LM06 Financial Analysis Techniques

Part 4

14. Equity Analysis and Valuation Ratios

One of the most common applications of financial analysis is that of selecting stocks. An equity analyst uses various tools (such as valuation ratios) before recommending a security to be included in an equity portfolio. The valuation process consists of the following steps:

• Understanding the company’s business and existing financial profile.
• Forecasting company’s performance such as revenue projections.
• Selecting the appropriate valuation model.
• Converting forecasts to a valuation.
• Making the investment decision to buy or not to buy.

This section, in particular, focuses on the ratios used to value equity. Research has shown that ratios are useful in forecasting earnings and stock returns. Note that this material is covered in more detail in the equity segment of the curriculum.

14.1 Valuation Ratios

Valuation ratios aid in making investment decisions. They help us determine if a stock is undervalued or overvalued.

Valuation Ratio	Formula	Interpretation
P/E		Most often used valuation measure. Prone to earnings manipulation. Non-recurring earnings may distort the ratio.
P/CF		Less prone to manipulation than P/E.
P/S		Used when net income is not positive.
P/BV		An indicator of what the market perceives. A value greater than 1 means future rate of return is higher than required rate of return.

Dividend-related ratios

Dividend-related formulae
Dividend Ratios	Formula	Interpretation
Dividend payout ratio		Measures the percentage of earnings a company pays out as dividends to equity shareholders.
Retention rate	1 – payout rate	Measures the percentage of earnings a company retains.
Sustainable growth rate		Measures how much growth a company is able to finance from its internally generated funds. Higher retention rate and ROE result in higher sustainable growth rate.

15. Industry-Specific Financial Ratios

Ratios serve as indicators of some aspect of a company’s performance and value. Aspects of performance that are important in one industry may be irrelevant in another. These differences are reflected through industry-specific ratios. For example, companies in the retail industry may report same-store sales changes because in the retail industry it is important to distinguish between growth that results from opening new stores and growth that results from generating more sales at existing stores.

Other examples of industry specific ratios include:

• Service companies: revenue per employee, net income per employee
• Hotels: Average daily rate, occupancy rate

Instructor’s Note: ‘Section 16: Research on Financial Ratios in Credit and Equity Analysis’ is not testable and has not been covered.

17. Credit Analysis

Credit risk is the risk that the borrower will default on a payment when it is due. For example, if you are a bondholder, credit risk is the risk that the bond issuer will not pay you the interest on time. Credit analysis is the evaluation of this credit risk. Just as ratio analysis is useful in valuing equity, it can also be applied to analyze the creditworthiness of a borrower.

Credit ratings are based on a combination of qualitative and quantitative factors.  Qualitative factors include an industry’s growth prospects, volatility, technological change, competitive environment, operational effectiveness, strategy, governance, financial policies, risk management practices, and risk tolerance. Quantitative factors include profitability, leverage, cash flow adequacy, and liquidity.

Some of the ratios commonly used in credit analysis are listed below:

Credit Analysis Ratio	Formula	Interpretation
EBITDA interest coverage	*Gross interest include non-cash interest on conventional debt instruments	A high value implies good credit quality.
FFO (Funds from operations) to debt	FFO / Total debt	A high value implies good credit quality.
Free operating cash flow to debt	CFO (adjusted) minus capital expenditures / Total debt	A high value implies good credit quality.
EBIT margin	EBIT / Total revenue	A high value implies good credit quality.
EBITDA margin	EBITDA / Total revenue	A high value implies good credit quality.
Debt to EBITDA		Low debt/EBITDA implies good credit quality.
Return on capital	EBIT / Average beginning-of-year and end-of-year capital	A high value implies good credit quality.

18. Business and Geographic Segments

A business or geographic segment is a portion of a company that has risk and return characteristics distinct from the rest of the company and accounts for more than 10% of the company’s sales or assets. Companies are required to report some items for significant segments separately.

Ratios can be computed for business segments to evaluate how units within a business are performing. Some of the key segment ratios are listed below:

Ratio	Formula	Measures
Segment margin		Operating profitability relative to revenue.
Segment turnover		Overall efficiency of the segment.
Segment ROA		Operating profitability relative to assets.
Segment debt ratio		Solvency.

19. Model Building and Forecasting

Analysts use several methods to forecast future performance. One commonly used method is to project sales and to combine the forecasted sales numbers with expected values for key ratios. For example, by using sales numbers and gross profit margin, one can determine cost of goods sold and gross profit. This method is particularly useful for mature companies with stable margins.

Besides ratio analysis, techniques such as sensitivity analysis, scenario analysis, and simulations are often used as part of the forecasting process.

• Scenario analysis shows a range of possible outcomes as specific assumptions or input variables are changed.
• With scenario analysis, a number of different scenarios are defined and outcomes are estimated for each outcome.
• Simulations involve the use of computer models and input variables which are based on a pre-defined probability distribution.

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