of outstanding shares. The current share price is then divided by this value to calculate PB. As with PE and all other price multiples, a low value for PB is considered better because it means that the investor is required to pay less per unit book value.

The trouble with using multiples is that a low price multiple doesn’t always indicate a good investment opportunity. Sometimes, it is a true reflection of poor company fundamentals. Similarly, a high multiple is also sometimes justified. For instance, if a company is investing in a new facility or undertaking another venture that will lead to a major boost in future earnings, a high PE may be warranted. Similarly, a very low PE may also be justified by certain factors. This calls for further investigation. In the following segment, we will discuss certain ratios that are used for this investigation.

• #### Understanding financial ratios: Profitability, liquidity, efficiency, risk ratios

Equity holders are principally concerned about the recovery of their investment, along with the dividend due on it. To verify the safety of their investments and ascertain its growth potential, they seek answers to four questions:

• Is the business making enough profits to meet its obligations towards shareholders?
• Does the business have enough cash readily available to meet its short term requirements?
• Is the business conducting its operations in the most optimum way, so as to maximize profits at the lowest possible cost?
• Is the business left with enough funds after meeting its necessary expenses to cover its capital charges?

• These questions are answered by calculating four categories of ratios—profitability, liquidity, efficiency and risk (coverage) ratios. Companies that perform well along these parameters generally have justifiably high price multiples.

#### Types of Financial Ratios

• Profitability ratios: These ratios seek to measure the profitability of a company based on measures like gross profit, operating profit, net profit and return on equity. Higher the profitability ratios of a company, the better it is. Commonly used profitability ratios include:
• Gross profit margin = Gross profit for the period/ sales revenue for the period
• Operating profit margin = Operating profit for the period/ sales revenue for the period
• Net profit margin = Net profit for the period/ sales revenue for the period
• Return on equity (ROE) = Net profit for the period/ average book value of equity*

• Liquidity ratios:These ratios measure whether the company has enough short-term assets to finance its short term liabilities. Recall the discussion on working capital in the section on the income statement. These ratios seek to measure whether the company’s working capital is positive. A value in excess of one is considered to be good for these ratios. However, a very high value is also not healthy as it indicates overinvestment in working capital. Some popular liquidity ratios are:
• Current ratio = current assets/ current liabilities
• Quick ratio = (cash + short term investments + accounts receivable)/ current liabilities
• Cash ratio = (cash + short term investments)/ current liabilities

• Efficiency (activity) ratios:These ratios comment upon the efficiency of a company’s operations. Efficiency is estimated by how quickly a company can convert its inventory into sales and use this money to repay its suppliers. This process is called the cash conversion cycle. More quickly a company is able to complete this cycle, more will be the number of cycles it will complete in a year and higher will be its revenue. To ascertain this, efficiency at every stage of the cycle – from inventory to sales, from sales to accounts receivables and from accounts receivable to payment to suppliers is measured.

As mentioned above, efficiency is measured in two ways—the length of each cycle and the number of cycles completed in the year. The ratios that estimate the first are:

• Inventory turnover = COGS/ average inventory*.
• Receivables turnover = sales revenue/ average accounts receivable*.
• Payables turnover: (COGS +opening inventory balance – closing inventory balance)/ average accounts payable*

The other category of efficiency ratios calculate the number of days it takes for each cycle to get completed. They include:

• Days of inventory on hand (DOH) = 365/ inventory turnover ratio.
• Days of sales outstanding (DSO) = 365/ receivables turnover ratio.
• Number of days of payables (DOP): 365/ payables turnover ratio.

Notice that each of the above ratios evaluates efficiency at one of the stages talked about earlier. Finally, we need to measure the total number of days taken in the completion of the entire cycle. This is done by adding the DOH and DSO and subtracting DOP from it:

• Cash conversion cycle: DOH + DSO - DOP

*All averages in the above mentioned formulas are calculated by dividing the sum of opening and closing values of the asset/liability by 2. For example, average book value of equity is the sum of book value at the beginning and the end of the year, divided by 2.

• Risk ratios: These ratios assess the proportion of debt in the company’s capital structure and its ability to meet its periodic debt obligations. It is primarily of interest to lenders but also interest shareholders. For shareholders, high debt represents an element of risk. This is because lenders always get paid before shareholders. If the proportion of debt is too high, there are chances that whatever remains of the company’s income after meeting all other expenses will go to lenders and shareholders will get nothing in the way of dividends. Also, if the company has to wind-up, debtors will get all of what remains and nothing will go to the shareholders. Important risk ratios include:
• Debt to total capital = total debt/ (total equity + total debt)
• Debt to equity = total debt/ total equity
• Interest coverage ratio = EBIT/ interest expense for the period
• Fixed cost coverage ratio = (EBIT + periodic lease expenses)/(interest + periodic lease expenses)
• #### What are the limitations of financial ratios

Thus far, we have only discussed the blessings of ratio analysis. A word of caution is in order before we move ahead in this section. Following are some of the limitations of ratio analysis.

• Ratio analysis is based on comparison between companies to find out which one is the best. However, no two companies, even within the same industry, are identical. Companies may differ in terms of size, strategy, product types, stage of growth etc. This prevents ratio analysis from being a like to like comparison.
• Accounting standards provide companies with a fair amount of freedom to choose among alternative methods for the calculation and reporting of the same values. Using different accounting approaches hinders comparability among companies.
• There is no good or bad value for a ratio. It purely depends on the general industry environment and the management’s ability to manage the company’s operations. Thus, ratios alone tell us nothing. They have to be looked at together with other ratios to get the complete picture. Even then, they leave scope for qualitative analysis.
• When ratios are calculated using current or previous period data, they are not always indicative of future trends. When expected future data are used, like in the case of forward PE, it may not cover for unexpected future events. This makes the dependability of ratio analysis questionable.

• #### Guide to value investing

Value investing is the style of investing where investors pick stocks that they feel are undervalued or ‘cheap’, relative to their peers or in light of their own future prospects. This approach contrasts with growth investing, where investors are not much concerned about the price of the stock. They pick stocks that they believe will appreciate because the company will realize exceptional earnings growth in the future.

Value investing is based on the concept of intrinsic value. Intrinsic value is the price investors, in general, feel the company’s shares should trade at, given its fundamentals. A value investor invests in a stock when its market price is below the intrinsic value because he expects the price to appreciate to intrinsic value over time. Intrinsic value is estimated using price multiples. This is done in two ways:

• In the first approach, an investor selects a company and calculates the price multiples for it and a group of its closest competitors. Then, he averages the value of the multiple for its competitors and compares it with the company’s multiple. If the company is trading at a lower multiple than its competitors, it is deemed to be undervalued. He buys the stock and waits for it to appreciate.
• In the second approach, the investor calculates the average of the competitors’ multiples, just as in the first case. Then, he uses this multiple to calculate the fair value of the company’s stock. If the market price of the stock is below this, he considers it undervalued and buys it. Let’s look at an example.

Assume that a company is trading at a forward PE multiple of 12 while a group of its competitors are trading at an average multiple of 15. This means that for every unit of forward earnings of the company, you have to pay Rs 12, whereas for its competitors, it is Rs 15. since the company is cheaper than its competitors, you may buy it.

For the second approach, let’s assume that the company has an estimated forward EPS of Rs 20 and is currently priced Rs 360 per share. The competitors’ PE is the same. Now, we can calculate the intrinsic value of the company by multiplying the competitor’s PE with the company’s EPS. This comes out to Rs 300. Since the market price is above this, you may leave the stock alone.

Instead of using competitors’ multiples, a comparison can also be made with the historical values of the company’s own multiples. Further, investors generally like to use a host of multiples rather than just the one to calculate intrinsic value.

As mentioned earlier, investors must not rely on numerical values alone. They must employ their logic and evaluate why the company’s multiples are different from the industry’s. In some cases, on doing so, they may realize that even a higher multiple for the company is attractive owing to its fundamentals. On other occasions, a much lower price multiple may also not be attractive enough, as the stock may never appreciate owing to limited potential. Investors who get attracted by low price multiples and invest in such stocks may never see them appreciate. This is called the value trap.

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