How ROA and ROE give a clear picture of corporate health

With all the ratios that investors toss around, it's easy to get confused. Consider return on equity (ROE) and return on assets. (ROA). Because they both measure a kind of return, at first glance these two metrics seem pretty similar. 

Both gauge a company's ability to generate earnings from its investments. But they don't exactly represent the same thing. A closer look at these two ratios reveals some key differences.

Together, however, they provide a clearer representation of a company's performance. Here we look at each ratio and what separates them.

Read more at:
https://www.investopedia.com/investing/roa-and-roe-give-clear-picture-corporate-health/ 

A 4-Step Guide to Growth Investing

Try this social experiment with some of your friends or colleagues who regularly air their views about the stock market. Ask them why they invest in the stock market.

Chances are, they will look at you as if you are an alien from another planet. Most will answer: To make money, of course!

Then you point out that money can be made by selling shoes through the Internet, or by smuggling gold, or by becoming a movie star, or a doctor or a lawyer. Why from the stock market?

You may get the odd well thought out response to that last question; others will hem and haw, and then blurt out the truth: To make some quick money.

That is precisely the wrong reason to enter the stock market. Stocks provide inflation-beating returns over the long-term. For that to happen, stocks need to be picked carefully, and then held for the long-term.

There are two schools of thought about stock investing - value investing and growth investing. Those interested in value investing can go through the 7-Step Guide.

Those interested in finding the 'next Infosys' or the 'next L&T' may like to follow the 4-Step Guide to evaluate growth stocks:-

1. Revenue Growth - ideally the average revenue growth of a company over the past 5 years

2. Profitability - during the initial years of a company's existence, growth may require in-flow of cash through debt or additional equity. Thereafter, it will be operating and net profit margins that will determine growth

3. Efficient use of Capital - two indicators of capital efficiency are Return on Assets (ROA) and Return on Equity (ROE) ratios

4. Industry Position/Competitive Advantage - qualitative assessments about whether a company can continue to grow and outperform.

Read more from this investopedia.com article.

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How to read the Cash Flow Statement – Part 2

In last Tuesday’s post, I had covered the first part of the Cash Flow Statement – Cash Flow from Operating Activities. The next two parts will be discussed in this post.

Part 2: Cash Flow from Investing Activities 

To remain in business over the long haul, a company needs to grow. Without growth, a business will stagnate and eventually die or get acquired. But growth has a price. Cash has to be spent to buy land, machinery and related equipment, build factories and offices, acquire other companies, start subsidiaries or joint ventures, and make appropriate investments.

All of the above comes under Cash Flow from Investing Activities. You don’t have to be a genius to guess that this figure will be a (negative) one for most companies. Many mature companies, particularly those in the FMCG sector, don’t have much need for Capital Expenditure (i.e. spending cash on factories and equipment) because their rate of growth has slowed down.

Ideally, the depreciation amount in the Profit and Loss statement should be less than or equal to the amount of cash being spent in investing activities – because depreciation is meant to cover the notional loss due to wear and tear of the existing plant and machinery. If a company does not continuously spend on upgrading and modernising its facilities, it will not be able to compete with newer entrants who may have the latest technology and equipment.

The definition of Free Cash Flow is:

Cash Flow from Operating Activities – Capital Expenditure

This is a (negative) number for companies in their early growth stage, when cash generated from core operations may be insufficient to cover the cost of capital expenditure. But for well-established companies, positive Free Cash Flow is an indication of financial health. The more positive Free Cash Flow a company can generate, the easier it is for them to expand, acquire, pay dividend or buy back shares, and pay off loans.

Part 3: Cash Flow from Financing Activities 

What if a company has (negative) Free Cash Flow, or still worse, has (negative) Cash Flow from Operating Activities? Where will they get the cash to pay their suppliers, interest to banks for any loans taken, and for growing the business?

They can either resort to more borrowings, and/or issue more shares. If such companies are showing a net profit, then they are also expected to pay dividends to their shareholders. All inflows and outflows of cash due to loans, share issues, share buybacks, dividend payments come within Cash Flow from Financing Activities.

Financial prudence should dictate a company’s growth plans. As a thumb rule for selecting good stocks, about 60-70% of the Cash Flow from Investing Activities (Part 2) should be funded by positive Cash Flow from Operating Activities (Part 1); the balance 30-40% should come from Cash Flow from Financing Activities (Part 3).

Many companies forget the simple adage that one should cut one’s coat according to the cloth. They may even have positive Cash Flow from Operating Activities, but their ambitious growth plans require far more cash than they can afford. They resort to frequent borrowings and share issues in the hope of reaching the top quickly. One or two bad years can bring such companies down to their knees. Pantaloon and Suzlon come to mind.

(Note: The financial health of banks and financial institutions can’t be judged by analysing the Cash Flow Statement alone – because they need to borrow cash to give loans, and invariably have negative Cash Flow from Operating Activities. Price to Book Value and Return on Assets are better measures for such companies.)

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How to use the Market Cap to Sales (or Price to Sales) ratio to value stocks

Before learning when and how to use the Market Cap to Sales (or Price to Sales) ratio, some definitions may be in order.

Market Capitalisation (Market Cap) = Total number of equity shares x Price per share

If the equity capital of a company is Rs 10 Crores and the face value of each share is Rs 10, then the company has issued 1 Crore shares. If the share price is Rs 50 (on a given day), the Market Cap (on that day) is Rs 50 Crores. As is evident, the Market Cap is a number that changes with the share's price.

Why should we be concerned about this number? It represents the total value of the company in the stock market. In other words, if you had a lot of money and you wanted to buy the entire company (which has to be listed in the stock exchange), then you will have to pay an amount equal to the Market Cap, i.e. Rs 50 Crores.

The Market Cap to Sales ratio, also referred as the Price to Sales ratio (P/S or PSR), is calculated by either dividing the Market Cap by the total sales of the previous 12 months, or by dividing the share price by the per-share sales of the past 12 months.

P/S or PSR = Price per share/Sales per share = Market Cap/Total Sales

If the company in our example had sales of Rs 80 Crores in the previous year, its Market Cap to Sales ratio will be 50/80 = 0.625. A ratio less than 1 is considered a sign of 'under-valuation'. Why? It means that for each Re 1 of sales you will be paying 62.5 paisa if you were buying the entire company.

If another company in the same sector has a similar equity capital, but a share price of Rs 60 and sales of Rs 100 Crores, then its Market Cap to Sales ratio will be 60/100 = 0.6. That means, the higher priced share is actually 'cheaper' valuation-wise.

This is an important point for small investors to note. Many say that they have limited capital and therefore, opt to buy shares that are cheaper in price. They end up buying a small cap or mid cap share. Valuation-wise, a higher priced large cap may be a better buy.

Please remember that different sectors have different operating criteria. Some require heavy capital expenditure, others don't. Some sectors have low sales and high profit margins. Others have large sales but low profit margins. The Market Cap to Sales ratio should be used only for comparing companies within the same sector.

Several other ratios, like Debt to Equity, Interest Coverage and Return on Assets, had been discussed earlier. Do we really need to look at another ratio? The Market Cap to Sales ratio is particularly useful in valuing companies which are incurring losses. Because they have no earnings, the more popular valuing metric P/E can not be used.

As a general thumb rule, small investors should avoid loss-making companies. What if an otherwise fundamentally strong sector or company gets into a temporary difficulty and incurs losses? It happened to Tata Motors and Hindalco. It happened to the export-oriented textile sector. The Market Cap to Sales ratio will help to separate the men from the boys.

Many analysts prefer to use the P/S ratio over the P/E ratio, because it is easier to fudge earnings, whereas sales can be more readily verified. That does not mean a 'creative' company like DLF can't fudge their sales figures!

It is best to check both the P/E and the P/S ratios when selecting a company from a particular sector. If both indicate 'under-valuation', then the stock can be included in a 'buy' list. If the indications are contrary to one another, it is an alarm signal that management is probably doing some fudging.

Debt-burdened companies often trade at low Price to Sales ratios. Their sales may not be affected and may actually be growing, but interest and capital repayments may be causing a drop in margins and cash flows. Investors should avoid such 'value traps' by checking the Debt/Equity and Interest Coverage ratios.

(A short exercise for readers: In the recent stock selection exercise, most readers chose Stock 'N' as the best of the three. However, on the basis of the Market Cap to Sales ratios, Stock 'N' is more expensive with a ratio of 0.79. Stock 'S' and Stock 'I' have ratios of 0.47 and 0.46.

Will readers still choose Stock 'N' over the other two? If yes, why? If no, why not?)

What is the Return on Assets (RoA) ratio?

The Return on Assets (RoA) ratio is a measure of profitability of a company relative to its total assets (which includes share capital plus all its short-term and long-term loans). It tells us how effectively and efficiently a company's management is utilising its assets to generate a profit.

There are a few different ways to calculate the RoA ratio (also called the Return on Investment ratio). The simplest is to divide the net profit during a 12 month period by the total assets. In other words,

Return on Assets (RoA) ratio = (Net profit / Total assets) x 100

If the Net profit of a company is Rs 5 Crores and total assets is Rs 100 Crores, then the RoA will be 5%. Another company may earn Rs 10 Crores on total assets of Rs 100 Crores. Its RoA will be 10%. Needless to say, the higher the RoA the better. Which means the company is able to generate more profits with less or equal amount of investment.

An RoA of 15% is considered the benchmark for profitability. But the figure is different for different industries. Therefore, the RoA should be used to separate the men from the boys within an industry or sector - and not used for comparing across sectors.

Why? Let us take a Bharti or RCom. They need to constantly invest in new equipment and towers for growth. Or, a Maruti or Tata Motors that need to innovate and invest in new models and infrastructure. Likewise, for power generating businesses like NTPC or Suzlon; airline companies like Jet and Kingfisher; metal producers. Such companies are asset-heavy. Therefore the RoA ratio tends to be 5% or lower.

Contrast these sectors with some asset-light ones like software services or travel services or brokerages. All you need are some furniture and computers and you are in business. Naturally, the RoA ratio is 20% or higher, because the real assets in these sectors are people.

The financial sector, particularly banks, need to constantly borrow money to loan it out again. So the RoA ratio can be as low as 1%. What is a small investor to do? Avoid banks and manufacturing, and only invest in services companies?

Obviously not. That would be putting all your eggs in one basket. Therefore, use the RoA ratio to find out which banks, or auto makers, or steel and power companies are more profitable than their peers in the same sector.

Some prefer to add the interest expenses to the net profit to calculate the RoA ratio. Others add the working capital requirements to the total assets. Which particular formula to use depends on the type of sector being analysed.

There is another formula to calculate RoA:

Return on Assets (RoA) ratio = (Net profit margin x Asset turnover ratio) x 100

where, Net profit margin = Net profit / Sales

and, Asset turnover ratio = Sales / Total assets

Mathematically, the second formula is the same as the first, but gives us a different view of a business. It shows that profitability can be attained in two different ways. The first is by increasing the net profit margin (by reducing costs, or better still, by charging premium prices - like the Tanishq retail stores of Titan). The second is by turning over your assets many times during the year (a practice followed by discount retail stores, like Pantaloon).

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(Wishing all my blog readers from near and far a very merry Christmas and a happy 2010.)