Ratio Analysis - A Lesson in FSA

Macro Projections and Top-Down Analysis

Fundamental valuation analysis is typically conducted via a top-down approach. What this means is that in order to ascertain meaningful projections of a firm's ability to make sales, its ability to utilise resources, and service its debt, we need to understand the environment in which it operates. Top-down analysis begins with a survey of the macro-economic environment before drawing down to examine the industry/sector (considering the geographic location, the firm size and whether the firms are of a private or public nature) in which a firm operates. The final part of the analysis involves examining the characteristics of the firm before we finally make those projections.

The macro-economic environment does and will not influence all firms in the same way. There are firms that move with the economic cycle - our struggling retail sector reveals, for example, what a significant downturn in the economy can do to consumer spending. Manufacturing, auotmotive industries and all other industries that esentially rely on the discretionary component of an individuals income will react with the economic cycle. Industries such as pharmaceuticals, health care, and consumer staples will not have the same set of issues to deal with as pro-cyclical firms and therefore are viewed as defensive stocks. Given that the majority of listed stocks that form the composite index vary with the economic cycle over the short-medium term, an understanding of where growth will be in the next six months, the next 5 years and beyond is necessary for our projection of industry sales, firm market share, and ultimately firm sales/revenues.

Some have termed the practice of trying to produce an estimate for future economic growth a voodoo science. We know that it cannot be perfect but we continue to refine our techniques hoping that something will come from it. Nevertheless, there are a number of things that can help us with our analysis.

1) A focus on leading economic indicators - Although components of this measure vary over time they usually include the number of unemployment applications, an evaluation of consumer sentiment, an examination of movements in the stock market (as this market normally leads the broader economy).

2) An examination of the yield curve / spread - We should examine the state of the yield curve - Is it uptrending, flat, or inverted? Is the yield spread (the difference between riskless and risky bonds) wide or narrow? It is your response to these questions that will dictate how you project future economic growth /sales.

3) An examination of CDS market - In this market insurance payments are made by investors against the default of a particular asset. As CDS spreads increase, the likelihood of default increases.

This is but a small list of things that we can use to project what future growth will be. Other less reputatble techniques include the dartboard method, the magic 8-ball, or the ask the taxi-driver for investment advice.

As previously mentioned broader economic growth will generally influence broad industry sales and also the allocation of those sales (i.e. firm market share). Market share tends to fluctuate particularly during periods of significant positive or negative economic growth, since we normally witness greater innovation during strong economic periods and significant asset reallocation during contractionary periods. Things like the concentration ratio, Herfindahl index, and the marketing share ratio can assist us with trying to understand whether, and by how much, market share is likely to change. If we are in an industry where the concentration ratio is high (take the banking industry) it is unlikely that we will see a substantial change in market share over the long term. This should make our projected growth analysis somewhat easier than trying to project growth for a retail company which will experince a change in growth and market share over the long term.

How can we take all this information and translate it into hard numbers? A number of techniques are available for transforming our worldy view of things into numbers used for our valuation analysis. For example, if we wanted to project future car sales for Ford (or Holden if you are that way inclined) for the next 5 years, without consideration for future economic growth our analysis will most likely be unrepresentative of the actual future state. What we can do to correct for this is to try and statistically model the relationship between car sales and growth. The adoption of a regression type analysis, where we regress car sales on growth (or the changes of the variables) and other potentially viable explanatory variables, will assist us in determining the following: if growth were to change by 1% what car sales for the car industry, and Ford will be? The flaws with this technique stem ultimately from the fact that the model may be mispecified, we may have not used the right explanatory variables or we have insufficient data. Again, its not perfect but what is?


Financial Statement Analysis

To take these sales projections and translate them into full-blown projections we need to forecast the efficiency with which a firm will produce these sales. This can be done via a ratio analysis - otherwise known as FSA (Financial Statement Analysis) and can be used by lenders, equity investors, tax practitioners etc...This involves studying the fim's past performance using financial ratios to try and predict future financial ratios. The ratios that we are interested in focus on the firm's efficiency, its profitability, its relative value, its liquidity, and use of leverage. We are therefore intrested in looking at things like a firms gross/net profit margin, its current ratio, its debt/equity ratio amongst other things.

A good ratio analysis will have both cross-sectional and time-series dimensions. A cross-sectional analysis will consider the relative position of a firm in comparison to its industry peers. In this type of analysis the following questions will normally need to be asked:
1) Who are the comparable companies?
2) Where is the firm's multiple (ratio) relative to other comparable companies?
3) What should the firm's multiple be if it were to be in line with comparable companies?
4) Can any abnormal ratios be explained?

A time-series analysis will alternatively try to extract patterns from the firm's historical records. We must be careful to draw projections from historicals, particularly if production, marketing, and financial policies of the firm can and do change over time.

The types of ratios we choose to focus on will vary from firm to firm and industry to industry. There are however, some ratios that are useful in any analysis. For example, the gross profit margin is equal to Gross profit / Sales. These two items can be drawn from the P&L statement with ease, however, we may need to make adjustments if depreciation is allocated to the COGS or SGA. The reason for this is that depreciation is generally allocated by accountants independent of the true relationship between marginal production costs and the value of production. If we truly want to understand the economic relation between operating costs and sales we will need to remove this component. The second thing that is important to examine is the proportion of COGS that is variable and that which is fixed. The gross margin implicitly assumes that there are no fixed costs and if we do not delve further into this relationship we potentially risk overstating future costs. Relying on statistical modelling like regression analysis can potentially help us with future projections in this area.

The final area of analysis covered was the selection of an appropriate tax rate. Tax expenses form an important component of a firm's free cash flows. A question often asked when projecting cash flows is whether the effective or statutory tax rate should be applied. The effective tax rate refers to the actual rate paid. This can be different from the statutory tax rate if a firm is carrying over net operating losses from a previous period, is able to utilise tax shields from depreciation costs or is able to secure some permanent reductions. Generally speaking, most reductions in the tax rate are temporary and for this reason I would advocate the use of the statutory tax in your analysis. This is not to say that you should not consider the use of an effective rate in the short term, but over the long term (terminal period) my preference is the use of the statutory rate.