Universes and Ratios By: Attilio Braga

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Universes and Ratios
By Attilio Braga Rick Taylor
WIC 04-05
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Categorizing Financial Ratios
Financial Ratios can be categorized into one of
four groups, their classification is dependant
on the information they display to the user.

• These four categories are
• 1. Profitability Ratios
• 2. Liquidity Ratios
• 3. Solvency Ratios
• 4. Cash Flow Ratios

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Profitability Ratios

• Profitability ratios measure the income or
  operating success of a company for a given period
  of time.
• Profitability Ratios make use of the statement
  of earnings.
• Examples of Profitability Ratios include
• - Return on Assets
• - Profit Margin

These Ratios help you to make sure you dont
chose Losers
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Liquidity Ratios

• Liquidity Ratios measure the short term ability
  of a company to meet current
• obligations.
• Liquidity Ratios make use of the balance sheet
• Examples of Liquidity Ratios
• - Current Ratio
• - Quick Ratio (aka ACID TEST)

Acid Test!!!
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Solvency Ratios

• Solvency Ratios measure the ability of a company
  to meet long term obligations.
• Solvency Ratios are important to long term
  investors and creditors.
• Examples of Solvency Ratios
• - Debt to Total Asset Ratio
• - Debt to Shareholders Equity Ratio

Michael Milkin Junk Bond King ExCon. Financed
numerous MA transactions through the use of
High Yield debt.
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Cash Flow Ratios

• Cash flow is the single most important aspect of
  a companies financial condition,
• it is important to know how the cash was
  generated and where it is being spent.
• Cash is primarily generated from two different
  avenues
• - operating activities
• - financing activities
• Cash flow ratios calculate additional measures
  of liquidity and solvency.
• Examples of Cash Flow Ratios are
• - cash current debt coverage ratio
• - cash total debt coverage ratio

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Interpretations of Financial Ratios

• The value in financial ratios does not lie in the
  number itself but rather in
• comparisons with other ratios.
• Comparisons can take on different forms, such as
  the following
• 1. Comparison from year to year for the company
  of interest. This
• can demonstrate the direction of change of the
  ratios over a time
• period, possibly leading to an indication of the
  companies financial
• health.
• 2. Comparisons from one company to another,
  comparing your company to the competition.
• 3. Comparisons to a Universe of Coverage

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The Universe of Coverage

• One of the most useful comparisons investors can
  make
• is comparing their companies ratios to ratios in
  a Universe of Coverage.
• A universe of coverage is a collection of
  companies which via some type of
• defining term allots the company either inside or
  outside the universe of
• coverage.
• The universe of coverage can be detailed to
  include only the most direct
• competition providing a better industry average
  than traditional industry
• definitions allow for.
• A universe of coverage is determined by the
  investor allowing him or her to
• dictate what type of companies should be included
  in his comparisons.

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Materials Universe
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The Metrics

• MARKET CAPitalization
• Outstanding Shares x Per Share Price
• Mega Cap Market cap of 200 billion and
  greater Big/Large Cap 10-200 billion Mid
  Cap 2 billion to 10 billion Small Cap 300
  million to 2 billion Micro Cap 50 million to
  300 million Nano Cap Under 50 million
• Market Cap is essentially what a company is
  worth
• ENTERPRISE VALUE
• (Market Cap Debt Preferreds) Cash / Cash
  Equivalents
• Represents an open market valuation of the
  business or enterprise that supports it. Another
  way to determine what a company is worth.

Oracle CEO Larry EllisonOracle has a Market Cap
of 65B, and an EV of 56B
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Value Ratios

• P/Earnings
• P/Sales
• P/Cash Flow
• How expensive is a company?

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Using Value Ratios

• Easy to calculate
• Can predict future share price
• Compare against competitors
• Indicate buying/selling opportunity

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Price-to-EARNINGS (P/E)

• How expensive given earnings
• Derived from Dividend Discount Model
• Higher PE indicates
• Higher company growth rate
• Lower risk rate (consider CAPM)
• Dont get trapped by sky-high PE, unless you
  believe a company will grow 1000

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Price-to-SALES (P/S)

• PE x Net Income Margin
• Never negative
• Less volatile than PE
• Less sensitive to creative accounting

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Price-to-CASH FLOW

• CASH IS KING!
• Greater immunity to accounting magic
• Good metric for companies generating stable cash
  flows (oil, utilities, etc)

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An Example of a Universe of Coverage

• For EnCana, Define the universe of coverage based
  on what qualities you know
• EnCana has as a company .
• EnCana is an independent oil and gas company (as
  opposed to Petro-Canada
• who has involvement in the upstream, midstream
  and downstream segments of
• the oil and gas industry), therefore our universe
  of coverage need only include
• independent upstream oil and gas companies.
• Further information was used in determining the
  universe of coverage for
• comparing EnCana to meaningful competition. In
  the end we defined a universe
• of coverage as Independent Upstream Oil and Gas
  Companies producing more
• than x barrels of oil and gas equivalents per day
  per U.S. dollar.

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Further information regarding the Universe of
Coverage

• So what does this mean for ratio analysis? It
  is fundamentally important to
• compare companies which an investor would assume
  operate under similar
• business conditions.
• For example, comparing hedging contracts between
  a junior upstream oil and gas producer and a
  senior upstream oil and gas producer would have a
  dramatic effect on conclusions drawn concerning
  cash flow. Total liabilities between junior and
  senior producers may not vary in the same degree
  as total
• assets (due to hedging).
• Furthermore, a universe of coverage defines
  industry in much more specific way, just as it
  would be ridiculous to compare an oil and gas
  company to a software company, it would be
  ridiculous to compare junior and senior oil and
  gas producers.

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Further Ways to Make Interpretations more
Meaningful
Given that we have defined a universe of
coverage, what else can lead to misinformed
results?
Accounting procedures can dramatically affect
the results of the ratios and their meanings. In
order to further improve our comparison we need
to improve the comparability of the ratios.
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Increasing Comparability

• The value of the ratios do not actually lie
  within the number,
• but rather in what the number represents. We
  need to change the components
• of the ratios so that include the same elements
  and do not include extras.
• This information can primarily be found in the
  notes to the financial statements.
• For example, hypothetically imagine the
  following circumstance. American airlines has
  acquired its fleet through various financing
  projects and cash contributions, they then record
  the airplanes as an asset and depreciate them
  accordingly. Now Imagine that Air Canada has
  decided to lease its fleet and record the cost of
  their Fleet as an expense. You would therefore
  need to adjust some numbers to ensure that your
  comparison is accurate.

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Summary
Financial Ratio Analysis should play a key role
in any investors decision making process, but the
results of these ratios can be improved
by allocating a Universe of Coverage and making
elements of ratio computations more Comparable.
And Remember