Mastering stock market basics for successful investing is simple, but it's not easy.
One of the big myths of the last bull market since 2003 was that the stock market was essentially a savings account that returned 15 percent per year-at the least. You read the Economic Times daily, watched a little of CNBC TV-18, you opened an online trading account, and you were on the road to riches. Unfortunately, as many investors discovered when the bubble popped in January 2008, things that look too good to be true usually are.
Management Effectiveness
- Return on Assets (ROA)
- Return on Equity (ROE)
- Return on Invested Capital (ROIC)
Return on Assets (ROA)
We know the first component of Return on Assets (ROA). Its simply Net Margin, or Net Income divided by Sales. And it tells us how much of each dollar of sales a company keeps as earnings, after paying all the costs of doing business. The second component is Asset Turnover, or Sales divided by Assets, which tells us roughly how efficient the firm is at generating revenue from each dollar/rupee of Assets.
Multiply these two, and we have the formula for return on assets.
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ROA = Earnings/Assets
Alternatively this can also be expressed as
ROA =(Earnings/Sales) x (Sales/Assets), or
ROA =Net Margin x Asset Turnover
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Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating Assets into Profits. ROA helps us understand that there are two routes to excellent operational profitability. You can charge high prices for your products (high margins) or you can turn over your assets quickly.
ROA tells an investor how much profit a company generated for each $1 in assets. When using ROA as a comparative measure it is best to compare it against a firm's previous ROA numbers or the ROA of a similar company. ROA for public companies can vary substantially and will be highly dependent on the industry.
Calculating Return on Assets
Rough benchmarks for analysing a firm's ROA
Return on Equity (ROE)
Return on Equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity. Think of it as measuring profits per rupee of shareholders' capital.
As a rule of thumb, firms that are consistently able to post ROEs above 20% are generating solid returns on shareholders' money, which means they are likely to have economic moats. Significantly, Return on Equity can tell us more than just the efficiency of using shareholders capital. ROE provides a direct peek into how well a firm balances - profitability, asset turnover and financial leverage - to provide decent returns on shareholders' equity.
This is because there are only three levers for boosting ROE -Net Margin, Asset Turnover and Financial Leverage. Lets see why this is so by examining the return on equity formula.
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ROE = Earnings/Shareholders' Equity
Alternatively this can also be expressed as
ROE =(Earnings/Sales)x (Sales/Assets)x (Assets/Shareholders' Equity), or
ROE = Net Margin x Asset Turnover x Financial Leverage
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So we have three levers that can boost Return on equity -net margins, asset turnover, and financial leverage. For example, a firm can have only so-so margins and modest levels of financial leverage, but it could do a great job with asset turnover (e.g. a well run discount retailer). Companies with high asset turnover are extremely efficient at extracting more rupees of revenue for each rupee invested in hard assets. A firm might have asset turns only middling, and the firm might not have much leverage, but say it has great profit margins (e.g. a luxury goods company)-that would make for decent ROEs. Finally, a firm can also boost its ROE to respectable territory by taking on good-size amounts of leverage (e.g mature firms such as Utilities).
Calculating Return on Equity
Rough benchmarks for analysing a stock's ROE
Two Caveats when using ROE to analyse stocks
Return on Invested Capital (ROIC)
Return on Invested Capital (ROIC) is a sophisticated way of analysing a stock for return on Capital that adjusts for some peculiarities of ROA and ROE. Its worth knowing how to interpret it because its overall a better measure of profitability than ROA and ROE. Essentially ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing. It removes the debt related distortion that can make highly leveraged companies look very profitable when using ROE. It also uses a different definition of Profits than ROE and ROA, both of which use Net Profits. ROIC uses Operating Profits after taxes, but before interest expenses.
Again, the goal is to remove any effects caused by a company's financing decisions -does it use debt or equity?- so that we can focus as closely as possible on the profitability of the core business.
The true operating performance of a firm is best measured by ROIC, which measures the return on all capital invested in the firm regardless of the source of the capital. The formula for ROIC is deceptively simple
ROIC =Net Operating Profit after Taxes (NOPAT)/Invested Capital
Invested Capital =Total Assets - Non-Interest bearing Current Liabilities - Free Cash Flow
(Non-interest bearing current liabilities usually are Accounts Payable and other Current Assets)
You may also want to subtract Goodwill, if its a large percentage of Assets.
What does all this mean to you if you hear someone talking about ROIC? Simply that you should interpret ROIC just as you would ROA and ROE - a higher Return on Invested Capital is preferable to a lower one!
Rough benchmarks for analysing a firm's ROIC
Valuation
- Free Cash Flow (FCF)
- Discounted Cash Flow (DCF)
- Intrinsic value
Free Cash Flow
Free cash flow (FCF) is calculated by subtracting Capital expenditures from Operating cash flow. Cash Flow from Operations measures how much cash a company generates. It is the true touchstone of corporate value creation because it shows how much cash a company is generating from year to year. As useful as the Cash Flow statement is, it does not take into account the money that a firm has to spend on maintaining and expanding its business. To do this, we need to subtract Capital Expenditures, which is money used to buy fixed assets.
Free Cash Flow =Cash Flow from Operations - Capital Expenditure
Free Cash Flow enables us to separate out businesses that are net users of Capital - ones that spend more than they take in- from businesses that are net producers of Capital, because its only that excess cash that really belongs to shareholders. Free Cash Flow is sometimes referred to as "Owners Earnings" because that's exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company's ongoing business.
There is a view that most analysts myopically focus on earnings while ignoring the real cash that a firm generates. While earnings can often be clouded by accounting tricks, it's much tougher to fake cash flow. For this reason, seasoned investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits).
Rough benchmarks for analysing a firm's Free Cash Flow
Discounted Cash Flow
Discounted cash flow (DCF) valuation is used to evaluate the investment-worthiness of a stock. If the value derived from DCF valuation is higher than the current market price, the opportunity might be worth considering. Discounted Cash Flow valuation uses future free cash flow streams and discounts them (using a risk free rate + risk premium) to arrive at the present value.
Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book - The 5 Rules for Successful Stock Investing - tells us about discounted cash flows (DCF) how we can go about calculating them.
What is a stock worth? Economists Irving Fisher and John Burr Williams answered this question for us more than 60 years ago. The value of a stock is equal to the present value of its future cash flows. No more and no less.
Companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some get re-invested in the business, and the rest is free cash flow. Remember we care about the free cash flow because that's the amount of money that could be taken out of the business each year without harming its operations. A firm could use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, which essentially converts a portion of each investor's interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and re-invest it in the business.
These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today.
Why are future cash flows worth less than the current ones? First, money that we receive today can be invested to generate some kind of return, whereas we cant invest future cash flows until we receive them. This is the time value of money. Second, there is a chance that we may never receive those future cash flows, and we need to be compensated for that risk, called the risk premium.
The time value of money is essentially the opportunity cost of receiving money in the future versus receiving it today, and is often represented by the interest rates being paid on government bonds. Its pretty certain that the government will be around to pay us our interest in a few years.
Of course, not many cash flows are as certain as those from the government, so we need to take an additional premium to compensate us for the risk that we may never receive the money we have been promised. Add the government bond rate to the risk premium, and we have what's known as a discount rate.
Now you can start to see why stocks with stable, predictable earnings often have such high valuations - investors discount their future cash flows at a lower rate, because they believe that there's a lower risk attached to the likelihood that those future cash flows will actually show up. Conversely a business with an extremely uncertain future should logically have a lower valuation because there is a substantial risk that the potential future cash flows will never materialise.
You can see why a rational investor should be willing to pay more for a company that's profitable now relative to one that promises profitability only at some point in the future. Not only does the latter carry a higher risk (and thus a higher discount rate), but the promised cash flows won't arrive until some years in the future, diminishing their value still further.
Changing discount rates and the timing of cash flows can have a telling effect on present value. In all three examples, below -StableCorp, CycliCorp, and RiskCorp -the sum of the undiscounted cash flows is about $32000.
However, the value of the discounted cash flows is quite different from company to company. In present value terms, CycliCorp is worth about $2700 less than StableCorp. That's because StableCorp is more predictable, which means that investors' discount rate isn't high. CycliCorp's cash flow increases by 20 percent some years and shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they are valuing its shares. As a result the present value of the discounted cash flows is lower.
The difference in the present value of the cash flows is even more acute when you look at RiskCorp, which is worth almost $8300 less than StableCorp. Not only are the bulk of RiskCorp's cash flows far off in the future, bu also, we are less certain that they will come to pass, so we assign an even higher discount rate.
Intrinsic Value - What a stock is worth?
Without knowing what a stock is worth- in other words its Intrinsic Value- how can you know how much you should pay for it? Stocks should be purchased because they are trading at some discount to their intrinsic value, not simply because they are priced at a higher or lower point than similar companies.
The big drawback of the ratios discussed in the Stock Valuation Basics section is that they are all based on price - they compare what investors are currently paying for one stock to what they are paying for another stock. Ratios do not, however, tell you anything about value, which is what a stock is actually worth. Comparing ratios across companies and across time can help us understand whether our valuation estimate is close to or far from the mark, but estimating the intrinsic value of a company gives us a better target.
Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book - The 5 Rules for Successful Stock Investing - tells us how we can go about calculating what a stock is really worth- in other words, its Intrinsic Value. His writings are the primary source for this article.
Having an intrinsic value estimate keeps you focused on the value of the business, rather than a piece of the stock - and that's what you want because, as an investor, you are buying a small piece of a business. Intrinsic valuation also forces you to think about the cash flows that a business is generating today and the cash it could generate in the future, as well as the returns on the capital that the firm creates. It makes you ask yourself, "If I could buy the whole company, what would I pay?
Second, having an intrinsic value gives you a stronger basis for making investment decisions. Without looking at the true determinants of value, such as cash flow and return on capital, we have no way of assessing whether a P/E of, for example 15 or 20 is too low, too high, or right on target. After all, the company with the P/E of 20 might have much lower capital needs and a less risky business than the company with the P/E of 15, in which case it might actually be the better investment.
Cash Flow, Present Value, and Discount Rates
Companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some get re-invested in the business, and the rest is free cash flow. Remember we care about the free cash flow because that's the amount of money that could be taken out of the business each year without harming its operations. A firm could use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, which essentially converts a portion of each investor's interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and re-invest it in the business.
These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today.
Why are future cash flows worth less than the current ones? First, money that we receive today can be invested to generate some kind of return, whereas we cant invest future cash flows until we receive them. This is the time value of money. Second, there is a chance that we may never receive those future cash flows, and we need to be compensated for that risk, called the risk premium.
The time value of money is essentially the opportunity cost of receiving money in the future versus receiving it today, and is often represented by the interest rates being paid on government bonds. Its pretty certain that the government will be around to pay us our interest in a few years.
Of course, not many cash flows are as certain as those from the government, so we need to take an additional premium to compensate us for the risk that we may never receive the money we have been promised. Add the government bond rate to the risk premium, and we have what's known as a discount rate.
Now you can start to see why stocks with stable, predictable earnings often have such high valuations - investors discount their future cash flows at a lower rate, because they believe that there's a lower risk attached to the likelihood that those future cash flows will actually show up. Conversely a business with an extremely uncertain future should logically have a lower valuation because there is a substantial risk that the potential future cash flows will never materialise.
You can see why a rational investor should be willing to pay more for a company that's profitable now relative to one that promises profitability only at some point in the future. Not only does the latter carry a higher risk (and thus a higher discount rate), but the promised cash flows won't arrive until some years in the future, diminishing their value still further.
Changing discount rates and the timing of cash flows can have a telling effect on present value. In all three examples, below -StableCorp, CycliCorp, and RiskCorp -the sum of the undiscounted cash flows is about $32000.
However, the value of the discounted cash flows is quite different from company to company. In present value terms, CycliCorp is worth about $2700 less than StableCorp. That's because StableCorp is more predictable, which means that investors' discount rate isn't high. CycliCorp's cash flow increases by 20 percent some years and shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they are valuing its shares. As a result the present value of the discounted cash flows is lower.
The difference in the present value of the cash flows is even more acute when you look at RiskCorp, which is worth almost $8300 less than StableCorp. Not only are the bulk of RiskCorp's cash flows far off in the future, bu also, we are less certain that they will come to pass, so we assign an even higher discount rate.
This is the basic principle behind a discounted cash flow model. Value is determined by the amount, timing, and riskiness of a firm's future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock. That's all it really boils down to.
Calculating Present Value
Generalising the previous formula, if we represent the discount rate as R, the present value of a future cash flow (CF) in year N equals
Fun with discount rates
Unfortunately, there is no precise way to calculate the exact discount rate that you should use in discounted cash flow (DCF) model, and academicians have filled entire journals with nothing but discussions on the right way to estimate discount rates for Intrinsic value calculations.
Here's what you want to know for practical purposes. As interest rates rise, so will discount rates. As a firm's risk level increases, so will its discount rate. Let's put these two together. For interest rates you can use the long-term average of treasury rates as a reasonable proxy. (Remember we use interest rate on treasuries to represent opportunity costs because we are pretty certain that the government will pay us our promised interest).
Now for risk, which is an even less exact factor to measure. Here are some factors that should be taken into account when estimating discount rates.
Size
Smaller firms are generally riskier than larger firms because they're more vulnerable to adverse events. They also usually have less diversified product lines and customer bases.
Firms with more debt are generally riskier than firms with less debt because they have a higher proportion of fixed expenses (debt payments) relative to other expenses. Earnings will be better in good times, but worse in bad times, with an increased risk of financial distress. Look at a firm's debt-to-equity ration, interest coverage, and a few other factors to determine the degree of a company's risk from financial leverage.
Cyclicality
Is the firm in a cyclical industry (such as commodities or automobiles) or a stable industry (such as breakfast cereal or beer)? Because the cash flows of cyclical firms are much tougher to forecast than stable firms, their level of risk increases.
Management/Corporate Governance
This factor boils down to a simple question: How much do you trust the folks running the shop? Although its rarely black or white, firms with promotional managers (who leave no opportunity to drum up stock prices through their media appearances), managers who draw egregious salaries, or who exhibit any of the other red flags are definitely riskier than companies with managers who do not display these traits.
Economic Moat
Does the firm have a wide moat, a narrow moat, or no economic moat? The stronger a firm's competitive advantage -that is, the wider its moat- the more likely it will be able to keep competitors at bay and generate a reliable stream of cash flows.
Complexity
The essence of risk is uncertainty. And its tough to value what you can't see. Firms with extremely complex businesses or financial structures are riskier than simple, easy-to-understand firms because there's a greater chance that something unpleasant is hiding in a footnote that you missed. Even if you think management is as honest as the day is long and that the firm does a great job running its operations, its wise to incorporate a complexity discount into your mental assessment of risk.
How should you incorporate all of these risk factors into a discount rate? There is no right answer.
Morningstar uses 10.5 percent as the discount rate for an average company based on the above factors and creates a distribution of discount rates based on whether firms are riskier or less risky than the average. A so mid-2003, firms such as Johnson and Johnson, Colgate and Wal-Mart fall at the bottom of the range at around 9 percent, whereas riskier firms such as Micron technology, JetBlue Airways, and E*Trade -top out at 13 percent to 15 percent.
The key is to pick a discount rate you are comfortable with. Don't worry about being exact -just think about whether the company you are evaluating is riskier or less risky than the average firm, along with how much riskier or less risky it is, and you will be fine.
Discount rates for the Indian market context
In the Indian market context we may use 15% as the discount rate for an average company (8 percent risk-free rate + 7 percent risk-premium). High-Quality companies may be discounted at a low rate of 12%, above-average companies at 13%, and poor quality companies may be discounted at a high of 18%.
Calculating Perpetuity Values
The most common way to calculate a perpetuity is to take the last cash flow (CF) that you estimate, increase it by the rate at which you expect it to grow over the very long term (g), and divide the result by the discount rate (R) minus the expected long-term growth rate.
The result of this calculation than must be discounted back to present, using the method discussed for calculating present value. For example, suppose we are using a 10-year DCF model for a company with an 11 percent discount rate. We estimate that the company’s cash flow in year 10 will be $1 billion and its cash flow will grow at a steady 3 percent annual rate after that. (Three percent is generally a good number to use as your long-run growth rate because it’s roughly the U.S. gross domestic product [GDP] growth. If you are valuing a firm in a declining industry, you might use 2 percent).
Perpetuity Value = $ 1 billion x (1+ 0.03) / (0.11-0.03)
= $ 1.03 billion/ 0.08
= $ 12.88 billion
To get the present value of these cash flows, we need to discount them using the formula
where n is the number of years in the future, CFn is the cash flow in year n, and R is the discount rate. Plugging these numbers, N = 10, CFn = $12.88 billion, R= 0.11
Discounted Perpetuity Value = $12.88 bn/ (1+0.11)^10 = $12.88 bn/2.839 = $4.536 bn
Calculating Intrinsic Value
That was a brief outline of the process. You can follow along by matching the following steps:
1. Estimate free cash flows for the next 4 quarters. This amount will depend on all of the factors discussed earlier -how fast the company is growing, the strength of its competitors, its capital needs, and so on. Using Clorox as an example, our first step is to see how fast free cash flow has grown over the past decade, which turns out to be 9% when we do the math. We could just increase the $600 million in free cash flow that Clorox generated in 2003 by 9 percent, but that would assume the future would be as rosy as in the past. Mega retailers like Wal-Mart -which now accounts for almost a quarter of Clorox sales -has hurt the bargaining power of consumer-product firms. So, let's be conservative and assume free cash flow increases by only 5 percent over the last year, which would work out to $630 million.
2. Estimate how fast you think free cash flow will grow over the next 5 to 10 years. Remember, only firms with very strong competitive advantages and low capital needs are able to sustain above-average growth rates for very long. If the firm is cyclical don't forget to throw in some bad years. We won't do this for Clorox because selling bleach and Glad bags is a very stable business. We will however be conservative on our growth rate because of the "Wal-Mart factor", and will assume free cash flow increases at 5 percent annually over the next decade.
3. Estimate a discount rate. Financially Clorox is rock-solid, with little debt, tons of free cash flow, and a non-cyclical business. So we will use 9% for our discount rate, which is meaningfully lower than the 10.5 percent average we discussed earlier. Clorox, is a predictable company, after all.
4. Estimate a long-run growth rate. Because people will still need bleach and trash bags in the future, and its a good bet that Clorox will continue to get a piece of that market, we can use the long-run GDP average of 3 percent.
5. That's it! We discount the first 10 years of cash flows, add that value to the present value of the perpetuity, and divide by the shares outstanding.
This is a very simple DCF model. The one used at Morningstar has about a dozen excel tabs, adjusts for complicated items such as pensions and operating leases, and explicitly models competitive advantage periods, among many other things. But a model doesn't need to be super complex to get you most of the way there and help you clarify your thinking.
The important thing is that we forced ourselves to think through these kinds of issues as discussed earlier, which we wouldn't have if we had just looked at Clorox's stock chart or if we had just said, "Sixteen times earnings seem reasonable". By thinking about the business, we arrived at a better valuation in which we have more confidence.
Valuing Clorox using a Discounted Cash Flow model
Margin of Safety
Here is how it works. Let's say we think Clorox's intrinsic value is $54, and the stock is trading at $45. If we buy the stock and we're exactly right about our analysis, the return we receive should be the difference between $45 and $54 (20 percent) plus the discount rate of about 9 percent. That would be 29 percent, which is a pretty darn good return, all things considered.
But what if we are wrong? What if Clorox grows even more slowly than we had anticipated -may be a competitor takes market share - or the firm's pricing power erodes faster than we had thought? If that's the case, then Clorox's intrinsic value might actually be $40, which means we would have overpaid for the stock by buying it at $45.
Having a margin of safety is like an insurance policy that helps prevent us from overpaying - it mitigates the damage caused by overoptimistic estimates. If, for example, we had required a margin of safety of 20 percent before buying Clorox, we wouldn't have purchased the stock until it fell to $43. In that case, even if our initial analysis had been wrong and the fair value had really been $40, the damage to our portfolio wouldn't have been as severe.
Because all stocks aren't created equal, not all margins of safety should be the same. It's much easier to forecast the cash flows of, for example, Anheuser-Busch over the next 5 years than the cash flows of Boeing. One company has tons of pricing power, dominant market share, and relatively stable demand, whereas the other has relatively little pricing power, equal market share, and highly cyclical demand. Because I am less confident about my forecasts for Boeing, I'll want a larger margin of safety before I buy the shares. There's simply a greater chance that something might go wrong, and that my forecasts will be too optimistic.
Paying more for better businesses makes sense, within reason. The price you pay for a stock should be closely tied to the quality of the company, and great businesses are worth buying at smaller discounts to intrinsic value. Why? Because high-quality businesses - those that have wide economic moats - are more likely to increase in value over time, and it's better to pay fair price for a great business than a great price for a fair business.
How large should your margin of safety be? It ranges all the way from just 20 percent for very stable firms with wide economic moats to 60 percent for high-risk stocks with no competitive advantages. For above-average firms we would require a 25 percent margin of safety, while on average, we require a 30 percent to 40 percent margin of safety for most firms.
Having a margin of safety is critical to being a disciplined investor because it acknowledges that as humans, we are flawed. Simply investing in the stock market requires some degree of optimism about the future, which is one of the biggest reasons that buyers of stocks are too optimistic far more often than they're too pessimistic. Once we know this, we can correct for it by requiring a margin of safety for all of our share purchases.
Every approach to equity investing has its own warts. Being disciplined about valuation may mean that you will miss out on some great opportunities because some companies wind up performing better for longer periods of time than almost anyone could have anticipated. Companies such as Microsoft looked very pricey back in their heyday, and its unlikely that many investors who were very strict about valuation would have bought it early in their corporate lives.
Being disciplined about valuation would have meant missing those opportunities, but it also would have kept you out of many investments that were priced like Microsoft, but which wound up disappointing investors in a big way. Although we acknowledge that some high-potential companies are worth a leap of faith and a high valuation, on balance, we think its better to miss a solid investment because you are too cautious in your initial valuation than it is to buy stocks at prices that turn out to be too high.
Picking individual stocks requires hard work, discipline, and an investment of time. Expecting to make a large amount of money with only a little effort is like expecting to shoot a great round of golf the first time you pick up a set of clubs. There's no magic formula, and there's no guarantee of success.
That's the bad news. The good news is that the basic principles of successful stock picking aren't difficult to understand, and the tools for finding great stocks are available to everyone at a very low cost - you dont need expensive software or high-priced advice to do well in stock market. All you need is patience, an understanding of accounting and competitive strategy, and a healthy dose of skepticism.
How can you equip yourself to make investment decisions yourself? Is it possible to cut short the learning curve in mastering stock market basics?
Financial Strength
- Financial Leverage
- Debt to Equity (D/E)
- Interest Coverage
- Current Ratio
- Quick Ratio
Financial Leverage
A common measure of leverage is simply the Financial Leverage ratio.
Financial Leverage =Assets/Shareholders' Equity
Think of it like a Mortgage - a homebuyer who puts Rs. 200,000 down on a Rs. 1,000,000 house has a financial leverage ratio of 5. For every Rupee in Equity, the buyer has Rs. 5 in assets.
The same holds true for companies. In 2008, a retailer like Trent has a financial leverage ratio of 2.1, meaning that for every Rupee in equity, the firm has Rs. 2.1 in total assets. (It borrowed the other Rs. 1.1.)
Financial Leverage is something you need to watch carefully. As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster. Look at the kind of business a firm is in. If it's fairly steady, a company can probably take on large amounts of debt without too much risk because there's only a small chance of the business falling off a cliff and the company being caught short when bondholders demand their interest payments. On the flip side, be very wary of a high finacial leverage ratio if a company's business is cyclical or volatile. Because interest payments are fixed, the company has to pay them whether business is good or bad.
Rough benchmarks for analysing a firm's
Financial Leverage
Debt to Equity ratio
Debt to Equity ratio is just what it sounds like - long-term debt divided by Shareholders' equity. It's a little like the financial leverage ratio, except that it is more narrowly focused on how much long-term debt the firm has per Rupee of Equity.
Debt to Equity =Long-Term Debt/Shareholders' Equity
A high debt equity ratio for a firm indicates it has been aggressively financing its growth with debt. Due to the the additional interest expenses that have to be borne by the firm, this can result in volatile earnings.
A firm could potentially generate more earnings If a lot of debt is used to finance increased operations (high debt to equity) than it would have if it did not have access to this external financing. Shareholders would benefit if this resulted in increased earnings by an amount greater than the debt cost (interest). However, the cost of this debt financing may become too much for the company to handle, especially if earnings are cyclical and volatile, and outweigh the return that the company generates on the debt.
The debt equity ratio also varies depending on the industry in which a firm operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt equity ratio above 2, while software companies have a debt equity ratio of under 0.5.
Times Interest Earned
Times Interest Earned is also known as "Interest Coverage" ratio. Look up pretax earnings, and add back interest expense- this gives earnings before interest and taxes (EBIT). Divide EBIT by interest expense, and you will know how many times the company could have paid the interest expense on its debt. The more times the company can pay its interest expense, the less likely that it will run into difficulty if earnings should fall unexpectedly.
Times Interest Earned =Earnings before Interest & Taxes (EBIT)/Interest Expense
Rough benchmarks for analysing a firm's
Interest Coverage
Current Ratio
The current ratio simply tells you how much liquidity a firm has - in other words, how much cash it could raise if it absolutely had to pay off its liabilities all at once. A low ratio means the company may not be able to source enough cash to meet near-term liabilities, which would force it to seek outside financing or to divert operating income to pay off those liabilities.
Current Ratio = Current Assets/Current Liabilities
Rough benchmarks for evaluating a stock's Current Ratio
Quick Ratio
The Quick Ratio is a more conservative test of a company's liquidity, than the Current Ratio. We have learnt that a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble. Unfortunately, some current assets - such as inventories - may be worth less than their value on the balance sheet. (Imagine trying to sell old PCs or last year's fashions to generate cash - you would be unlikely to receive anything close to what you paid for them.) Current assets less inventories, divided by liabilities equals Quick Ratio.
Quick Ratio =(Current assets - Inventories)/Liabilities
In the event that short-term obligations need to be paid off immediately, there are situations in which the current ratio would overestimate a company's short-term financial strength. By taking inventories out of the equation, Quick Ratio lets us find out if a company has sufficient liquid assets to meet its short-term operating needs. It is especially useful for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories.
Rough benchmarks for analysing a stock's
Quick Ratio
- Dividend Yield
- Earnings Yield
- Price to Book (P/B)
- Price to Sales (P/S)
- Price to Earnings (P/E)
- Cash Return
PE Ratio
Now we come to the most popular valuation measure- the Price to earnings ratio or the PE ratio, which can take you pretty far as long as you are aware of its limitations. The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales, and they are more up-to-date than book value. Moreover earnings per share results (and estimates) are easily available from just about any financial data source imaginable, so it’s an easy ratio to calculate.
The easiest way to use a PE ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, the industry average, or the same company at a different point in time. Each of these approaches has some value, as long as you know the limitations. A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels and growth rates, all of which effect the Price to earnings ratio. All else equal, it makes sense to pay a higher P/E for a firm that’s growing faster, has less debt, and has lower capital re-investment needs.
You can also compare a stocks P/E to the average P/E of the entire market. However the same limitations of industry comparisons apply to this process as well. The stock you are investigating might be growing faster (or slower) than the average stock, or it might be riskier (or less risky). In general, comparing a company’s P/E with industry peers or with the market has some value, but these aren’t approaches that you should rely on to make a final buy or sell decision.
However comparing a stock’s current P/E with its historical Price to earnings ratios can be useful, especially for stable firms that haven’t undergone major shifts in their business. If you see a solid company that’s growing at roughly the same rate with roughly the same business prospects as in the past, but it’s trading at a lower P/E than its long-term average, you should start getting interested. It’s entirely possible that the company’s risk level or business outlook has changed, in which case a lower P/E is warranted, but it’s also possible that the market is simply pricing the shares at an irrationally low level.
This method works generally with more stable, established firms than with young companies with more uncertain business prospects. Firms that are growing rapidly are changing a great deal from year to year, which means their current P/Es are less comparable to their historical P/Es.
P/E drawbacks
Relative P/Es have one huge drawback. A PE ratio of 12, for example, is neither good nor bad in a vacuum. Using PE ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. (peer, industry, market).So, let’s try to look at the PE ratio on an absolute level. What factors would cause a firm to deserve a higher PE ratio? Because risk, growth, and capital needs are all fundamental determinants of a stock’s PE ratio, higher growth firms should have higher PE ratios, higher risk firms should have lower P/E, and firms with higher capital needs should have lower P/E. We can see why this is true, intuitively.
Firms that have to shovel in large amounts of capital to generate their earnings run the risk of needing to tap additional funding, either through debt (which increases the risk level of the company) or through additional equity offerings (which may dilute the value of current shareholders’ stake). Either way, its rational to pay less for firms with high reinvestment needs because each dollar of earnings requires more of shareholders’ capital to produce it.
Meanwhile, a firm that’s expected to grow quickly will likely have a larger stream of future cash flows than one that’s growing slowly, so all else equal, it’s rational to pay more for the shares (thus the higher Price to earnings ratio). On the flip side, a firm that’s riskier –maybe it has high debt, maybe it’s highly cyclical, or maybe it’s still developing its first product –has a good chance of having lower future cash flows than we originally expected, so it’s rational to pay less for the stock.
When you are using the Price to earnings ratio, remember that firms with an abundance of free cash flow are likely to have low reinvestment needs, which means that a reasonable PE ratio will be somewhat higher than for a run-of-the mill company. The same goes for firms with higher growth rates, as long as that growth isn’t being generated using too much risk.
Some other aspects that can distort PE ratios
A few other things can distort a PE ratio. Keep these questions in the back of your mind when looking at P/E, and you’ll be less likely to misuse them.Has the firm sold a Business or an Asset recently?
If a firm has recently sold off a business or perhaps a stake in another firm, it’s going to have artificially inflated earnings, and thus a lower P/E. Because you don’t want to value the firm base don one-time gains such as this, you need to strip out the proceeds from the sale before calculating the P/E.
Has the firm taken a big charge recently?
If a firm is restructuring or closing down plants, earnings could be artificially depressed, which would push the P/E up. For valuation purposes, its useful to add back the charge to get a sense of the firm’s normalized P/E.
Is the firm cyclical?
Firms that go through boom and bust cycles –commodity companies, auto manufacturers are good examples –require a bit more care. Although you will typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon.
Does the firm Capitalise or Expense its Cash flow generating assets?
A firm that makes money by inventing new products –drug firms are the classic example- has to expense all of its spending on research and development every year. Arguably, it’s that spending on R&D that’s really creating value for shareholders. Therefore, the firm that expenses assets will have lower earnings –and thus a higher P/E- in any given year than a firm that capitalizes assets. On the other hand, a firm that makes money by building factories and making products gets to spread the expense over many years by depreciating them bit by bit.Price to Sales ratio
The most basic ratio of all is the Price to Sales ratio, which is the current price of the stock divided by sales per share. The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings. In addition sales are not as volatile as earnings –one time charges can depress earnings temporarily, and the bottom line of economically cyclical companies can vary significantly from year to year.
Price to Sales = Current stock price /Sales per share
This relative smoothness of sales makes the P/S ratio useful for quickly valuing companies with highly variable earnings, by comparing the current P/S ratio with historical P/S ratios.
However the P/S ratio has one big flaw. Sales may be worth a little or a lot, depending on a company’s profitability. If a company is posting billions , but it is losing money on every transaction, we would have a hard time pinning an appropriate P/S ratio, because we have no idea what level (if any) profits the company will generate.
Therefore, although the P/S ratio might be useful if you are looking at a firm with highly variable earnings –because you can compare today’s P/S with a historical P/S ratio – it’s not something you want to rely on very much. In particular don’t compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.Price to Book ratio
Another common valuation measure is price to book ratio (P/B), which compares a stock’s market value with the book value (also known as shareholder’s equity or net worth) on the company’s most recent balance sheet. The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm’s tangible assets in the here-and-now. Legendary value investor Benjamin Graham, one of Warren Buffet’s mentors, was a big advocate of book value and P/B in valuing stocks.
Although price to book ratio still has some utility today, the world has changed since Ben Graham’s day. When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory –all of which had some objective tangible worth – it made sense to value firms based on their accounting book value. But now many companies are creating wealth through intangible assets such as processes, brand names, and databases most of which are not directly included in book value.
For service firms in particular Price to book ratio has little meaning. If you used P/B to value eBay, for example, you wouldn’t be according a shred of worth to the firm’s dominant market position, which is the single biggest factor that has made the firm so successful. Price-to-book may also lead you astray for a manufacturing firm such as 3M, which derives much of its value form its brand name and innovative products, not from the size of its factories or the quantity of its inventory.
Another item to be wary of when using P/B to value stocks is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value. When one company buys another, the difference between the target firm’s tangible book value and the purchase price is called goodwill, and its supposed to represent the value of all the intangible assets –smart employees, strong customer relationships, efficient internal processes –that made the target firm worth buying. Be highly skeptical of firms for which goodwill makes up a sizeable portion of their book value.
Price to book ratio is also tied to Return on Equity (equal to net income divided by book value) in the same way that price-to-sales is tied to net margin (equal to net income divided by sales) . Given two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio. The reason is clear – the firm that can compound book equity at a much higher rate is worth far more because book value will increase more quickly.
Therefore when you are looking at P/B, make sure you relate it to ROE. A firm with low P/B relative to its peers or to the market and a high ROE might be a potential bargain, but you will want to do some digging before making that assessment based solely on the P/B.
Although P/B isn’t very useful for service firms, its very good for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets. The nice thing about financial firms is that many of the assets included in their book value are marked-to-market –in other words they are revalued every quarter to reflect shifts in the marketplace, which means that book value is reasonably current. (A factory or a piece of land by contrast, is recorded on the balance sheet at whatever value the firm paid for it, which is often very different form the asset’s current value). As long as you make sure that the firm does not have a large number of bad loans on its books, P/B can be a solid way to screen for undervalued financial firms.Earnings Yield
The first yield based measure is what is called the Earnings Yield. In addition to multiple-based measures, you can also use yield-based measures to value stocks. If we invert the P/E and divide a firm’s earnings per share by its market price, we get an earnings-yield. If a stock sells for Rs. 200 per share and has Rs.10 in earnings, it has a P/E of 20 (20/1) but an earnings-yield of 5% (1/20).
Earnings Yield = Earnings per share / current market price
The nice thing about yields, as opposed to P/Es, is that we can compare them with alternative investments such as fixed deposits, to see what kind of a return we can expect from each investment. (The difference is that earnings generally grow over time, whereas fixed deposit payments are fixed).
A stock with a P/E of 20 would have a yield of 5 percent which is worse than the current bank FD rate of 8%. A stock with a P/E of 10, however, will have a yield of 10% which is better than the FD rates. Thus I might be induced to take the additional risk.Dividend Yield
A popular yield based measure used to value stocks is the dividend yield. It allows investors to compare the latest dividend they received with the current market value of the share as an indicator of the return they are earning on their shares. Note, though, that the current market share price may bear little resemblance to the price that an investor paid for their shares.
Dividend Yield = Latest Annual Dividends per share/Current market price per share
Dividend Yield is thus an easy way to compare the relative attractiveness of various dividend-paying stocks. It tells an investor the return he / she can expect by purchasing a stock and can thus be compared with other investments such as bonds, certificates of deposit, etc. Investors who look to secure some regular income from their investments can do so by investing in stocks paying relatively high, stable dividend yields.
For example, if two companies both pay annual dividends of Rs.10 per share, but company A's stock is trading at Rs.200 while company B's stock is trading at Rs.400, then company A has a dividend yield of 5% while company B is only providing an yield of 2.5%. In this case, if we assume all other factors are equivalent, investors looking to supplement their income would likely prefer company A's stock over that of company B.
Mature, well-established companies tend to have higher dividend yields, while young, growth-oriented companies tend to have lower yield. Many fast growing companies do not have a dividend yield at all because they do not pay out dividends as they reinvest all the cash in expanding the business.
What to look for while analysing a stock's dividend yield
A high dividend yield may be an indication of a stock's current attractiveness. However this can be misleading, if not sustained. Look at the dividend paying history of the company of last 5 years. A track record of maintaining and/or increasing dividends per share over the years is one indication of sustainability of dividends. A consistent dividend payout ratio for a firm with stable growth offers better clues towards sustainability of dividends.Cash Return ratio
The best yield-based valuation measure is a relatively little-know metric called Cash Return ratio. In many ways it’s actually a more useful tool than the P/E. To calculate cash return, divide free cash flow by enterprise value.
Cash Return = Free Cash Flow/Enterprise Value
= Free Cash Flow/(Market Cap + long-term debt – Cash)
The goal of Cash Return is to measure how efficiently the business is using its capital –both equity and debt-to generate free cash flow. Essentially cash return tells you how much free cash flow a company generates as a percentage of how much it would cost to buy the whole shebang, including the debt burden.
Cash Return is a great first step to finding cash cows trading at reasonable prices.
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