Numbers We Like To See

In this article we will be exploring some quantitative measures I review as part of the Traditional Value Investing portion of the AVI portfolio. Whilst no single metric should be used to measure the value or financial strength of a stock/business, utilised together with other metrics and fundamentals, they can be a powerful tool to interpret a stock/business's potential for investment. 

Price-to-Earnings Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? PE ratio is a measure of the relationship between a company’s stock price and its earnings per share. High PE ratios indicate that investors are willing to pay more for every unit of earnings generated. To put it simply, a PE ratio of 25x indicates that investors are willing to pay $25 for every $1 of earnings generated by a company. Conversely, a low PE ratio can indicate that a stock is out of favour with investors as they are not willing to pay as much for the earnings generated.

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Whilst we would naturally want to purchase the stock with a high PE ratio to pick stocks that are in favour the reality of a value investor is to be a contrarian, searching for stocks with a low PE ratio. By doing so the potential returns of an investment are greatly increased as stocks moving from a low PE ratio (out of favour) to a high PE ratio (in favour) will likely see significant increases in stock price. Further to this, the 𝙝𝙞𝙨𝙩𝙤𝙧𝙞𝙘𝙖𝙡 𝙖𝙫𝙚𝙧𝙖𝙜𝙚 𝙋𝙀 𝙧𝙖𝙩𝙞𝙤 of the $SPX500 stocks is 𝟭𝟲𝙭 indicating stocks with PE ratios above this being over-priced and below this being under-priced. This is an extremely simplistic view on PE ratios as companies with high growth prospects may demand higher PE ratios to companies that have stagnated/are in decline.

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• PE ratios can help investors understand whether a stock is over or under priced.
• PE ratios can indicate whether a stock is in favour or not and whether they are potentially expected by investors to experience significant growth in the near future.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Earnings can be easily manipulated through accounting techniques which can lead to PE ratios that misrepresent a stock’s value.
• PE ratios can also misrepresent the value of a stock based on its position in a cycle. For example, PE ratios for mining companies tend to be at their lowest when mining has outperformed expectations and supply outweigh demand. This supply and demand unbalance will eventually catch up with the stock price causing the price to drop.

Return on Invested Capital

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? ROIC is a calculated measure of the return received by a company for the capital (either debt or equity) it invests. These investments can range from research and development, new equipment, investing in third party ventures and beyond. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? ROIC, being an efficiency measure of a business, can tell us whether our own capital invested is in good hands. Therefore, a high ROIC is much more preferable than a lower one. However, measures of ROIC taken at a single point in time can misrepresent how efficient a company is at utilising capital as it does not consider past investment decisions. As such, measures of ROIC over longer periods of time, 3-, 5- or 10-year averages, are a much better indication of a company’s efficiency to allocate capital. Given that the 𝙡𝙤𝙣𝙜-𝙩𝙚𝙧𝙢 𝙖𝙫𝙚𝙧𝙖𝙜𝙚 𝙍𝙊𝙄𝘾 of companies in the US market is 𝟭𝟬% it is reasonable to favour investment opportunities that present 3-, 5- and/or 10-year average ROICs above this level. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• ROIC provides a conclusive measure as to whether a company’s management is making good decisions year-on-year.
• ROIC can help identify stand out companies from their direct competitors.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• ROIC can be very complicated to calculate and there are many ways in which ROIC can be calculated (which will provide varying results).
• ROIC doesn’t tell you what a company is investing in and whether the high returns experienced will continue into the future.

Revenue Growth

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? Quite simply, has the revenue generated by an investment opportunity increased over the past 5- and 10-year periods. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Whilst revenue growth is often overlooked in favour for earnings growth it is an important measure to ensure a company is keeping up with inflation and maintaining a strong position against its competitors. High levels of Revenue Growth are preferable however growth in revenue that is simply in line with inflation over the past 5 to 10 years can indicate that a company is maintaining its position within its market against its competitors. As a measure for value investing this is all we need to look for. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• Revenue Growth can indicate a company is keeping up/surpassing its competitors.
• Revenue Growth can also be used as an indicator of an impending drop in stock price. To explain, should a company’s revenue (and therefore earnings and free cash flow) increase exponentially due to a short-term tailwind (such as the COVID-19 lockdowns) the level of revenue growth is unlikely sustainable and could indicate a coming “crash” in stock price (due to the over exuberance in the market over the stock).

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Revenue Growth does not reflect the expenditures associated with an increase in revenue. At times, increased revenue can be a result of an increase in operational and/or capital expenses that greatly outweigh the revenue generated (resulting in lower earnings and free cash flow).
• Searching for Revenue Growth can leave opportunities on the table. Companies can go through re-structuring and times of change in which revenue may decline for periods of 3 to 5 years only to skyrocket in the following years.

Net Income Growth

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? Quite simply, has the net income generated by an investment opportunity increased over the past 5- and 10-year periods. High levels of Earnings Growth are preferable however growth in Earnings that is simply in line with inflation over the past 5 to 10 years can indicate that a company is maintaining its position for return to its investors. As a measure for value investing this is all we need to look for however higher Earnings Growth is the target.

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Similar to Revenue Growth, high levels of earnings growth are preferable over the past 5 to 10 years as these are seen as the funds that will be returned to shareholders. As such, any growth in earnings can be taken as a positive. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• Net Income Growth can indicate a company is becoming more efficient, reducing operating costs and improving profitability.
• Net Income Growth can indicate the company’s ability to grow in general and therefore assist investors in understanding the underlying value they can expect to receive.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Earnings can be easily manipulated through accounting techniques which can lead to a misrepresentation of a stock’s performance.
• Searching for Net Income Growth can leave opportunities on the table. Companies can go through re-structuring and times of change in which earnings may decline for periods of 3 to 5 years only to skyrocket in the following years.

Change In Shares Outstanding

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? Change In Shares Outstanding is the measure of how many shares, have been issued or repurchased as part of a buyback scheme over a period of time. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? For purposes of long-term investment, we are looking for companies that have repurchased more, or as many, shares than they have issued over the past 5- and 10-year periods. When a company issues additional shares, for whatever purpose, the existing shareholders are being diluted. Whilst there are merits to issuing new shares (such as generating capital for an acquisition or development opportunity) and issuance of new shares should, in the long run and as a minimum, be balanced out buy share repurchases to ensure shareholders are not diluted. As a minimum there should be a repurchase plan in place following a share issuance. Dilution buy share issuance can be explained like this: You own 10 out of 100 shares (10%) in a company which entitles you to 10% of a company’s earnings. The company issues 100 additional shares. Now you own 10 shares out of 200 (5%) and the company has no plan or intention to repurchase the shares issued. Through no fault of your own, you are only entitled to 5% of the company’s earnings compared to the 10% you previously had. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• Provides a view into how much a company values it’s shareholders.
• Provides a warning to potential investors of a pattern of historic dilution.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Doesn’t provide insight into why share have been issued and any plans to buyback shares.

Long-term Liabilities-to-Free Cash Flow Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? The LTL/FCF Ratio looks at the long-term liabilities in comparison to the free cash flow generated by the company. Free cash flow is the cash available for a company to pay dividends, buyback shares, make acquisitions, growth the business and importantly pay off debt. Whilst current liabilities are important, long-term liabilities carry most the 𝙙𝙚𝙗𝙩 𝙧𝙞𝙨𝙠 of a business.

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? While debt, used in the right way, can be beneficial for a business to grow, it also carries risk. Long-term liabilities are subject to increases in interest throughout the life of the debt (likely due to increased interest rates from the FED, BoE, ECB or other financial institution). As such, it is good to know if a business can pay off long-term liabilities in the short to medium term, should interest rates unexpectedly increase and repayments become unwieldy. With this I like to see a company can pay off their long-term liabilities within a 5-year period by comparing the average free cash flow generated over the past 5 years against the existing long-term liabilities. Therefore, a LTL/FCF ratio of less than 5 is preferable.

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• The LTL/FCF ratio can provide an understanding of how leveraged a company is.
• The LTL/FCF ratio can also indicate how quickly the company’s debts can be paid off without the use of cash on the balance sheet.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Cash on the balance sheet is not accounted for, therefore a company may have a high LTL/FCF ratio whilst the cash on the balance sheet would cover the total/majority repayment of these liabilities.
• Capital lease agreements such as shops and stores are classified as long-term liabilities however these can be either unavoidable (you can’t sell coffee without a coffee shop) or the lease agreements may have fixed interest for extensive periods of time (20yrs+) and therefore are unlikely to be a risk.

Free Cash Flow Growth

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? Free Cash Flow is the cash available for a company to pay dividends, buyback shares, make acquisitions, growth the business and pay off debt. The key indicator of a strong business, therefore, has the Free Cash Flow increased over the past 5- and 10-year periods. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Whilst Free Cash Flow growth is often overlooked in favour for earnings growth it is an important measure to ensure a company is keeping up with inflation and maintaining a strong return to its investors. High levels of Free Cash Flow Growth are preferable however growth in FCF that is simply in line with inflation over the past 5 to 10 years can indicate that a company is maintaining is position within its market against its competitors. As a measure for value investing this is all we need to look for, however, high levels of Free Cash Flow Growth is significantly more favourable. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• Free Cash Flow Growth can indicate a company is generating more and more return for its investors.
• Free Cash Flow is extremely hard to manipulate through accountancy functions and therefore shows a true reflection of the companies performance.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Free Cash Flow is acutely affected by capital expenditures and therefore large costs of this type can skew Free Cash Flow in the short-term.
• Searching for Free Cash Flow Growth can leave opportunities on the table. Companies can go through periods of significant capital expenditure which may decline Free Cash Flow only to skyrocket in the following years.

Price-to-Free Cash Flow Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? PFCF ratio is a measure of the relationship between a company’s stock price and its Free Cash Flow per share. High PFCF ratios indicate that investors are willing to pay more for every unit of free cash flow generated. To put it simply, a PFCF ratio of 25x indicates that investors are willing to pay $25 for every $1 of free cash flow generated by a company. Conversely, a low PFCF ratio can indicate that a stock is out of favour with investors as they are not willing to pay as much for the free cash flow generated. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Whilst we would naturally want to purchase the stock with a high PFCF ratio to pick stocks that are in favour the reality of a value investor is to be a contrarian, searching for stocks with a low PFCF ratio. By doing so the potential returns of an investment are greatly increased as stocks moving from a low PFCF ratio (out of favour) to a high PFCF ratio (in favour) will likely see significant increases in stock price. This is an extremely simplistic view on PFCF ratios as companies with high growth prospects may demand higher PFCF ratios to companies that have stagnated/are in decline. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• PFCF ratios can help investors understand whether a stock is over or under priced.
• PFCF ratios can indicate whether a stock is in favour or not and whether they are potentially expected by investors to experience significant growth in the near future.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• High levels of capital expenditure can reduce free cash flow and therefore increase the PFCF ratio. Short term increases of capital expenditure can be a sign of either a future potential growth opportunity or a company struggling to stay relevant. Either way this is not reflected in the PFCF ratio.
• PFCF ratios can also misrepresent the value of a stock based on its position in a cycle. For example, PFCF ratios for mining companies tend to be at their lowest when mining has outperformed expectations and supply outweighs demand. This supply and demand unbalance will eventually catch up with the stock price causing the price to drop.

Dividends Paid-to-Free Cash Flow Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? DFCF ratio is a measure to identify how much of a company’s free cash flow is being paid out as a dividend to its shareholders.  Dividends are sort after by many investors however if the company is unable to sustain dividend payments when they go through a rough patch these dividend payments will likely be cut. The DFCF ratio takes the Dividends paid out and divides this by the Free Cash Flow generated by the business. Taking 5- or 10year averages of Dividend payments and Free Cash Flow is more favourable as this will provide a normalised picture of the DFCF ratio. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Being a sustainability metric for dividend payments we would like to ensure that the DFCF ratio is such that a company can be hit by financial downturns without having to reduce dividend payments. Whilst there is no guarantee a dividend won’t be cut/reduced we can have more confidence that this will not be the case if the DFCF yield provides a reasonable 𝙢𝙖𝙧𝙜𝙞𝙣 𝙤𝙛 𝙨𝙖𝙛𝙚𝙩𝙮. In most cases, especially for growing companies I like to see a DFCF ratio of 0.5 or less providing a 50% margin of safety for that dividend payment. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• Provides confidence that a dividend being paid out is sustainable.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• A DFCF of 0.5 can leave some companies on the table as there are many companies known a 𝙙𝙞𝙫𝙞𝙙𝙚𝙣𝙙 𝙘𝙝𝙖𝙢𝙥𝙞𝙤𝙣𝙨 that despite having a DFCF ratio of 0.7, 0.8 or 0.9 are able to sustain their dividend payments regardless of economic downturns.

Cash Flow-to-Capital Expenditure Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? The CFCapEx ratio is a measure to identify how much a company is spending on capital expenditures to maintain the cash flow it generates. This ratio allows investors to understand if a company is struggling to relevance or generating a good cashflow with little capital expense. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Whilst the CFCapEX ratio in itself can tell us if a company is overspending on capital expenses (having a ratio of less than 1), there are other insights that can be drawn from this metric. By reviewing the CFCapEx ratio for each year over the past 5- to 10-years investors can see whether this ratio is increasing, decreasing or maintaining at a stable level. Should the CFCapEx ratio be consistently decreasing it is a likely sign that a company is struggling to remain relevant and therefore having to spend more and more on capital expenditures to maintain its position in the market. On the other hand, should the CFCapEx ratio be increasing each year the company is likely building a strong customer base, allowing it to capture additional revenue without additional capital expense. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• Provides some initial insight into how a business is performing against its competitors/in its market.
• Can help identify an overspend in capital expenses which can be investigated further.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Can neglect the fact that increasing capital expenses compared to cash flow could be drawn out due to deep research and development projects (such as the metaverse, or EV battery developments in the early days of EVs).
• Cash flow can be adversely affected by short-term events (such as COVID-19) which can misrepresent the intensity of capital spending.

Cash Acquisitions

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? Cash Acquisitions are reported on a company’s cash flow statement indicating what acquisitions, if any accompany has made in cash throughout the period covered by the cash flow statement. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Buy reviewing the Cash Acquisitions we can understand two things. Firstly, by reviewing the cash flow statements over the past 5 to 10 years we can identify any significant acquisitions made which will prompt further investigation, and secondly, we can understand whether a company is making acquisitions on a regular basis (it is quite common that companies making regular acquisitions are searching for relevancy). 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• By identifying significant acquisitions investors can conduct further research to understand whether the investment is complementary to the company’s ongoing operations.
• By identifying the frequency of acquisitions an investor can be prompted to conduct further research into these acquisitions to understand whether the company is making acquisitions for acquisitions sake, or they are justified (regular small acquisitions could be a sign of a company searching for relevancy, searching for a unique selling point it doesn’t currently hold).

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Whilst the Cash Acquisitions are a good starting point for the identification of acquisitions made it does not cover the acquisitions made by the issuance of new shares or debt which will need further investigation.

Price-to-Free Cash Flow-to-Price-to-Earnings Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? The PFPE ratio is a comparative measure of the price-to-free cash flow ratio against the price-to-earnings. The relationship between PFCF and PE ratios can help us understand how a company is managing its free cash flow and if there are some unusual goings on in the income and cash flow statements. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? A PFPE ratio above 1 is ideal as the company is generating more free cash flow than its earnings, likely due to investments made. In the case of a PFPE ratio below 1 the free cash flow is being hindered and will need to be further investigated. Whilst free cash flow can drop below earnings for many legitimate reasons (such as CapEx spend) it can also be a warning sign to would be investors of accounting manipulation. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• The PFPE ratio can signal strong investment decisions by management through the generation of free cash flow beyond normal operations.
• The PFPE ratio also acts as a yellow flag, informing investors that research is required when free cash flow drops below earnings in a significant way.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Free cash flow can drop for a number of legitimate reasons such as increased CapEx spend or poor investment choice. Therefore, the FCFE ratio can be misleading should further research not be conducted into the disparity between free cash flow and earnings.

Shares Outstanding to PE Comparative

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? Whilst the SOPE comparative is not strictly a metric it is a measure of efficiency. Each year over a 5- to 10-year period is reviewed to identify if a company has issued new shares or bought shares back. For each year we also look to understand the average PE ratio throughout that year. Understand then the average PE ratio and whether shares were bought back or issued by the company and at what PE ratio we can understand whether the shares purchased or issued were done when the share price was cheap of expensive for each year. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Whilst not a perfect measure we can review share buybacks and issuance and the average PE for each year against a PE we determine to be reasonable. The truest method for this comparative would be to compare the SOPE with the individual stocks 10yr average PE ratio, alternatively this can compared to the long-term average of an index such as the S&P500 (PE ratio of 16). Nonetheless we are looking for shares being issued when expensive (based on the PE ratio) to take advantage of the opportunity and share buybacks being cheap (based on the PE ratio) to ensure value for money is achieved. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• This comparative can provide insight into how efficiently management are conducted share buybacks and issuances, generating value for its investors.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Average PE ratios won’t tell investors what price shares were issued or bought back at.
• Using the 10yr average PE ratio or the long-term average of an index as a comparative measure may not correctly represent when the stock is expensive or cheap.

Whilst the SOPE comparative has highly ambiguous, making a number of assumptions, it can provide some much needed insight into the mindset of management. If management are buying back shares regardless of price they may be destroying value. Also, if they are issuing new shares whilst the share price is cheap they are diluting existing shareholders for little financial gain.

Current Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? The Current Ratio is calculated as the Total Current Assets of a business divided by the Total Current Liabilities. This ratio provides insight into a company’s ability to pay off short-term debt with current (liquid) assets. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? The Current Ratio takes a picture in time of a company’s liquidity however for long-term investors it is better to review the average Current Ratio over the past 5- and 10-years. This will show what level of liquidity the company usually runs at. Different industries tend to standardise around different current ratios (for example the automotive industry will have a lower Current Ratio compared to the construction industry). However, generally speaking a Current Ratio between 1 and 1.5 is ideally liquid (more current assets than current liabilities) whilst a Current Ratio below 0.5 (twice as many current liabilities than current assets) is at risk of defaulting on their debts and a Current Ratio above 3 indicates that management are not efficiently utilising debt. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• The Current Ratio can identify companies at risk of defaulting on their debts (a bad year with a lot of debt can mean payments are missed).
• The Current Ratio can identify when management is debt adverse (which can be good or bad depending on the company. Generally however, underutilisation of debt can mean a business is either missing opportunities or relying on equity from shareholders/operations).

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Each industry operates in a different way, meaning standardised Current Ratios can paint an unwarranted negative picture.
• Current Ratios do not identify the terms of the current liabilities and the payment plans associated. Just because the current ratio is low doesn’t mean a company cannot pay its debts. Conversely, just because a current ratio is high doesn’t mean a company is being inefficient with debt if the interest payments would be excessively high.

Net Debt-to-Equity Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? The Net Debt-to-Equity ratio is calculated by subtracting cash from total debt and dividing this by the book value of equity. This ratio indicates what proportion of equity and debt the company has been using to finance its assets (a.k.a. how leveraged a company is). 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Leverage, when managed appropriately, can help a business grow however, if a business is over-leveraged it is at greater risk of being over-burdened by the debt. As such, a company with a Net Debt-to-Equity ratio over 1 should be considered risky and a ratio above 0.5 would require further investigation to understand the reasons for the leverage (is it mostly short-term debt?). The name of the game is lower equals better and a negative ratio is spectacular. Should the Net Debt-to-Equity ratio be negative then the company has net cash (i.e. cash at hand exceeds debt). 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• Understanding the Net Debt-to-Equity ratio enables investors to understand the risk associated with the company’s debt burden.
• Being a bit of a traffic light system (Red=Avoid, Amber=Investigate, Green=Go), risk adverse investors can quickly dismiss those that flash red should they wish to avoid debt heavy companies.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• The Net Debt-to-Equity ratio does not identify the type of debt (long or short term), payment plan or interest rates incurred, therefore those identified as highly leveraged may only be so due to debt which is due to be paid off in 12 months or has a long term, low interest repayment plan in place.
• Additionally, should a company rely on retail space, long-term capital leases may make up the majority of the “leverage” identified.

Return On Invested Capital (ROIC) vs Weighted Average Cost of Capital (WACC)

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? We looked at ROIC in part 2 of this series. The Weighted Average Cost of Capital, or WACC, is the average cost of capital from all sources including stocks, bonds and debt. The way in which WACC is calculated is very complex however details have been provided in the link at the end of this post. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? As you will likely remember value investors pay particular attention to the Return On Invested Capital of a stock as this provides a strong indication of the return take can be achieved from an investment. Whilst ROIC is extremely important many investors forget a very important step, understanding the cost of capital in the first place. For instance, an ROIC of 10% is great however if the Weighted Average Cost of that Capital (WACC) is 11% the real return is -1% (the company is destroying value, not creating it). Therefore, we should focus on companies with a higher ROIC than WACC correct? Well, yes, however measures of ROIC and WACC can both be inaccurate as they are both measured as a snapshot in time. As such, to ensure value is being created and not destroyed we should take to precautions: 

• We should calculate the 5 or 10yr average ROIC and WACC for comparison (this will normalise the results; and
• We should give this measure a margin of safety, say 2% (a.k.a. the ROIC should be 2% above the WACC to ensure value is being created and not destroyed).

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• Knowing that the 5/10yr average ROIC is more than 2% greater than the 5/10yr average WACC long term investors are reassured that good decisions are being made and that any investment made will not be wasted by management.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• A number of assumptions are made when calculating the ROIC and WACC which can cause issue with their comparison (this is why we have a 2% margin of safety).

Cash Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? The Cash Ratio is calculated as the Cash and Cash Equivalents of a business divided by the Total Current Liabilities. This ratio provides insight into a company’s ability to pay off short-term debt with the cash on hand. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? The Cash Ratio takes a picture in time of a company’s liquidity however for long-term investors it is better to review the average Cash Ratio over the past 5- and 10-years. This will show what level of liquidity the company usually runs at. Different industries tend to standardise around different cash ratios. However, generally speaking a Cash Ratio between 0.5 and 1 is ideal as debt is being carefully managed for short-term activities/purchases. A Cash Ratio below 0.3 however can indicate that the company is taking unnecessary risks with short-term debt obligations. Finally, a Cash Ratio of above 1 indicates that the company is over cautious with short-term debt, which is also unflattering to investors looking for growing companies as debt is not being efficiently utilised. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• The Cash Ratio can identify companies taking on too much short-term debt.
• The Cash Ratio can identify when management is debt adverse (which can be good or bad depending on the company. Generally, however, underutilisation of debt can mean a business is either missing opportunities or relying on equity from shareholders/operations).

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• Each industry operates in a different way, meaning standardised Cash Ratios can paint an unwarranted negative picture.
• Cash Ratios do not identify the terms of the current liabilities and the payment plans associated. Just because the Cash Ratio is low doesn’t mean a company cannot pay its debts. Conversely, just because a current ratio is high doesn’t mean a company is being inefficient with debt if the interest payments would be excessively high.

Total Debt-to-Capitalisation Ratio

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? The Total Debt-to-Capitalisation ratio is calculated as the Total Liabilities of a business divided by the Total Liabilities plus the Shareholder Equity. This ratio provides insight into a company’s ability to pay off short-term debt with the cash on hand. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? Another measure of leverage. When managed appropriately, leverage can help a business grow however, if a business is over-leveraged it is at greater risk of being over-burdened by the debt. As such, a company with a Total Debt-to-Capitalisation ratio over 0.6 should be considered risky and a ratio above 0.3 would require further investigation to understand the reasons for the leverage (is it mostly short-term debt?). Again, the name of the game is lower equals better. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• Understanding the Total Debt-to-Capitalisation ratio enables investors to understand the risk associated with the company’s debt burden.
• Being a bit of a traffic light system (Red=Avoid, Amber=Investigate, Green=Go), risk adverse investors can quickly dismiss those that flash red should they wish to avoid debt heavy companies.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• The Total Debt-to-Capitalisation ratio does not identify the type of debt (long or short term), payment plan or interest rates incurred, therefore those identified as highly leveraged may only be so due to debt which is due to be paid off in 12 months or has a long term, low interest repayment plan in place.
• Additionally, should a company rely on retail space, long-term capital leases may make up the majority of the “leverage” identified.

Sustainable Growth Rate

𝙒𝙝𝙖𝙩 𝙞𝙨 𝙞𝙩? The Sustainable Growth Rate is the rate at which a company can grow without the need to take on additional equity or debt. The Sustainable Growth Rate is calculated by dividing the company’s Return on Equity (ROE) by 1 minus its dividend pay-out ratio. The ROE is a percentage expressed by the net income divided by the average shareholder equity. The dividend pay-out ratio is the percentage of earnings per share paid to stakeholders as dividends. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙬𝙚 𝙡𝙤𝙤𝙠𝙞𝙣𝙜 𝙛𝙤𝙧? As the Sustainable Growth Rate is not a fundamental measure of performance we are looking to understand how the company might perform in the near future. Whilst a company will likely take on additional debt and equity, and a raft of unforeseen factors will likely affect a companies future growth, by knowing the Sustainable Growth Rate we can us it to sense check future assumptions of growth for valuation. 

𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙨𝙩𝙧𝙚𝙣𝙜𝙩𝙝𝙨? 

• The Sustainable Growth Rate can be used as a sense check when conducting future valuations of a company.

 𝙒𝙝𝙖𝙩 𝙖𝙧𝙚 𝙞𝙩𝙨 𝙬𝙚𝙖𝙠𝙣𝙚𝙨𝙨𝙚𝙨? 

• The Sustainable Growth Rate assumes the perfect world in which growth is unhindered by factors such a recession, war and innovation (the list goes on).
• Past performance is not indicative of future results.

Final Note

Quantitative analysis is not the be all and end all of traditional value investing. Whilst understanding the numbers behind a business is extremely important, they must always be backed up with solid qualitative analysis and a final thesis. Areas of qualitative analysis are discussed in the 𝘽𝙚𝙮𝙤𝙣𝙙 𝙏𝙝𝙚 𝙉𝙪𝙢𝙗𝙚𝙧𝙨 article, however every investor must develop their own research and decision process to match their own risk/reward tolerance as investing is as much an art as it is a science.