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Numbers jungle unfurled - Views on News from Equitymaster
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  • Nov 21, 2000

    Numbers jungle unfurled

    With improvement in technology there is a whole load of financial information now easily accessible. In fact, users now have access to content that probably analyse the stocks to death. So before it kills you, Equitymaster.com has attempted to identify some key ratios and what they signify to help you traverse the numbers jungle alive.

    Operating Profit Margin (OPM)

    OPM = EBIDTA / Sales * 100

    EBIDTA = PAT + interest + depreciation + tax

    Company Sales
    (Rs m)
    Profit (Rs m)
    ACC 31,385 1,688 5.4%
    Madras Cement 4,977 1,316 26.4%

    The operating profit of a company is calculated as the earnings before interest, depreciation, tax and other amortisations. OPM is the acid test of a company's operating efficiency. In can be compared across companies in an industry to identify the lowest cost producer. However, it may not give a fair picture when compared across industries.

    Company Sales
    (Rs m)
    Profit (Rs m)
    Guj. Ambuja 13,025 3,693 28.4% 12.9%
    Hind. Lever 109,176 12,201 11.2% 9.8%

    Both these players are leaders in their respective fields. However, the numbers indicate that Gujarat Ambuja is more efficient than Hindustan Lever Ltd. (HLL), which is not necessarily true. HLL has to incur substantially higher costs in the post manufacturing stage. This includes packaging, distribution and advertising expense (advertising / sales = 7%). Although, Ambuja incurs costs under similar heads, in percentage terms these heads constitute a smaller fraction of its costs (advertising / sales = 1%). Therefore, across industries the OPM may not show the real picture.

    At the net profit level the margins are almost the same between HLL and Ambuja. Being an asset intensive company, Ambuja incurs higher post operating expenses in percentage terms i.e. depreciation and interest. The company's capital requirement will be more to set up an asset base. Consequently, it will incur higher depreciation costs on these assets and incur higher costs for servicing its capital.

    Return on Net Worth (RONW)

    RONW = PAT / Networth * 100

    Networth = Equity capital + Reserves + Preference capital

    RONW is a measure of the return on shareholders funds. It reflects the efficiency with which the management has utilized the shareholders funds that are at its disposal.

    Company PAT (Rs m) Networth (Rs m) RONW
    ACC (589) 10,456 -5.6%
    Gujarat Ambuja 1,686 15,075 11.2%

    Intra industry comparisons will highlight companies with better operating efficiencies and consequently, managements that have been able to utilize shareholders fund more efficiently.

    Company PAT (Rs m) Networth (Rs m) RONW
    Gujarat Ambuja 1,686 15,075 11.2%
    Hind. Lever 10,699 21,033 50.9%

    However, inter industry comparisons prima facie will not exhibit a true picture. At a more discerning level it brings forth certain characteristics of the businesses.

    • To set up a cement plant Gujarat Ambuja needs to invest more heavily in assets. It needs to achieve economies of scale to remain competitive. Consequently, its business model is less scalable and its requirement for initial capital will be higher. HLL on the other hand will need to spend heavily on building brands. However, the model is more scalable. It can test market a product and then undertake a gradual national rollout. Therefore, the expansion can be funded by internal accruals and consequently, the initial capital requirement is lower.

    • The difference in returns also shows that as an industry the fast moving consumer goods (FMCG) business is more lucrative than the cement business. HLL is in a 'product' based business, in the retail segment and meets the impulsive demand of consumers, which enables it to command higher margins. Ambuja on the other hand is in the commodity business, in the wholesale (bulk buyers) segment and demand is cyclical (economy dependent).

    Return on Invested Capital (ROIC)

    ROIC = EBIT / Invested capital * 100

    Invested capital = Equity capital + Reserves + Preference capital + Long and short term debt

    Company EBIT
    (Rs m)
    Capital (Rs m)
    ACC 1,029 25,330 4.1%
    Gujarat Ambuja 2,941 26,899 10.9%

    Invested capital is the capital employed in the business. ROIC is a critical parameter in analyzing companies. It reveals the efficiency with which the management has been able to utilize the entire resources that are at their disposal. The factors guiding RONW also hold true for ROIC.

    Company EBIT
    (Rs m)
    Capital (Rs m)
    Gujarat Ambuja 2,941 26,899 10.9%
    Hind. Lever 10,923 22,805 47.9%

    ROIC tells the company the return it earns from the business before it can service its capital. This investment return percentage can be analysed along with the cost of servicing the capital invested. The resultant spread between the two percentages will indicate the economic profit / loss percentage attained by the business. It will give an indication of the esoteric economic value added (EVA) earned in percentage terms.

    Debt to Equity Ratio (D/E)

    D / E = Total debt / Equity shareholders funds

    Total debt = long + short term debt

    Equity shareholders funds = equity capital + reserves

    One can dig a little deeper to determine the constitution of the company's capital, which reveals the proportion of debt and equity shareholders funds carried on its books. It will reveal the leveraging capacity available with the company.

    Company Total Debt (Rs m) Equity-
    funds (Rs m)
    ACC 14,873 10,456 1.4
    Gujarat Ambuja 11,824 15,075 0.8
    Company Total Debt (Rs m) Equity-
    funds (Rs m)
    Gujarat Ambuja 11,824 15,075 0.8
    Hind. Lever 1,773 21,033 0.1

    However, the ratio should not be looked at in isolation but along with the interest coverage available with the company.

    Interest Coverage Ratio

    Interest Coverage Ratio = EBIT / Interest charges

    Company EBIT
    (Rs m)
    charges (Rs m)
    EBIT / Interest
    ACC 1,029 1,618 0.6
    Gujarat Ambuja 2,941 1,255 2.3
    Hind. Lever 10,923 224 48.8

    At a more discerning level it not only signals the extent to which the company can leverage its equity but also indicates whether the company is enjoying cash profits.

    Dividend Yield

    Dividend Yield = Dividend per share / Market price * 100

    Many a times the yield can put a floor to the price of a stock. An important point to remember is that dividends are tax free in the hands of the investor. Hence, the effective yields - based on the investors tax bracket - to that extent are higher. The yield assures a steady stream of income (like a fixed income security) while it also makes available the benefits of any upside potential.

    Company DPS
    Price (Rs)
    DPS / Market
    Gujarat Ambuja 4 141 3%
    Hind. Lever 3 184 2%
    Hind. Petroleum 11 139 8%
    Castrol 20 204 10%

    However, the sad part is that there could be a downside to the stock, which will eat into the effective yield. Therefore, a more in-depth study of the company is required. The investors should ascertain and satisfy themselves that the fundamentals of the company remain strong and it can continue to sustain paying dividends.

    Such a scenario is applicable to utilities, which witness strong earnings growth but as penetration levels saturate the growth rate slows down. However, the utility continues to enjoy strong earnings and accumulates cash, which can be distributed to the shareholders. Consequently, these stocks have higher dividend yields.

    Price to Earnings Ratio (PER)

    PER = Market price / Earning per share (EPS)

    EPS = (PAT - preference dividend) / shares outstanding

    This is the mother of all ratios. It suggests how many times current earnings the stock price is trading at. Therefore, at a more discerning level, it indicates the number of times the company's earnings an investor is currently willing to pay for the stock. It also reveals the return the company will earn on the price paid by the investor to become a part owner in the company. Therefore, the investor must ask what return do I expect for being a part owner in the company?

    Wipro at Rs 9,000 was trading in excess of a multiple of 850x FY00 earnings. At that price the company would be able to earn a return of 0.12% on the amount invested for acquiring part of the ownership. Is it worth it?

    Company Market
    Price (Rs)
    Madras Cement 4,418 333 13
    Gujarat Ambuja 141 29 5
    Hind. Lever 184 5 37

    Comparing the PER across industries will not give an accurate picture. One of the determinants of the ratio is the growth in earnings, which will vary across industries and consequently, the PER's will be different. However, intra-industry comparison will illustrate how pricey the stock is vis--vis its industry peers. Therefore, it will highlight the comparative valuations of companies.

    These are some of the key ratios one would like to look at when researching on a company. The article should help you overcome the impediments of the numbers game.



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