Top 5 financial ratios: Manufacturers
We continue our top 5 financial ratios series with a look at manufacturers. And you thought theyd all moved to China.
Last issue, we kicked off an extended series revealing our top five ratios for various important industries. The series opener focused on listed property trusts, a fairly generic bunch. Today, we're considering a far more diverse category, one that incorporates almost all companies that make 'stuff' – manufacturers.
This category doesn't lend itself to a one-size-fits-all approach as neatly as property trusts. But because the sector includes some outstanding companies that don't logically fit under any other category, we thought it important to undertake the task early in the series. From our current Buy list alone, this article will be helpful in understanding at least parts of the businesses owned by ARB Corporation, Aristocrat Leisure, Brickworks, CSL and Fisher & Paykel Appliances.
We've selected what are typically the five most important ratios to consider. But due to the varied nature of the sector, we'll also suggest other ratios that may be useful for analysing manufacturing companies.
In showing how to put theory into practice, we'll use two manufacturing companies that sit at opposite ends of the quality spectrum – packaging company Amcor and hearing implant manufacturer Cochlear. If it's not immediately apparent which company sits where, it should be by the end of this article.
Interest cover ratio
We'll start off with an important 'safety' ratio, because further analysis is unnecessary if the company's finances are too shaky. Last issue, we discussed the net debt-to-equity ratio, which certainly can be useful here. But it can miss the point, particularly for high quality manufacturers that aren't particularly capital intensive (such as Cochlear).
The interest cover ratio measures the company's ability to fulfil its interest payments as they fall due, by comparing the annual interest expense with how much the company earns.
The interest cover ratio can be calculated from either the profit & loss statement or the cash flow statement. Both figures can be useful. But we lean towards cash flow interest cover, because it's a lack of cash, rather than a lack of reported profit, that will send a company broke.
|Operating cash flow before interest ($m)||864||156|
|Interest paid ($m)||190||9|
|Interest cover (times)||4.5||17.3|
We explained how to calculate the interest cover ratio in the Investor's College article Debt demystified – part 2 of 15 Apr 04. In table 1, we've calculated the ratio for both Amcor and Cochlear from their results to 30 June 2009.
As far as safety is concerned, the higher the interest cover, the better. Cochlear clearly generates enough cash to satisfy its interest payments, and Amcor's coverage isn't too bad either. But Amcor's cash flow is historically quite volatile and for that reason we're not completely comfortable with a ratio of four.
Calculating interest cover is a nuanced process. For example, you could argue the case for using pre-tax operating cash flow, although we'd argue the tax bill generally relates to the prior year's profit and an outstanding tax bill can send a company broke.
There is also the case for using net interest paid (interest paid less interest received), but we prefer to take the more conservative interest paid figure, because cash in the bank can be spent in a hurry. For the eagle-eyed, that explains the difference between the $181.7m 'net finance costs' in Amcor's 2009 annual report, and our estimated interest paid figure of $190m in table 1.
Other potential safety ratios: P&L-based interest cover, net debt-to-equity, net debt-to-market capitalisation.
The EBIT margin measures how many cents in earnings before interest and tax (EBIT) a company squeezes from each dollar of sales. For obvious reasons, this can be considered a 'profitability' ratio but, for reasons Phil Fisher set down many years ago in Common Stocks and Uncommon Profits, it's also a 'safety' ratio. We explained this in the Investor's College article Bad stocks and boom times of 3 Aug 05 and through example in ARB focus leaves CMI behind of 24 May 06.
In short, a higher EBIT margin means there's more left over for shareholders, for reinvesting in the business (to trounce the competition) and as a buffer in case of a general economic downturn or specific company problem.
|EBIT margin (%)||4.5||25|
Importantly, what matters most is the EBIT margin measured against the competition, rather than as an absolute or against unrelated companies. The fact that Cochlear's 25% EBIT margin leaves Amcor's 5% margin in the dust doesn't say nearly as much as Woolworths supermarkets' 5.8% EBIT margin does compared with Coles supermarkets' 2.9%. Note Woolies' relatively low absolute EBIT margin has been no impediment to creating shareholder wealth over the years.
Woolies has been able to use those higher margins to cut prices for customers and reinvest in improving efficiences, creating the virtuous cycle referred to in our review of the company on 17 Feb 10 (Long Term Buy – $25.90) while still making lots of money for shareholders.
While our example shows the EBIT margin of just one year, it often also makes sense to look at a margin average over three years, five years, or some other period designed to encapsulate the entire business cycle (Ben Graham advocated seven years).
Return on capital employed (ROCE)
We explained ROCE and its siblings, return on equity (ROE) and return on assets (ROA), in a two-part Investor's College article starting on 14 Dec 09. ROCE is predominately a profitability ratio.
ROE, which is a measure of post-tax profit against all the shareholders' equity in a business, often steals the limelight. But ROE will shift up and down depending on how the business is financed (whether the company uses debt lavishly or sparingly).
So while ROE is useful for comparing two debt free businesses, it fails when comparing a debt free company with an indebted competitor. Put another way, ROE won't tell you the difference between a 6 footer and a 5 foot 9er in platform shoes. Return on capital employed (ROCE) will.
|Capital employed ($m)||5,719||473|
ROCE measures the EBIT of the business against the entire capital base, both equity and debt. So if a company, for example, takes on debt to buy back shares, the ROCE doesn't change like the ROE does. The ratio measures the company's historic ability to both cover its debts and to make a profit for shareholders.
In the year to 30 June 2009, Cochlear's ROCE of 37% ran rings around Amcor's 7.6%. Again, it makes some sense to consider an average of several years' ROCE figures, especially with a more cyclical business.
Higher ROCE shows higher returns on the debt and equity invested in a business, and is almost always a good sign. Remember, though, that it's future ROCE that impacts returns for shareholders, and past ROCE is only ever a guide (and sometimes a misleading one).
Free cash flow to net profit
You might choose to call this either a watchdog ratio or a metabolism ratio, although neither are official tags. We calculate this ratio to ensure that net profit is turning up as free cash. This helps ensure against profit manipulation (the watchdog function), and it also gives us an idea of the capital intensity of the business (the metabolism function). Because free cash flow and reported profit can legitimately differ in any one accounting period, longer term averages are the key to getting the most out of this ratio.
Bear in mind, though, many factors can pollute this analysis, such as a significant capital expenditure item in the period being considered. Also, we think it's important to use profit before one-off items. Writedowns, for example, reduce normalised profit without affecting the comparable free cash flow.
Generally, we like to see something approaching 100% of net profit turning up as free cash flow, but the factors vary greatly from business to business. Table 4 shows net profit after tax and free cash flow for Amcor and Cochlear over the past five years. At first glance, it might be surprising that Amcor's profits have turned up in free cash flow (and then some), whereas Cochlear's haven't in full. But there are several valid explanations.
|Year to 30 June||2005||2006||2007||2008||2009||Avg.||Cash/profit (%)|
|Net profit ($m)||173.2||379.2||545.1||266.5||217.8||316|
|Free cash flow ($m)||287.4||511.1||496.3||267.1||212.8||355||112|
|Net profit ($m)||54.5||78.2||97.7||115.2||130.5||95|
|Free cash flow ($m)||90.6||37.9||65.8||66.7||126.7||78||82|
Most importantly, Amcor's business has been going backwards these past five years in terms of sales, assets and equity. If we think of it in terms of a business in partial liquidation, the excess cash flow makes sense.
Similarly, Cochlear's slight cash flow shortage is understandable. The business has grown rapidly these past few years, with sales and equity approximately doubling between 2005 and 2009. Because of this growth, it's logical that capital expenditure has been greater than depreciation, and the company has also needed to increase its investment in inventory and other working capital.
Price earnings ratio (PER)
The prior ratios have told us something about the quality of the business, its financing and profitability. But we need to ascertain whether the stock is cheap, fairly priced or significantly overpriced. After all, a good company won't make a good investment if bought at a bad price. And lesser companies can make great investments if bought cheaply enough.
|Share price ($)||5.91||65.59|
No one ratio tells us everything. But if the accounting is conservative and not distorted by unusual events, the price earnings ratio (PER) can tell us a lot. The PER – and its inverse, the earnings yield – put the current share price into context next to current earnings per share. Calculating and interpreting PERs was covered in the Investor's College article of 17 Jan 07, Getting to grips with PERs.
On a PER basis, Amcor is significantly cheaper than Cochlear, although that should be no surprise. But PERs can be misleading, particularly for cyclical businesses like Amcor, and it's not cheap enough for us for a variety of other reasons.
Cochlear's share price isn't a bargain, either. But it is an incredibly high quality business. Current consensus forecasts for 2010 EPS is $2.75, up 18% on 2009's result. That makes for a forecast PER of 24, and a few more years of rapid earnings growth has the potential to make today's price look cheap. In short, we're closer to upgrading Cochlear.
Other potential valuation ratios: price to sales, price to book value, price to NTA, cash flow earnings ratio, enterprise value to EBIT multiple, dividend yield and dividend payout ratio.
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