How to interpret common financial ratios
There is a veritable alphabet soup of financial ratios that many investors struggle to comprehend and interpret effectively.
At Morningstar we are fundamental investors. We believe that over the long-term the driver or share prices is how a company performs. Simple as that. Great companies will be rewarded for their performance regardless of the level of interest rates or how the overall economy is doing.
There are also many ways to analyse a company’s performance. For a lot of investors, ‘earnings’ are at the heart of fundamental analysis. However, there are a multitude of ratios and measures of financial health that provide insights into future earnings.
Our analyst reports are littered with terms like adjusted NPAT, underlying EBITDA, operating earnings and underlying profit after tax. How as mere mortals are we supposed to understand why these measures are used and the context within which they are used? The first step is reading this article.
Director of Equity Research, Brian Han, explains that there is no single best earnings measure that best encapsulates performance. It all depends on individual company circumstances, the stage of the economic cycle and investor needs.
Using consistent measures for similar companies is the key to comparing performance historically and extrapolating into the future. As investors, we are trying to assess the business and its performance. Of course, all businesses are different. The industries in which they operate are different. Their competitive forces in those industries are different. This means that earnings measures can’t just be standardised across all companies.
For example, EBITDA and margins based on EBITDA. These measures allow an assessment of which companies or industries are operationally more profitable than others.
EBIT and margins based on EBIT allow an assessment of companies in industries that may be capital-intensive (mining, construction) or capital-light (e.g. software and IT companies).
More importantly, all these measures standardise earnings so that investors can apply multiple-based valuation methods and compare stocks, both intra-industry and inter-industry, as well as on a global basis.
So, what are each of these measures of earnings, and when should investors use them?
Standard measures of profitability
The first set of measures can be used for most companies and seeks to isolate different measures of profitability that allow investors to learn more about a company based on management’s proficiency in operating the company. They also provide insights into decisions made around capital structure or how a company is financed, and the amount of assets held by a company. While valuable, all of these measures require context and an understanding of the basics of how a company operates to add value to the decision-making process for an investor.
Earnings before interest, tax, depreciation and amortisation (“EBITDA”)
EBITDA measures a company’s operating performance at the most basic level. Many investors use this as a proxy for cash flow because it removes the non-cash charges of depreciation and amortisation.
Both depreciation and amortisation are non-cash charges that impact earnings and are used to slowly reduce the value of assets held on the balance sheet. Deprecation is used for tangible assets like a building which has a useful life. Amortisation is used for intangible assets that are on the balance sheet and have value but are not a physical asset. An example is a patent or trademark with a limited life. Neither deprecation or amortisation cost a company any cash.
Interest and taxes are both impacted by the financing decisions that a company makes. A company with a heavy debt load would have higher interest payments and different tax outcomes than a company with lower levels of debt.
EBITDA allows an investor to isolate the operating performance of a company. The measure gives insights into how much revenue is generated, and how successful the company is at extracting a profit out of that revenue. EBITDA gives insights into the competency of management at managing cost of goods sold, staff costs and other operating expenses.
This is not to say that debt levels don’t matter or diminish the importance of asset deterioration when they will eventually need to be replaced. However, there is still value in isolating the ability of management to run efficient operations and generate cash for shareholders.
Earnings before interest and taxes (“EBIT”)
EBIT goes a level deeper than EBITDA, by looking into the company’s capital intensity or the ongoing investment required to sustain the business. It looks at how much the company needs to spend on its machines, networks and software development to keep generating EBITDA.
This is an important measure because many companies need assets to generate profits over the long-term. A company like Qantas (ASX: QAN) carries airplanes on their balance sheet as assets. The depreciation of these assets are non-cash charges but eventually they need to be replaced for Qantas to keep making profits.
Net profit after taxes (“NPAT”)
NPAT goes one level deeper still, by looking into the impact of a company’s financial and tax structure. It looks at how much debt the company has as the cost will be reflected in the “net interest expense” line in the profit and loss statement. It also takes into account the tax status of the company as the cost will be reflected in the “income tax expense” line in the profit and loss statement. NPAT is the result after considering these expenses and looks at the overall profit available to shareholders.
Earnings per share (“EPS”)
EPS is the level down from NPAT. It represents how much of the NPAT accrues to each shareholder. For example, if NPAT is $100m and there are 100m shares on issue, EPS would be $1.00. If a shareholder has 1,000 shares, his/her share of the company’s NPAT would be $1,000.
This is an important measure because investors are concerned with how much profit they are entitled to as a shareholder. If overall profit increases but a company issues more shares it will dilute existing shareholders. For example, a company might issue more shares as part of an acquisition. This may increase the overall profit for the company but a shareholder is interested if the acquisition and the resulting new share issuance increased the profits per share.
Dividend per share (“DPS”)
Dividend per share is what the shareholder gets in their pocket after the company’s board decides how much of the NPAT is to be paid out to shareholders. This is called the payout ratio. For example, if the payout ratio is 50%, the same shareholder holding 1000 shares would get $500 in dividends, with the rest of the $500 remaining in the company. This could be used for reinvestment in the business (organic or inorganic) or to strengthen the balance sheet.
Industry and situationally specific measures
There are some industries that require unique views on how a company is performing. In addition, there are certain situations where financial measures are adjusted to reflect unique events. Below is summary of these measures and how investors should interpret them.
Funds from operations
“Funds from operations of AUD 10.74 cents per security looks on track for our full-year estimate of AUD 20.99 cps, and distributions of AUD 8.25 cps are halfway to our full-year estimate of AUD 16.5 cps”
. – Morningstar Scentre Group (ASX: SCG) Analyst Report
Funds from operations is a common earnings measure for Real Estate Investment Trusts (REITs). These vehicles essentially exist to pay out all earnings to security holders as distributions.
Funds from operations are a proxy for distributable earnings, and is the primary number that security holders are interested in. The measure removes non-cash charges such as depreciation which are generally high for REITs given that they hold buildings as assets on their balance sheets. Buildings are typically assets with extremely long useful lives provided they are maintained with the upkeep costs captured as part of funds from operations.
“Adjusted NPAT was USD 13.4 billion, or USD 2.65 per share, down from USD 23.8 billion last year. Adjusted EBITDA fell by about a third to USD 28 billion driven by lower prices and higher costs, partially offset by higher volumes and favourable foreign exchange rates”
. - Morningstar BHP Group Ltd (ASX: BHP) Analyst Report
Theoretically, companies present “adjusted” or “underlying” NPAT and EBITDA to take out non-recurring items such as profit on asset sales, large foreign exchange losses, revaluations, intangible/goodwill impairments, redundancy costs and impact of abnormal events (for example, an earthquake or a flood).
This takes out the “noise” from the numbers, isolates underlying, sustainable earnings that investors can then value, and allow better comparisons with historical numbers to determine how the company is doing.
According to Brian, “Unfortunately, in practice, such adjustments have become rampant, such that ‘adjusted’ or ‘underlying’ numbers invariably just take out any negative elements (which management attributes to external factors) while keeping in any positive elements (which management attributes to its prowess).”
As Brian alluded to investors need to be careful about adjustments made by management. Sometimes these adjustments are warranted and truly reflect one-time events. Some one-time events may be a reflection on poor practices by management such as regulatory fines and can be used by investors to assess the ability of senior leadership to manage complex operations.
Any earnings number that is preceded by “statutory” is a number an investor can actually identify and point to in the consolidated profit and loss statement. The number that you find in the financial statement is heavily influenced by auditors.
Statutory numbers were originally designed to reflect the true picture of company’s earnings, and reflect a true picture of a company’s earnings, taking into account revenue generation, cost structure, operating efficiency and capital structure.
Brian says, “Unfortunately, accounting bodies have run amuck and users of the financial statements (e.g. analysts, investment bankers, fund managers) have gone rogue, so much so that “statutory” numbers have become a sideshow to the main circus of ‘adjusted”, ‘underlying’, ‘normalised’ manipulations, some with good intentions, some with dubious ones.”
How investors should evaluate financial measures
These measures might appeal to different businesses, but ultimately it needs to be underpinned by consistency. You don’t want to see these numbers bouncing around each earnings season, as unpredictability means heightened uncertainty regarding future earnings.
As investors we must always focus on the future. What has occurred in the past is most valuable as a way of trying to predict how a company will fare in the future. There is no substitute for gaining a true understanding of a company to contextualise reported financial results.