The ratio analysis mistakes that we compose here show you once again how a shortcut could bring to an inaccurate conclusion.
In This Issue
Chapter 1: What You Pay, What You Get
Ratio Analysis Mistakes for PER
Remember the old man saying?
Price is what you pay.
That is the market cap.
Value is what you get, it is earnings.
This is why PER is the simplest yet most powerful approach to apply that wisdom. Market capitalization is divided by earnings. The rule of thumb is – like a squat – the lower, the better.
Let’s get closer by taking an illustration.
Suppose you are a newbie value investor and believe that by looking at the PE ratio you could determine whether the stock is undervalued, at a fair price, or overvalued. Someday you find that Disney’s PE ratio drop below its 5 years average. So, you take the conclusion that Disney is undervalued today.
In some cases, that conclusion may not represent the real condition. Here are they:
Chapter 2: PER Under Several Case
Little Examination on Ratio Analysis Mistakes
Case 1: One-Off Revenue
In this situation, a drop in PE ratio (which we call PER in the rest of this article) is contributed by a surge in earnings. It doesn’t necessarily become good news for investors since they should ask, “how long”. A sudden change in earning sometimes due to something that only happens once. For instance, due to Work from Home, people tend to watch online through streaming services like Disney+, thus, bringing a sudden change in earnings. But, after things back to normal. The trend does not have a guaranteed resume.
Thus drop in PER means nothing.
Case 2: Selling Cash Generating Machine
A worse case of a surge in earnings is when the company sells its asset or business division. For example, when GE sells its BioPharma unit to Danaher or when Merck sells consumer healthcare to P&G. Both transactions could impact the income statement and make its earnings suddenly go to the sky. As consequence, the PER could be dragged down, making it looks very attractive.
But it is not.
Mistake 3: Ignoring Debt
Another limitation of PER is its ignorance about debt. In some situations, when short-term debt is bigger than company liquidity, it could force the company to issue another debt bond, trimming the earning even more in the upcoming years.
The Need to Understand Business Model
Even it is simple and powerful, we hope the previous example could show you its limitation. Thus, investors never depend solely on these matrices.
Chapter 3: The Accelerator
Return on Equity is not an Exception when we talk about Ratio Analysis Mistakes
Return on Equity (Then we call ROE in the rest of the article) is one of the most worshiped ratios for investors, especially those who seek growth companies. In the simple term, ROE speaks how much return for every investor money. Your money. In some cases, it doesn’t matter if the PER is high, as long as ROE is also high enough, the premium price will be paid.
If PER measures the distance, ROE is an accelerator one.
But, it is also an imperfect one.
Chapter 4: ROE Under Several Condition
ROE Ratio Analysis Mistakes In Some Situation
Case 1: Manipulating Equity, Buyback
One circumstance that could make ROE seems high is the buyback policy. Buyback (which is continued by deletion of treasury stock) effectively reduces the number of shares outstanding (common stock). Thus, reducing the amount of equity. As consequence, the ROE figures will sky up.
As an illustration, imagine average Joe wants to make his company “Watermelon” goes public through IPO. Joe issued 1,000,000 shares of Watermelon stock and offer it to the public. Since Watermelon has great potential, people are crazy to buy it. By selling that 1 million shares, Joe obtain $1 billion in funding. This $1 billion is the equity and the 1,000,000 shares are share outstanding.
It is investor money.
ROE tries to measure how good the company returns on this money.
Suppose watermelon generates $2 billion in earnings, we have ROE = 2, due to $2 billion earnings divided by $1 billion investor money. Next year, because Joe wants to keep his company more for him, he buys the Watermelon stock back from the investor. Lucky for Joe, some investors are willing to sell theirs. After all the tiring transactions, Joe gets 2,00,000 shares of Watermelon stock. This 2,00,000 share is called treasury stock.
After getting some revelation, Joe then retires his treasury stock. This move makes the existing shares of Watermelon just 800,000 shares – as you guess, the equity becomes less than before. As consequence, ROE climbs, attracting more investors.
But actually, nothing fundamentally changes. A higher ROE doesn’t mean that the company delivers more returns.
Case 2: Ignoring Debt, Same Mistake
What if, Joe not only depends on investor money. What if, Joe, due to his connection with Washington can get a cheap loan? Because Watermelon will be the next Google, Joe could get money easily. For instance, besides getting funding from $1 Billion investors, he also gets a $3 billion loan from his colleague.
What happens with ROE? Nothing.
But if Watermelon just generates $2 billion earnings. Investors should think that it isn’t good as expected before.
Once again we see that without a basic understanding of financial statements could lead us to some inaccurate information. Which, in turn, could lead us to a suboptimal investing return.
Chapter 5: Conclusion So Far
More Ratio Analysis Mistakes Are Waiting
So what we have
- Actually, we have the Price to Book Value ratio, Free Cash Flow ratio waiting. But we avoid making too long articles.
- Back to topic, ratio serves as a precursor, not a sole determinant. The ratio is secondary to secondary things. Why? For us, even the financial statement itself is secondary. The financial statement is a product of qualitative characteristics. This characteristic dictates the instincts value.
- Never invert the step. The first is not the ratio. The first thing to do is understand the business. The ratio is nothing if you know nothing about business.
Investor Corner, Why People love ratio
The same reason why people love DCF.
Because it is simple and accountable. You even do not need to calculate by yourself. You could access Morningstar under the financial or ratios tab. It is much easier than opening the income statement to understand the company operates and what is its recent development.
We tell you, everyone could do it.
To perform fundamental analysis, you need to do more than this.