The Equity Edge 2 – Ratio Checks

The Equity Edge

Today’s post is our second visit to a new book – The Equity Edge by Mark Jeavons.

Earnings checks

Having covered a lot of stock screens last time out, today we are looking at secondary checks on companies.

  • I’m not clear at this stage why these checks wouldn’t be incorporated into the stock screens.

I will try to combine the two approaches when I look at building Mark’s screens in Stockopedia.


First up are earnings checks, for which Mark uses data from Morningstar.

  • The site has 10-years of earnings data (reported, and normalised, which excludes exceptional items) for all companies, in the income statement of the company profile.
Positive earnings

Mark eliminates any firms with a negative earnings (EPS) figure (reported or normalised) in the last five years.

His preference is for a positive and rising trend.

  • He scores each of the past 10 years of reported and normalised earnings, awarding one point for a year where earnings are positive (>0).

He looks for a score of 16 out of 20.

Earnings growth

Mark has two standards on earnings growth:

  • Growth companies should have 15% EPS over five years.
  • Income and value companies need earnings growth between 3% and 15% pa over five years.

Growth over 15% pa is unlikely to be sustainable.

Broker forecasts

As a minimum, broker forecasts should be for higher EPS over the next two years.

  • Ideally, growth should be higher than inflation (say 3%) and if possible, 5%.

For growth companies, Mark wants the forecast to show 10% EPS growth.

Upward revisions in earnings are desirable as they indicate that market sentiment has turned more positive.

Stockopedia provides this information over one and three months.

Pre-tax profits

Mark targets 3% pa growth over 5 years in income and value companies, and 15% pa for growth companies.

  • Broker forecasts should match.

Mark also introduces a valuation measure here – the market cap should be no more than 15 times pre-tax profits.

  • Profit margins (pre-tax profit/revenue) should also be rising.
PE and PEG

For income and value companies, the PE should be between 5 and 20, with 5 to 15 the preferred range.

  • Growth companies can have a PE of up to 40.

PEG can also be used.

  • Mark looks for a PEG below 0.75 for large caps (FTSE-100), and a PEG below 0.6 for riskier small caps.

A PEG below 0.3 is “too good to be true” and the company should be removed from the shortlist.

Sales checks

Sales information is once again available from Morningstar.

Sales growth

Sales should have grown over the past five years.

  • The only exception is for a large-cap recovery play.
Sales valuation

Here we use the price to sales ratio (PSR).

  • This is market cap divided by sales.

Companies with high profit margins and strong growth (such as technology companies) typically have high PSRs, while companies with high turnover and low profit margins (such as supermarkets) typically have low PSRs.

A PSR below 3 indicates good value, and below is very good value.

  • Above 5 is expensive, above 20 is prohibitively expensive.
  • Below 0.1 is “too good to be true”.

Looking at the highest and lowest PSR figures over the past five years helps to give an indication of where future PSRs (and hence prices) might lie. Ideally the current PSR should be below the average company PSR for the last five years.

So we don’t want to see a deteriorating trend.

  • Mark also looks at sector comparisons:

If the company PSR is more than 1.5 times the sector average PSR remove it from consideration.

Inventory to sales

This is the average inventory divided by sales.

  • Mark wants this to be stable over time or falling.

He doesn’t set absolute targets for this number.

Receivables to sales

Again, this is average accounts receivable to sales.

  • The trend should once again be stable or falling.

The upper limit for this ratio is 0.7.

Cash flow checks

As most people know, cash flow is harder to manipulate than earnings.

  • Cash flow per share (CFPS) is available from Morningstar.
Quality of earnings

The best way to evaluate the quality of earnings for a company is to compare cash flow per share to the reported and normalised EPS figures.

If operating cash flow per share is greater than reported EPS, earnings are of high quality because the company is generating more cash than is reported on the income statement.

Ideally, the ratio of CFPS to EPS should be higher than 1.5. You should also check that the five-year average of CFPS is in excess of average EPS over the last five years.

Cash to Capex

Capital expenditure per share (capex ps) is the amount per share the company invests in the business to acquire or upgrade physical assets, such as buildings and equipment. You want to avoid companies that have high capital expenditure relative to operating cash flow.

Capex ps is available from Morningstar.

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Capital expenditure is cyclical, so Mark uses 5-year averages for Capex ps and cash flow per share.

  • Surplus cash flow is the difference between the two, and Mark has a target of 20% of operating cash flow per share.
Price to cash flow

The PCF ratio is calculated by dividing the share price by the cash-flow per share.

  • A PCF below 15 is good value, and one between 5 and 10 is excellent value.
  • A PCF above 20 is poor value and a PCF above 40 is very expensive, even for growth companies.

Mark’s target range for PCF is 5 to 15.

Dividend checks

A rising dividend is a signal that an income company is confident in its prospect, [but] a company that has markedly slowed its dividend growth rate or has held the dividend constant for a few years may be signalling trouble ahead.

So Mark looks for what is known as a “progressive dividend history”.

  • Any dividend cuts in the last five years remove a company from consideration.

Mark also considers broker forecasts for dividends.

Ideally, the consensus dividend forecast for the following year should be higher than the previous year.

If dividend cuts are forecast, remove the stock from the shortlist.

Dividend cover

Companies that aren’t generating enough profit (or free cash) to cover the dividend are more likely to cut.

Dividend cover is EPS divided by dividends per share.

  • As usual, Mark is more interested in the trend than in a single data point.

Ideally the company should have a stable, or gradually increasing, dividend cover that remains above 2. If dividend cover looks like it is trending down and will fall below 1.5, eliminate the company from the shortlist.

Dividend outlook

Mark looks for statements in annual reports and RNSs that indicate a company’s commitment to maintaining and growing the dividend.

Future dividend yield

Mark looks at the likely average dividend yield over the next five years.

  • The requires estimates of the growth rates for dividends, earnings and revenues.

Income companies are removed from the shortlist if they do not offer an average dividend yield in excess of the market dividend yield plus 1%, with a maximum requirement of 4%. Value companies should have an average dividend yield above 3%.

These are the same rules from the stock screens but applied to a model of a likely future.

Sector comparison

Some sectors have higher yields than others, so Mark compares the yield to the sector.

  • Here, it is possible to have too much of a good thing.

A company that has a dividend yield significantly higher than its sector average may be more inclined to cut the dividend if it runs into trouble. Remove companies from the shortlist that have dividend yields that are more than double the sector average.

Growth companies

It is desirable for growth companies to pay a dividend because it helps reinforce financial discipline.

Mark sets the bar low, at a 1% yield, since most of a growth company’s earnings should be reinvested for the future.

Debt and solvency checks

Our next port of call is the balance sheet, which shows what the company owns and owes.

Debt

Debt sucks cash from a business into paying interest (or at least, this used to be the case before the era of zero interest rates).

  • A weak balance sheet can also lead to dividend cuts.

Net borrowing is total debt minus cash.

  • Increasing net borrowing is a warning sign.

Earnings before interest, taxes, depreciation and amortisation (EBITDA) is the equivalent of net profit with interest, taxes, depreciation and amortisation added back.

  • This is a Marmite number which divides investors – or as Buffett calls it, a bullshit number.

Net borrowing to EBITDA is a measure of leverage.

  • It shows how many years of EBITDA would be needed to repay all debt.

Companies that have net borrowing to EBITDA ratios that are trending above 2 should generally be avoided. If current net borrowing to EBITDA ratios are above 4 then the company is overburdened by debt and should be excluded from consideration.


Enterprise value (EV) adds debt to equity to give the full valuation of a company.

  • You add net borrowing to market cap.

The EV/EBITDA ratio shows how many years it would take to repay debt and equity.

Investors should prefer a company with an EV/EBITDA ratio below 12. If the ratio is above 25 then the company is likely to be very expensive and should not be invested in.

Mark also warns against buying a stock where the EV/EBITDA ratio is well above trend.

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Net gearing is another measure of (financial) leverage.

  • This is net borrowings/shareholder’s equity (assets minus liabilities).

If net gearing is trending above two thirds, investing in the company should be considered with caution.

In some sectors (eg. utilities) high asset levels and reliable income make more debt permissible.

  • But in general, Mark would leave companies with net gearing of more than two thirds alone.

When gearing is high, check short-term debt as a proportion of total debt.

  • This will soon need to be refinanced or paid off.
Solvency ratios

The current ratio measures how well a company can meet its short-term obligations.

Current assets include cash, accounts receivable, inventory, marketable securities, prepaid expenses and other liquid assets that can be readily converted to cash.

A current ratio of less than 1 is bad.

  • But in some industries (eg. fast-food) high inventory turnover in comparison to accounts payable can lead to a low current ratio.

When the current ratio is below 1, Mark checks its history.

  • A score consistently below 1 is more likely to reflect the industry.

Comparison against other companies in the same sector can be used to show the same thing.


The quick ratio is an even more conservative version of the current ratio.

  • It excludes inventory from the current assets definition.

Your preference should be to have a quick ratio above 1 with an improving trend. If the current ratio is significantly higher than the quick, it indicates a company’s current assets are dependent on inventory.


Interest cover measures how easily debt interest can be serviced.

  • It is calculated as EBIT / debt expense.

A low number is bad, and Mark likes to see 3 or more.

  • Less than 1.5 is problematic, and less than 1.5 means that there is significant bankruptcy risk.

We met the Altman Z-score in the stock screens.

A score below 1.8 means the company has a high probability of becoming distressed, while a score between 1.8 and 3 is a grey area. Our preference is to invest in companies that have an Altman Z-score above 3.


We’ve also seen the Piotroski F-score before.

Normally a Piotroski F-score above 7 is preferred, but in some circumstances a score of 6 or more, such as for larger blue-chip companies, may be acceptable. A score of 3 or less should result in a company being removed from consideration.

Competitive advantage checks

As we saw when we looked at the competitive advantage screen, these are really Quality tests in the main.

Return on capital and equity

Companies with a strong, durable competitive advantage can generate high ROCE and ROE compared with their peer group.

Mark wants to see 5-year ROCE and 5-year ROE above 10% for income and value companies.

  • Growth companies should be at more than 20%, but 15% is acceptable.

Ideally, the trend in ROCE and ROE should be stable or gradually rising.

Operating margin

Companies with a competitive advantage will normally have operating margins above 20%.

If the margin is below 10%, disregard the company.

Consistency score

Mark calculates a consistency score to measure how reliable profits, dividends and growth in revenues, profits and dividends have been.

  • There are five measures and he goes back 10 years, so the maximum score is 50.

The first two measures score a point for being positive, whereas the last three require a year to be a new high score for that measure.

Mark likes to see a score of 40, and companies with a score of less than 25 should be eliminated.

Relative strength

Performing better than the market average is a sign that the market is starting to appreciate the qualities of the company.

Unusually, this is a momentum indicator rather than a quality measure.

For growth companies, you should require the three- and 12-month relative strengths to be positive, with the 12-month strength being greater than the three-month. Positive one-month relative strength is a bonus.

Conclusions

It’s been a strange day.

  • We’ve covered a lot of the same ground as last time, but today we’ve looked at the ratios from an accounting perspective, rather than looking at groups of stock screens arranged according to the companies they are trying to find.

On the plus side, we’ve made up a lot of ground, and we are now half-way through the book.

  • Given the large difference in the amount covered today compared to last time, I’m not sure if we will need another two or three articles to cover the rest of the book.

Up next is valuation.

  • Until next time.

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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The Equity Edge 2 – Ratio Checks

by Mike Rawson time to read: 8 min