The post High Price to Book Ratios – Proper Interpretation and Evaluation first appeared on ValueInvestingNow.com.
]]>With stock investing, one of the valuation ratios used for comparison purposes is the price to book ratio. It identifies the spread between market value and book value for a share of stock. As the spread increases the ratio increases. A good example is Coca-Cola. Its price to book ratio hovers in the 11 range. Coca-Cola is a Dow Jones Industrial top 30 stock. With Coca-Cola, the current book value is $4.37 per share and its currently trading at $52.80. The price to book ratio as of today 11/06/19 is 12.08. Whereas on the other end of this spectrum sits Walt Disney Company. Disney’s price to book is customarily low, around two and half times book value. It’s current book value is $50.80 per share and it is trading today at $132.96, exactly 2.62 as the price to book ratio.
Think about this for a moment, both companies are in the top 30 for market capitalization in the United States, both companies produce profits and have vast amounts of assets. The question for any investor is: ‘Is there any preferred price to book ratio and if so, why would there be such a big difference with highly respected companies?’
In general, more conservative, value based investors look for low price to book ratios. Why? Well, a low price to book ratio minimizes the downside risk associated with the investment. This is very beneficial with stocks that have strong market capitalization positions. For example, Disney’s market capitalization value is around $236 Billion which means there are plenty of holders of the stock, therefore, there is a good market to ditch the stock if something appears off. Coca-Cola has a market capitalization of $226 Billion which means there’s a similar market. Anytime, the market capitalization for a company hits more than $10 Billion, a seller of that stock will have no problem finding a buyer within a few pennies of the current market price per share. The lower price to book ratio simply reduces the overall risk with losing money. Note that it reduces risk of losing money, it doesn’t necessarily increase the opportunity to make money. Think of a lower price to book ratio as a shield when doing battle in the market, it does help to protect your investment. But this still does not answer the question posed: Is there a preferred price to book ratio and why is there such a wide dispersion even among well respected companies?
This article is going to help the reader/investor understand why there are such differences, but more importantly how to interpret and evaluate high price to book ratios. Can a high price to book ratio still be a good investment?
To answer this, first the reader must understand what drives the price of stock higher for some companies and thus generate high price to book ratios. Once the reader understands the underlying force of price for the stock, the next step is to evaluate the associated risks of higher price to book ratio stocks. With this fundamental understanding, now the investor can develop opportunities or discover common patterns that unfold with high price to book ratio investments. With this knowledge, the investor can make better decisions and ultimately increase their wealth with good buy and sell decisions.
Forces That Drive Stock Prices Higher
There’s one single word with investments that drives stock values higher – stability. With business, stability is defined as consistent profits over long periods of time. For Coca-Cola, celebrating 100 years in business in 2019, they have generated solid profits every year for the last 15 years. The lowest profit during this period was a meager $1.24 Billion in 2017. To give you an idea of its stability, the initial shares of Coke sold for $40 each. Had your great grandparents purchased a single share in 1919, it would be worth approximately $10 Million today – Wiederman, Adam J. (August 14, 2012). “One Share of Stock Now Worth $9.8 Million – Is It Really Possible?”.
Investors have an expectation for the corporate management team to maintain this stability and continue to perform well. Anything less is considered grounds for termination. Shareholders have little to no tolerance for even average management of the company. Good management results in positive business factors that drive stock prices higher. For Coca-Cola, they include:
- Dividends of around $1.60 per year producing a yield of more than 3% at current market price;
- Earnings per share of no less than $1.02 during the last 15 years excluding 2017 (the company took advantage of the new corporate tax rate to pay a lower tax rate on tax deferrals);
- Gross margins in excess of 60% in every year for the last 15 years;
- Only one year with an EBITDA margin less than 25% over the last 15 years; AND
- Operating cash flow of at least $6 Billion per year over the last 15 years.
Consistent performance year after year drives the market price higher for stock. This stability provides comfort to buyers of stock.
Disney is different in several ways though. Let’s not misinterpret this, just like Coke, over the last 15 years, Disney has had profits in every year. Disney is a DOW top 30 industrial stock and has similar market capitalization. The lowest profit earned was $2.6 Billion in 2006. The differences are the other factors that drive stability. Unlike Coke over the last 15 years:
- Disney’s dividend payout finally exceeded $.50 (50 cents) per share in 2011, thus the yield has never exceeded 2% in the last 20 years:
- Earnings per share have steadily improved from $1.22 in 2005 to over $8 in 2018; but unlike Coke that pays out its earnings to its shareholders, Disney holds back most of it via retained earnings;
- Gross margins didn’t exceed 20% until 2013;
- EBITDA margin has averaged more than 25% in only 4 of the last 15 years; AND
- Operating cash flow finally reached more than $6 Billion in 2010.
Why is it that Coca-Cola’s price in comparison to its book value is almost six times greater? Go back to the force of stability. Disney’s stability isn’t anywhere near the consistency Coca-Cola generates. Although Disney is without a doubt a good investment, it can’t match Coke’s aggregated factors:
- Coke’s yield is at least 50% greater than Disney;
- Disney retains much of their earnings which increases the book value per share, Coke pays out almost of their earnings per share as dividends;
- Coke’s gross margin (revenue less cost of goods sold as a percentage of revenue) is often twice as much as Disney’s;
- Coke’s EBITDA is consistently higher than Disney’s; AND
- Coke’s operating cash flow totaled $124.3 Billion over the last 14 years; Disney’s operating cash flow during the same period was $118.4 Billion. Coke’s operating cash flow is almost 6% higher over time than Disney.
These other factors drive Coke’s market price higher against its book value. With this understanding, an investor can now identify risks that exist with higher price to book ratio stocks.
Evaluating Higher Price to Book Ratio Stocks
From above, stability drives higher price to book ratios. However, a key business ratio factor related to the price to book ratio is of course the book value of the share of stock. Notice from above, Disney retains much of its earnings thus increasing the book value. Look at this historical chart of the book value for Disney and compare it to Coke.
Walt Disney Book Value Per Share
Basically, Coca-Cola’s book value remains relatively flat over the last 15 years. Disney’s book value has increased more than $20 per share over the same period of time. These two companies have a philosophical difference related to equity, one allows equity to grow, the other simply distributes earnings to its shareholders.
Since Coke’s book value has remained relatively flat, did this affect the market price over the same period of time, i.e. did the price to book ratio grow over time? Look at this chart:
It hasn’t always been high, it grew over time driven by other stability factors. It wasn’t until 2014 that it really began to take off as a higher ratio. However a good part of that increase is directly related to reduction in the book value from 2014 to 2018; thus the growth is not purely tied to the market price. But still, the market price does increase and it is driven by stability and other strong factors of business.
Now let’s look at Disney’s price to book over time:
Disney’s price to book ratio remains somewhat stable until 2014 and then increases. If you compare it to Coke, its the same. Coke is also stable during the period up until 2014. But both actually begin to increase through 2018, most likely driven by the overall stock market’s increase during this time period. It is interesting how back in 2009 the book value of Disney was greater than the market value, in a way it made sense. That was right when the country was in a recession and of course the stock market lost some confidence with the entertainment industry thus dampening the market price of Disney.
With such a high price to book value for Coke, is it possible it is over priced right now? It is unlikely for several reasons. First off, even at this high price, the yield is very strong at more than three percent. Furthermore, Coke has many strong business factors, remember its gross margin has exceeded 60% over the last 14 years. Very few companies have that high of a gross margin. It appears that Coke has reached its epitome of value.
What are the risks here with Coke? There doesn’t appear to be any. How can an investor take advantage of high price to book value stocks? What do you look for to trigger a buy?
Many large institutional investors buy more for the yield than the capital gain. A three percent yield is very strong at the current market price. Imagine those that bought the stock back in 2014 for $33 share.Their yield is almost 5%. Value investors are different, value investors are looking for long-term gains in addition to yield. For those that bought in 2014 for $33 share and if they sell their stock today they would receive almost $20 a share gain.This is at least a 60% gain over 6 years. In the aggregate, those that invested six years ago would earn about 12 to 15% per year as their overall return on their investment. That is acceptable, but value investors want 30 to 40 percent return on their investments per year.
High price to book ratio investments rarely provide high returns for value investors. Value investors must wait for the price to drop. With high price to book ratio stocks, the market price’s volatility is the only way to buy a good investment at a good price. Look at Coke’s market price over the last five years:
Only twice in the last five years has Coke dropped below $40 per share. It dipped to $39.23 back in June of 2015. The volatility of the market price just doesn’t exist. A value investor must be patient related to this particular stock. Naturally, if the price drops below $45 a share, its a buy (under current corporate financial results). But the reality is that as the price drops, more buyers are interested in the stock given its stable history.
Downward trends in market price are long and slow to occur. Unless something significant happens related to the stability factors for Coke, it is unlikely there will be a sudden and remarkable decrease in the share price. But when it happens, it is time for value investors to jump on the opportunity. This same principle applies to all high price to book ratio stocks. Wait for sudden and significant decreases in the stock price. Look at the underlying reason for the change and if it is an unusual event then it may be time to act. Here’s a good example.
Apple Inc.
In September of 2018, Apple’s share price hit $227.63 per share. Three months later on 12/30/18 the price dropped to $148.26, a whopping 35% decrease. Look at this share price chart for Apple:
Look at the circled period of time. What drove this share price decrease?
From mid October to mid November 2018, the price took the biggest fall, it went from $216 on 10/21/18 to $172 on 11/18/18.
On November 5, 2018, Apple filed its Form 10-K reporting its annual financial results. There were no notable changes in their financial results to drive this stock price decrease. So what caused this?
There were several market concerns that arose affecting Apple’s stock price. First, there was heightened concern about Chinese and US tariffs, secondly, the market indicated concern about continuing iPhone sales. Finally, there was some general worry in the market about the overall economy and its impact on Apple. In effect, the price decrease had nothing to do with Apple’s financial performance; it was strictly worry among existing owners of stock and the market as a whole.
The simple reality is that share price should be tied to the financial performance of the company. Apple does have a high price to book ratio, currently around a 12. A value investor builds a model and uses that model’s trigger points to buy and sell the stock. With Apple, the trigger point for a buy might be a 21% decrease from the prior peak. Remember from above, in order to reap financial gain an investor must look for a sudden and deep decrease in high price to book value stock. In the above chart, the prior peak was $228.36 on 08/31/18. The 21% decrease equates to $180.40 which occurred on 11/20/18. Once bought, the value investor simply waits for the stock to recover to a certain point. Suppose in this case the investor decides on a 14% increase over the buy price. This means the value investor sells at $205.66 which happens on 04/23/19, about 6 months later. With this model, the investor makes $25.26 per share capital gain and earned about $1.50 per share in dividends during this 6 month holding period. Altogether, the investor’s return on his investment is $26.76 on $180.40 or a straight 14.8% return. However, if annualized this equates to almost a 30% return on the value investor’s money.
The lesson here is straight forward. When thinking about buying high price to book ratio stocks, you must wait for deep and sudden decreases in the stock price. If this happens, look at the financial fundamentals, if they are unchanged, then it is time to buy. The trigger point must be a remarkable decrease, more than 20% in order to justify the investment. As with most high price to ratio stocks, it takes a long time to recover due to the rule of stability. The greater the stability the less likely an investor will find 20% decreases in stock price, but when it happens it is a great opportunity to make a good return on your investment. ACT ON KNOWLEDGE.
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]]>The post Valuation Ratios first appeared on ValueInvestingNow.com.
]]>Valuation ratios are the only group of business ratios that are externally and not internally driven. The market dictates valuation ratios. All three core valuation ratios are determined by the market price of the stock. All three have the same numerator, the market share price or market capitalization value of the company.
The denominator for each ratio is the particular ratio’s namesake. For example, the price to earnings ratio is the entire market capitalization of the company divided by the most recent 12 months of earnings. Here is the actual Price to Earnings Ratio on 05/01/19 for Microsoft:
Microsoft’s P/E Ratio = Market Capitalization on 05/01/19 = $1,000,000,000,000 (1.0T) = 28.57
Past 12 Months of Earnings $35,000,000,000 (35.0B)
(Approximate Values)
The Wall Street Journal has the trailing twelve months PE as 28.42 on 05/01/19.
The other two core valuation ratios are:
This section of the book explains these three ratios and their respective nuances. For the reader, there are two important attributes of valuation ratios that must be grasped to be a good investor.
First off, valuation ratios are market indicators and as such, investors rely heavily on their values in their respective decision models. The first section below explores this in more detail and how the reader must use some common sense when using valuation ratios in their respective decision models.
Secondly, valuation ratios are easily distorted due to the respective underlying elements in their equations. The second section below will explain this and how important it is for the user to ascertain the driver of value related to the respective ratio.
Finally, an illustration of how unreliable the ratios are is presented. With greater knowledge of the valuation ratios, a user can properly equate their results into their decision model on whether to buy or sell a stock investment.
Valuation Ratios are Market Indicators
The most important attribute of valuation ratios is this: valuation ratios are determined by the market, not by the company’s performance. As stated before, the numerator is an outside value and is not a function of any of the five financial sections of the company. The numerator is always the price per share or market capitalization. A user of valuation ratios understands that either the per share price or the market capitalization is used and they both mean the same. Market capitalization is merely the price per share times the number of shares in the market (shares outstanding). To assist you in understanding this relationship, look at the following table:
Company Price/SH (05/03/19) #of Shares Outstanding Market Capitalization
Microsoft $128.90 7.67 Billion $988.66 Billion
Verizon $57.54 4.14 Billion $238.22 Billion
Apple $211.75 4.70 Billion $995.23 Billion
Kroger $25.74 798 Million $20.54 Billion
Market capitalization is merely the value of all shares. Thus, when using any valuation ratio, the denominator may either be as a single share or for all shares. The key is that the denominator must match the relationship.
Most importantly, the price is determined by buyers and sellers in the market conducting transactions based on the principle of greed, i.e. getting the most out of the transaction. Since most activity, via volume, is conducted by institutional buyers (retirement plans, mutual funds, insurance companies, governmental agencies and holding companies), it is assumed that the value or current trading price is the going true worth of the stock. Why does it fluctuate throughout the day and throughout the share’s lifetime?
The answer is expectations. Most buyers are convinced that the stock will improve in value over time and that they have seen something in the financial statements, government reports, news releases and social media that the company will perform better in the future. Whereas, sellers believe otherwise.
Many of these buyers and sellers use business ratios to assist them in understanding the company’s overall performance. Thus, valuation ratios are really the resulting outcome of the other four categories of business ratios. This leads into the second attribute of valuation ratios, they are easily distorted by the financial results.
Distortion by the Underlying Elements of Valuation Ratios
The three primary valuation ratios are:
- Price to Earnings
- Price to Sales
- Price to Cash Flow
Each valuation ratio’s denominator is easily manipulated, even under Generally Accepted Accounting Principles (GAAP). This is why it is important for the user to understand each valuation ratio’s business elements. Each section below explains each ratio’s underlying elements and some tools used in accounting to manipulate the results thus affecting the outcomes.
Earnings
Every publicly traded company issue financial statements. One of the financial sections is a set of ‘Notes’. Usually within the first five notes is a statement by the company that they use estimates to determine certain values on the income statement and balance sheet. Estimates are customarily determined for:
- Depreciation/Amortization
- Deferred Revenue
- Percentage of Completion
- Bad Debt
- Extraordinary Events
Historically, the estimates are reasonable and reliable. However, the fact is they are used. Often, estimates are so extreme, the value is unreliable and affects the stock price negatively. A good example is the estimate made by PG&E related to the cause of the famous ‘Camp Fire’ from November/December 2018. Here is the actual note:
(3) The Utility incurred costs, net of insurance, of $9.5 billion (before the tax impact of $2.7 billion) during the twelve months ended December 31, 2018 associated with the 2018 Camp fire. This includes accrued charges of $10.5 billion (before the tax impact of $2.9 billion) during the twelve months ended December 31, 2018 related to estimated third-party claims.
From the financial report: http://s1.q4cdn.com/880135780/files/doc_financials/2018/2018-Annual-Report-FINAL-web-ready-version-4-24-19.pdf . Go to page V at the bottom.
This force the company into Chapter 11 bankruptcy (reorganization) on January 29, 2019.
It will take almost a decade for the final costs to be determined. Thus, this single event greatly distorts earnings, even estimated earnings. Prior to the Camp Fire, PG&E’s price to earnings ratio was approximately 14 to 15 times earnings to a staggering 95 times earnings today (05/19). The dramatic change is a reflection of the uncertainty related to the stock today. It is unknown what the future will be under the reorganization and if current shareholders will be entitled to any value.
Sales
Another underlying element of value is sales. Sales are also easily manipulated. One of rules with GAAP relates to defining sales. In general, to qualify as a sale, the transaction must be both quantifiable and certain. Many industries marginalize both elements of a sale. The issue at hand is the subjective nature of both. Here are a couple of historical cases addressing either of the underlying elements.
Health South
Health South was a large publicly traded health care company in the late 90’s and early 2000’s. The CEO ordered the staff to create fake transactions (certainty element) causing earnings to inflate $1.4 Billion dollars over several years. The CEO was caught by the Securities and Exchange Commission and the company was forced into bankruptcy in 2003.
AIG
American Insurance Group booked loans as revenue (sales) thus inflating earnings. Total fraud was in excess of $3.8 Billion. The 2005 bankruptcy forced the US taxpayers to foot the bill.
Cash Flow
Of the top three valuation ratios, this one is the easiest to manipulate. Cash flow is a difficult financial relationship for even the most sophisticated readers of financial statements to understand. It is a result of three major areas of cash uses/sources:
- Cash Flow from Operations
- Cash Flow from Investing
- Cash Flow from Financing
Each of the three major uses/sources of cash can be manipulated. For example, cash flow from operations, starts with the value from earnings. In addition, there are adjustments for changes in current assets including receivables and current liabilities. All elements of this one area of cash flow are easily manipulated. A good example is a simple line of credit draw on the last day of the accounting period. A financial draw increases cash and increases liabilities. Thus, the resulting cash flow from operations is easily manipulated higher.
With the price to cash flow ratio, if cash flow increases and the price stays the same, the ratio decreases making the stock look more appealing. Think about this for a moment, the company borrowed money and the stock price will increase in value in order to maintain a consistent price to cash flow ratio.
For the reader, it is important to understand how reliable valuation ratios truly are.
Reliability with Valuation Ratios
Valuation ratios are tied disproportionately on one single concept, consistency. All valuation ratios are a multiple of the underlying denominator. To predict a reasonable multiple of the denominator, the user of the ratio assumes the denominator is consistently calculated from one accounting period to the next.
Most sophisticated users rely on GAAP for consistencies with the calculation of the denominator value. There are historical problems with this reliance on GAAP. First off, GAAP has over 160 standards which were recently codified into a new structure. The key is that these standards are modified from time to time and new ones are added regularly. The fact that they change means that its difficult to have true consistency from one accounting period to the next.
Another valuation principle assumes that the respected valuation ratio is comparing two similar companies. The simple truth is that no two companies are alike. It is actually very difficult to find two similar companies within the same industry. For example, the average investor would think that electric utilities are similar. After all, they are merely taking a resource and turning this into electricity and selling the end product to the consumer. Actual results are significantly different. Duke is a large electric utility based out of North Carolina. If you go deep into their financials, you’ll discover that about one-fourth of their revenues are derived from power distribution and not from power generation. Whereas Dominion Power, its neighbor directly to the North, derives the bulk of its revenue stream from pure energy sales and gas distribution. One earns its revenue from electric energy and distribution, the other from electric energy and gas. Would their respective Price to Sales or Price to Earnings be a fair comparison?
Even their respective earnings are regulated differently. Both are governed by different governmental boards that approve of rate hikes or rate adjustments for respective energy sources. The proverbial comparison of apples to apples does not exist between these two utility companies.
A final valuation principle assumes that the value result for each ratio is a derivative of high volume of stock transactions. Without this high volume, there are not enough buyers/sellers to forecast the value of the respective company. Low volume activity is subjective and tends towards terminal value of the entity and not its future value.
Each of the articles in this section of the website explain the respective valuation ratio and the underlying principles to calculate a result. There are several examples in each chapter illustrating the respective formula’s and the subjective criteria. ACT ON KNOWLEDGE.
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]]>The post Price to Sales Ratio: A Poor Indicator of Value first appeared on ValueInvestingNow.com.
]]>The price to sales ratio is a marginal valuation ratio at best. It is really an offshoot of an antiquated concept of valuing a business. In the past, one of the more common methods to value a business deal was to use a multiplier of sales. It is still used today by many organizations to value a book of business such as a property and casualty insurance agent or the entire firm. If an agent wants to retire, the agent sells his book of business based on a multiple of the revenue he generates. The idea is that the buyer will receive a return on future sales to compensate the buyer for the money paid to buy the book of business.
The price to sales ratio used with business ratios is similar. Simply stated, the price to sales ratio is the entire market value of the company (the price) as a function of revenue (sales). To illustrate, let’s look at some common price to sales ratios for various large companies traded in the market.
Market Price/Sales
Name Capitalization Sales Ratio
Verizon $242B $131B 1.85
3M $124B $33B 3.76
Exxon Mobile $341B $279B 1.22
Target $42B $75B .56
Notice the wide latitude of results?
As with all business ratios, there is no correct value nor a threshold to state whether the result is good, bad or indifferent. The reality is that the ratio can only be used to compare one company against a similar company. In the above illustration, 3M is a chemical and consumer products manufacturer; whereas Target is involved in retail sales. Their price to sales ratio results are vastly different and as such, the ratio can’t be used to compare two dissimilar companies.
This chapter explains the ratio in-depth by first exploring the concepts of the price to sales relationship. In the second section below, the author explains the differences between a trailing ratio and a leading ratio. In addition, it will cover the best usage of both. Finally, this chapter in business ratios covers why this ratio has little value and is only marginally contributive in a business investment model. The price to sales ratio is only useful in a highly defined set of circumstances and must be used properly to gain benefit from the outcome.
For the reader, understanding the concept of the price to sales ratio is the foundation for a full appreciation of the limitations of this ratio.
Price to Sales: Concepts
Value is defined as the ‘worth’ of something. In business, it is quantified in the form of dollars. A value investor wants to buy low, i.e. buy stock that is actually worth more than the current sales price. Keep this in mind as the price to sales concepts are explained here.
In business, calculating worth is difficult, easy solutions include book value or liquidation value. However, it is nearly impossible to find stock sold on the public market currently priced below book or liquidation value. Prior to the United States highly regulated stock market exchange system started after the 1929 market crash, stocks were traded with limited public information available. Worse yet, independently audited financial statements were non-existent. Stocks were traded based on indicators. One of those indicators was sales. Thus, the price paid for a stock was often derived by sales. It was thought that sales indicated market share and therefore the ability to generate profits.
You would be a fool to base your purchase solely on sales. Yet, today many small business exchanges of ownership are tied to sales. Read a small business shareholder’s agreement, a common clause in this document is the price formula a buyer (an existing owner) must pay to buy out another owner. This price formula is almost always a function of sales, not profitability, purely sales.
Given this, why would a modern-day investor base or give a lot of weight in the decision model on the price to sales ratio? To answer this, the formula must be explored first.
Formula
There are actually two formulas. Don’t roll your eyes just yet, it will make sense. The formulas are merely a relationship to each other. Both will end up with the same result. The most commonly used formula is:
Price to Sales Ratio = Market Value of the Company
Sales for the Prior Year
Market value refers to market capitalization which is merely the number of shares in the market currently times the price per share. It is the value the market believes the company is worth. For example, on August 2nd 2018, Apple was worth over a trillion dollars.
Another company coming close is Amazon. On 04/17/19, the stock was trading for $1,870 per share with 491.2 million shares in the market. Multiple the two values and the result is $918,544,000,000 ($918.5B). Amazon sales for the prior year were $232.9B. Thus, Amazon’s price to sales ratio is:
Price to Sales Ratio = $918.5B = 3.94
$232.9B
The second formula is merely a step down of the overall formula. The second formula is on a per share basis. Thus, it is the current market trading price divided by the sales per share for the company. For Amazon it is:
Price to Sales Ratio = $1,870 = 3.94
$474/Share
Look at the result above. Let’s put on our thinking caps for just a moment. If you look again, notice the current market price for a single share is $1,870. Each share generates a mere $474 in sales. If Amazon’s costs were ZERO, it would take 3.94 years of sales at this level to earn enough cash for Amazon to buy back all the stock. YES, that is right; the price to sales ratio also serves as a reminder that even under the most optimum conditions, it identifies the absolute earliest you could get your money back. Amazon’s actual net profit margin is 4.33%. At 5% net profit margins per year and assuming Amazon paid out the entire amount as dividends, then it will take 79 years to get your $1,870 back with no capital gain.
This means, the lower the ratio, the more likely the investment is lucrative. Ratios less than 1:1 are customarily more desirable. Remember, the price to sales ratio is a valuation indicator; the lower the ratio the more valuable the investment. As a value investor, you want desirable valuation ratios.
Thus, there are two concepts related to the price to sales ratio the reader must remember:
- The price to sales ratio has little to any value in a business decision model as it is based on outdated usage.
- The lower the ratio value the more lucrative the investment; ratios of less than 1:1 are desirable; the lower the better.
An interesting aspect of the ratio formula. It is most frequently used in the past tense. It refers to sales from the past. There is another variation of this ratio.
Trailing and Leading Price to Sales Ratio
The most common usage of the price to sale formula relates to the most recent 12 months of sales. This is referred to as the trailing twelve months or TTM for short. When reading the ratio’s results, it is inferred that the result is based on the previous twelve months of sales.
However, sometimes the ratio’s results are qualified by stating that the ratio is LTM or FTM. This means the ratio is based on leading twelve months or future twelve months. The sales value is substituted with the estimated sales for the future. Let’s explore the difference.
Currently Netflix has a market valuation of $157B (04/17/19) and the most recent twelve months of sales are $15.8B. The price to sales ratio is:
Market Capitalization = $157B = 9.9:1
Sales $15.8B
Netflix is currently experiencing a high growth rate in sales. Analysts anticipate a 35% increase in sales over the next year. Therefore, future sales are estimated at $21.3B. Now, let’s look at the results:
Price to Sales Ratio (LTM) = $157B = 7.37:1
$21.3B
Note the significant difference in the ratios. In general, the LTM should be lower than the current price to sales ratio. It is important for the reader to look for the qualifier for the ratio, don’t substitute the past with the anticipated future.
In general, older more mature companies use the current price to sales ratio (based on history) and not the leading indicator. High growth companies tend to utilize the leading formula when indicating results. Again, determine the source of the information; trustworthy sources will use the historical results and always indicate otherwise that the formula is a result of using future sales.
The leading formula results are commonly used by investors that seek out high growth investments. Value investors tend towards conservative values in order to get best results in their business decision models.
Best Application of the Price to Sales Ratio
In general, this ratio contributes very little value in determining a stock buy or sell decision. However, it does have utility.
In highly stable companies where profits are normal and consistent for many years in a row, the price to sales ratio comes into play. Sometimes, good companies will see sales increase beyond marginal amounts. Often this is driven by quality of product or service. When sales increase more than 20% in a given year and its anticipated that sales will again continue the same pattern for several years, this ratio now becomes important. Why? Let’s find out.
Medtronic is in the medical technology field, specifically medical equipment. Sales over the last 5 years are as follows:
2014 $17.0B
2015 $20.2B
2016 $28.8B
2017 $29.7B
2018 $29.9B
From 2014 to 2016 the company grew its sales 69%. The company experienced positive earnings per share per quarter for the last 12 years making it a highly stable business. Medtronic’s price to sales ratio table over the last 6 years is as follows:
End of Fiscal Year Ratio
2013 2.6
2014 3.2
2015 3.6
2016 3.7
2017 3.8
2018 3.6
Notice how the ratio mimics the increase in sales from 2014 to 2016 and then levels off as sales leveled off from 2016 to 2018. From 2014 to 2018, the stock price doubled, thus the market capitalization doubled. Remember one of the concepts learned above, the more stable the company, the more likely the price to sales ratio will stabilize.
But the real key is that if at the end of 2013, had the investor compared the TTM to the LTM, the investor would discover a significant gap (from 2.6 to 3.2) indicating value. Indeed, value did occur, at the end of fiscal year 2013, the stock price was $47 per share and it grew to $58 a share in 2014; a direct reflection of the TTM and LTM results. Again, the only reason those results were reliable back in 2013 would be because of the highly stable results the company has generated over many years.
Therefore, the price to sales ratio has some marginal value when the following conditions exist:
- Long-term earnings stability (>10 years)
- There exists a significant spread (>10%) between the TTM and LTM for the price to sales ratio.
- The current price to sales ratio is less than or equal to other similar companies.
It is within this narrowly defined set of conditions that the ratio can be valuable to the user. Other than this, the ratio’s value can only provide validity in the decision model if using a graph of the ratio over an extended period of more than five years.
Summary
In this chapter, the reader learned of the following concepts related to this business ratio:
- The ratio had greater reliability on its results prior to the 1929 stock market crash and is marginally valuable under current market reporting and compliance requirements.
- The lower the ratio, the greater the chance the ratio indicates value with the investment. A price to earnings ratio less than 1:1 is worth investigating especially if the company has a history of stable earnings and low risk.
- The price to sales ratio is more informative when comparing the trailing and leading results; the greater the difference, the more likely the investor has value in the investment.
As with all business ratios, use a historical graph for each ratio to evaluate the investment. In addition, ratios can only be compared to similar sector companies or industries. Finally, NEVER base a decision on a single ratio; a good investor will utilize more than 12 ratios to evaluate the investment. ACT ON KNOWLEDGE.
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]]>The post Performance Ratios first appeared on ValueInvestingNow.com.
]]>The most common thought among business owners, consultants, investors and students is the ‘bottom line’. The proper word is of course ‘PROFIT’. In business, the single number one reason to operate is to make a profit. To start, there are three reasons to be in business:
- Make a profit,
- Provide long-term security for employees, and
- Satisfy the consumer.
Take note, making a profit is the primary purpose. Without profit, the company will fail to return money back to the investors via dividends and reduce risk for all parties involved. Risk reduction includes reducing debt, expanding operations and/or improving the product/service lines.
Performance Ratios
Performance ratios measure the ability of the company to achieve those three goals. 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
G&A 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 beginning balance of either equity or total assets. 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.
Of all the performance ratios, the gross profit margin is the most critical and should have the greatest importance of all the ratios. This single ratio really tells the story of how well the company compares to its competition. As stated many times throughout this business ratio series, it is important to only compare the ratio against similar industry entities. You can’t compare retail against transportation nor retail against utilities. Here is an example of some industries and some noted companies and their gross profit margin.
- Walmart (Retail) 25.10%
- Duke Energy (Utilities) 27.44%
- Union Pacific (Transportation) 41.78%
- Verizon (Communications) 44.52%
- Camden Property Trust (Real Estate) 29.57%
As an investor, you must discover the zone or endpoints of the gross profit margin for the respective industry you invest. You can not compare one industry against another, Walmart is the largest traditional retailer in the world. Walmart’s annual sales exceed $510 Billion per year. A 25% profit margin means they are generating more than $100 Billion in contribution before traditional general and administrative costs. Whereas Camden has sales of $957 Million (about .2% of Walmart’s sales) yet Camden has a higher percentage of gross profit margin. Verizon has sales of $131 Billion and has a gross profit of $58.32 Billion. As an investor, it is important to understand this relationship and of course the importance of only comparing similar businesses.
The respective chapters in this section covering these ratios explain the respective formula and the proper application. In addition, an investor has to use similar sourced values or the investor will end up with misleading results. Following up from the gross profit margin relationship example above, retail defines cost of sales differently than transportation. Transportation and real estate are highly dependent on fixed assets to deliver the service they provide. Thus, cost of sales includes the operational costs of those assets. In retail, it is inventory based, thus the formula for cost of sales is significantly different. Understanding these nuances separates the investor from others and allows them to exercise this knowledge and put this information to good use by investing based on good comparative information.
As stated above and reiterated here, performance ratios should carry the greatest weight in your decision model. In the author’s opinion, performance ratios should exceed 30% of the total decision value and in many instances will approach 50%. However, even though performance is important, it doesn’t necessarily mean that the company is doing well. The other ratios provide the necessary information to the readers of how well the management team administers the company’s assets and ability to properly utilize debt (leverage ratios) to reduce risk and increase performance. Therefore, keep the weighted value of performance ratios between 30% and 50%. Always tend towards the 50% level than the 30% level. However, as the entity is more asset intensive such as real estate, the performance ratios should total no more than 40% weighted value. Asset intensive businesses are customarily stable and thus, the leverage ratios become more important with this group of industries. ACT ON KNOWLEDGE.
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]]>The post Leverage Ratios first appeared on ValueInvestingNow.com.
]]>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.
Wow, this seems relatively easy to understand, why not do this a lot more and make a lot of profits for the shareholder’s?
The problem is RISK. Since debt is relatively long-term, bonds to buy planes have extended maturity dates, up to 20 years. There is a good possibility that sales via passenger tickets will decrease in the future related to that particular flight, i.e. that plane. If this happens, where will the cash come from to pay the interest? The airline is still indebted and must make the interest payments on that bond.
There are solutions to reduce risk associated with debt, they include:
- Appropriate Leverage
- Incremental Leverage
- Debt Disposal Processes (Sale of the asset to pay off the debt)
- Cooperative Agreements with Other Airlines
To measure this risk factor, an investor looks at the leverage ratios for risk exposure. Leverage ratios consist of:
- Debt Ratio
- Interest Coverage Ratio
- Debt to Equity
This section of the book explains these ratios in detail, how their respective formulas are utilized and the proper interpretation of the respective ratio. The following sections introduce the respective leverage ratios.
Leverage Ratios – Debt Ratio
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. Other industries have lower ratios of debt. Retail has less than 65% of its assets covered by debt. Here are some guiding ratios based on the respective industry:
- Hospitality (Marriott Hotels) – 84.4%
- Utilities (Duke Energy) – 71.9%
- Transportation (Union Pacific) – 57.0%
- Retail (Walmart) – 60.5%
The debt ratio reflects all liabilities as a percentage of all assets. In this chapter, you will discover two subset ratios of current liabilities and long-term debt ratios to their respective asset groups. The overall ratio is the debt ratio, but it is of extreme importance to break this respective ratio into the two sub components and then evaluate comparative information based on the two sub ratios.
Leverage Ratios – Interest Coverage Ratio
This particular ratio brings into play a business concept with the acronym – EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization.
Interest is customarily paid from the earnings of the company, as referred to as operational income. EBITDA is often mistaken as operational income. With most publicly traded companies, depreciation and amortization is deducted prior to the calculation of operational income. Interest and taxes are deducted after operational income to determine net profit.
Thus the formula requires the user to modify operational income, at least determine how it is derived to calculate earnings before interest, taxes, depreciation and amortization. The formula is as follows:
Interest Coverage Ratio = EBITDA
Interest Paid
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, however they may be taxable in certain states for income taxes) 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.
Leverage Ratios – Debt to Equity
The debt to equity ratio is really a variance of the debt ratio. Interestingly, if you know one of the ratios, you can easily calculate the other. Since the balance sheet is comprised of three major areas of assets, debt and equity; if you know two of the three, the third is simple addition/subtraction formula. Now with all three values, a user of ratios can easily calculate the debt ratio and the debt to equity ratio.
So why have both?
The answer is dependent upon the respective industry a business ratio user is evaluating. The debt to equity ratio is a very common evaluation tool used by banks. Banks are interested in knowing the risk factor for their respective position in a company’s finances. For a bank, an asset’s fair market value can decrease suddenly and the equity of the company absorbs that market fluctuation.
An historic example was the real estate downturn that occurred back in 2008. Real estate decreased in value 15 to 20% within months. Banks held loan positions whereby debt to equity of their customers were five or six to one. This meant, the bank’s collateral could no longer substitute as full payment in case of default. To fully understand this, let’s review a simple debt to equity ratio and the impact a market change has on the ratio.
Company XYZ owns a set of office buildings and rents out suites to long-term service based companies. XYZ’s balance sheet identifies the following summary presentation:
ASSETS
Current $300,000
Fixed (Land & Buildings) 2,340,000
Other 115,000
Total Assets $2,755,000
LIABILITIES AND EQUITY
Current Liabilities $28,000
Long-Term Bank Notes 2,150,000
Total Liabilities $2,178,000
Equity 577,000
Total Liabilities and Equity $2,755,000
As expected both halves of the balance sheet equal each other. The debt ratio is:
Debt to Equity Ratio = $2,178,000 = 3.77:1
$577,000
The bank’s loan terms state that XYZ can not exceed a four to one ratio. If XYZ’s rents were to suddenly decrease due to market conditions, the company would experience financial losses that would in turn decrease equity. Let’s see what happens if in year X+1, the company experiences $125,000 in losses.
- Assets decrease by $137,000 to $2,618,000 (losses of $125,000 plus $12,000 of cash out for principal payments)
- Debt decreases by $12,000 due to principal paid on loans to $2,166,000
- Equity decreases by $125,000 due to losses to a new balance of $452,000
Debt to Equity Ratio = $2,166,000 = 4.79:1
$452,000
See how quickly the ratio increases (which indicates poorer performance with this particular ratio) with a mere 22% decrease in equity? This same principle is true for bond holders and other creditors. A small market change can increase the risk position of debt holders. For the sophisticated investor, the key is to monitor the trend line for the debt to equity position. The greater the elastic position of the company’s product/services; the more important to protect against bankruptcy with lower debt to equity ratios. With many publicly traded companies, the CEO and the Board of Directors will pursue expansion of their company by issuing debt, thus increasing the debt ratio. Expansion of debt increases risk and this should negatively impact stock values.
In effect, debt is good to a certain point in the overall financial position of the company; remember leverage is designed to increase net profits. However, after a certain point, debt begins to drag down profits and especially affect profits if market conditions decline for the respective product/service the company renders. Every industry has an acceptable and reasonable zone of debt to equity ratios. Exceed the zone with higher ratios and the company’s risk exposure increases at a faster rate. If the debt to equity ratio is lower than average, then the company can expand operations by incurring more debt and in turn increase profits. Higher profits tend to support higher market values for the respective stock.
Application of Leverage Ratios
As a user of business ratios, you are wondering where they fit in in the overall scheme of building a good stock buy/sell model. The best answer is for you to understand the overall importance of leverage ratios. Within the five categories of ratios, leverage ratios are at best in the middle or tend towards less importance in overall value. Why?
First off, interest rates are relatively stable in comparison to their volatility back in the 70’s and 80’s. The more unpredictable market interest rates are, the more important leverage ratios become. Secondly, leverage ratios identify future issues. Most buying and selling decisions are based on past performance. As leverage increases, it is a key indicator that the future will have greater risk associated with market conditions if they wane. Those organizations where growth is expected, leverage ratios will be higher as the Board pushes growth through the expansion of debt. It is important to weigh where the company is in its life cycle and overall market position.
Finally, leverage ratios are more critical in the decision model for highly leveraged industries such as real estate, banking, or construction. As with all ratios, the user must look at the trend lines related to ratios to determine if the current period ratio is and indicator of good or poor performance. ACT ON KNOWLEDGE.
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]]>The post Price to Cash Flow first appeared on ValueInvestingNow.com.
]]>The price to cash flow ratio is a valuation tool used to assist buyers and sellers of stock in determining timing of purchases or the disposition of shares. Unlike the other valuation ratios, this particular ratio utilizes the cash flows statement in determining the outcome. The formula is simple:
Price to Cash Flow = $Market Price of a Share of Stock
Cash Flow in Dollars Per Share of Stock
To illustrate, lets take a look at the price to cash flow for a share of Walmart stock. The current price for a share of Walmart stock is $98.87 (noon) on 03/21/19. The most recent reporting of cash flow from their 4th quarter 2018 financial statements is $17.4 Billion for the year (Ending on 01/31/19). Total number of shares in the market on the same date are 2.9 Billion. Therefore:
Price to Cash Flow (Walmart) = $98.87 = $98.87 = 16.48:1
$17.4/2.9 Billion Shares $6.00
As the cash flow per share increases, the formula’s outcome decreases. At $7.00 per share of cash flow, the ratio decreases to 14.12:1. In effect, the lower the ratio, the more valuable the share becomes at the current market price. Similar to all valuation ratios, as the valuation ratio decreases, there is greater incentive to buy the stock. As the ratio increase, it behooves the owner of stock to sell the share. Therefore there is a key investment principle here, an investor should constantly monitor the trend line related to this ratio, for that matter, all valuation ratios should have trend lines and the results are monitored constantly to trigger buy and sell decisions.
This leads to several issues related to this ratio. First off, is it a good ratio to work with, can it be improved and what is the best way to utilize this formula? The second section below evaluates this formula in detail. Secondly, is there a proper way to apply the formula? The third section explains this in detail and will also address timing issues and more. Finally, how does this ratio relate to the other valuation ratios and where does it rank in the hierarchy of business ratios.
One last thing before digging into the details. Many readers will not be well learned about cash flow and how it is calculated or even why it is calculated. Therefore, there is an introductory section that covers cash flow; for those of you already well versed in the nuances of cash flow, please skip the introductory section and move onto ‘Price to Cash Flow – A Mature Approach’.
Understanding Cash Flow
This one area of accounting is probably the most difficult to comprehend even for the most sophisticated entrepreneurs. The primary purpose of providing a cash flows statement to readers of financial reports is to help the user understand where any increases or decreases in cash stem from with the company. In small business, its purpose is the conversion of accrual accounting to cash accounting. It helps the owner to evaluate why the business increased or saw decreases in the overall cash position.
The cash position is the primary starting point. Basically, the reader wants to understand why the cash position changed during the accounting period. For example, using the Walmart illustration above, on February 1, 2018 at 12:01 AM (the first day of the Walmart’s 2019 fiscal year), Walmart’s cash position was $7,014,000,000 ($7.014 Billion). On January 31, 2019, Walmart’s cash position improved to $7.756 Billion, a $742 Million increase.
How did this happen? In order to understand, the user must first understand how a cash flows statement is presented.
The cash flows statement is divided into three major sections:
- Cash Flows from Operations
- Cash Flows from Investing
- Cash Flows from Financing
The following explains these sections in a summary format.
Cash Flows from Operations
This section of the cash flows statement is commonly called the cash flows from operating activities. It represents the net profit and adjustments to reflect cash earned from normal business. For investors, you really want this part of the cash flows statement to be positive. It means, the company is generating enough profit to pay bills and meet their current operational cash needs. Smaller businesses and penny stock companies often do not have positive cash flow from operations. This is because their growth, which demands cash, is paid from operational income. Thus, smaller companies should have significant profit margins to augment growth.
Large companies like Walmart will and should always have large sums of cash provided by operations, typically driven by their profits. In Walmart’s case, during 2019, Walmart had a profit of $7.2 Billion and this is after depreciation of $10.7 Billion. With other adjustments, cash flows from operations were $27.75 Billion that year. This is sourced from their unaudited financial report via Form 8-K dated February 19, 2019.
Cash Flows from Investing
Investing activities are different. Your common layman would say it means the purchase of stocks and bonds. But most companies are not in the business of buying stocks and bonds. They are in the business of making a profit. To do this, they must invest in additional stores or warehouses, distribution systems, manufacturing equipment and so on. Utility companies spend money on new or replacing existing power plants and distribution systems. In Walmart’s case, they add stores, buy up existing businesses, invest in new revenue lines of operations and more. In general, most companies have to spend money related to investing. In most cases, this part of the cash flows statement has a negative or outgoing spending of cash. During 2019, Walmart net investment into fixed assets and new lines of businesses equaled $24 Billion.
Think about this for a minute, they made $27.75 from regular operations and spent $24 Billion of that to add new or modify existing facilities and to purchase additional businesses.
Cash Flows from Financing
The financing section of the cash flows statement reflects borrowing of money and any cash payments related to stock. This includes the payment of dividends and the repurchase of stock. Stock may be bought back and permanently retired or it may be available for future sale, called Treasury Stock.
As companies mature and move into the top 2,000 companies worldwide, this section of the cash flows statement is often negative. Why? Well, over time, as companies mature and expansion becomes more difficult or expensive, the shareholders begin and demand a return on their investment via dividends. Recently, many companies have started to buy back stock as excess cash is not needed and so the best tool is to decrease the volume of existing stock in the market. In Walmart’s case, during 2019, Walmart used $7.4 Billion to buy back 80 Million shares. Take note, Walmart had over 3,000,000,000 (3 Billion) shares outstanding (held by investors) at the beginning of fiscal year 2019. In addition to buying back stock, Walmart paid $6.5 Billion in dividends to existing shareholders, about $2.08 per share.
In total, Walmart had to borrow money to facilitate investing activities above and to ensure payment of dividends and the repurchase of stock. This makes sense, in total, Walmart borrowed $15.9 Billion and made principal payments of $3.8 Billion for a net borrowing of $12.1 Billion. If you look up in the investing activities section, Walmart spent $24 Billion for investing activities and funded this with $12.1 of net borrowings. Other financing items required the use of $491 Million. Altogether, cash flows from financing used $2.5 Billion.
When you add up all three major sections and adjust for currency rate exchanges (Walmart operates almost worldwide), cash increased $742 Million.
If you want to look at this in more detail, here is the link to Walmart’s K-8 Report on February 19, 2019. Scroll down to page 12 in the report which is page 9 of the consolidated financial statements. Please remember, these reports are unaudited and most likely will be audited by mid April 2019 and presented in the final annual report of Walmart for Fiscal Year 2019.
For the reader, remember there are three major sections of the cash flows statement, cash flows from operating activities is the most important of the three. For mature companies, this should be very positive.
For those of you requiring additional help in understanding cash flows, go to businessecon.org and search for cash flows. There are over 20 articles that cover cash flows from general concepts to a very intensive understanding.
Now that you have a general understanding of cash flows and the statement, it is now time to understand the price to cash flows formula in greater detail.
Price to Cash Flow – A Mature Approach
The price to cash flow flow formula has several advantages over other valuation ratios. First off, it is based on cash and not earnings. Earnings can be deceitful due to timing issues and more. For example, even though the company may have generated a profit from ongoing operations, it doesn’t necessarily mean it will realize that profit in the form of cash. Why? Well, sometimes the customer doesn’t pay their bill in a timely fashion. Recently, the U.S. government shut down, did they pay their bills to many vendors and contractors doing business with them during that one month hiatus? Nope, didn’t happen.
Also, profits are a derivative of estimates. With every set of financial statements are a set of notes. There are about 20 to 30 notes for publicly traded entities. One of those notes is a standard note that states that the company uses estimates to derive their profits. Estimates are used for determining useful lives of fixed assets, the value of inventory, and amounts owed for deferred items such as taxes and employee benefits. All of these items directly affect the profit of the company. Thus, the profit can be way off, often its close, but it could be over or understated.
A good example of how profit can be greatly misstated relates to unforeseeable accidents. Recently, California experienced a costly fire known as the Camp Fire. This fire was started by PG&E’s (a utility company) electric sub station. This forced the company into bankruptcy. The company’s profit was estimated at $1.6 Billion for the nine months ending September 30, 2018. By the end of December 2018, the fire had caused an estimated $16.5 Billion in damages. Nobody could foresee this accident coming. Many accountants estimate some form of unforeseen future costs related to normal occurrences. PG&E didn’t set aside $16.5 Billion for a fire. This is an extreme example. But there are many others that happen and happen frequently.
Non-Recurring Items – these are one time adjustments usually related to a compliance issue or a monetary exchange situation. Other non-recurring items include impacts to profit for international situations such as civil unrest, wars and governmental actions.
Market Adjustments – fair market value is elusive and thus companies may have to adjust the value of their assets such as inventory or real estate due to market conditions.
Discontinued Operations – with this form of profit adjustment, the company has decided to stop performing operations by shutting down a plant or deciding to convert to a new or different line of business.
The above are extremes, but it is designed to illustrate to the reader that often, profit is merely an estimate. However, cash is not an estimate. Cash is the hard truth. This formula is grounded in the concept of cash and not profit. Thus its importance within the valuation group is often downplayed due to its complexity. For the sophisticated investor, it should be one of the top five ratios to rely on for stock transactions. Many investors don’t use this ratio because they don’t really understand how to calculate the ratio.
Proper Application of the Price to Cash Flow Ratio
Let’s go back and revisit the formula:
Price to Cash Flow Ratio = Current Market Price for a Single Share of Stock
Cash Earnings Per Share of Stock
At first glance, it appears simple. To acquire the numerator, just look up the current market price per share. It is constantly changing, thus this formula is always in a state of flux. Its the denominator that is the difficult part of the formula to determine. One simple way to do this is to look at the cash flows statement and look at the bottom line. If you opened the Walmart report, the cash flows statement states that in 2019, Walmart generated a positive $742,000,000 in cash. Here is a simple snapshot of that line from the report:
Net increase (decrease) in cash, cash equivalents and restricted cash 742
The values are in millions of dollars.
Now, you simply divide this value by the number of shares to get the cash earnings per share. There are 2.9 Billion shares outstanding, therefore, each share earned 25.6 cents in cash.
That does not seem like a whole lot does it? If we insert this into the formula and use the trading price from 03/22/19 this is the result:
Price to Cash Flow Ratio = $98.87 = 386:1
$00.256 (25.6 cents per share)
The ratio is 386 to one. This is a crazy number to work with. This can’t be right.
Actually, its worse than that. Take a look at the report, look at the 2018 column. In 2018, Walmart’s total cash flow was a negative $130,000,000. This would mean each share lost money for the company in terms of cash flow. How do you divide a positive numerator by a negative denominator? In math, it is referred to as a negative fraction and it will not work with business ratios.
Therefore, the first obvious requirement for the price to cash flow ratio if using total cash flows is that the cash flow has to be positive. This doesn’t happen every year and therefore as an investor, you can’t get a consistent trend line. It is common for large corporations to have decreases in cash from one accounting period to the next. It doesn’t mean they are performing poorly, it just means they utilized the cash for other purposes such as paying down debt, purchasing fixed assets and so on.
How does an investor address this then? What is the proper value to use in the price to cash flow formula?
The answer to both questions is ‘Free Cash Flow’. Free cash flow is the amount of cash a company generates from operations less amounts spent on capital expenditures. This simply means that cash available to reduce debt or release to shareholders is discretionary.
With most companies, capital expenditures are necessary to maintain facilities or maintain market position. For example, with the transportation sector, it is necessary for companies to replace units within the aging fleet. Capital expenditures are a normal and necessary function of every major company in the world. Therefore, cash from operations is used to fund these capital expenditures. Yes, the company can indeed borrow money to fund the capital expenditures. This merely binds the company to additional requirements on future cash flow. An investor wants to really know how much is truly free to use in the current period. Thus the term ‘Free Cash Flow’.
With Walmart, cash flows from operations was $27.75 Billion. Walmart had to spend $10.34 Billion on new or upgrades to facilities, equipment, distribution systems etc. Therefore, free cash flow was $17.41 Billion.
Some of you may wonder why debt reduction isn’t included in the formula. Although it appears logical, debt reduction can simply be replaced by borrowing the same amount to pay down the debt. Debt in large companies can be easily neutralized by swapping existing debt. In reality, this is normal. When a bond is issued, it is often replaced with a new bond of similar face value upon maturity. Thus, debt is excluded in the formula.
Another exclusion is the investment for new business lines or the purchase of existing businesses. It would seem reasonable to include these capital expenditures as a deduction from operations. But the logic is simple, how much of the cash earnings from operations is used to fund the replacement of existing assets or depleted assets via capital expenditures. Expansion is a decision based on how the investors want the company to exist in the future. In most cases, there is a general understanding to invest some money into growth and return some money to the shareholders. Walmart follows this pattern. In 2019, Walmart spent $14.7 Billion to acquire new businesses. Expansion is excluded from the formula.
If free cash flow is negative, as an investor, you will want to seriously investigate why. Stay away from purchasing stock in companies with a negative free cash flow.
Here are some examples of similar businesses and their respective cash flow earnings per share and the price to cash flow outcomes:
- Walmart (Jan 31, 2019 FY End) – 16.5:1 (See Above and Sourced From Unaudited Financials as Reported on Form 8-K)
- Target – (Feb 2, 2019 FY End) $78.32 (Close of Business on 03/22/19) = 37.3:1
. $2.10 - Costco – $237.56 (Close of Business on 03/22/19) = 49.6:1
. $4.79 - Kroger – $24.34 (Close of Business on 03/22/19) = 25.62:1
. $.95 (95 Cents)
When evaluating the above, remember there are other circumstances that affect the cash flow per share thus impacting the ratio. DO NOT USE THE PRICE TO CASH FLOW RATIO AS THE SOLE DECISION FORMULA. For example, in 2018, Target’s Form 10-K reveals that the company spent $1 Billion more on capital expenditures than it took for depreciation. This means that had they matched their depreciation similar to how Walmart’s capital expenditures and depreciation were somewhat similar, Target’s free cash flow per share would have been $3.95. Now let’s see the adjusted results:
Price to Cash Flow (Target for 2019 FY End) = $78.32 = 19.83:1
$3.95
Walmart actually had $300,000,000 more depreciation than its capital expenditures for the same time period. Thus, Walmart’s Price to Cash Flow can be restated as:
$98.87 = $98.87 = 16.76:1
$17.1 Billion/2.9 Billion Shares $5.90
Now the formulas are more in line with each other and can be fairly compared. In this case, Walmart is a better ratio than Target’s; but Target is significantly better than other large retailers.
Price to Cash Flow as a Valuation Ratio
In the author’s opinion the price to cash flow ratio is a superior ratio within the group of valuation ratios. There are several reasons for this opinion:
- The ratio is based on cash and not an estimated value of profit.
- The formula requires knowledge of cash flow within the corporate financial statements and therefore requires the user to do some analytical processing prior to implementing the formula.
- Many investors don’t truly appreciate cash flow as a value determinate, thus those that apply this formula correctly have a distinct advantage over others.
- The price to sales ratio has several drawbacks with its use and thus has no significant contribution as a valuation ratio.
Because the price to cash flow ratio requires an understanding of the cash flows statement and operational issues, proper application of this formula provides the user with a distinct advantage over other investors. It is the author’s opinion that this particular ratio should be one of the top five used by every investor. ACT ON KNOWLEDGE.
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]]>The post Activity Ratios first appeared on ValueInvestingNow.com.
]]>Activity ratios are often the most ignored of the business ratios. In reality, they are the most important. Why?
The majority of activity ratios measure the ability of the company to turn assets into earnings. All businesses utilize a simple principle, buy an asset at a low price and sell it at a higher price. Even service based operations do this. Labor is purchased for a certain value and then sold for a much higher price. Retail businesses purchase inventory and then turn around, mark it up and then sell it to make a profit. There isn’t any business out there that doesn’t exercise this basic business tenet.
Activity ratios measure this aspect of business. With activity ratios, the word ‘Turnover’ is the common binding word used. When you hear the word turnover, think of an activity ratio.
All, except one, of the activity ratios are tied to the respective asset groups. For clarification, let’s review the respective asset groups.
Current Assets – This group consists of cash, inventory, receivables and prepaid expenses. Within this group, only two of the assets are tied to the income statement, i.e. turning assets into revenue. Inventory and receivables have a direct relationship to sales.
Fixed Assets – These assets exist in every business. Some industries have a greater reliance on fixed assets as access to that asset is what is being sold. For example, think of a utility company. They are selling the use of their plant to turn into energy or transfer energy. Real estate operations effectively rent out fixed assets. Manufacturing use fixed assets to produce products and so on. For many companies, there is a relationship between fixed assets and sales.
Total Assets – All assets added together equals total assets. Many users of business ratios will shortcut the system and just utilize total assets as a relationship to sales to determine activity performance. There are many issues with this generic approach as many operations have dead or dormant assets, assets as offsets to liabilities and investments held for future use.
There is one activity ratio that does not measure the ability to turn assets into sales or cash. This one measures the ability of the company to pay its bills. It is the accounts payable turnover rate. It is argued by some scholars that it should be in the liquidity group of ratios because of its relationship to cash. However, the frequency of paying vendors is often a reflection of activity with sales. The respective article on this site covering the accounts payable turnover rate explains this well and ties it to activity ratios.
Altogether, there are six activity ratios:
- Inventory Turnover Rate
- Receivables Turnover Rate
- Working Capital Turnover
- Fixed Assets Turnover Rate
- Total Assets Turnover Rate
- Accounts Payable Turnover Rate
Again, note that activity ratios relate a balance sheet section, mostly assets, to sales.
Proper Application of Activity Ratios
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.
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, 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. To illustrate, let’s look at some publicly traded companies and select the best activity ratio to apply.
Activity Ratios – Inventory Turnover Rate
Department stores, grocery chains, specialty stores (clothing, shoes, jewelry etc.), and hardware chains are perfect examples of emphasizing the inventory turnover rate to evaluate performance.
Let’s compare two publicly traded hardware chains. Let’s compare Lowe’s and Home Depot to see which one has the better inventory turnover rate.
The formula for the inventory turnover rate is:
Inventory Turnover Rate = Cost of Goods Sold During the Accounting Period
Average Value of the Inventory
Lowe’s results for 2018 and 2017 are:
$48.8 Billion = 3.87 (2018) $46.2 Billion = 4.05 (2017)
$12.6 Billion $11.4 Billion
Home Depot for 2018 and 2017 are:
$71.0 Billion = 5.11 (2018) $66.5 Billion = 5.23 (2017)
$13.9 Billion $12.7 Billion
Naturally, there are advantages Home Depot has over Lowe’s including more retail stores. But notice something important here, both businesses saw their respective inventory turnover rates decrease. Lowe’s decreased 4.5 percent, whereas Home Depot decreased 2.3%.
In general, Home Depot outperformed Lowes related to this activity ratio. Home Depot’s overall rate is superior and its year on year change was better too.
This business ratio, inventory turnover rate, is effective if applied correctly.
Activity Ratios – Working Capital Turnover Rate
Working capital refers to the excess amount of current assets over current liabilities. It is the amount of available capital to increase productivity. There are multiple nuances involved, the article, working capital turnover rate, in this section of the website goes into extreme detail with this particular ratio.
This particular ratio is well suited for all industries and it is in the best interest of the reader to fully understand this ratio to take advantage of the respective results.
Some industries have little to no inventory. They rely almost exclusively on their fixed assets to generate revenue.
Activity Ratios – Fixed Assets Turnover Rate
Fixed assets intensive industries are those that have huge up-front investments in real estate, structures, equipment and/or technology to generate revenues. Good examples include REIT’s, resorts, transportation, hospitality and entertainment industries. Pharmaceutical industries marginally fit into this category too. However, they do have a large investment into research and development that is often capitalized as an asset in ‘Other Assets’ once a patent is issued. But that’s a different subject for a different function. For now, exclude pharmaceutical from this section.
One thing I have learned is that invariably, the fixed assets turnover rate improves from year to year; at least it should. Why? Well, the key is the formula for this ratio. The denominator is the historical cost of the fixed assets. For those companies with large investments, especially early on in their lives, the dollar amount is weighted down due to inflation. Basically, the only way to have a truly accurate value is to use fair market values for the respective assets. This makes it complicated and convoluted to determine the true year on year fixed assets turnover rate. For comparative purposes, the user would have to apply a cost adjustment factor for all prior years which will change every year.
When using this formula, you should expect improvement from year to year. Some of that improvement is related to the effect of older assets at older dollar values. Therefore, keep this in your mind when evaluating the outcome.
A good example for this activity ratio is the comparison of two railroad companies. Note that they are in the transportation sector of the economy. Again, transportation industries are asset intensive businesses. Let’s look at the results for two large publicly traded railroad companies, Norfolk Southern and Union Pacific. Here are their results:
Norfolk Southern
2018 2017
Revenues $11.5B = .264:1 $10.6B = .252:1
Fixed Assets $43.5B $42.2B
Union Pacific
2018 2017
Revenues $21.4B = .294:1 $19.8B = .280:1
Fixed Assets $72.8B $70.8B
Union Pacific improved 5% from 2017 to 2018, whereas Norfolk Southern improved 4.76%. Based on this, the novice user of ratios would believe that Union Pacific did a better job at improving their ratio. The reality is starkly different. Notice the much greater fixed asset value for Union Pacific. A sophisticated business investor will understand that a good portion of this value relates to historical costs at older dollars. Thus, the user of this value should expect a significantly better gain in ratio than a mere 4.8% [.05/(.05 – .0476)] over Norfolk Southern.
These nuances are explained in the chapter for this respective ratio. The point is that this formula along with other formulas can be and are complex. A user must still use their experiences and knowledge of the business sector and the overall economy to evaluate the results. In effect, take the results in perspective and not as an absolute value.
One last thing, in 2016, Union Pacific’s fixed assets turnover ratio was .270:1. Therefore, 2017’s improvement was 3.7%. This means that Union Pacific did a much better job at improving this ratio from 2017 to 2018 than the prior year. Improvement is what a user of business ratios is really trying to ascertain. As stated multiply times throughout the articles for business ratios, look for improvement not an absolute value.
Activity Ratios – Total Assets Turnover Rate
Within the group ofactivity ratios, the total assets turnover rate is the broadest in scope. Similar to other activity ratios, it utilizes net sales as the numerator. However the denominator doesn’t focus in on a single balance sheet asset group like the working capital turnover or fixed assets turnover rates, it includes all assets. This means all other assets (non-current and intangible assets).
The total assets turnover rate is really an all-encompassing blanket activity ratio. The other activity ratios have parameters and are more beneficial especially to businesses that depend heavily on its sales from that particular asset group. As an example, retail relies more on inventory than fixed assets. Some companies rely distinctly on unique assets for their sales. Here are some examples:
* Entertainment is almost entirely operated sourced from their copyrights to movies, music, games etc. to earn their income.
* Pharmaceuticals depend on research and development of new drugs and approval from the Food and Drug Administration; in effect, federal permission to sell their products.
* Communications is centered on owning a part of the frequency spectrum sold by the government. This sole ownership of the airwaves frequency allows them to charge fees from advertisers.
* Professional sports purchase talent with contracts from ball players. These potential stars generate ticket sales and marketing rights allowing the franchise to recoup their costs. These types of businesses rely essentially on intangible assets to generate revenue.
Activity Ratios – Receivables Turnover Rate
This particular activity ratio has two purposes. Its overall purpose is to evaluate the collection frequency of the receivables. The average person would tend to think that it helps to determine liquidity, the ability to liquidate the receivables for cash flow purposes. This is generally its purpose. But it really tells another story. It helps the user to understand the quality of customers for the company. Good customers pay timely; its that simple. Marginal customers take longer to pay their bills and this is a bad sign for business operations.
As the ratio decreases (customers take longer to pay) it points to the following potential problems:
- Increases in bad debt
- Gross profit margin decreases (the company is selling to more price conscious customers)
- Potential insolvency
This particular ratio is an indicator of success. The key is to maintain consistency from one period to the next. This tells the reader that management is keeping tabs on its customers and that cash receipts will continue in a normal pattern into the future assuming sales continue in a similar pattern.
Activity Ratios – Accounts Payable Turnover Rate
The receivables turnover rate is an asset side of the balance sheet activity ratio. Actually, five of the six activity ratios are asset driven. The accounts payable turnover rate is the only activity ratio that is liability driven. It measures the frequency of paying the corporate bills in a timely manner.
In general, as the frequency increases, it is a sign that cash is available to pay the bills. Cash is provided from three different sources. The first is of course the sale of stock. This occurs infrequently and is generally not one of the reasons accounts payable would be paid more frequently. The second source is borrowing money. For larger companies, the issuance of debt is generally used to purchase fixed assets or replace existing debt, not to pay bills.
The third source of cash is what most frequently affects the ability to pay bills. That is of course sales. If sales generate good margins, then in general the accounts payable turnover rate will increase over time. Profits put extra cash into the bank account allowing management to pay the bills faster ultimately reaching a pinnacle rate that will be consistent from one period to the next. Now any excess cash is used to pay down debt and reward the shareholders.
Summary – Activity Ratios
Keep in mind, activity ratios are the heart (lifeblood) of the ability of the company to be successful. They truly measure the ability to perform. Remember what business is all about, buy low, sell high. The four production based activity ratios of inventory, working capital, fixed and total assets turnover measure this ability to produce. Of course, all four are not applicable to every business. Each industry is different and so the sophisticated user of ratios applies the best one of these four or a weighted approach to the respective industry when evaluating performance.
The other two activity ratios are utilized to measure the quality of overall operations. Better customers, better margins provide better receivables and payables turnover rates. ACT ON KNOWLEDGE.
The post Activity Ratios first appeared on ValueInvestingNow.com.
]]>The post 20 Private Industry Sectors first appeared on ValueInvestingNow.com.
]]>The gross domestic product comprises 20 private industry sectors and two government groups. All together 22 distinct sectors contribute to the gross domestic product (GDP). The governmental sectors consist of the federal and state/local governments. This article will identify the 20 private industry sectors and their corresponding annual production in dollars and percentage of the total GDP.
Here is a basic table taken from a news release dated February 21, 2019 from the Bureau of Economic Analysis, Department of Commerce. See pages 9 and 10.
Take note of a couple interesting items from the above table.
- The largest industry sector is real estateat 13.3%. This makes sense as the customary number one cost for the typical family unit is housing.
- The third largest industry is finance and insurance. Again, this ties to the traditional family unit related to financing of housing and transportation.
- The fourth biggest contributor to the private side of the GDP formula is health care at 7.4%.
The governmental side of the equation contributes 12.2 percent of the total economy. ACT ON KNOWLEDGE.
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]]>The post Liquidity Ratios first appeared on ValueInvestingNow.com.
]]>Liquidity ratios are a group of ratios created to measure the ability of a business operation to meets its current obligations. Liquidity ratios are similar to the initial medical tests a patient receives at a doctor’s visit. Doctors take blood pressure, temperature, and pulse rate. The doctor wants assurance that the primary indicators of health are good. Liquidity ratios are exactly the same. The user wants to know that the basic measurements of a business indicate good health today.
Liquidity ratios identify various time periods of liquidity. From the longer operating cash ratio down to the immediate cash ratio, there are four ratios in this group. Many novice business people mistakenly place too much emphasis on this set of ratios in their decision models. The simple truth is that liquidity ratios are easily manipulated and sophisticated business reviewers understand this and apply the ratios appropriately. This article will help the reader understand how to properly apply the ratios and interpret the information.
The four liquidity ratios are:
This article will explain the four liquidity ratios individually and finish by revealing the proper application of this group of ratios with various decision models.
Liquidity Ratios – Operating Cash Ratio
The operating cash ratio is the most complicated ratio of all the business ratios. This is because the user must understand how to derive cash earnings from normal operations. In effect, it is equal to the cash flow from operations part of the cash flows report. This cash earnings is the numerator in the formula used to determine how frequently, i.e. turns, the cash can pay current liabilities. The greater the ratio, the more liquidity exists.
The formula is:
Operating Cash Ratio = Cash Flow From Operations
Current Liabilities
The formula does have a built-in flaw related to using the change in current liabilities to calculate cash flow from operations. To adjust for this, sophisticated users of this formula use the current liabilities beginning balance, not the ending balance. A second drawback is a negative cash flow from operations. The equation is impossible to solve with negative cash flow.
It is important for the reader to understand, although this formula is complex, it is the best overall indicator of liquidity. Why? The operating cash ratio reflects the ability to pay current liabilities from cash generated by operations. It is the complete picture. The other liquidity ratios are limited to the actual current assets on the books and not cash sourced from operations. Another interesting perspective is that the operating cash flow ratio is more stable because the business is utilizing an entire accounting cycle to determine liquidity. Simply stated, the operating cash ratio is the broadest of the liquidity ratios and should be given the greatest weight in a decision model about liquidity. If there is one ratio you truly want to understand and appreciate, this is the one.
The other liquidity ratios are narrower in scope.
Liquidity Ratios – Current Ratio
The current ratio is the simplest of all the business ratios. It is inherently flawed and therefore unreliable. The current ratio formula relates to the respective accounting cycle due to the formula:
Current Ratio = Current Assets
Current Liabilities
It is all-inclusive of current assets and current liabilities. Since both groups of balance sheet items include relatively short-term items such as cash and accounts payable along (immediate and 30 day accounts respectively) with other items that are much longer in time impact such as prepaid expenses and current portion of long-term debt, the ratio reflects a mix of fiscal year information. Many different cash changes can happen within one year, thus this ratio is merely a point in time along that one year spectrum. A sophisticated user of business ratios will use a line graph of the ratio over the entire year to understand the ratio’s true value and corresponding impact.
Examples of items that can easily affect the current ratio in the short-term include, borrowing money with a line of credit, cash infusion from non operating activities (sale of a fixed asset, sale of stock etc.) and cash disbursements for dividends. Here is a simple example.
XYZ Company has $250,000 of current assets and $120,000 of current liabilities. It is a seasonal company and is ramping up activities for the new season. XYZ Company exercises its line of credit for $200,000 to begin purchasing additional inventory. The before and after ratios are as follows:
BEFORE,
Current Ratio = $250,000 of Current Assets = 2.0833:1
$120,0000 of Current Liabilities
AFTER,
Current Ratio = $450,000 of Current Assets = 1.4605:1
$320,000 of Current Liabilities
Note the significant decrease in the ratio which would have the common entrepreneur think twice about this change. However, a line graph of the ratio over a period of one year (minimum should be around 3 years) will provide a better understanding of XYZ’s ability to pay its current obligations as a result of this ratio.
The keys to this ratio are:
- It is simple and broad in scope,
- There are too many possibilities to influence the ratio thus making it unreliable, AND
- The ratio should only be evaluated as a line graph over an extended period of time (3 years minimum).
It is better to use a more focused liquidity ratio.
Liquidity Ratios – Quick Ratio
The quick ratio is much narrower in scope and time as compared to the current ratio. This ratio is often referred to as the ‘Acid Test‘ ratio. The acid test refers to the old system of testing gold by placing a drop of acid on the element. The color change would tell the buyer of gold its purity and thus the value. Here, this is somewhat similar for liquidity. To make current assets purer, the user drops out of the equation the one current asset that will take time to liquidate, inventory.
Inventory turnover can be short-term such as food or long-term such as construction in process. By dropping out inventory in the formula, the user doesn’t have to concern the ending value related to the inventory sale. Thus, the quick ratio removes time as the primary detriment to a result. The formula is exactly like the current ratio except it remove’s inventory from the numerator.
Quick Ratio = Current Assets Less Inventory
Current Liabilities
This ratio is flawed too. Notice how nothing changes with current liabilities even though some portion of those liabilities are tied to the inventory, e.g. supplier accounts payable. Worse, those companies with a high reliance on financing inventory, such as contractors, seasonal sellers, big-ticket sellers (appliances, furniture, auto dealerships etc.); this ratio can get lopsided. As an example, look at this RV Dealership’s current ratio and quick ratio based on the balance sheet.
RV Dealership
Current Assets:
Cash $1,300,000
Inventory 4,000,000
Sub-Total Current Assets $5,300,000
Current Liabilities:
Accounts Payable $300,000
Floor Plan 3,600,000
Accruals 200,000
Sub-Total Current Liabilities $4,100,000
The current ratio is 1.29:1. The quick ratio is:
Quick Ratio = Current Assets less Inventory = $1,300,000 = .317:1
Current Liabilities $4,100,000
This ratio is valuable if used with the correct industry or industries. As with the current ratio, use a line graph over an extended period of time to evaluate improvement. As with all ratios, comparing several periods of time is best when evaluating the ability to pay current obligations.
Some users of liquidity ratios want an immediate understanding of the ability to pay current liabilities. The user wants to know about today only. There is one liquidity ratio that is highly narrow in its focus, that is the cash ratio.
Liquidity Ratios – Cash Ratio
The cash ratio is very narrow in time period utility. It reflects the ability to pay current obligations today, right now, not tomorrow or the next day or even 30 days from now. Today.
This ratio takes all cash as the only asset with the ability to pay current obligations. It is extremely pure as it relates to liquidity. Its formula is really simple:
Cash Ratio = Cash
Current Liabilities
For most businesses, it is never greater than 1 to 1. The more cash intensive the operation, such as restaurants, salons and banking, the higher the ratio’s outcome. With the food service industry, it should always be greater than 1:1. As the entity operations shift towards fixed assets reliance, the less likely this ratio will exceed 1:1.
As a liquidity ratio, it has a purpose. It is more useful to the owners than an outsider interpreter of information. For the owner, the ratio sets a minimum threshold to stay above in order to maintain solvency. It can also identify trigger points for distributions and dividends.
If you are using this ratio as a potential investor with this business, take into consideration several factors before relying on this ratio. Consider:
- The sector and particular industry,
- Industry standards,
- Sources of cash and ability to obtain cash at a moment’s notice,
- The other liquidity ratios.
Proper Application of Liquidity Ratios
Proper application of liquidity ratios helps the user to understand the operations current solvency status and the ability to maintain solvency in the near future. Liquidity ratios should never be used to predict the ability to pay obligations beyond a 30 day window.
All the ratios have inherent flaws, the most obvious is the ability to add to or subtract from current assets without affecting current liabilities. Long-term borrowings, infusion from the owners or the sale of fixed/other assets can cause spikes (upward or downward) with all four liquidity ratios.
Proper application of the liquidity ratios include:
- Utilizing line graphs over an extended period of time for all four of the liquidity ratios. Three years of information is the minimum time period a user needs to evaluate the respective ratio.
- The order of credit-ability of the ratios is as follows:
- Operating cash ratio adjusted to beginning current liabilities
- Current ratio
- Quick ratio
- Cash ratio
- Give the operating cash ratio the greatest weight factor when using liquidity ratios.
- Identify the ability of the company to infuse cash from non-operating sources such as loans, owner contributions, sales of fixed assets etc.
- Never make a decision solely based on liquidity ratios.
- Liquidity ratios are designed to measure solvency and not bankruptcy; liquidity ratios can only measure the ability to meet obligations in the near future, i.e. 30 days or less.
- Economic sectors and their corresponding industries have their own respective standards to gauge liquidity ratios against, use the standards from a comparative industry when evaluating results. If there are no standards available, use a long time line of the ratio’s change. There should be continuous improvement.
The key for the user is to look at the ratios as an immediate indicator of financial health. Just as a doctor performs an initial batch of tests on a patient to gauge any immediate concern, users of ratios turn to liquidity ratios to gauge solvency of the business. Use other ratios to determine the long-term success of a business. Liquidity ratios should not have a lot of weight with a business decision model. Use liquidity ratios with at least a dozen other ratios to evaluate a business operation. ACT ON KNOWLEDGE.
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]]>The post Return on Equity first appeared on ValueInvestingNow.com.
]]>Another performance ratio used in business is return on equity. It is similar to return on assets except return on equity uses one section of the bottom half of the balance sheet. This section is technical what the owner’s have rights along with the earnings of the business entity. Recall that the balance sheet formula is:
Assets = Liabilities plus Equity
If there are no liabilities, then the return on equity will equal return on assets as identified here:
Assets = Liabilities plus Equity
Assets = None plus Equity
Therefore: Assets = Equity
Naturally it is rare in business not to have liabilities, especially with small business. Since liabilities are normal, the return on equity equals the return on assets less the portion assigned as return on liabilities. Look at this illustration to further understand.
Preston Light Fixtures
Preston manufactures custom light fixtures for high-end hotels and conference centers. The balance sheet is as follows:
Assets $11,706,400
Liabilities 6,402,500
Equity 5,303,900
Liabilities and equity combined equals $11,706,400 matching total assets.
Earnings for the year were $903,600 (adjusted for depreciation). Return on assets equals:
Return on Assets = $903,600 = 7.72%
$11,706,400
The traditional formula for return on equity is:
Return on Equity = Net Profit
Equity
Using the information from above:
Return on Equity = $903,600 = 17.04%
$5,303,900
A sophisticated user of ratios is also interested in the return on equity as equity is a ratio of all invested capital (liabilities and equity). To figure this out, first determine ratio of earnings to liabilities and equity both as follows:
Liabilities Equity
Net Profit $903,600 $903,600
Capital Amount $6,402,500 $5,303,900
Return 14.11% 17.04%
Then determine the ratio of the total capital invested. Liabilities are 54.7% of all capital and equity is 45.3% of the total. Now multiply each return by their respective percentage of the total and it should match return on assets. Let’s find out.
Return on Liabilities 14.11% X its percentage of capital 54.7% and its result is 7.72%
Return on Capital 17.04% X its percentage of capital 45.3% and its result is 7.72%
From above, the return on assets is 7.72%.
A secondary method is to allocate the earnings to the two respective pools of capital, determine their results as a percentage of all capital and to simply add the two results together. It should match return on assets. Let’s find out.
Net Profit X 54.7% for liabilities is $494,269 divided by $11,706,400 = 4.22%
Net Profit X 45.3% for equity is $409,331 divided by $11,706,400 = 3.50%
Total Profit divided by all Capital (which equals all assets) = 7.72%
This modified version allocates the net profit between the liabilities and equity to formulate the relationship between liabilities and equity in the aggregate. It is of the utmost importance that the reader understand the relationship between the traditional definition and the summation result. The outcomes are completely different and a user of ratios needs to understand the underlying variances to truly evaluate how effective a company generates value for the investor. In a traditional formula the denominator is a lower value therefore the result is higher. When using this formula, understand both elements of the results as follows:
Traditional Return on Equity = 17.04%
Relational Return on Equity Element = 3.50%
Every organization utilizes debt, thus there will always be a significant difference in the two values. As the two values get closer, it is an indication that the organization relies less and less on debt to fund its capital.
As an example, there will always be a large disparity between the two values for debt based industries. For example, real estate investment trusts (REITs) will have assets financed with long-term debt at 70% or more. Therefore the disparity will be significant, look at this simple illustration.
Cumberland Woods Apartments Assets $10,500,000
Total Debt $8,500,000
Equity $2,000,000
Profit 900,000
Return on Equity 45%
Relational Return on Equity 1.63% (of the total 8.57% return on assets, equity is 1.63%, debt is 6.94%)
Similar to what was explained in return on assets, the return on equity is not a pure or perfect formula. The user must make adjustments in order to get an accurate result. To help the reader understand this particular business ratio and its application, the reader must first understand how equity is derived in business. With this knowledge the formula’s nuances are explained and how various changes impact the outcome. Finally, this lesson explains proper application and interpretation of the ratio. There are pitfalls to this formula and a sophisticated user is on the lookout for them. If they exist, there are other options to evaluate performance.
Equity in Business
Equity in business is commonly referred to as owner’s investment (outside money) in the business operation. It has multiple names depending on the type of entity as illustrated in the following chart.
Equity Title Legal Entity
Stock Corporation/S-Corporation
Capital Account/Units Partnership/Limited Partnerships
Capital Account/Units Limited Liability Company (multiple members)
Corpus Trust/Business Trusts
Fund Balance Non-Profit Organization
There are actually several more.
Equity not only includes the initial investment (outside money) but it also includes the lifetime earnings (inside money) to date net of lifetime distributions/dividends and draws dispersed to date. The equity section is divided into four sub groups as explained below.
- Initial Investment – This section identifies the initial stock authorized and outstanding (sold) to investors. It includes any shares sold from the inception date. In corporation status, it consists of the par value (face value) plus any amounts (capital) paid in excess of par for the stock from initial investors (owners).
- Treasury Balance – Sometimes when companies perform well, the company buys back some of the outstanding equity and gives up assets (cash) in exchange; it is commonly shown as a negative value in the equity section.
- Retained Earnings – Represents the lifetime to date earnings less amounts paid in the form of dividends, distributions, draws or benefits disbursed to the holders of an ownership interest.
- Current Earnings – Those earnings to date for the current calendar/fiscal year as reported on the income statement.
Depending on the legal form of existence the four sections will have different titles but essentially have a similar meaning. For example, with partnerships, the treasury balance refers to capital accounts for retired or inactive partners. It is similar to a trust balance that is paid out over time in accordance with the partnership/trust agreement.
The following is an example of the equity section of a corporation.
Grantsville Pilot Beef & Cattle, Inc.
Balance Sheet – Equity Section Only
November 30, 2016 (Fiscal Year-End)
Stock/Shares
Preferred Stock – 2,000 Shares @ 5% $2,000,000
Common Stock – Par Value $1.00/Share 10,000
Common Stock – Capital Paid In Excess of Par 792,400
Sub-Total Stock $2,802,400
Treasury
Preferred Stock Redemption – 800 Shares (Nov 2015) (800,000)
Retained Earnings Net of Dividends Paid
Earnings Dividends Net
Prior $2,647,591 ($102,000) $2,545,591
2011 402,752 (150,000) 252,752
2012 317,809 (73,000) 244,809
2013 596,937 (281,000) 315,937
2014 773,868 (400,000) 373,868
2015 906,482 (450,000) 456,482
Sub-Totals $5,645,439 ($1,456,000) 4,189,439
Current Earnings
Net Profit Year-To-Date $1,261,318
Dividend Payments (Tax Payments on Behalf of Owners) (380,000)
Net Earnings 881,318
Total Equity $7,073,157
Along with liabilities the capital is used to purchase buildings, fencing, cattle, feed, supplies etc. The sale of beef cattle generates revenue which in turn has costs ending in a profit of $1,261,318. The profit generates a tax liability for the owners of which Grantsville Pilot paid $380,000. Thus the comparative profit to a publicly traded entity is $881,318. Take note, the net profit is the result of using the land, buildings, equipment, feed, veterinarian skills, even water and waste management to maximize the weight of cattle. All those assets were used to fulfill this single goal.
However, the assets were not purchased from equity alone, debt is used too. An investor is interested in the return on the equity component of all this.
Nuances with Return on Equity
In Grantsville’s case total equity exists because of three sources. First is the initial investment by outside entrepreneurs, i.e. other people’s money. In this case, it is $2,002,400. This outside money is composed of both preferred, common and treasury stock. Please note, the initial overall investment was $2,802,400 and $800,000 of that was bought back by the company via treasury stock.
The second source is inside money denoted as retained earnings. Retained earnings are the lifetime to date profits as of the beginning of the year. The last source is current earnings net of any current year dividends/distributions or draws.
As explained in return on assets, the more accurate denominator is the beginning balance of the equity section. In Grantsville’s case the beginning balance is the actual stock value (outside money) plus retained earnings through the prior year as follows:
Stock (Outside) $2,002,400
Retained Earnings (Inside) 4,189,439
Beginning Balance of Equity $6,191,839
The correct formula for return on equity is:
Net Profit = $881,318 = 14.23%
Beg. Bal. Equity $6,191,839
The traditional results are:
Net Profit = $881,318 = 12.46%
Total Equity $7,073,157
Notice how including all equity increases the denominator reducing the result.
Now let’s break the return on equity into the sub components of return on initial stock and retained earnings, i.e. outside and inside money.
Outside
The original investment is $2,002,400 and all other types of investment are various forms of leverage (see leverage ratio) in business. Therefore, the amount truly at risk for the owners are the original invested dollars, $2,002,400. The return on the original investment is:
Net Profit = $881,318 = 44.01%
Outside Money $2,002,400
Again, a smaller denominator increases the result.
Inside
Similar to outside money, a user can evaluate the return on investment for inside money as:
Net Profit = $881,318 = 21.04%
Inside Money $4,189,439
Notice the denominator is larger reducing the result.
There are some interesting twists to the above. In accordance with the equity breakout, Grantsville’s current net earnings are $881,318. Suppose Grantsville dedicated those earnings to buying back preferred stock. Just as in 2015, it buys back an additional $800,000 (800 shares) of preferred stock. The outside money is now $1,202,400. The return on outside money increase to 73.3% as follows:
$881,318 = 73.3%
$1,202,400
The above identifies a flaw with this evaluation. The beginning balance of equity did not actually change as the above formula is really using the ending balance of outside money.
The return on equity analysis for inside and outside money is never used in publicly traded companies for two reasons. First, the outside money is actually what the company has sold in shares initially and doesn’t reflect what the current owners paid for the stock. Only current owners can evaluate their return on equity from the perspective based on what they paid for the stock in the market. Secondly, inside money is in a constant state of flux as shareholders often demand dividend payments changing the value of retained earnings.
With small business, both inside and outside money are locked as small business uses inside money to pay for growth and outside money rarely if ever changes hands. Given this, the return on outside money is the most appropriate ratio to evaluate closely held entities.
Overall, return on equity works best if looking at total equity and not broken out into the respective equity groups. But this analysis is different when evaluating for all capital invested into assets.
Leverage and Return on Equity
One of the drawbacks to relying on return on equity is it isn’t really a ratio for comparison purposes. This is because leverage (the use of debt) is different across the various business sectors. As debt increases the net profit earned will change. If leverage is properly utilized, net profit should increase to pay the principal component of the debt service payment. This increase in net profit results in a higher return on equity as an increase in the numerator without a change in the denominator results in higher returns on equity.
To illustrate, let’s assume Grantsville’s net profit is equal per dollar value of capital (liabilities and equity combined). It currently has four million dollars of debt for total beginning balance of $10,191,839 (liabilities of $4,000,000 plus equity of $6,191,839). Therefore, the net earnings per dollar of capital is:
$881,318 = 8.647 cents per dollar
$10,191,839
Using this value, if Grantsville’s debt increase to eight million and the net earnings per dollar is the same (remember, leverage should increase the earnings per dollar of capital), then the net earnings equals:
$14,191,839 times .08647 = $1,202,048
Now the return on equity (beginning balance) is:
$1,202,048 = 19.41%
$6,191,839
The return on equity increases dramatically; this is due to the use of leverage in business. When comparing two different entities in the same business sector, take into consideration the amount of leverage used by each. Look at the earnings per dollar of capital as a better comparative tool then return on equity. As an example, let’s combine Grantsville Pilot with total capital of $10,191,839 ($4,000,000 of debt) to an apartment complex with $9,000,000 of debt and $1,000,000 of equity.
Grantsville Pilot Apartment Complex
Debt $4,000,000 $9,000,000
Equity (Beg Bal) 6,191,839 1,000,000
Net Earnings 881,318 202,707
Return on Equity 14.23% 20.27%
Earnings/$of Capital 8.647 cents/dollar 2.027 cents/dollar
The apartment complex is by far an inferior performer of earnings, yet leverage boosts the return on equity. Both have $10,000,000 of capital invested (yes I know that Grantsville is $10,191,839 but it is only 1.92% more).
The lesson here is to evaluate return on equity considering leverage. Do not use return on equity to compare dissimilar business operations. To be effective, a user of this ratio should properly apply the formula.
Application and Interpretation
As a performance ratio the return on equity is really measuring the overall ability to create value for the organization. Value is a result of thousands of decisions summed up into one single number. Throughout the year the management team via policies of the company generate long-term profitability by making good decisions. Good decisions lead to positive long-term results. To properly interpret management’s performance look at the trend line for performance. Using Grantsville’s equity report, let’s look at a five-year trend for performance. Step one is to set-up a chart (table) of required information. Since Grantsville is a small closely held company and dividend payments are directly tied to owner needs and not consistently applied, it is best to use gross earnings and not net earnings for evaluation purposes. Here is the table:
Beginning Return
Year Earnings Equity Balance on Equity
2012 $317,809 $5,600,743 5.67%
2013 596,937 5,845,552 10.21%
2014 773,868 6,161,489 12.56%
2015 906,482 6,535,357* 13.87%
2016 1,261,318 6,191,839 20.37%
Average $771,283 $6,066,996 12.71%
The trend line would be a continuous increase with a steeper slope from 2015 to 2016.
* In 2015, Grantsville paid the preferred stockholders $800,000 to buy back some of the stock. This is either because the stock certificates mandated this step or the Board of Directors decided to buy it back voluntarily. Either way, the equity balance decreased during 2015 as follows:
Beginning Balance 2014 $6,161,489
Earnings in 2014 773,868
Dividend Payments (400,000)
Ending Balance 11/30/2014 $6,535,357
Beginning Balance 12/01/15 6,535,357
Earnings in 2015 906,482
Dividends in 2015 (450,000)
Buy Back of Preferred Stock (800,000)
Ending Balance 11/30/15 $6,191,839
In 2016, the return on equity accelerates to 20.37%, a significant increase over 2015. The buy back reduces the equity balance thus increasing the return on equity. If the buy back had not occurred, the equity would have been $6,991,839 and the return on equity would now be 18.04%.
To properly evaluate performance, all variables must be consistently applied. Therefore the 2016 beginning balance of equity is adjusted to $6,991,839 and the trend line results in a dampened output for the transition period from 2015 to 2016, i.e. it isn’t as steep.
It is easy for the Board to manipulate return on equity by simply buying back stock. Some readers may wonder, well assuming this, why don’t dividends/distributions affect the results? Actually they do; however, dividends are customarily a consistent percentage of earnings as illustrated here:
Year Earnings Dividends Dividends as a %
2012 $317,809 $73,000 22.97%
2013 596,937 281,000 47.07%
2014 773,868 400,000 51.69%
2015 906,482 450,000 49.64%
2016 1,261,318 380,000 30.13%
Notice in general the dividend payments are consistently between 20 and 50% of earnings. The key attribute is consistency. If dividends were not paid, equity increases would dampen the successive results for return on equity. In effect, the entire trend line would simply shift downward as a whole. The ratio evaluates the performance of management and the Board of Directors with their ability to make good long-term decisions. An upward trend line identifies good decision-making, a downward trend line is a sign to replace the management team.
As with all business ratios, there are drawbacks and volatility issues to address. In Grantsville’s case, the market price of beef greatly affects the revenue and doesn’t affect costs to raise cattle. Therefore, volatile price changes affect profit thus impacting return on equity. The trend line results would be more ups and downs and not a smooth line in a distinct direction. For industries that are easily affected by outside forces, specifically market trends, relying on the return on equity as a performance gauge is inappropriate. Other business ratios are used to evaluate management decisions.
Summary – Return on Equity
Return on equity is one of the performance ratios used to evaluate management and the Board of Directors. Over several years a positive trend line indicates good policies and decisions. The ratio is easily manipulated but with a clear understanding of equity and its underlying elements a sophisticated user can adjust for manipulations to obtain more accurate results.
The basis formula is:
Return on Equity = Net Profit
Equity
Always use the fiscal/calendar year’s beginning balance for the equity value as the denominator. Take the information one step further by evaluating both debt and equity in relation to each other to determine the impact leverage has with the ratio. ACT ON KNOWLEDGE.
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