Sunday, January 12, 2014

Limitations of some numbers and ratios

Just a beginner blog of some of the limitations of some numbers and ratios.

PE.

There is limitations if the company you are looking at is highly cyclical. It my be at the peak of the cycle and hence PE is at the lowest, but earnings might fall, and PE increase.

Earnings of core operations might not be that high, earnings might be very high due to revaluation of assets (properties or biological). Palm oil companies have good revaluation of their plantations due to the increasing CPO prices. Such revaluation might be one-off and are unsustainable. 

If you are looking to invest in a good turnaround company, you might still buy into a company with high PE anyway.

So, one might look at the industry and company, and compare average PE with another peer and think about PEG for PE to be useful.

P/B

Not all assets are equal. Freehold properties in SIngapore have a really good chance of appreciation over time, leasehold factories, and machinery (PPE), might need a big discount. Even if you are looking at cash and receivables, you have to consider if the receivable can be collected (ever-increasing receivables increasing at a rate higher than revenue consistently is a red flag), as for cash, is the next capex cycle coming, which will reduce it significantly?

Hence there is a reason why, so many are looking at FCF.

How about ROE?

It can be boasted by increasing bank loans. Also, we should not be too damning or demanding if a company with a good record of profitability and FCF, but start to have low ROE, and ROA because they start to return the cash to shareholder and not piling it back to work because they see nothing worthwhile for the time being.

Yield (Dividends)

Yield need to be seen with payout ratio, track record of payout, and sustainability of payout. If a company is paying close to 100% of FCF or earnings, and have no obvious growth drivers, chances are it might be sustained.

That is why, graham who uses numbers and ratio extensively talk about having qualitative explanation of the numbers. Are the numbers stable, are the operating environment stable. That why his disciples, one of whom is warren buffet, talks about economic moats. Economic moats, according to Pat Dorsey can be wide, or narrow, can be around for a long time or ceded territory to competition after a few years. Porter 5 forces can make one ask important questions and make sense of the long prospectus one is reading.

Anyone, anything to add? 

 

 

 

 

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