Financial Ratios: Evaluating a Company’s Health and Worth

 

Peter Hand is an investment analyst with the North American Equity Team at Aberdeen Asset Management in Philadelphia. Hand joined Aberdeen full-time in 2010 as a graduate business analyst, having interned with the North American Equity Team in 2008. Previously, he worked as an economist for the Department of Homeland Security in Washington, D.C. Hand graduated with an economics degree from Princeton University in 2009. He sat down with Knowledge@Wharton High School editor Diana Drake to discuss financial ratios and how they help to inform investment decisions.

Below is an edited transcript of the conversation. 

Knowledge@Wharton High School: Peter Hand is an investment analyst on the North American Equity Team at Aberdeen Asset Management in Philadelphia. He’s going to help us understand financial ratios, and what investors should watch out for. Peter, thank you for joining us.

Peter Hand: I’m happy to be here.

KWHS: Before we get into the nuts and bolts of financial ratios, tell us a bit about yourself. What is an investment analyst on the North American Equity Team? What do you do?

Hand: We’re about a dozen people, split between managers and analysts. We have meetings with corporate management teams, either over the phone or in our offices. Sometimes we go to their offices, in the hopes of finding out things that you can’t necessarily discover through [the company’s] financial statements. We want to see if we think the business is investable for the long term and if it’s a business that we want to be involved in.

We have multiple meetings with management teams of companies we hold in our portfolios  [collections of varied investments] as well as companies we don’t hold. We occasionally have meetings with sector-specific analysts, who can give us deeper insights into sectors that we don’t know about. [An example is] the health care sector, where it’s very regulatory-driven, or where a specialist might not know what drives the markets. We have meetings and do in-depth research on companies that we think are investable for the long term.

KWHS: Describe your career track. How did you end up at Aberdeen?

Hand: I first discovered Aberdeen when I was a junior in college. I held an internship with the North American Equity Team. I graduated in 2009 and was unable to get a job in the financial markets. I went down to Washington, D.C., to work as an economist for a year and returned to Aberdeen a year later, which eventually led me back to the North American Equity Team.

KWHS: You had an internship as well?

Hand: Yes, I interned originally in 2008. That was my first exposure to the company.

KWHS: Was that useful in helping you figure out what you wanted to do with your life?

Hand: Yes, absolutely. An internship is an invaluable experience. They say entering college that nobody really knows what they want to major in, or what they want to have as a career track. As you progress through college, you start to figure out what you think you might want to do. An internship is an integral process in discovering [whether or not] a career is right for you. Is this something I could see myself doing in the long term? For me, it was. For me, it was a great experience. I had a great time with the people I worked with. I thought it was a great corporate environment, and that’s what led me to come back.

KWHS: Onto our investment lesson. What are financial ratios?

Hand: Financial ratios are what they sound like. They are ratios of two different metrics that can be combined into one metric to give you a sense of how a company is faring, or how a company compares in terms of valuation [an estimate of what a company is worth] to another company. They are metrics that can be used to help you compare companies across sectors, or companies with competitors, or just get a sense of how companies are performing — how companies are evolving and driving profitability [making money after all expenses are paid].

KWHS: What can they tell you about a company’s performance and its health?

Hand: A wide range of ratios covers different characteristics of companies. There are profitability ratios, which tell you how profitable [companies are]; how much profit they make per dollar of sale, or how much profit they make in relation to the assets [property of some kind owned by a company that has value] they hold, or to the equity [the value of an ownership interest in property] that shareholders hold.

There are debt ratios, which tell you how much debt [an amount owed for funds borrowed] they have compared to how many assets they have. This gives you a sense of how companies will be able to meet their financial obligations going forward, whether that is through interest payments, or if they have convertible securities, where debt can become equity. That changes the way the company can be classified in terms of liquidity [a company’s ability to pay its bills from cash or from assets that can be turned into cash very quickly].

There are ratios where you can compare companies in the same sector to each other, in terms of whether one company is more profitable than the other, or whether one company is fundamentally becoming better than another, based on how the ratios are evolving. They are a means of comparison, for which you really need a benchmark [a standard against which performance can be measured]. Ratios by themselves are not necessarily useful, unless you have something to compare them to – whether it be historical ratios or ratios of another firm.

KWHS: How do financial ratios help inform investment decisions?

Hand: They play an integral role in not only security analysis, looking at an individual company, but also in comparing company A to company B. They give you that ability to say, “Okay, this is how the company has changed through time.” Is it getting better? Are the fundamentals deteriorating? Are we concerned that the company is taking on too much debt and won’t be able to service its debt load?

You can also compare companies to each other. Is one company more profitable than another? Is one better managed than another? You can tell that, based on a company’s return on assets, or return on equity, or gross profit margins [proportion of money left over from revenues after accounting for the cost of goods sold]. You can see how much space a company has to improve, based on how its competitors are faring. You can get industry trends out of these ratios, but also company-specific trends.

KWHS: Is any one ratio more important than another?

Hand:  It depends on what you’re looking at. We [regularly] look at operating margin, which gives you a sense of how much profit a company is making. For each dollar of sales, how much of that is profit for the company? That is one of the underlying drivers of earnings for a company. That, coupled with top-line revenue growth, or how much sales increase every year, is the driver of earnings for any company.

But then you can also look at the company’s debt-to-equity [ratio], which is the total amount of debt, divided by the total amount of debt plus equity, which tells you how much the company owes, or how much its obligations are in relation to its total equity, or total assets. If you look at that and a company’s income, it’s going to give you a sense of how it will be able, going forward, to pay its debt. The last thing you want to see one of your companies do is go bankrupt — be unable to pay off its debts. Keeping an eye on these ratios can [tell you if] this company is going to stay profitable. Can it stay healthy?

If you are looking at valuations, a very common [ratio] is price-to-earnings, or p-to-e, which takes the price of the stock divided by the earnings-per-share. That gives you what we call a multiple. Certain sectors will have multiples that are considered normal. A company that’s trading above normal, unless they have superior fundamental characteristics, would be expected to regress towards the normal multiple. A company that’s below multiple, or below normal, is considered probably a less well-run company, a lower-quality company. People would look for the company to be improving through time, to move up to that multiple.

KWHS: You’ve talked about some of the strengths. Do financial ratios have limitations, as well?

Hand: Yes, certainly. One of the main limitations is that by themselves, the ratios don’t mean much. You have to have some means of comparison, whether it’s the historical ratios from that same company, or the ratios from another company or a set of companies, by which you can compare. If you want to compare company A to company B, ratios are very useful. But if you just look at company A’s ratios at one point in time, it’s meaningless.

Management can also manipulate certain things on the income statement or balance sheet, so they don’t reflect the true state of being. There are ways to defer revenues or expenses into future periods. Management can manipulate these ratios so they appear better than they are, or even worse than they are. [Ratios] are not a guarantee of the actual state of the company.

KWHS: All of this is a lot of information to process. How did you learn it? You didn’t step into this industry and overnight know everything. Has there been a strong learning curve? Who has influenced your career the most?

Hand: It’s an ongoing learning process. I think that’s true for myself and even for the managers who have been doing it for 25 years. The great thing about the industry is that you never stop learning. Covering a dozen sectors and thousands of companies, there’s always something new that pops up that you didn’t know before. Receiving the tutelage of people I work with — the older managers, but also people my age who know things that I don’t know — has been very beneficial. Doing a lot of work on these companies, and putting time into understanding how the market works and how the market evolves over time, is invaluable. It’s a lifelong learning experience.

In terms of people who have influenced me, there could be any number of answers to that question. All the people we work with are keen to provide knowledge that they have to the younger guys like me. They know that we will be the future of this business going forward. They want us to know everything they know about valuing securities, valuing companies, looking across sectors and how the market works in general.

There’s also a wide world of information out there away from work. The Internet is an invaluable resource. There are so many great websites that you can check out, and learn most of what you need to know — at least the formulas, if not the application, for doing these ratio analyses. It is something that you feel you never can master. Things are constantly changing, and the market is never the same from one year to the next.

KWHS: That also keeps it interesting.

Hand: Absolutely. Every day.

KWHS: Thank you for joining us.

Hand: Thank you.

 

Want to comment on the content of this video? Use these questions to start the conversation:

What key insights can you gain by analyzing financial ratios?

What is a multiple?

What are some limitations of financial ratios?

 

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“Ratios by themselves are not necessarily useful, unless you have something to compare them to – whether it be historical ratios or ratios of another firm.”
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