How to calculate financial ratios used in value investing: a step-by-step guide

Personal finance, Value investing

This is a lengthy post that will go through each step of calculating the ratios used in value investing to find a defensive investment, as opposed to an “enterprising” one, which I’ll save for a later date. For more information, I suggest reading , which is the best book on investing, value or otherwise, that I can recommend. The edition shown here comes with commentary from Jason Zweig that helps show how Graham’s advice applies even to recent times.

The ratios here are taken from those listed in the book in chapter 14, and so that readers can follow along, I’ve selected Gerdau AmeriSteel Corp (GNA) as the example we’ll be using. If you’re not familiar with the company, you can read about it on Yahoo! Financials’ profile page. The only complication this adds is that due to its foreign headquarters, GNA files 40-Fs instead of 10-Ks (for our purposes, they’re the same thing, just called different things due to SEC’s specific regulations governing foreign companies and subsidiaries). I didn’t intentionally choose a foreign-based company, but it was about the only example I could find that met most of Graham’s criteria, which might say something as well about the market right now!

To simplify things, I’ve created a document showing GNA’s most recent annualized financial statements, which I pulled from their 40-F filing for the fiscal year ending December 31, 2005. I’ve highlighted and labeled the particular numbers we’ll be using as well. Keep in mind that just calculating these figures and arriving at attractive numbers is only one of many steps in identifying a good investment, so don’t ignore the rest of the information contained in the 10-K or 40-F.

Value Investing Ratios

Ok, let’s begin. To follow along, click here (launches a plain-text file in a pop-up window) so you can see where on the income statement and balance sheet I’m pulling these numbers from. Also, I’ll be using GNA’s closing price of $9.45 on May 12, 2006 for some of these calculations. I should note also that these ratios also apply themselves best to industrial (as opposed to financial or utility) companies.

Market Cap: Graham’s criteria for a defensive investment is that the market cap be at least $2B, updated for today’s market. (His original amount was $50M back in 1972.) Essentially, he’s trying to keep away from small companies that may not weather changes in the marketplace as well as big companies do. To calculate this, we take the number of outstanding shares times the current stock price. In the event that you can’t find the number of outstanding shares listed in the financial statement portion of the 10-K (or 40-F), you can always find the number on the front page of the report. So, for GNA this gives us:


Market cap = $9.45 x 304,471 million = $2.88B

Current Ratio: Graham required that current assets / current liabilities (also known as the current ratio) be greater than or equal to 2 to ensure a strong enough financial condition. For GNA:


1,551,103 / 435,051 = 3.57

Net current assets / Long-term debt: The second part of testing a company’s financial strength was to ensure that this calculation was greater than or equal to 1. Graham defined net current assets or net working capital as current assets – total liabilities, which is slightly different (and a lot more stringent) than the usual definition of current assets – current liabilities. You’ll find that most companies don’t meet this criteria. As far as long-term debt is concerned, to be conservative, I’ve chosen to include convertible debt. My next step would be to read the 40-F later for specifics on this to determine whether or not this should be included, or appropriately adjusted for. For GNA, this calculation would be:


(1,551,103 – 1,245,432) / (423,737 + 96,594) = 0.58

Earnings Stability: The company should have had some positive earnings for each of the last 10 years. We can check previous years’ reports to find that GNA had negative earnings in both 2003 and 2001, so GNA doesn’t meet this requirement.

Dividend Record: The company should have uninterrupted dividend payments for the last 20 years. Looks like GNA didn’t start paying out dividends until 2005. Then again, this company didn’t turn public on NYSE until 2004.

Earnings growth: Earnings at the beginning and end of the past 10-year period should show an increase of at least 33%, based on 3-year averages. For GNA, I don’t have 10 years of information at my fingertips right now (especially since they bought Co-Steel in 2002 and only went public in 2004). I would either have to try to find this data. Based on the five years of financials I do have access to though, the company had negative earnings in 2001 and 2003, so there’s been growth, but I can’t calculate how much since my 3-year beginning average is a negative number.

P/E: Graham’s criteria was that this figure be less than or equal to 15. One of his big concerns was using trailing earnings, not forecasted earnings, because, as he stated, you could never predict the future with certainty. Most people nowadays (analysts included) look to future earnings, but they run into the same problem: how do you predict future earnings accurately? Graham’s method is far more conservative (and makes it tougher to find potential candidates for investing). Again, for GNA:

Current EPS = net income / average number of outstanding shares = $294,497 / [(304,471 + 304,028)/2] = $0.971
Year before EPS = $1.34 (not shown in pop-up attachment)
Two years before EPS = -$0.139 (not shown in pop-up attachment)
Average EPS = $0.726


P/E = $9.45 / $0.726 = 13.02

P/B: P/B should not be more than 1.5. An alternative that Graham also considered was for P/E * P/B to be less than 22.5, which is the same as 15*1.5. But this allows companies that have higher P/Es and lower P/Bs or vice versa to be considered. We’ll calculate both for GNA here:

Book value = (Shareholder equity – intangibles) / avg. number of outstanding shares = (1,584,019 – 122,716) / [(304,471 + 304,028)/2] = $4.80/share


P/B = $9.45 / $4.80 = 1.97

Some comments about book value: some companies may carry a high amount of intangibles or goodwill due to the nature of their business. For example, think Coke (KO), or other brand-heavy companies. For these and others, you can adjust the book value as you see fit, if you desire.

Summary

Whew. Well, that’s a basic introduction to the main ratios used in valua investing to identify a defensive investment. Keep in mind that everyone does things slightly differently, and there are probably other successful ways to identify a good investment. From a financial standpoint, I personally also look at ROE, cash flows, how they’ve performed historically on these ratios, and a few other metrics. So how does GNA look so far?

Not surprisingly, GNA doesn’t most of Graham’s criteria. It does meet a few, however, and there are those who might want to delve deeper to see if the company is worth investing in anyway, not as a defensive play, but one that would need additional watching over. Keep in mind that this is just a basic tutorial, and there are plenty more seasoned value investors out there who could explain better than I what calculations to adjust and why.

If I liked what I saw in the calculations, I would proceed to read their 40-F to better understand the company, its liquidity, plans for the future, and risks. I’d also do some other peer comparisons and industry research. For the value investors out there, do you still use Graham’s basic ratios as a starting point for your own research or screens? I’d be curious to find out what methods you use if you’d care to share!

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17 Feedbacks on "How to calculate financial ratios used in value investing: a step-by-step guide"

Market Participant

One of the problems with applying Graham’s criteria blindly, is that they do not apply for all sectors.

For example, most companies today try to minimise the amount of capital that is tied up in inventory and raw materials on hand. That tends to result in fewer current assets on the balance sheet and thus lower current ratio’s and Graham NCAV values.



Carnival of Investing #22 on InvestorGeeks

[…] How to calculate financial ratios used in value investing […]



Ricemutt

@Market Participant: Thanks for making that point. It’s true, calculations are only data until you turn them into information. I see from your site that you’re much more experienced in value investing, so I’ll be sure to read some of those book recommendations you’ve posted. I guess what you’re saying to keep in mind is that with all the emphases on companies being leaner and more efficient, you may need to adjust criteria for certain ratios.

There are also a few other calcs (such as Dupont analysis) that can be used to confirm whether Graham’s ratios reflect efficiency or the opposite, especially in relation to peers. I’ve still got a lot to learn when it comes to investing!



Market Participant

Part of it has to do from when Graham was writing his book. The intelligent investor was published in 1973. His last major work before that was the 1962 Edition of “Security Analysis”. His thinking basicly predates modern financial theory which dates to the late 1950s.

Companies without capital assets were uncommon prior to the 1970s. For example the idea of an industrial company like Microsoft with $70 Billion in assets of which “Property Plant and Equipment” is only 2.3 billion, just didn’t exist back then.

In the 1980s between corporate raiders focused on ROE and very effecient Japanese companies, most companies have aligned themselves toward creating shareholder value rather than being towers of financial strength.



Ricemutt

Thanks for providing the background. That makes a lot of sense. Guess the world is definitely becoming more complex with time. May I ask if there are specific things you look for in an investment, then, or do they really vary widely depending on industry and sector, or do you evaluate on a company-by-company basis?



Market Participant

Well, I guess I just look for cheapness. ultimately cash is cash. And the only question is how much you are paying for it and how much risk you are taking on.

I think it’s important to understand the business/industry that a company is involved in so you can figure out if its cheap or not. And if you have a margin of safety or not.

Basicly you are banking on three things.

*Cash flow generated by the business, which creates going concern value.

*An increase in the market price for that cash flow.

*A narrowing of the gap between the market price and the value of the business as a going concern.

Given the amount of time and effort involved I think most folks would do fine to invest in value oriented ETFs.



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Dr. K.V.S.S. Narayana Rao

I gave specific numerical values to the various rules of the Graham model to make it applicable to India and also specified a valuation formula that emphasizes and growth and values growth.

The performance of the share portfolio recommended by the model in January 2003 was studied in this month (August 2006). The portfolio outperformed the BSE sensex, the popular market index in India. My paper on the method can be accessed through my blog.



Review of The Little Book of Value Investing | Experiments in Finance

[…] I think the book can best be described as a nice little reference manual. In it, Browne details both his mindset and philosophy as well as details on the calculations and ratios he uses to evaluate a company or stock. Actually, from what I could tell, all the financial ratios and criteria that Browne uses are identical to those written for the defensive investor in Graham’s The Intelligent Investor. (Here’s a quick summary of Graham’s defensive value investing ratios and criteria.) I would have liked to have seen Browne’s own tweaks to these ratios, if he had any, given that many people believe some of Graham’s criteria are a little out-of-date. […]



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felix

i love ur site it is informative



Mike

great post.

frankly speaking i hate to read books. as i want to further enhance knowledge on value investing, im now tempted to read the intelligent investor book! i will get it soon.

even though i have not read his book, i did almost similar screening for stocks.



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Max

Great Post.
great resource for my finance education
thank you



Eddy

I’m a Graham friend too. Well, I also read Philip Fisher “Common Stock, uncommon profit”. It is weird, you will see a completely different point of view. Fisher is more into quality of a company rather than quantity.

My thoughts are, if a company lacks quality, its fundamentals will deteriorate. It might have a pretty financial statement that fits all the Graham criteria for now, but it will be gone in a year or two if the industry changes or more competitors show up.

I’m also considering competitive advantages. A good company should be able to make it hard on competitors by either, owning a piece of mind of the consumers (brand awareness), or being a low-cost producer. There’s so much more into this, I recommend reading Philip Fisher to get more details.



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