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Using Pairs of Financial Ratios to Speed Up Your Analysis
Posted by: Mark Lin (IP Logged)
Date: December 12, 2012 11:20AM
I previously wrote about misused and misunderstood ratios such as ROA and dividend payout. However, the fault always lies with the user, not the tools. There are two sides to everything. Intelligent users of financial statements and ratios can draw significant insight from the financial number in the shortest possible time and make better investment decisions.
I will illustrate one of the methods here: using pairs of financial ratios to speed up your analysis.
Price-to-Book Ratio (P/B) Versus Price-to-Net Tangible Asset (P/NTA)
Some book value investors fall into the trap of buying low-P/B, high-NTA companies, which are actually serial acquirers. Serial acquirers buy over companies and record the excess of the purchase price over the assets of the target as goodwill. In such cases, the book value is artificially boosted by goodwill (instead of earnings) and the P/B ratio is distorted. I will usually compare P/B and P/NTA, as a shortcut to alert myself to serial acquirers.
Return on Equity (ROE) Versus Return on Assets (ROA)
The two elements that investors focus on almost immediately when it comes to stocks is net gearing and ROE. The end result is that companies with both huge amounts of cash and debt, and poor operating performance (low ROA) may be mistaken for good companies. Such companies boost their ROEs through leverage and present a "strong" balance sheet with low net gearing or even net cash. I will typically use the DuPont equation to disaggregate the the drivers of the companies' ROEs.
EPS Growth Rate Versus Net Income Growth Rate
Investors are typically taught to use EPS growth rate as a proxy for the company's growth, rather than net income growth rate. This is because net income growth does not account for the change in the number of shares outstanding. Companies may be growing at the expense of excessive and expensive equity funding, diluting existing shareholders in the process. However, the contrary can be true. An above-average EPS growth may be the result of significant amounts of share repurchases rather than improvement in the company's operations. I will typically compare both the EPS growth rate and the net income growth rate, if EPS growth seems to be too good to be true.
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