Equity analysis focused on valuation which involves: (a) understanding the business, (b) forecasting performance, (c) selecting valuation model, (d) converting forecasts to valuation, and (e) making an investment decision. Ratio analysis is useful in the first two steps.

Valuation ratios

Analysts often use valuation ratios to work out the relative value of a company’s stock.

Popular ratios are price to earnings (P/E), price to cash flow (P/CF), price to sales (P/S), and price to book (P/BV) which are calculated by dividing the current stock price of a company its earnings per share (EPS), cash flow per share, sales per and book value per share respectively. Analysts may also work out many per-share quantities, such as basic earnings per share (EPS), diluted EPS, dividend per share, etc. which are calculated by dividing relevant quantities by weighted average number of shares.

Price to earnings (P/E) ratio tells us the price of earnings, i.e. how many dollars an investor is paying per dollar of earnings. Other price-multiples can be interpreted similarly. Since earnings are sensitive to estimates and judgments, price to cash flow ratio may be used, particularly where the earnings quality is low. Where earnings and/or cash flows are negative, P/E and P/CF are meaningless. In such situations, the price to sales ratio is useful.

Analysts may also use price to book value (P/B) ratio which is an indicator of investor perception about a stock. A P/B of 1 means that investors believe the company’s assets to be fairly valued, but a ratio lower than 1 means that investors value the future prospects of the company highly.

Dividend ratios

There are many ratios that help in analysis of a company’s dividend policy. The dividend payout ratio is calculated by dividing dividends by earnings or dividends per share by EPS. Since dividend per share is typically fixed (because companies tend to keep dividends stable), dividend payout may fluctuate. Retention rate/ratio equals 1 minus dividend payout ratio. It measures the percentage of earnings that are not distributed to shareholders. Retention rate is an important determinant of a company’s sustainable growth rate which equals retention rate multiplied by return on equity:

$$ SGR=(1-DPR)\times ROE $$

Business risk and industry-specific ratios

Analysts often assess business risk by calculating coefficients of variation of sales, operating income, etc. which are calculated by dividing the standard deviation of each metric by its average. For example, the coefficient of variation of sales equals the standard deviation of sales divided by average sales.

Many other ratios are used only in specific industries:

  • Financial sector: capital adequacy, monetary reserve, liquid asset requirement, and net interest margin (net interest income divided by total interest-earning assets).
  • Retail sector: comparable store sales, sales per square meter.
  • Service companies: revenue per employee, income per employee.
  • Hotel: occupancy rate, average daily rate (room revenue divided by rooms sold).

Historical research has shown that financial ratios can have predictive power in a company’s equity analysis. Ratios that are useful in forward-looking analysis include price to book (P/B) ratio, justified P/E ratio, etc.

Credit analysis

Credit analysis refers to evaluation of credit risk, the risk that a counterparty would not be able to make a promised payment.

When credit analysis is carried out in the context of acquisition financing, it resembles equity in analysis in that it involves forecasts of a company’s performance. However, a credit analyst focuses on the company’s ability to pay interest payments, meet covenants, etc.

Credit analysis either focuses on the credit risk of a specific issue or the issuer (company) in general. Common approaches to credit analysis include credit scoring, crediting rating approach, etc.

The credit rating process

The credit rating process considers both qualitative factors, such as industry growth prospects, technological change, etc., and on a company level, the risk management processes, governance, etc., and quantitative factors, such as ratios calculated from financial reports. The focus of rating agencies is to see how a company’s business risk translates into its financial risk. In assigning a rating, rating agencies compare ratios of a company with median ratios of the similar ratios calculated for all other companies.

Credit rating agencies make certain adjustments to financial statements, for example, to bring off-balance-sheet financing on balance sheet, etc. Following are a few of the common ratios used in credit analysis:

  • EBITDA interest coverage, calculated by dividing EBITDA by total interest.
  • FFO to debt, calculated by dividing funds from operations (which equals EBITDA minus interest minus taxes) by total debt.
  • Free operating cash flow to debt, calculated by dividing cash flows from operations minus capital expenditures, by total debt.
  • EBIT margin, which equals EBIT divided by total revenues.
  • EBITDA margin, which equals EBITDA divided by total revenues.
  • Debt to EBITDA, i.e. debt divided by EBITDA.
  • Return on capital employed, i.e. EBIT divided by the sum of total debt and equity.

Historical research on ratios in credit analysis

Historical analysis suggests that ratios such as cash flow to total debt, ROA, total debt to total assets, working capital to total assets, the current ratio, etc. have predictive power in assessing a company’s credit risk. Altman Z-score is a combination of different ratios that can correctly predict financial distress. Z-score combines working capital to total assets, retained earnings to total assets, EBIT to total assets, market value of stock to book value of liabilities, and sales to total assets ratios.

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