Rational Investing with Ratios (eBook)

Preface 5
Why Do You Need This Book? 5
Ratio Quality and Limitations 5
Accuracy or Trend 6
Comparisons Have Limitations 6
Ratios Are a Beginning, Not an End Unto Themselves 6
Ratios Are Numerous 6
Ratios for Family Businesses and Corporations 6
Enterprise Value (EV) 6
A Touch of Behavioral Finance 7
The Narrative Thread 7
Acknowledgments 9
Contents 10
List of Figures 14
List of Tables 16
Chapter 1: Presentation of Key Financial Metrics and Enterprise Value 19
1.1 The Balance Sheet, Income and Cash Flow Statements 19
1.1.1 The Balance Sheet 20
Liability Versus Debt, Definition and Scope 20
1.1.2 The Income Statement 22
1.1.3 The Cash Flow Statement 23
1.2 The Cash Flows 23
1.2.1 FCFF and FCFE 23
1.2.2 EBITDA 25
1.2.3 Recurring Cash Flows 26
Company Comparison: Bogey or Eagle? 26
1.3 Enterprise Value (EV) 27
1.3.1 Capital Employed and Operating Assets 27
1.3.2 Examples of Capital Employed Calculations 28
The Treatment of Cash and Cash Equivalents Can Be Complex! 29
Conclusions: SGVSL’s Capital Employed 30
Conclusions: SGVSL and SGVSL Excess’s Capital Employed 31
1.3.3 Non-Core Assets 32
1.3.4 Definition of Enterprise Value 33
EV Is Valued at Market Price 34
EV and the Market Value of Equity 35
1.3.5 The EV Concept Applied to Comparable Companies 35
1.3.6 The EV Concept Applied to Real Estate Investments 37
Successive Sales of Real Estate Property Alpha 37
Creation of a New Lot, Beta, Within the Large Tract of Land in 2020 39
1.3.7 EV Equations 40
Market Value of Debt Versus Book Value of Debt 41
Market Capitalization Definition 42
1.3.8 EV Calculation (MTM Accounting) 42
Company SEGA’s EV Calculation 42
1.3.9 EV Calculation (Using DCF Method) 43
On the Importance of Non-Core Assets 46
1.4 Key Takeaways on Key Financial Metrics and Enterprise Value 46
References and Further Reading 47
Chapter 2: Efficiency Ratios 48
2.1 Efficiency Ratios 48
2.2 Inventory Days 50
2.3 Accounts Receivable Days 51
2.4 Accounts Payable Days 52
2.5 Working Capital Definitions 53
2.6 Non-Cash Working Capital Financing 57
2.7 Working Capital Management 60
2.8 Key Takeaways on Efficiency Ratios and Their Limitations 61
References and Further Reading 62
Chapter 3: Key Liquidity and Solvency Ratios 63
3.1 Liquidity Versus Solvency 63
3.2 Key Liquidity Ratios 64
3.2.1 The Three Main Liquidity Ratios 64
3.2.2 Liquidity Ratios of an Illiquid Company 65
Company Omega 65
3.2.3 Liquidity Ratios of a Financially Sound Company 66
Company Sigma 66
3.3 Key Solvency Metrics 67
3.3.1 Net Worth and Solvency Ratios 68
3.4 Case Studies of Three Companies Showing Contrasting Financial Situations 69
3.4.1 The Best-Case Scenario 69
Liquidity Ratios 69
Solvency Ratios 70
3.4.2 The Grey Scenario 71
Liquidity Ratios 71
Solvency Ratios 72
3.4.3 The Worst-Case Scenario 74
Liquidity Ratios 74
Solvency Ratios 75
Solvency at Its Worst! 76
3.5 Key Takeaways on Liquidity Plus Solvency Ratios and Their Limitations 77
References and Further Reading 78
Chapter 4: Debt Ratios 79
4.1 Introduction on Indebtedness 80
4.2 Financial Leverage 80
4.3 Debt to Equity Ratios 81
4.4 Debt Coverage Ratios 83
4.5 Debt Ratios Using Enterprise Value 86
4.6 Limitations of Debt to Equity Ratio 87
4.6.1 Companies with Negative Equity 87
Example: Company Libertee 88
4.6.2 Companies with Large Real Estate Holdings 90
1st Method: Separating Real Property from Operating Assets when Analyzing Debt Leverage 92
Negative Net Debt and Its Meaning 92
2nd Method: Using Non-Core Assets and Enterprise Value 93
4.7 Debt and Industries 95
4.8 Financial Instability 96
4.9 Key Takeaways on Debt Ratios and Their Limitations 99
References and Further Reading 100
Debt and Industries: Balance Sheets Used 100
Chapter 5: Profitability and Performance Ratios 101
5.1 Book-Value Based Versus Market-Value Based Profitability Ratios 102
5.2 Book-Value Based Profitability Ratios 102
5.3 Market-Value Based Profitability Ratios 105
5.4 Case Study (Operating, Financial Performance and Leverage) 110
5.5 Case Study (Forward P/E and EV Multiples) 113
5.5.1 The Forward P/E Approach 114
5.5.2 The Forward EV Multiple Approach 115
5.5.3 Target Market Capitalizations Using the Forward Sector EV Multiple 116
Target Market Capitalization of Company Serenity 116
Target Market Capitalization of Company Bold 117
5.5.4 Conclusion Incorporating the Debt Situation 118
Conclusion, According to the Limited Information Available 118
5.6 Value and Growth Investing 119
5.7 Key Takeaways on Profitability Ratios and Their Limitations 119
References and Further Reading 120
Chapter 6: Case Studies 121
6.1 Brief Introduction to the Case Studies 121
6.2 A Private Company in Trouble: PAB Limited 122
6.2.1 PAB’s Efficiency Ratios 123
Findings 124
Conclusion on Working Capital 124
Inventory Days 124
Accounts Receivable Days 125
Accounts Payable Days 126
Conclusion on Working Capital Days 126
6.2.2 PAB’s Liquidity Ratios 126
Conclusion on Liquidity 127
6.2.3 PAB’s Debt and Solvency Ratios 128
Debt to Equity Ratios (Static Approach) 128
Debt Coverage Ratios (Dynamic Approach) 128
Cost of PAB’s Debt 129
Solvency Metrics 129
Conclusion on Debt and Solvency 131
6.2.4 PAB’s Profitability Ratios 131
EBITDA Margin 131
Detailed calculations 131
Operating Margin 131
Detailed calculations 131
Profit Margin 131
Return on Capital Employed (ROCE, Net After Tax) 131
EV Multiple 132
Detailed calculations 132
Return on Equity 132
Conclusion on PAB’s Profitability 132
6.2.5 Summary and Final Thoughts on Company PAB 133
6.3 Comparison Between Alibaba, Amazon and Walmart 133
6.3.1 Alibaba Group 134
6.3.2 Amazon 137
6.3.3 Walmart 138
6.3.4 Liquidity and Efficiency 140
Formula Used in the Cash Ratio Calculation 140
Formulas and Definitions Used in the Working Capital Calculations 141
Findings on Working Capital 141
Another Meaningful Comparison 142
Workforce Productivity 143
6.3.5 The Debt and Solvency Situation 143
Findings on the Debt and Solvency Situation 144
6.3.6 The Compared Profitability 144
Forward Earnings Methodology 146
Formulas Used in the Forward Profitability Calculations 147
Profitability Findings 147
6.3.7 Summary and Final Thoughts 148
Quantitative and Qualitative Comments 148
Final Thoughts 149
References and Further Reading 149
Webography 150
Balance Sheets 150
Chapter 7: Investment Thesis 151
7.1 Definition of an Investment Thesis 151
7.2 Benefits of an Investment Thesis 153
7.3 Possible Investment Theses for Alibaba, Amazon and Walmart 156
7.4 Market Hedging 158
7.5 Selection of Damaging Behavioral Biases 159
7.6 Key Takeaways on Investment Thesis 167
References and Further Reading 167
Correction to: Rational Investing with Ratios 169
Appendix: List of Key Ratios 171
A Selection of Key Financial Metrics (Chap. 1) 171
A Selection of Efficiency Ratios (Chap. 2) 172
A Selection of Liquidity and Solvency Ratios (Chap. 3) 172
A Selection of Debt and Leverage Ratios (Chap. 4) 173
A Selection of Profitability and Performance Ratios (Chap. 5) 173
General Bibliography, Webography and Further Reading 174
Webography 175
Balance Sheets 175
Index 176