Friday, October 2, 2015

Financial Models, Ratios: Updating Them

Analysts and researchers should understand when it's time to adapt and update their financial models when they analyze companies
Working Capital/Sales, 
Market Value/Book Value

Financial ratios. Financial models.

MBA's, who have labored in finance courses and are headed into long careers in corporate finance, know all about them. Analysts, associates, researchers, and deal-doers at investment banks, corporate banks, private-equity firms, and asset-management companies are smothered by them.

Are the same financial ratios and calculations financial analysts have used for generations still useful? With new businesses and new industries sprouting all over the business landscape and with companies expanding desperately into new markets and countries, are the same techniques still relevant?

Financial ratios drive home the conclusions financial analysts make. They use popular ratios and calculations to describe the financial health of the companies they analyze. They use them to confirm the values of companies.  They use them to help decide whether to lend or not lend, invest or not invest, merger or not merge.

Ratios tell a financial story of what’s going on or what will or could happen to a company’s ability to make money, pay down debt, and reward investors with stable dividends. Sometimes analysts use them carelessly or in rote fashion, not always understanding thoroughly what they mean. Some ratios are self-explanatory. Some are tricky, misunderstood, or misinterpreted. Others convey different messages at once.

Shrewd analysts go beyond the definitions to grasp what they mean: What do they convey? How do they help in assessments of profitability, liquidity or leverage? How might they be flawed? What factors do they neglect? When should they be revised or adjusted? For what industries are they most relevant?

Analysts (credit analysts and equity analysts) nowadays analyze large, complex companies in global industries or in businesses that didn’t exist a generation ago. What ratios, therefore, should analysts use to describe activities for Internet and telecommunications businesses or for financial institutions that trade exotic financial instruments?

Old Companies, New Companies, New Industries

What special ratios are applicable for companies like Google, Facebook and Twitter, all companies not even two decades old? What ratios might explain the business models of companies like Groupon, Zygna, Uber, and Yahoo? How do companies like Amazon, eBay, PayPal, AT&T and NetFlix translate business activity into real cash flow?

The companies under review could be old stand-outs like Coca-Cola, IBM, Boeing, General Mills or Exxon. Or they can be new companies like Twitter or struggling ones like J.C. Penney or Sears. What ratios or financial techniques explain best whether these companies have adequate cash to make debt payments and deliver handsome returns to investors—now and in the years to come?

What ratios, financial models and analytical methods show how some companies have resources to meet debt payments, pay dividends, repurchase stock, and commit to capital expenditures to ensure long-term growth?

For example, is cost of goods sold (relative to total sales, CGS/Sales) applicable to Internet companies like Yahoo, Google and Twitter? Are there raw-material purchases and inventory for these kinds of companies?

What does the popular ratio, Debt/Ebitda, used to assess many syndicated loans and debt transactions really mean or imply? Is it a fair, realistic assessment of a company’s leverage? Why is it a sometimes preferred a benchmark when comparing debt levels with peer companies?

What does the analyst do when valuing all those Silicon Valley start-ups with no history of earnings, no cash flows to speak of, but all with great promise, engineering marvels, and innovative products>

How useful is the customary quick ratio (Cash/Current Liabilities) in measuring a company’s liquidity? What if some of that cash resides in foreign countries, subject to high repatriation taxes, or is cash “encumbered,” set aside or pledged for other purposes (e.g., collateral or required capital expenditures)?

Or what does it matter if a company has cash to meet all short-term debt, but shows few signs of revenue growth to meet long-term obligations and to help boost market valuation?

How does an analyst grapple with a hedge fund with unregulated amounts of leverage, derivatives exposures, and “short” trading positions?

When faced with complex, evolving, and growing companies in new industries, what approach should the analyst take? What if the company is old and stumbles to generate any sufficient amount of cash, still convinced that obsolete ways and old products can still lead to sales growth?

Time to Update Models and Ratios

Whether the company is old or new, struggling or surging, those who are responsible must be willing update their models. They should:

(a) know what financial ratios mean or how they can be useful or relevant,

(b) understand what financial messages or signals they convey,

(c) understand how they apply to a particular industry,

(d) revise them, when necessary, based on the industry or the company’s business model,

(e) understand how ratios are occasionally incomplete, flawed, or not meaningful,

(f) avoid drawing bad conclusions or making false inferences,

(g) create new ratios or approaches if they explain a company’s business better

As companies (borrowers) grow globally, expand and become more complex, analysts must be willing to adapt and change their ratios and financial models to find the best way to capture the essence of financial performance. That might mean discarding some familiar ratios and techniques or revising the analytical framework as necessary.

They should do the same when they encounter a new company in a new industry, delivering the product (likely a technology gem) or service that didn’t exist a few years ago. Uber, for example, only few years old, might require different ratios and techniques to explain how it manages costs, generates cash flow, and reinvest earnings. Airbnb, another new company, may require different approaches to explain its financing needs and explosive growth.

In an analysis of a company like Facebook, who are the real “customers”—those who use the service or those who place ads and contribute advertising revenues? For companies like Coca-Cola or Pepsico, what ratios explain whether their operating models of franchised bottling companies are working efficiently?

For pharmaceutical companies like Pfizer or Eli Lily, are there R&D-related ratios that prove that related expenses will eventually yield soaring revenues, high profit margins, and high returns to shareholders?

For companies with operations around the world, what ratios or approaches prove their business activities are properly hedged or show that their cash reserves are trapped abroad because they hesitate to repatriate them homeward?

As borrowers grow, tap into new markets and customer bases, take advantage of revolutions in technology and as debt deals get larger and more complex, analysts must keep up, too. As new companies are formed in new industries, analysts must be prepared.

Always be willing to adapt, revise, change or take a novel approach.

Tracy Williams

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