Magic Numbers

Do professional investors really need another primer on how to analyze a set of company accounts? The examples of Enron, Tyco, and the whole mania of the last bull market suggest they do.

Do professional investors really need another primer on how to analyze a set of company accounts? The examples of Enron, Tyco, and the whole mania of the last bull market suggest they do.

Analysts were only too ready to suspend disbelief in the hope of currying favour with the management of latest hot IPO. And the current level of valuation on Wall Street, and the hype surrounding the Google IPO, suggest that the fever has not really been purged from the system.

My recent book 'Magic Numbers for Stock Investors', John Wiley & Sons (Asia), was really targeted at self-directed private investors, who wanted to increase the odds of picking a good stock and eliminate the possibility of buying a bad one. In it I take 25 key ratios and deconstruct them. We look at what their component parts mean, and where the information is, before putting the ratio back together and working the numbers through a real-life example.

This is, I believe of real relevance to all investors, particularly as new markets open up. Some emerging markets will conform to US or other widely accepted accounting standards: others will not. But just because a company conforms to US GAAP does not mean we have to leave our critical faculties at home. After all, most notorious scandals of the last bull market took place at companies that were, on paper at least, subject to US GAAP.

In fact some of the ratios that serve us best are the simple ones. Most owners of small businesses, with the exception of those that operate on a cash basis, will tell you that there is a world of difference between making a sale and collecting the money you are owed by the customer.

In other words it is cash flow that matters not sales. If cash flow does not match sales, the signs usually show up in ballooning working capital. But there is a simple ratio that can tell us what we want to know. Operating cash flow should always be greater than operating profits. If it is less, it is a sign that creditors are extracting tighter terms or that customers are not paying quickly enough. Neither of these is a particularly good sign.

Similarly as a profession let us lay to rest the idea that companies use pro-forma earnings to make things clearer for investors. The old-style use of pro-forma, and probably the only really justifiable use of it, is in a takeover situation. Here investors need to be shown how the accounts will look, pro-forma, if the two companies in question are put together. Any other use of pro-forma is likely, on the evidence of recent years, to be a way of ignoring any bad stuff and adding in good stuff to make the company more appealing to investors.

The same goes for EBITDA. Many investors, including some professionals, appear to believe that EBITDA is similar to cash flow. It is not. Ignoring interest and tax, as this confection does, is likely to lead to disaster. These are charges that a company has to pay if it wants to stay in business. Ignoring them because they are inconvenient or because they send the wrong message does not make them go away. Even depreciation, though a book entry, does not bear too much ignoring if you need to replace fixed assets at some point in the future.

Finally, for an in-depth look at a company's financial condition, take a look at the Z-score. This ratio has been the subject of exhaustive academic research and is generally considered to be an accurate indicator of creditworthiness. Its basic premise is to add together a number of key items weighted to allow for their relative importance.

The items in question are working capital/total assets, accumulated retained earnings/total assets, EBIT/total assets, market capitalisation/total liabilities and sales/total assets. The precise formula to apply to listed companies is given in my book. A separate formula using the same items is used for private companies.

While this ratio is not suitable for every company, its originator believes that it will signal 85% to 90% of bankruptcies ahead of time. Ignoring a tool like this simply is not an option.

In short I believe that all investors, whether professional or private, need to keep in questioning frame of mind. Simon Cawkwell, a famous short-seller in the UK, believes that company accounts are a tissue of lies unless they can proved otherwise. That view is, I think, a little extreme.

But we all need to keep our wits about us and use a healthy dash of scepticism when picking our investments, or the people we might advise. Nothing is worse for an accountancy or investment bank than being associated with a bankrupt client.

Peter Temple is a freelance financial journalist and author. He worked for 18 years in investment banking and fund management before becoming a full-time writer in 1988. He has written several books about investing, mainly published by John Wiley & Sons (Asia), including the books in the 'Magic Numbers' series. He is currently working on 'Magic Numbers for Bond and Derivatives Investors'.

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