Friday, 6 September 2013

Rationalising The Use of Financial Ratios and Indicators


I remember when I started serious investing about 2 years ago, it was an absolutely daunting task to dissect the financial reports and sieve out relevant financial indicators and ratios to help me in my analysis, as there were simply too many financial ratios out there!

Lets do a quick gauge: PE, PB, PEG, P/NTA, ROA, ROE, Current Ratio, Quick Ratio, Debt/Equity, Debt/Assets, Dividend Payout Ratio, Price/Sales, Assets Turnover, Gross Margin, Operating Margin, Net Margin, EBITDA Margin, Dividend Yield, Free Cash Flow Yield, Cash Conversion Cycle, Inventory Turnover, Receivables Turnover etc.

Which one do I use? Which one is important? Which one is relevant? I can vividly remember the confusion and frustration I felt back then.

As I tried calculating ALL the ratios and studied them , I realised each  told me different things. A company may have very low PE, but is ROE is 3%. The other company may be in a net cash position for past 5 years, but its earnings were stagnant, or slowly decreasing. Looking at the table, I found it difficult to reason if a company is fundamentally strong, leave alone making decision on whether to buy.

Then it struck me that what I was doing was taking whatever I could lay my hands on, and try to make sense of it, due to my lack of knowledge. I was afraid to make wrong decision, hence thought that the more analysis I do, the better my decision will be. How wrong was I!! That behaviour simply led me to a dead end. I was paralysed by the information I had on hand. Talking about info overload and analysis paralysis.

Fast forward to present day. I have managed to tidy up a template of important indicators that I always look out for in all my counters:

P/L Statement: Revenue, Operating Margin and Earnings
Balance Sheet: Cash/Total Debts, Total Liabilities/Total Assets,
Cashflow Statement: Net Ops CF, FCF
General: ROE, PE, Dividend Yield, Dividend Payout Ratio

Some others that I look out for in specific industries:

P/NTA and Interest Cover - Property stocks, REITS and small cap construction companies
Assets Turnover - Industrial or manufacturing companies that rely heavily on assets to generate profits
Inventory Turnover and Receivables Turnover - For retail companies, industrial materials stockists, or small cap companies

Its much simpler, cleaner, and more importantly, it allows me to make decisions easier. Its both time and energy consuming to want to know about all the indicators, and worse, it doesn't help me make decisions. I only need the key indicators that matter, and nothing more than that. Analyse till you feel it is sufficient to make decision. Going beyond that can make things difficult for oneself. Whether its enough is, of course, subjective to each individual, but what I am trying to say is do not fall into the behavioural blindspot of over analysing and rendering yourself incapable of making decisions.

Most importantly, analyse these over a long term. By long I mean 10 years. 5 years is too short to prove the company's ability to withstand against the boom and bust cycle. I am looking for solid track record shown by consistency, and slow and steady growth over years. Consistency is the key here. Of course if any year shows an anomaly, probe deeper to check if it is due to once off events.

After that, I try to buy them at a low price during crash or correction, entering in tranches. I have much to share under purchase actions in terms of tranche approach and the emotional aspects, and it warrants a separate post to talk about that.

Have a great weekend! 

4 comments:

  1. Hi, which are these simpler ones that you use?

    ReplyDelete
  2. Very informative and useful, you showed very useful info about financial ratios Analysis. Great and Detailed work.

    ReplyDelete
  3. Very Informative and useful... Keep it up the great work. http://goodfridaymorning.com/

    ReplyDelete

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