Five reasons not to rely on ratios

When buying a stock, most investors look at key financial ratios. But while it's vital to consider the financial health of a company, you can't rely on ratios alone, says Tim Bennett. Here are five reasons why.

When buying a stock, most investors look at key financial ratios, such as price/book-value (p/b) and price/earnings (p/e). But while it's vital to consider the financial health of a company, you can't rely on ratios alone. Here are five reasons why.

There's no ratio for management

Ratios tell you nothing about the quality of the management team running a business. Yet decent managers are crucial to maintaining good performance, or turning around an ailing company. So what should you be looking for?

You want to see a decent track record. Experience counts, especially when the economy is going through a rough patch. It's no coincidence that most of the CEOs of failed dotcoms were young guns. You don't have to limit your screen to CEOs, such as Ken Morrison, who have always worked for just one firm. But a decade or more (i.e. at least one business cycle) of success in their chosen sector is a big plus.

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Also look at remuneration. Structured badly, remuneration by way of shares can give directors the incentive to boost the share price in the short term at the expense of long-term growth. However, properly structured, share ownership increases the odds that a manager will try to deliver what shareholders want share price and dividend growth. You can check the stake a manager has in the company by looking at the 'remuneration report' in a set of financial statements.

A good example of a director who ticks both boxes, notes Motley Fool, is Mark Coombs of emerging-market investment specialist Ashmore Group (LSE: ASHM). He has been at the helm since leading a buy-out in 1999 and owns around 43% of the company. The group carries virtually no debt and enjoys big profit margins. It also recently reported a 25% rise in assets under management, much of which is down to Coombs.

Ratios can't measure a 'moat'

Decent management also makes it more likely that a firm can withstand competitive threats. As Warren Buffett once put it, you should seek "economic castles protected by unbreachable moats". By that, Buffett means you should be looking for firms with solid defensive barriers against competition. These come in different forms. At investment banking giant Goldman Sachs (NYSE: GS), it's the quality of the people (who are locked into the company with eye-popping bonus payments). At a firm such as consumer staples producer Unilever (LSE: ULVR), it's a big stable of brands. At an oil major such as BP (LSE: BP), it's the sheer scale of the group's investment in exploration, combined with its huge levels of oil and gas exploration know-how.

There are four main types of moat and ratios won't help you spot them. First, high switching costs that prevent customers from dropping a company's product. Second, a price advantage that allows a firm to cut costs more than its rivals. Third, product differentiation Apple's iPhone for example, with its 800 or more 'apps', is unique for now. Finally, look for firms that can lock out competitors, perhaps by holding, say, a drugs licence or patent.

The numbers can be unreliable

Ratios are generally drawn from two sources. Either they're based on the latest set of published data (the 'historic' p/e ratio), or they are built on estimates. So a 'forward' p/e might compare the current share price to one year's forecast earnings. There are obvious pitfalls to using an estimate analysts often get things wrong. But even externally audited data in published accounts aren't 100% reliable.

First off, accounts are always out of date. The fully audited version is prepared once a year, with listed companies updating once every six months or every quarter. Next, accounts look backwards, not forwards. So the p/b ratio, for example, gives a snapshot of where the company was then, not where it's headed since.

Then there's the problem of missing risks. Enron and Lehman Brothers both collapsed even though their auditors had signed off the previous set of accounts as 'clean' (or 'true and fair' in accountant-speak). Some big assets can be missing too. For example, unless a football club buys all its players, it can't show them on the balance sheet. Under accounting rules, a club can't put a price on home-grown talent for accounting purposes, yet anyone trying to buy a club undoubtedly would.

No one agrees on the best ratios

For every investor who raves about the p/e ratio, you'll find another who thinks it is riddled with limitations and prefers a substitute, such as enterprise value to earnings before interest, tax, depreciation and amortisation (EV/Ebitda). The trouble is that EV/Ebitda has plenty of drawbacks too. In isolation, single ratios are not much use there is no magic number that can remove the need for judgement. One safety measure is to ensure that if you think a firm is cheap because it has, say, a low p/e, check that this is supported by other ratios perhaps a low p/b, price/sales, or EV/Ebitda. When ratios start telling different stories, watch out.

Sometimes they just don't work

The final drawback with some ratios is that sometimes you just can't use them. For example, a p/e ratio is useless for valuing loss-making firms. A p/b ratio is no good for a software firm that has little in the way of tangible 'book' assets. And beware the temptation, prevalent during the dotcom boom, to start making up fanciful ratios as substitutes. Basing a buying decision on a comparison of price to something spurious, such as page clicks or 'eyeball views', is unwise.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.