Use these 5 ratios to unearth superior stocks

We all want to find the next Rio Tinto, but long before it’s trading at $100 a share, or Google when it was a tiny IT company with only a vision. But how do we know that a company will be a superior player over the long haul? What key ratios unlock the secret to its success?

With capital markets still in disarray, it could be argued that fundamental analysis is akin to renovating in the midst of a hurricane. But David Cassidy equity strategist with UBS reminds investors that while financial storms are seasonal, value is a more permanent proposition. And even though short-term hype often overlooks the fundamentals, Cassidy warns against ignoring a few key ratios when it comes to unearthing stocks with a sustainable competitive advantage.

Let’s take a look at key ratios used to spot superior stocks.

1) EPS Growth Rate: Within normal markets share prices typically increase if EPS increases. And the faster a company grows its EPS, the higher those earnings tend to be valued.

2) Relative PEs: While it’s not a measure of absolute value, a stock’s PE (current share price divided by EPS) provides a playing-field for comparing different stocks within like or similar sectors.

3) Price to Earnings Growth Ratio (PEG): A combination of the PE divided by the prospective EPS growth rate gives the PEG Ratio which measures the price of earnings growth.

4) ROIC: Measures the cash rate of return on capital a company has invested. In some cases it’s modified by replacing earnings with earnings-plus the interest on long-term debt. In this case, comparison with return on equity (ROE) determines whether the company benefited from the extra debt. So if ROE is higher than ROIC, the debt has added value.

5) ROE: A key measure of how well management uses its equity, ROE is earnings (revenue minus expenses, taxes and depreciation) divided by equity. According to Roger Montgomery chairman of Clime Capital as long as debt remains modest, there’s no better indicator of business performance than ROE. “It’s a way of determining whether or not every $1 used in financial growth is able to convert into $1 of market value,” says Montgomery. “If you’re looking for a required return of 15% you should look for stocks delivering an ROE significantly greater than this to ensure a margin of safety.”

But while a company’s ROE might look attractive, Cassidy says it reveals little about the sustainability of future earnings. “The trap with ROE is it doesn’t show how much the balance sheet was geared to deliver those earnings, and whether this impacts on its ability to reinvest at the same ROE going forward,” says Cassidy.

As a broader definition, encompassing the company’s full capital structure (equity and debt), he says ROIC reveals more about a company’s true financial position. According to Cassidy, it’s not only the level of ROIC that matters, but the direction in which it’s trending.

While a rising trend-line is prima facie for earnings sustainability, Cassidy says this is more relevant for industrial stocks. Similarly, he says a downward ROIC trend can trigger alarm bells about future earnings. And even though resource stocks are top performers in today’s ROIC-stakes, he says underlying volatility in commodity prices makes deciphering future growth trends problematic at best.

Cassidy uses a variety of ratios to measure stocks, but based on ROIC he currently likes the look of Woolworths, Worley Parsons, QBE and Computershare as businesses generating consistent returns (relative to peers). While there’s no magic number defining good ROIC, he says investors should look for stocks delivering double digits. “While Boral’s ROIC doesn’t currently attract due to downturns in housing (in the US and locally), an expected rebound in these markets could make for a good contrarian play,” he adds.

Cassidy says the temptation of some companies to window-dress top-line results by focusing on pre-abnormal (including writedowns) ROIC or ROE is one of many reasons why no single financial ratio should be reviewed in isolation. One ratio that Cassidy rates highly is a measure of valuation that determines the extent to which the market is pricing excess returns in future PE. “The purest way to do this is on DCF (discounted cash flow) to establish certain cash flows on ROIC,” explains Cassidy.

Montgomery also encourage investors to pay specific attention to a stock’s payout ratio. As a percentage of net profit paid out as dividends, he says the payout ratio is an important indication of the sustainability of a company’s dividend while providing clues into future growth upside. In other words, a very high payout ratio means the company lacks a large buffer in annual earnings and may need to cut dividends if earnings fall over time.

Another critical metric, adds Cassidy is measuring a company’s ROIC against its weighted average cost of capital (WACC) which is the the minimum rate of return (adjusted for risk) a company must earn to create shareholder value. Expressed as a percentage, brokers typically refer to this measure as the ROIC-WACC spread.

He says the greater the ROIC is over the WACC, the more value a stock is creating. So if company A returns 15% on its capital base and its WACC is 10%, it’s making a real return of 5% on every dollar of invested capital – and its share price should perform well. Conversely, if Company B returns only 5% on its invested capital compared with a similar WACC of 10%, it’s destroying shareholder value and the share price will (typically) fall.