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Module 8Ratio Analysis

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Module 8 - Learning Objectives

• Define key valuation ratios: price to earnings, PEG, price to sales, price to book, and price to cash flow.

• Evaluate stocks using valuation ratios.• Define profitability ratios and use these ratios to

evaluate stocks.• Define management effectiveness ratios and use these

ratios to evaluate stocks.• Define financial health ratios and use these ratios to

evaluate stocks.• Define operating efficiency ratios and use these ratios

to evaluate stocks.• Locate and download financial ratios from a financial

website.

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True or False

• A company with a 10% profit margin is better than a company with a 7% profit margin.

• You should always choose a company growing at 15% over a company growing at 10%.

• A company with $100 million debt is more shaky than a company with $50 million debt.

• A company with a great CEO is always a good investment.

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Financial Ratios

• Valuation ratios tell you whether or not you’re getting a good deal.

• Financial strength ratios let you know the state of the company’s financial health.

• Profitability ratios let you know how the company does on the bottom line.

• Management effectiveness and efficiency ratios tell you how well management is doing.

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Valuation Ratios

• What you pay for every $1 of earnings, sales, book value, or cash flow.

• All other factors being equal, lower valuation ratios tend to perform better.

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Valuation - Price to Earnings Ratio

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Using PE Ratios

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PEs differ by sector and industry.

Price to Earnings Ratio by Sector(First Quarter 2001)

0 5 10 15 20 25 30 35 40 45

Basic Materials

Capital Goods

Conglomerates

Consumer Cyclical

Consumer NonCyclical

Energy

Financial

Healthcare

Services

Technology

Transportation

Utilities

Stock Price Divided by Earnings Per ShareSource: www.multex.com, early 2001

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More recent information

Sector PE Dec 2004

0 10 20 30 40 50 60 70

S&P 500Consumer Discretionary

TelecommunicationsConsumer Staples

MaterialsIndustrials

Health CareEnergy

FinancialsUtilities

Information Technology

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Check out the PE’s of the following companies from Fortune’s 2001 Fastest-

Growing list. Does high growth mean high PEs?

Company Industry 3-year Annual

Growth in EPS PE

Immunex (IMNX) Biotech and drugs. 973% 54 Zomax (ZOMX) CD manufacturer 93% 11 Sonic Automotive (SAH)

Automobile retailer 79% 11

4Kids Entertainment (KDE)

Pokemon licensing, toys and games.

242% 14

Siebel Systems (SEBL)

Customer management software.

155% 58

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PEG

• High PEs don’t necessarily mean high growth.

• PEG used as a measure that combines PE and growth in one number.

• Compare value (PE) for every percent of growth

• The lower the better.

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Calculate PEGs. Which company represents the best value?

• Gateway (GTW), a computer manufacturer, has earnings of -$1.13, a stock price of $6.22 and a projected 12% growth rate for the next five years.

• Dell (DELL), a computer manufacturer is selling for $42 and has earnings of $1.21. Its projected growth rate is 20%.

• Hewlett Packard (HPQ) is selling for $20.58 and earns $1.15 per share. Its projected growth rate is 10%.

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Valutation - Price to Sales Ratio

• Works the same as PE but gives you what you’re paying for every $1 of sales.

• Some analysts claim this is the best ratio to use

• All other things being equal, the lower the better.

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Price to Sales varies by sector or industry

Price to Sales by Sector

0 1 2 3 4 5 6 7 8

Basic Materials

Capital Goods

Conglomerates

Consumer Cyclical

Consumer NonCyclical

Energy

Financial

Healthcare

Services

Technology

Transportation

Utilities

Stock Price Divided by Sales Per ShareSource: www.multex.com, early 2001

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Latest dataPrice to Sales as of Dec 2004

0 2 4 6 8 10 12 14 16 18

S&P 500

Consumer Discretionary

Telecommunications

Consumer Staples

Materials

Industrials

Health Care

Energy

Financials

Utilities

Information Technology

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These companies were all hot in the communications equipment arena during

the technology bull market. Evaluate them in terms of price to sales.

The current market price to sales ratio is 4 and the industry price to sales is 7.

Which would be the best buy based on this ratio?

Company Price to Earnings Price to SalesJDS Uniphase (JDSU) No earnings 6.03

Ciena (CIEN) 99.88 11.85Nortel (NT) No earnings 1.37

Sonus (SONS) No earnings 36.74Juniper (JNPR) 89.5 19.67

Sycamore (SCMR) 222 6.07

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Valuation - Price to Book Value Ratio

• Book value is the net worth (assets minus liabilities) of the company on the books.

• Academic studies show that companies with low price to book value perform better than companies with high price to book value.

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Price to Book Value varies by sector or industry.

Price to Book Value by Sector

0 2 4 6 8 10 12

Basic Materials

Capital Goods

Conglomerates

Consumer Cyclical

Consumer NonCyclical

Energy

Financial

Healthcare

Services

Technology

Transportation

Utilities

Stock Price Divided by Book Value Per ShareSource: www.multex.com, early 2001

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Low price to book (or high book to market) perform better over

the long run

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Find the book value and the market value

• General Motors (GM)• Boeing (BA)• Oracle (ORCL)• Ebay (EBAY)• Citigroup (C)• MCI Worldcom (WCOM)

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Low price to book value and high growth?

Stock screeners can identify stocks by their financial ratios. You decide what kinds of financial ratios you want and they sort through all stocks and give you a list of the ones that meet your criteria. Let’s say, you are looking for stocks with low book value. Are there any companies selling below book value? Low book value might be warranted because of slow growth. Let’s add another criteria: growth of 25%.http://www.morningstar.com

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Valuation - Price to Cash Flow• Similar to PE ratio, what you’re

paying for every $1 cash flow.• Used for established companies.• New companies are not expected to

throw off cash right away.• The lower, the better the value.

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Investors look at supermarkets to throw off cash.

Look at the following supermarket companies.

Which presents the best value based on price to cash flow?

Company Price to Cash FlowKrogers (KR) 10.1SuperValu (SVU) 3.1Safeway (SWY) 13.9Albertson (ABS) 6.8

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Profitability

• Profitability ratios come in many levels.

• Return on sales is the bottom line profitability picture.

• Operating margins leave out taxes.

• Gross margins consider only the cost of the product.

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Profitability varies by sector or industry.

Net Profit and Operating Margins by Sector(First Quarter 2001)

0% 5% 10% 15% 20% 25% 30%

Basic Materials

Capital Goods

Conglomerates

Consumer Cyclical

Consumer NonCyclical

Energy

Financial

Healthcare

Services

Technology

Transportation

Utilities

Percent of Revenues

Operating Margin

Net Profit Margin

Source: Marketguide early 2001

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These are all computer manufacturers. Compare their net profit margins. Which is the most

profitable company?

Company Net Profit Margin (%) Gateway (GTW) 2.6 Dell (DELL) 7.0 IBM (IBM) 9.2 Hewlett Packard (HWP) 6.3 Compaq (CPQ) 1.4

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Here are 5 well-known retailers and their 2000 profit margins.

Find the most recent net profit margin information.

Use www.thomsoninvest.net or www.multexinvestor.com.

How do they compare to 2000 profit margins?

Company Net Profit Margin Gap (GPS) 6.4 Limited (LTD) 4.3 Nordstrom (JWN) 1.9 Abercrombie & Fitch (ANF) 12.7 Talbots (TLB) 7.2

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Management Effectiveness - Return on Assets and Return on

Equity• Return on Assets lets

you know how much the company earns on all the assets it has.

• Return on Equity let you know how much the company earns on its net worth or book value.

• The higher the ratio the better.

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Return on Assets and Return on Equity

vary by sector or industry.Return on Equity and Return on Assets by Sector

0% 5% 10% 15% 20% 25% 30% 35% 40%

Basic Materials

Capital Goods

Conglomerates

Consumer Cyclical

Consumer NonCyclical

Energy

Financial

Healthcare

Services

Technology

Transportation

Utilities

Return on Assets

Return on Equity

Source: www.multex.com, early 2001

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Looking at the return on equity and return on assets for the following

semiconductor manufacturers. Which is the best managed?

Company Return on Assets Return on Equity Intel (INTC) 22 29 Advanced Micron Dev (AMD) 20 40 Micron (MU) 15 21 Texas Instruments (TXN) 17 26 Applied Materials (AMAT) 28 36 Taiwan Semiconductor (TSM) 25 37

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You are a bank loan officer. Evaluate two people for a

$15,000 loan.• Individual A

– Assets = $80,000 – Debt = $60,000 – Equity = $20,000

• Individual B– Assets = $80,000– Debt = $20,000– Equity = $60,000

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Financial Health - Debt to Equity Ratio

• Variety of ratios show whether the company is able to handle yearly obligations

• Debt to Equity ratio gives overall financial health

• The lower the debt to equity, the better

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Drug companies usually have to finance the development of new drugs. Which drug

companies are financially strong? Which are weaker? Use debt to equity ratios to

evaluate these companies. Company Total Debt to Equity Merck (MRK) 0.25 Johnson and Johnson (JNJ) 0.17 Pfizer (PFE) 0.36 Eli Lilly (LLY) 0.53 Astra Zeneca (AZN) 0.08 Schering Plough SGP .35

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Efficiency Ratios

• Revenue per employee or net income per employee - Revenues divided by number of employees or earnings divided by number of employees

• Accounts receivable turnover - Net sales divided by accounts receivable

• Inventory turnover - Cost of goods sold divided by inventory

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Dividend Yield

Sector Dividend Yield Dec 2004

0% 1% 1% 2% 2% 3% 3% 4% 4%

S&P 500

Consumer Discretionary

Telecommunications

Consumer Staples

Materials

Industrials

Health Care

Energy

Financials

Utilities

Information Technology

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High dividend companies perform better over the long

run.

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Analyst Ratings

• Security analysts do indepth fundamental analysis on stocks

• They create financial models and projections of what the stock price will be in the future

• They make recommendations.

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Analyst Ratings

• Buy (also referred to as Strong Buy). The analyst is very enthusiastic about the stock and thinks the price will go up a lot in the next year or two.

• Buy/Hold (also referred to as Buy or Outperform). The analyst likes the stock and recommends that you buy.

• Hold (also referred to Neutral). Prospects for the company may be uncertain and the analyst is not recommending a sell as yet.

• Hold/Sell (also referred to as Underperform). This stock will not do as well as its counterparts.

• Sell. Get rid of the stock now.