Updated: May 14
Welcome back to our "Ratio Analysis 101" series. We concluded our last article on liquidity and solvency ratios by elaborating their significance to lenders. The return and valuation ratios we are discussing in this article are generally more applicable, but not exclusive to shareholders. If you recall, the ultimate aim of corporate finance is to maximize shareholders' value! But what is value and how do we measure it? What is the role of return in valuation?
Keen to find out more? Without further ado, let's commence our journey into the world of return and valuation ratios! Do feel free to leave a comment or like.
TABLE OF CONTENT
Understanding Return Ratios
Return I - DuPont Return of Equity
Return II - Dividend & Capital Gain
Return III - Degree of Leverage
Valuation I - P/E Ratio
Valuation II - P/B and P/CF Ratios
Valuation III - EV/EBITDA Ratio
UNDERSTANDING RETURN RATIOS
It is important for internal and external users of the financial statement to define value and identify the factors that drive value. Returns generated from the business is one of the crucial determinants of value. Return measurement is important as we live in a capital market that is dominated by supply and demand where shareholders are the supply side. Other than the companies in their investment portfolio, there are also many other firms and funds that are hungry for their capital. So businesses compete for capital and capital tends to gravitate towards those with more attractive return/risk trade-offs.
If a manager fails to generate returns in excess of cost or lower than market returns, it drives investors away and starves the business from much-needed capital needed to operate and expand. We will focus on a 3 categories of ratios that we find more significant.
For example, Donald is an investor of Lei's Odyssey Inc., a maker of sleek augmented-reality glasses. In a bid to obtain additional financing to expand its R&D program and production capacity, it decides to seek an additional round of fundraising. He receives a proposal and a copy of the company's latest financial statements.
RETURN I - DUPONT RETURN ON EQUITY
The simple Return on Asset (ROA) ratio measures how well the business is using its assets to generate returns. As the sum of assets is the total of liabilities and equity, the ROA ratio also computes the returns on capital. Lastly, averaging of the denominator is done to make the formula more consistent as the denomination measures asset at a single point in time while the numerator is measured over a period of time.
The general rule of thumb is that formulas should be simplified. However, when working with the DuPont ROA ratio, its expanded form helps one yield insights on return by decomposing the ratio into its 2 return drivers, profitability and asset turnover. As both factors are within complete control of internal users like managers, the ratio is often used to assess their performance. As per usual, return ratios are only meaningful when used in trend analysis by comparing against past and expected results and relative performance analysis by contrasting with peers and the industrial average.
Donald finds out that for every dollar of asset, the company is generating $0.50 of net profit. It is due to the 18.7% net margin and 265.5% asset turnover (amount of sales generated from each dollar of invested assets). So how do the net margin of 18.7% and asset turnover of 265.5% stack against other players in the industry? What is the trend over the past? How it is expected to change in the future? To answer them, Donald should conduct trend and relative performance analysis,
3-FACTOR DUPONT ROE
The 3-factor DuPont Return on Equity (ROE) builds upon the ROA formula by considering the impact of leverage on shareholders' returns. For example, with everything else equal, a 5% ROA on $100 worth of assets generates a return of $5. If the company borrows $100 and invests in the asset, the 5% ROA on $200 asset base will generate a return of $10!
For Lei's Odyssey Inc., for every dollar of equity which comprises of shareholders' investments plus accumulated returns, the business is generating $0.97. A financial leverage ratio of 194.8% also indicates that 49.7% of the company's assets are funded by debt. He examines the finances and finds out that the ratio is higher than the industry average. Donald then reads the prospectus and discovers that part of the proceeds raised will be used to pay down debt.
There is also a 5-Factor DuPont ROE which further expands the profitability portion to generate insights on the effectiveness of the company's tax and corporate finance strategies.
LIMITATIONS OF RELYING ON ROE AT FACE VALUE
Although the ratios provide insights on the sources of returns, it is inappropriate to take ROE at face value without considering its potential shortcomings.
Non-Operating Income & Expense The inclusion of non-recurring incomes and expenses such as gain and loss from an asset sale, property rental income for non-real estate companies, etc, affects the quality of earnings and distorts the ROE calculation. A workaround is to normalize the earnings, recalculate the ROE, and compare against the original ratio to assess the impact.
Negative Net Income & Equity If you combine negative shareholders' equity (from years of accumulated losses) with net losses for the current period, the ROE will return with a false positive.
Shares Buyback A firm buys back shares for corporate finance reasons such as to offset dilution from the exercise of stock options, defend against a hostile takeover, etc. Repurchases decrease equity and increase ROE without an increase in financial performance.
Off-Balance-Sheet Financing Sometimes, the business may intentionally or unintentionally omit "debt-like" obligations from the balance sheet, such as the debt from joint-ventures, factoring arrangements etc, which causes asset and debt to be understated. An answer is to add back them back, recalculate the ROE, and compare against the original ratio to assess the impact.
SUSTAINABLE GROWTH RATE
Assuming that the ROE is not adversely affected the above shortcomings, a manager can approximate the business's sustainable growth rate (SGR) by multiplying ROE with the percentage of earnings that is reinvested in the company. The retention rate is calculated as 1 - Dividend Payout Rate.
RETURN II - DIVIDEND & CAPITAL GAIN
One of the ways to measure the required return for shareholders is by using the Capital Asset Pricing Model (CAPM). The required return by investors commensurate with business risks and the company generates returns to return to them through a combination of capital appreciation and dividend distributions.
HOLDING PERIOD RETURN
When the company has its shares listed on the stock exchange, the price becomes more transparent and is determined by supply and demand. The holding period return (HPR) considers the effects of dividends distributed and capital gain. The HPR should then be calculated at fixed intervals such as on a quarterly basis, using the quoted market price and dividend distributed during that period.
This ratio can also be used to measure the return-generating ability of private companies after they are properly valued. However, as they are not listed and subject to supply and demand forces, the subjective value assigned by the valuer or analyst might differ from its "true" market value. One measure is to calculate the HPR on a range of values generated from scenario analysis, instead of a single value. This way, investors can better appreciate the inherent risk of subjectivity.
RETURN III - DEGREE OF TOTAL LEVERAGE
If you are a regular reader, you would be no stranger to the amplifying effect that leverage has on the company's earnings. The degree of total leverage (DTL) breaks down leverage into its operating and financial leverage elements, enabling users to assess their contribution to the volatility of returns.
DEGREE OF OPERATING LEVERAGE
The Degree of Operating Leverage (DOL) accounts for the level of fixed operating overheads in the company's cost structure and measures how a change in sales can affect the operating profitability (EBIT). The higher the proportion of fixed costs, the more the profit is affected by the change in sales due to the spreading of fixed cost among units.
For example, Donald computes a 1.5x DOL for Lei's Odyssey Inc. and concludes that a 1% change in sales is going to change EBIT by 1.5%. As the business is expected to invest the capital raised in more capacity, Donald expects the operating leverage to increase further. To better assess the impact on sales change, he proceeds to check the sensitivity of past sales level to the general economy and the economic forecast for the foreseeable future.
DEGREE OF FINANCIAL LEVERAGE
The Degree of Financial Leverage (DFL) considers the interest expense, which is a product of the firm's capital structure and corporate finance decisions. It measures how a change in operating profit can affect the earnings per share (EPS), the ultimate amount of earnings that is attributed to each shareholder. The higher the proportion of interest expense, the more the EPS is affected by a change in EBIT.
For example, Donald computes a DFL of 1.25x for Lei's Odyssey Inc. and concludes that a 1% change in EBIT is going to change EPS by 1.25%. As part of the proceeds will also be used to pay down debt, he expects the proportion of interest to decrease, lowering the DFL. The lower sensitivity to a change in EBIT helps lower the risk profile of the business.
DEGREE OF TOTAL LEVERAGE
The Degree of Total Leverage (DTL) measures the effect on EPS by the change in sales by combining DFL and DOL. It is a good measure of the volatility of shareholders' return and is useful when integrated with an accurate sales forecast. However, the DTL is built on the premise that past relationships that drove changes are still valid. So it is important to revise the DTL ratio periodically.
Donald calculates the DTL of 1.875x for Lei's Odyssey Inc. by multiplying 1.5x DOL and 1.25x DFL. A 1% change in sales will result in 1.875% change in EPS. After reading various economic forecasts and examining the past sales performance, he believes that the sales level is going to grow by 10% next year. He expects the EPS to increase by 18.75% in the absence of any corporate finance activities.
Before we move into valuation ratio, let us introduce the concept of valuation. The goal of maximizing shareholders' value requires the value to be defined and quantifiable. Firstly, valuation is subjective and therefore, assigning a value would be impossible without a common vocabulary within the investment community, Secondly, value is also subject to market supply and demand forces, and is therefore affected by behavioural finances to a certain degree.
Value is important to shareholders as they are the owners of the business and the value of their shareholding rises and falls with the company's fortunes. For lenders, they are also interested as they have priority claims on the assets when a company is liquidated, so it is concerned with the potential loss when the firm defaults. There are 3 commonly-accepted methods of valuation.
This method estimates the value of the firm's net assets by firstly attaching a liquidation price to the company's assets, then deducting liabilities from the accumulated liquidation value. It does not consider value-adding "off-balance-sheet" assets such as human capital, branding, the strength of processes that make the organization ticks and worth more than the sum of its parts. The resulting value is a significant discount from the going-concern value, which serves as the "potential loss given default" value and is of special interests to creditors.
This approach measures the company's future ability to generate cash based on the combination of historical performance and market insight. The expected net cash inflows are then discounted to arrive at the value. Thereby, this method is calculated independently of market forces. Due to the number of subjective assumptions needed to forecast financial performances, large amount of resources needed to construct the financial model and plenty of risk management to account for possible scenarios as projected performance is never a certainty, it is typically only employed to value private and unique companies or act as a devil's advocate for a market-derived valuation.
The market approach values a business or an intangible asset relative to other market transactions. For private businesses, the process is more complicated and subjective as the shares are illiquid. To estimate market value, one can use the 3 methods (shaded in grey). This approach is typically the most favoured as it accounts for demand and supply. For public companies, the process is relatively straightforward as the market capitalization represents the value of the firm's equity.
VALUATION II - P/E RATIO
The P/E ratio measures the current share price of a public company relative to its earnings per share (EPS) to measure its relative value. It is one of the most widely-used indicators by investors and financial institutions.
As valuation is a function of the company's future prospects, the use of forward-looking EPS from the earning guidance or financial model is more applicable as opposed to the trailing EPS. Before using it though, it is a good practice to compare the forward EPS against actual EPS, to determine if there is a trend of overestimating or underestimating and adjust accordingly.
SIGNIFICANCE TO MANAGERS
This ratio is also important for internal corporate finance decisions. If the P/E ratio is very high relative to the peer group, it is expensive and detrimental to its liquidity. In response, the manager may declare a stock split or stock dividend to increase the supply of shares to lower the P/E ratio in order to promote its liquidity. Conversely, when the P/E ratio is very low and to prevent the stock from being delisted, the company might repurchase shares to reduce supply and push up the prices. The justified P/E ratio also provides a guide for managers to increase EPS for the benefits of shareholders. Increasing the dividend payout rate, reinvesting in the company to achieve higher SGR, and lowering the required return of equity by improving its fundamentals are ways to increase the P/E ratio.
HOW TO USE THE P/E RATIO?
Donald decides to use the P/E ratio to value Lei's Odyssey Inc. He gathers the P/E of 20 publicly-traded tech firms and arrives at the average P/E multiple of 20x. He then adjusts the P/E multiple downwards to 10x after accounting for fundamental differences. With $2.80 EPS, he arrives at the intrinsic price of $28 per share. As the company has 100 shares, the total shareholding is valued at $2,800.
Find the average P/E ratio for the peer group.
Adjust the P/E ratio (typically downwards) to account for differences.
Calculate at the adjusted P/E multiplier.
Multiply the business's EPS with P/E multiplier to estimate its share price.
LIMITATIONS OF P/E RATIO
Despite the wide adoption of the P/E ratio by the investment community, there are a few significant shortcomings that demand the attention of users.
Earnings Manipulation Knowing the significance of the P/E ratio to the investment community, the ratio has regrettably become the prime target for manipulation for unscrupulous managers. The solution is to first normalize earnings and finally compare the old P/E ratio with the new P/E ratio based on the normalized EPS to assess the impact.
P/E Ratio Offers Zero Insight on Debt A business can take on excessive debt to drive unsustainable growth and putting the company's long-term solvency into question. Unfortunately, the P/E ratio provides zero insight into the level of indebtedness. Therefore, an investor should also view the P/E ratio in context with other financial ratios, such as liquidity and solvency ratios.
P/E Ratio Offers No Indication of Growth It is foolhardy to assume at face value that the P/E ratio is high because of priced-in growth expectations without reasonable basis. One workaround to scale the ratio to growth using the PEG or P/E to Growth ratio. By calculating the ratio and comparing its relative performance, it will help investors better sense of value in the context of growth.
P/E Ratio is Volatile The ratio could be volatile as it is sensitive to the supply and demand for the shares. Instead of taking the P/E at a single point of time, a moving-average P/E could be used when valuing a share as it helps smooth out volatility.
Dangers of Taking P/E Ratio at Face Value We should never take the P/E ratio at face value. If the P/E ratio is high, it could mean that 1) the stock is overvalued or 2) investors are expecting the price to increase due to favourable factors. Contrariwise, if the P/E ratio is low, it could mean that 1) the stock is undervalued or 2) the market is pessimistic about the company's development and has priced-in the downbeat. Some amount of due diligence is needed when analyzing the ratio.
VALUATION II - P/B AND P/CF RATIOS
Price/Book (P/B) ratio is an alternative approach that compares the firm's market value to its book value. The higher the P/B ratio, the more the market values the business. The book value of equity can be measured by deducting liabilities and preferred equity from the asset. Preferred equity which 1) promises to pay preferred dividends for perpetuity, 2) issued without voting rights and ownership, and 3) offers holders priority claim of firm's assets during its liquidation, making it akin to a debt obligation.
BENEFITS AND CHALLENGES OF USING THE P/B RATIO
If the P/B ratio is below 1.0, it suggests that the share is priced below the Book Value Per Share (BVPS), which represents a potentially good buy. But some caveats are 1) the book value of assets is influenced by the company's accounting standard, depreciation and amortization policies which could cause book value to significantly deviate from the market value and 2) the book value does not include internally developed processes and technology, human talent, branding, etc. So it is unsuitable for measuring a service company which has little assets but relies heavily on its human resource capital.
Although the P/B ratio is more stable than EPS, corporate finance activities like M&A, divestitures, debt fundraising/redemption, shares secondary listing/buybacks, etc, distorts the measure and makes comparison challenging. It is also suitable to assess the value of a distressed company that is facing liquidation and a business holding assets that are marked-to-market, such as a firm in the financial sector.
PRICE/CASH FLOW RATIO
Price/Cash Flow (P/CF) ratio is another alternative to the P/E ratio. The cash flow refers to the CFO (Cash Flow from Operating Activities), which is the cash flow derived recurring everyday operating activities by adjusting net income for non-cash items and change in working capital. The metric can be found in the Statement of Cash Flow. Generally, the higher the P/CF ratio, the more the market values the business.
The increase in current liabilities (eg. trade payables) and a decrease in current assets (eg. receivables) equate to higher CFO due to lower level of operating cash outflows. The change in working capital is the difference between the respective current and prior current assets and liabilities. The information can be calculated in the balance sheet or found in the cash flow statement.
MERITS AND SHORTCOMINGS OF USING THE P/CF RATIO
The CFO is less prone to manipulation as the changes in cash have to be reconciled with the organization's bank balance. But it could still be artificially-managed by increasing CFO through unsustainable means.such as 1) misclassifying CFI and CFF inflows as CFO inflow, 2) wrongly categorizing CFO outflows as CFI and CFF outflow, and 3) increase current CFO by delaying the payment of payables and collecting advance deposits at the expense of future CFOs.
The P/CF ratio is generally better used to assess the value of a company with stable CFOs. If we would use a fast-growing organization that is burning up cash fast to grow its business and production capacity, such as a tech unicorn, the ratio would turn up very high, making it very overvalued and possibly, unattractive. Hence, like the P/E, P/B and P/CF ratios have to be viewed in the context of growth and other meaningful return ratios, such as DuPont ROE and DTL.
VALUATION III - EV/EBITDA RATIO
Enterprise Value/Earnings Before Interest, Tax, Depreciation and Amortization (EV/EBITDA) ratio compares the business’s EV to its EBITDA. Functioning as a quick and dirty approximation of CFO, the EBITDA excludes the significant non-cash depreciation and amortization expenses. The ratio is commonly used to measure the relative value of a business (including its equity and liabilities), as opposed to P/E, P/B and P/CF ratios, which only measures the value of equity.
CALCULATING THE ENTERPRISE VALUE
The EV estimates the value of the business if it were to be sold by firstly summing of the market value (NOT book value) of the equity and liabilities, then deducting cash and marketable securities from it. Cash and marketable securities are deducted from the equation as they can be immediately liquidated without significant transaction costs to offset the purchase price.
For publicly-listed companies, the market value of the equity can be approximated first using the P/E, P/B or P/CF ratio to determine its value. The market value of liabilities can be estimated using the price of the bond quoted in the stock exchange or by computing the present value of future repayments. The income approach of measuring value is then done to independently compute a valuation for the firm. The 2 values are then compared against each other to see if they corroborate or contradict against each other.
To use the EV/EBITDA ratio, one should
Calculate the EV for the peer group.
Calculate the EBITDA by adding depreciation & amortization to EBIT
Compute the EV/EBITDA ratios for the peer group and take the average
Adjust the EV/EBITDA ratio (typically downwards) to account for differences.
Calculate at the adjusted EV/EBITDA multiplier.
Multiply the business's EBITDA with the multiplier to estimate the firm's value.
CRITICAL ANALYSIS OF EV/EBITDA
An EV/EBITDA ratio should 1) be compared against the ratios of a peer group and 2) be viewed with DuPont ROE and other relevant financial ratios, along with the accounting disclosures. If the business possesses excellent EV/EBITDA and DuPont ROE ratios, it is indicative that the business has good fundamentals. This ratio is beneficial when an investor or manager needs to value the whole company in preparation for a corporate finance transaction, such as M&A, divestiture, restructuring, fundraising, etc.
However, EBITDA might not be a good proxy for CFO when the interest expense is relatively high or when earnings consist of a significant amount of accruals, such as unearned revenue and trade receivables. Like P/E, P/B and P/CF ratios, it also offers the valuation at a single point of time and therefore, has to be viewed in the context of the firm's future prospects.