Financial Ratios with Some Bang
Friday August 22, 7:00 am ET
By Matthew Scholz
Are there financial ratios that can measure the value and prospects of a company, and if so, how are these calculated?
The short answer to this question is "yes, but..." Some financial ratios are useful; however, before we dig into them, it's worth reiterating that the fair value estimates we calculate at Morningstar are based on discounted cash flow (DCF) analyses.
For our purposes it's important to note one vital difference between DCF and financial ratio analysis: A DCF analysis attempts to pinpoint a firm's intrinsic value based on the present value of its future cash flows, whereas financial ratio analysis examines a firm based on market prices and/or historical accounting numbers. Although we believe that a DCF provides a more thorough valuation methodology, financial ratios can still be useful.
Types of Financial Ratios
A ton of different financial ratios are out there, so it's helpful to think about grouping ratios into certain categories, such as those that relate to internal liquidity or to operating performance. The two broadest categories of financial ratios are those used to measure relative valuation and those used to examine some aspect of a company's fundamental performance. The most common ratio used for relative valuation is the price/earnings (P/E) ratio. Although relative valuation measures have significant limitations, they do provide a second set of valuation tools, which can serve as a gut-check for a DCF analysis.
On the other hand, fundamental ratios measure the relationship between two financial statement items. An example is the net profit margin, which is calculated by dividing net income by sales. Fundamental ratios are indispensable building blocks used in the construction of a DCF analysis. Financial Ratios in Context
Before hanging your hat on a certain ratio, it's important to keep some limitations in mind. Besides the fact that financial ratios depend on market data and historical accounting values, ratios are useless in isolation.
For example, the fact that Home Depot's (NYSE:HD - News) current ratio (the ratio of current assets
over current liabilities) is 1.4 means nothing unless it is compared to some benchmark. Possible benchmarks might be Home Depot's current ratio from previous time periods, the current ratio of a competitor such as Lowe's Companies (NYSE:LOW - News), the average current ratio of all large
retailers, or the current ratio of a broad index such as the S&P 500. As you can see, selecting the right benchmark is tricky because no other company is exactly like Home Depot.
Another problem is that most ratios are calculated using financials based on generally accepted accounting principles (GAAP), which allow plenty of room for interpretation. For instance, two companies could have separate interpretations of a GAAP rule on revenue recognition, so any financial ratios for the firms that employ revenue in either the numerator or denominator won't be directly comparable.
The idea of comparability can be carried to its logical conclusion. If a company's managers pursue overly aggressive--or downright fraudulent--accounting policies, the issue of comparability is moot. Many of Enron's (Other OTC:ENRNQ.PK - News) accounting numbers--and hence any ratios using
these numbers--were wrong, so comparisons based on these numbers would have been spurious. A Sampling of Useful Financial Ratios
A first step in using historical financial data is to examine the growth rate--the trend--in various line items. Regardless of what sort of company you examine, it's instructive to look at how the firm's revenues, expenses, cash flows, assets, liabilities, and equity have changed over time, both separately and in relation to one another. These growth rates aren't true ratios, so you should also look at the trend in fundamental ratios such as gross profit margin (sales minus cost of goods sold divided by sales), total asset turnover (sales divided by average total assets), and equity to assets (equity divided by average total assets). You can compare these trends to the trends at similar companies, and use the data to help forecast future growth rates in a DCF model.
Some of the more useful fundamental ratios are those that measure the financial health and flexibility of a company. When compared to some benchmark, solvency ratios such as the debt/equity ratio (long-term debt divided by equity) or the interest coverage ratio (operating income divided by interest expense) indicate how much financial wiggle room a company has. Solvency ratios can be quick, helpful measures of financial strength, but remember to double-check the accounting data to make sure it is correct and relevant. For example, in this case, you'll want to make certain that any off-balance-sheet financing vehicles such as operating leases are included in your solvency calculations. Although Morningstar's valuation model is centered on the DCF analysis, relative valuation measures can be useful, too. Because earnings are easier to manipulate than cash flow, we're usually more inclined to calculate a company's price/cash flow ratio rather than a price/earnings ratio. For companies that own many liquid assets (think banks and insurance companies), price/book (P/B) ratios are frequently used. Of course, a P/B ratio wouldn't be helpful in examining a fast-growing technology company with few tangible assets. This example illustrates the fact that some of the most relevant fundamental ratios can be very industry specific. For instance, in the staffing industry, revenue per staffing assignment is a useful ratio to consider, while in some sectors--especially technology--you would look at the book/bill ratio, which measures the ratio of new orders booked to orders shipped or billed.
Helpful, But No Silver Bullet
Financial ratios have many uses. They can be a quick way to get a handle on relative valuation, or gauge things such as the financial health, operating profitability, or operating efficiency of a company over time (relative to both the company's past performance or relative to another benchmark). Financial ratios also help analysts to forecast future performance, which aids in the construction of a DCF analysis. But there aren't any silver bullets. It's best to use financial ratios as a supplement to or in conjunction with an absolute valuation methodology such as our DCF approach.
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