Lies, Damned Lies and...Financial Ratios

Friday, Mar 04 2011 by
14
Lies Damned Lies andFinancial Ratios

Following on from a previous excursion into Return on Equity, and the very good debate which ensued on, I have been pondering further on how to identify and recognise what constitutes a great company.

Why Great?

It sounds like a redundant question, but why the interest in great companies? To paraphrase the likes of Buffett and Co, they would rather buy a great business at a fair price, rather than a fair business at a great price.

This makes perfect sense as the stronger a business is (and is likely to remain so in the future), the stronger the likelihood that future profitability will increase. Get the quality business at a discount and then you can make a killing a la Greenblatt.  I may have come to it a bit late, but there seems to have been a lot of excellent analysis and discussion around the subject recently, particularly with UK Value Investor's screening based on ROE and other attributes, and Richard Beddard's Herculean efforts in attempting to apply Greenblatt's Magic Formula to the UK with ROA being a key component. I have been taking a closer look at other ratios that are commonly used alongside ROE. 

Useful Tools for the Tool-kit?

1 - Return on Assets (ROA). ROA = Adjusted Net Income / Total Assets

Adjusted Net Income = PAT + Interest (and the tax effect) - to show (kind of) operating profits without the cost of the capital base (ie interest)

Total Assets = Net Assets (opening or average)

Observations. Trying to adjust for interest and the tax effects is fiddly (Sharelockholmes in its ROTA calculation gets around this by using EBIT (I think)). Net Asset Value will include book values of intangibles and goodwill, and fixed assets, all of which may be very detached from market value.

2 - Return on Capital (ROC)

ROC = EBIT / (Net Working Capital + Tangible Assets )

NWC = net current assets/liabilities - ie stock + debtors + cash - current liabilities. Cash should be operating cash

TA = opening or average book value of Tangible Assets

Observations. This is very similar to Greenblatt's Magic Formula measure, although adjusting for surplus cash remains problematic. At least intangibles and goodwill are excluded from Assets, but there is still the issue of tangible assets at book cost. Maybe a high ROC is a sign that the assets could be undervalued?

3 - Return on Capital Employed (ROCE)

ROCE = EBIT /  (Total Assets - Current Liabilities)

Very similar to ROC but includes long-term debt.

So What?

They all sound fine and dandy and they have particular strengths and weaknesses, but it is too easy to get hung up about the finer details of these ratios in isolation. Every man and his dog seem to tweak each definition, and each sector has different drivers which will influence the outputs when compared to other sectors. Formulas are useful, but should not be the 'be all and end all' and do not remove the need to understand the movements in a company's finances. At the end of the day, we're all try to find good quality companies at an appropriate price, and I'm going to use them as an early stage screening tool.  I am in the process of re-writing/tweaking my Rules, but am considering using the following measures for screening purposes:

1 - ROE > 15% average over 10 years 
2 - ROC > 25% (as suggested by Greenblatt - ROA equivalent)
3 - ROCE > 15%
4 - PER
5 - Yield > 2.5%
6 - Gearing > 50%
7 - Mkt cap > £20m

A first pass has thrown up 19 interesting companies, including the likes of Astrazeneca (LON:AZN) and Unilever (LON:ULVR) . In an ideal world, I would want to back-test these parameters so see what the results are like, but for the time being I will judiciously select a few targets and take them to the next level of analysis. Watch this space...


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AstraZeneca PLC (AstraZeneca) is a global biopharmaceutical company. The Company discovers, develops and commercializes prescription medicines for Cardiovascular and Metabolic diseases; Oncology; Respiratory, Inflammation and Autoimmunity, Infection, Neuroscience and Gastrointestinal. The Company's medicines include Crestor for managing cholesterol levels; Seloken/Toprol-XL for hypertension, heart failure and angina; Onglyza for Type 2; Iressa for lung cancer; Faslodex for breast cancer; Zoladex for prostate and breast cancer; Pulmicort for asthma; Symbicort for asthma and COPD (chronic obstructive pulmonary); Nexium for acid-related diseases; Seroquel XR for schizophrenia, bipolar disorder and depressive disorder, and Synagis for RSV (respiratory syncytial virus), a respiratory infection in infants. The Company's pipeline includes 133 projects, of which 118 are in the clinical phase of development. AstraZeneca operates in over 100 countries. more »

Share Price (Full)
4320p
Change
0.0%
Mkt Cap (£m)
54,589
P/E (fwd)
16.2
Yield (fwd)
4.1

Unilever PLC is engaged in the supply of food, home and personal care products. The Company's portfolio ranges from nutritionally balanced foods to indulgent ice creams, soaps, shampoos and household care products. The Company operates through four segments: Personal Care, Foods, Refreshment and Home Care. Its personal care segment products include skin care and hair care products, deodorants and oral care products. Its Foods segment includes products, such as soups, bouillons, sauces, snacks, mayonnaise, salad dressings, margarines and spreads. Its Refreshment segment's product includes ice cream, tea-based beverages and weight-management products. Its Homecare segment products include home care products, such as powders, liquids and capsules, soap bars and a range of cleaning products. The Company offers over 400 brands, including Lipton, Knorr, Dove, Axe, Hellmann's, Omo, Persil, Blue Band, Domestos, Wall's ice cream, Marmite, Magnum, Lnynx, Pureit and Suave. more »

Share Price (Full)
2907p
Change
0.6%
Mkt Cap (£m)
82,683
P/E (fwd)
21.1
Yield (fwd)
3.1



  Is AstraZeneca fundamentally strong or weak? Find out More »


5 Comments on this Article show/hide all

fourayes 5th Mar '11 1 of 5
1

Perhaps in condition 6 you meant less than, which is often shown as " fourayes

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fourayes 5th Mar '11 2 of 5

my comment was truncated.

Did condition 6 read gearing > 50, or was that a mistake? fourayes

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StockHound 5th Mar '11 3 of 5

In reply to fourayes, post #2

re. Gearing - would be a mistake for sure... 'great' companies tend to be very cashflow generative thus having little need for much gearing.

The 10 year average condition - would that exclude companies with an operating history of less than 10 years?  I think that would be a mistake in the UK market - it would preclude companies such as ASOS and Abcam from making the list.

I think you should add a cashflow criterion to your screen though. Great companies generate free cashflow to turnover ratios of at least 5%. Accounting profits aren't the real thing - any company can announce profits - its much harder to announce consistent operating cashflow far in excess of capex. Ultimately in the long term the market is a weighing machine, and what it weighs is the long term discounted free cashflow due to equity shareholders.

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10 Value 10 7th Mar '11 4 of 5
1

Hi Fourayes

Well spotted - yes, there was a typo in the first draft, which got corrected but didn't seem to pull through to this article properly

Condition 6 should be 'less than'; Gearing
Thanks

Blog: 10 Value 10
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10 Value 10 7th Mar '11 5 of 5
1

Hi StockHound

I am coming round to the view that the 10 year period is aspirational rather than mandatory. The logic of looking at a ten-year time-frame is that it theoretically encompasses a full business cycle, and thus you can see how a business performs in the bad times as well as the good. As you point out, the danger is that you miss interesting, but young, companies. I decided to invest in Vertu recently and they only have 3/4 years of history as a listed company, so I am being flexible for that one.

In my Rules, which are detailed on my blog - http://10value10.blogspot.com/search/label/value%20investing - I do have a look at the cash flows to get a feel for working capital management and whether the business is generating enough operating cash to meet its needs. I'm using my screen to identify a list of potential candidates, which will receive a more detailed anlysis in time.

I certainly agree with you re FCF and I'm contemplating tweaking my Rules to look at P/FCF as an alternative to PER.

Thanks

Blog: 10 Value 10
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10 Value 10

I am a private investor, who happens to be a Chartered Accountant with experience in corporate finance, venture capital and banking. Living in Yorkshire has driven my desire to find value in all things even further! more »



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