Financial Ratios: Much More Than Meets The Eye

Looking at financial ratios is part and parcel of the fundamental analysis process, where it is carried out to determine if a company’s share, REIT or corporate bond is worth to invest. For today’s post we shall look at the mathematical aspect of ratios and how we could gain more insights into these numbers.

Ratio Basics

While most financial ratios are given as numbers, it is the actual end result of a fraction. A ratio is just that, a fraction, and it is made up of a numerator and a denominator. A Price-to-Book (P/B) ratio of 0.8 could mean anything; it could be 0.80/1.00, or 1.20/1.50.

When comparing ratios across different time periods, it is important to look at the numerator and denominator, not just the ratios. Take for instance the dividend yield ratio of a fictitious Company A over three years below:

2015: 3.5%

2016: 4%

2017: 5%

At first glance it looks good, with an increasing dividend yield ratio over the three years. But if we look deeper at the numbers that results in the ratios, you may want to reconsider investing in Company A:

2015: ($0.035/$1.00) x 100% = 3.5%

2016: ($0.032/$0.80) x 100% = 4%

2017: ($0.030/$0.60) x 100% = 5%

In actual fact, Company A’s dividend amount and share price is reducing over the three years. So it is important that you should look at the make-up of the ratios instead of taking them at face value.

Another point on ratios is purely math 101; if a ratio is rising, it could mean one of the five possible reasons:

• The numerator is getting larger while the denominator remains the same.
• The numerator is getting larger while the denominator is getting smaller.
• The numerator is getting larger while the denominator is getting larger but at a slower pace than the former.
• The numerator remains the same while the denominator is getting smaller.
• The numerator is getting smaller while the denominator is getting smaller but at a faster pace than the former.

Thus if a ratio is falling, the five possible reasons are:

• The numerator is getting smaller while the denominator remains the same.
• The numerator is getting smaller while the denominator is getting larger.
• The numerator is getting smaller while the denominator is getting smaller but at a slower pace than the former.
• The numerator remains the same while the denominator is getting larger.
• The numerator is getting larger while the denominator is getting larger but at a faster pace than the former.

Fun With Financial Ratio Math

If you know your financial ratios well, you can probably see more things from just a simple ratio. For example, the Return on Equity (ROE) ratio of a company is simply:

ROE = Net Income / Average Shareholders’ Equity

Since shareholders’ equity is akin to book value (assets – liabilities), and net income is also known as (net) earnings, we will have this:

ROE = Earnings / Book Value

Here comes the interesting part.

If P/B = Price / Book Value, and Price-to-Earnings (P/E) = Price / Earnings, then:

ROE = Earnings / Book Value = (Price / Book Value) / (Price / Earnings) = (Price / Book Value) x (Earnings / Price)

Hence, ROE = (P/B) / (P/E)

In other words, we could also use the relationship between a company’s P/B and P/E ratios to analyse the ROE.

The Dupont Analysis

The Dupont analysis, which was named after the Dupont conglomerate (the makers of Teflon and Kevlar), is an in-depth look of the ROE ratio by splitting it into three main components; profit margin, total asset turnover and financial leverage.

Under the Dupont analysis, the ROE is:

ROE = Profit Margin x Total Asset Turnover x Financial Leverage = (Net Income / Sales) x (Sales / Assets) x (Assets / Equity)

Breaking it down further on the profit margin part, we have:

ROE = (Net Income / Pretax Income) x (Pretax Income / Earnings Before Interest and Taxes) x (Earnings Before Interest and Taxes / Sales) x (Sales / Assets) x (Assets / Equity)

By analyzing the ratios of these components, one can see which part is affecting or contributing to the resulting ROE.

Conclusion

I hope this post provides you with some general knowledge on financial ratios. Still, ratios are just one aspect in fundamental analysis; a complete and holistic picture is needed when researching and analysing your next company share, REIT or corporate bond.

The Value Trap

We all love cheap things, and in the investment circles a lot of people also love “cheap” companies based on their valuations, for they are not really priced at their actual value, thus there is money to be made in the price-value difference. Whether you are a value investor, a growth investor, a dividend investor or a combination of either two or all three, the potential is there.

However, there is also this term that floats around the investing community, and that is “value trap”. This phrase is usually used, seen and/or heard when sourcing for “cheap” companies.

What Is A Value Trap?

According to Investopedia, a value trap is “…a stock that appears to be cheap because the stock has been trading at low valuation metrics such as multiples of earnings, cash flow or book value for an extended time period”¹.

In other words, a company can be trading at below its value for a very long time, with no indication of the price reaching its actual valuation. This is bad as if you happened to buy a cheap company hoping its price will go up but did not after a relatively long time, and then you may be stuck with a value trap.

How To Avoid A Value Trap

Simple, just do a full-scale fundamental analysis (FA) on the company. Typically, some investors fell for a value trap by focusing too much on valuation numbers/ratios and ignored the rest. Some investment literature had suggested looking at other things instead of just valuation, such as (and not exhaustive): 

• earnings per share over the past few years
• debt to equity ratio 
• free cash flow
• the company’s sectorial trends
• management vision, etc.

You could apply the three-tiered FA model in The Bedokian Portfolio (Company, Environmental Factors, Economic Conditions)² or any other FA methods and styles that you have learnt to distinguish between a really “cheap” company or a value trap.

Not All Value Traps Are Bad

Sometimes there are other factors besides bad fundamentals that made a company a value trap. A company may be profitable, have a steady cash flow, not much debt and in a stable sector/industry, yet it is still not priced at its true value. This could be due to its obscurity and being away from the public (and analysts’) eye, or the sector/related sector(s) that the company is in is not due for take off. Eventually, they may become the next value, growth and/or dividend companies, but exactly when is unknown.

And from a Bedokian Portfolio investor’s point of view, sometimes being invested in a value trap is a good thing, particularly if the company is in good financial health and paying good dividends consistently. Do your due diligence when you are exploring this option.

1 – Investopedia. Value Trap. https://www.investopedia.com/terms/v/valuetrap.asp(accessed 27 Oct 2018)

2 – The Bedokian Portfolio, p85