Specific Balance Sheet parameters used for fundamental analysis

There are hundreds of financial ratio and balance sheet parameters available from a company's annual report. Surely some are more important than others. Try finding them and searching through many threads I mainly noticed broad statements with some exceptions. From another thread:

McLovin said:

For the business: Good balance sheet (ratio analysis), good margins, low revenue concentration, high return on equity, low CAPEX, strong free cash flow. Ideally I also like companies that have a high % of recurring revenue. And most importantly, a business I can understand.

For the share: Margin of safety.

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a. Which ones do you prefer to use and are most important to you?
b. How many parameters do you use at ones?
c. What do you use as a benchmark to determine if the parameter is good or bad
d. Have you developed a grading system that incorporates them together as your 'first-cut' list

ottg said:

There are hundreds of financial ratio and balance sheet parameters available from a company's annual report. Surely some are more important than others. Try finding them and searching through many threads I mainly noticed broad statements with some exceptions. From another thread:



a. Which ones do you prefer to use and are most important to you?
b. How many parameters do you use at ones?
c. What do you use as a benchmark to determine if the parameter is good or bad
d. Have you developed a grading system that incorporates them together as your 'first-cut' list

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I have a spread sheet that i use for analysis of companies that make it into my intial list, they can come to my attention by various paths, mentioned in the media, on ASF, news, my own screening, etc.

The initial check i do is to look at a few big picture numbers on Commsec, so P/E, interest coverage, debt/equity, operating margin, ROC, ROI, earnings and cash flow. I dont take too much notice as Commsec is notoriously wrong with a lot of numbers, but at least it gives me a sense of the state of the business.

I will also do a quick scan of previous announcements, threads in ASF and company website to get a better idea of what the company does.

If I am still interested I will download the annual report to make sure I get the right numbers and calculate free cash flow, operating margin, check interest coverage and debt to equity, EPS, ROC, ROE, price to sales, market to book and finally an IV calculation based on a modified DCF formula.

I really look at all of that data in an overall sense and comparitive sense, if I am still interested and understand the business, then it will get highlighted on my watchlist as a potential buy. Nothing more may come of it, but it narrows the watchlist to a buy list in the event of capital becoming available.

Hope that helps!

c. Confirmation of its statistical robustness via various means: Well run academic studies (many are not). Multiple angles of the 'parameter' tested with similar result. Relatively robust to tweaking. Tested over relatively very long periods, not just years or a decade or two. Behavioural explanation is possible and makes sense (according to my understanding of human behaviour). Works internationally, not just tested market. Not convoluted; explainable to a new-investor or child. Practioner confirmed (i.e. people have made money with the factor) on top of the studies.
Guesses, discretionary "on the fly" approaches...I don't get that. For me, deciding which to use is a very important consideration. I don't know any way other than a statistical or scientific approach to figure this stuff out. I'm extremely fussy. As an investor with life savings on the line; much less is 'proven' to my satisfaction than perhaps might be expected by a newer investor. Academic studies are fun, even the not so great ones (most of them?); people's stories and opinions are fun, too. I love it. But investing funds that mean something to you is a different matter.

d. Not just first, but final cut. I wouldn't know what else to do!

galumay said:

... and finally an IV calculation based on a modified DCF formula.

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You mention your valuation in other posts. So as to obtain better context of how this is obtained and, from this entry, gaining some insight into what you are looking at, would you care to expand on this formula? Montgomery? Clime? HOLT? Leibowitz? Gulamay?

DeepState said:

You mention your valuation in other posts. So as to obtain better context of how this is obtained and, from this entry, gaining some insight into what you are looking at, would you care to expand on this formula? Montgomery? Clime? HOLT? Leibowitz? Gulamay?

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Its essentially a version of Damodaran's spreadsheets for IV calculation, so DCF using an implied equity risk premium. I use current year eps as a base, a two step case for future earnings generally, (very conservative). Its not a quantitive thing for me in the sense that I dont expect an exact value, all I am trying to do is get a feel for relative IV along with everything else I take into consideration.

galumay said:

Its essentially a version of Damodaran's spreadsheets for IV calculation, so DCF using an implied equity risk premium. I use current year eps as a base, a two step case for future earnings generally, (very conservative). Its not a quantitive thing for me in the sense that I dont expect an exact value, all I am trying to do is get a feel for relative IV along with everything else I take into consideration.

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Thanks Galumay.

I screen first for companies with proven revenue growth and near commensurate growth in EPS.

In terms of specific balance sheet parameters, my main list in order of importance is 1) return on equity, 2) debt/equity, 3) interest coverage (EBIT/interest) and 4) quick ratio.

I like ROE to average more than 10% over a long period of time (10 or more years). I like debt/equity to be below 50% and shares outstanding to exhibit slow growth, no growth or negative growth, other than equity raised for opportunities that have either already panned out well or look very solid going forward. I used to like interest coverage to be greater than 5X, but at today's interest rates I think it should be higher (haven't picked a new threshold yet, but maybe 10X). I like the quick ratio to be positive most of the time, because I believe that means the CFO is aggressive at bringing cash in, stingy letting it go out, and well in front on financing activities.

I don't care much about depreciation, amortization, book value, net tangible assets or income tax rates.

For smaller companies or faster growers, I dig deeper and look at both cash flow and free cash flow to debt. I don't have a specific threshold but make a judgment call whether or not their bank would be likely to support them with new lending for a good opportunity, if it occurred simultaneous with a hiccup elsewhere in the business.

A big distinction to be made is whether you are screening to select a single company, or a group.

When asked about what makes a quality company, most will come up with parameters such as:

- low debt
- high ROC/ROE
- consistency
- cash flow
- margins
- low capex

The logical flaw of this is that while great company/investment has these factors, not all companies with these factors are great. In fact, if you try and backtest on any of these, or combinations of these, you will likely find that as a group, they underperform the market. So, this kind of screen is only of use to those that can then make a judgement call which ones are special.

The other way to do it is to develop screens that tend to outperform the market as a group. Low-anything are well know variants that stubbornly continue to outperform, even if by only a small margin.

If you move away from the well researched strategies, the biggest concern you will have is make a distinction between discovery of an edge and noise. You will not have a well defined strategy, it will need to be backtested from many different angles and trades may need to be parsed one by one to make sure it is not a statistical anomaly.

You will start off with a theory of what may outperform, that will make sound economical foundation and reasons for why it would outperform. You would then throw all kinds of backtests at it to see if it holds. Ideally, over many different markets and time periods. Or the other way round, get something that works, then find a theory that fits. But the two need to be together.

Thank you for all the replies. Hope it will invoke a sensible discussion from long term investors.
Perhaps first a strategy (gathered from books, other systems, gurus and screeners http://www.nasdaq.com/reference/stock-screener.aspx etc) that I have adopted.
Define what my quality parameters are? Shares that provide either consistent price growth and dividend growth over long periods of time (you cannot have both at all times). Add to that the level of risk tolerance/appetite from the investor (high, medium, low). Thus we have 6 broad groups with some over lap. One extra group just to capture the best of the best irrespective of risk.

Broad filter: Categorise the market into segments of capitalisation eg: <$200m; $200m <$1b; >$1b < $5b; >$5b < $10b;> $10b < $30b; >$30b. Let say 5 categories. Split out all those with capitalisation >$5b that dont trade often into another category. Use various balance sheet parameters eg dividend per share, earnings per share, intrinsic value per share, current liabilities, PAT, current liabilities, interim dividends and a few more. Compare the latest parameters to the average of the market and also to their group as a whole. Apply a weighted score and tally.

Next filter: Then look at their individual growth trends over a short, medium and long term. Compare that against the overall market growth trend and group trends. Apply a weighted score and tally. Updated weekly as new data becomes available.

Add the two tallies together to get an overall score. Filter according to the score for the various groups.

Next filter: Look at interim declarations of earnings and dividends. Use as early warning when comparing to previous periods as an indication things are different as before and need attention.

Risk filter: Perform least square fit on share price over long term share. Perform annual average price growth rate. When deviation from the mean is below long term trend then risk is lower and vice versa is high risk.

Other broad filter parameters to be scored and added to tally:
Market "darlings": Short term favourites. Comparing dividend growth against price growth. Then compare against the current market trend. High value in raising market is good.
Price Rating: Perform least square fit on share price over long term share. When deviation from the mean is below long term trend then low price and vice versa is high price.
Price volatility: price oscillates around long term mean price. High volatility is higher risk

Most of the balance sheet parameters mentioned is not available from the standard free downloads. See World Vest Base Financial Intelligence Service. Often data need to be cleaned and adjusted for splits, corporate actions and dividends and previous years accounting reclassification.

ottg said:

High volatility is higher risk

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Just be careful not to blindly accept this mantra, there is a lot of research to suggest the opposite and that using beta as a measure of risk is erroneous.

Coincidentally Buffett refers to this indirectly in his address to shareholders this year,

"Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray."

galumay said:

Just be careful not to blindly accept this mantra, there is a lot of research to suggest the opposite and that using beta as a measure of risk is erroneous.

Coincidentally Buffett refers to this indirectly in his address to shareholders this year,

"Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray."

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Beta does measure risk - risk of unemployment for the analyst and fund manager.

Buffett also said something like: they lost me when they say that if the prices go lower it become riskier.

I spend quite some time since my last post to test different concepts I got from books, forums, people, experience etc. Perhaps you can comment. Received from S & P Capital IQ the entire annual ASX share market database over the past 15 years for 1900 shares. It runs from 2000 to 2014 (it included some S & P shares as well)
Found it good for testing long term concepts and not to worry about daily data.

Per share it included the following fundamental parameters:
Capital employed; Dividend per share (final); Earnings per share; intrinsic value per share; shares in
issue; current liability; ordinary shareholders interest; after tax profit; EBIT; annual profits; interim
earnings per share; interim dividends per share; special dividends declared, share price

The database runs till Dec 2014 and the test will be to see how the selected shares performed then in the early 2015 part.

For each parameter calculate the growth per year for year-on-year
= (previous year – current year)/previous year

For example BHP:
'14 '13 12 11 10 09 08 07 06 05 04 03 02 01 '00
BHP 1.28 1.27 1.09 0.94 1.03 1.02 0.73 0.55 0.48 0.37 0.37 0.22 0.23 0.25 0.25

Growth 0.01 0.16 0.16 -0.08 0.01 0.39 0.32 0.14 0.32 -0.02 0.73 -0.06 -0.06 0.00

For each parameter calculated the average growth for the past 5 years. Do for all the shares
For each parameter calculated the average growth for the past 10 years. Do for all the shares

Then calculated per share:
Avg 5 yr Div growth ; Avg 10 yr Div Growth; Avg 5 yr EPS growth; Avg 10 yr EPS Growth; Avg 5 yr Cap Ret growth; Avg 10 yr Cap ret Growth; Avg 5 yr Price growth; Avg 10 yr Price growth

Then calculated, combined and added various growth indexes to provide a performance filter.
There is a rational behind each one.

Example: Total score per share for Div + Eps + Cap (for 5 yrs)

Sort on capital employed for 5 years. This is to filter out the recent big cap companies.
Check the results based on the above indexes by sorting



Evaluate performance based on above. Note that data is as if we are at end of Dec 2014. So how did we do in 2015?

Enter the tickers into Yahoo Finance

iShares Trust - iShares Europe ETF ARCA:IEV - Excellent growth from 1/2015 till 15/5/2015
Fortescue Metals Group Limited ASX:FMG – not good
Infratil Limited NZSE:IFT – Excellent growth from 1/2015 till 15/5/2015
Premier Investments Limited ASXMV - Excellent growth from 1/2015 till 15/5/2015
Whitehaven Coal Limited ASX:WHC – short term rally then stagnation
Goodman Fielder Ltd. ASX:GFF - Excellent growth from 1/2015 till 1/5/2015
OZ Minerals Limited ASX:OZL - Excellent growth from 1/2015 till 1/5/2015
New Hope Corporation Limited ASX:NHC – bad performance
Spark Infrastructure Group ASX:SKI - short term rally then sharp decline

So we have a score of 6/9 good calls. Note you will review this weekly in case a wrong selection was made. Therefore you need the daily ASX data.

If we also compare the above against the ASX200 overall performance we noted that there was a sharp decline till from 1 Jan till 15 Jan then a sharp rally till 1 March and then stagnation till 25 April and then a sharp decline thereafter.

Just by a quick visual inspection it seems if the selection did perform better.

Still more tests to come - any comments will be great! However I'm still looking for a similar tool instead of me trying to create something.

ottg said:

I spend quite some time since my last post to test different concepts I got from books, forums, people, experience etc. Perhaps you can comment. Received from S & P Capital IQ the entire annual ASX share market database over the past 15 years for 1900 shares. It runs from 2000 to 2014 (it included some S & P shares as well)
Found it good for testing long term concepts and not to worry about daily data.

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I'm interested in the Capital IQ database too, but I'm unsure how to purchase it and what the costs are (googling was quite confusing). If you don't mind me asking, how much did it cost you for the DB and how did you purchase it?

To answer the initial question what I would suggest is that different fundamental metrics are for different things, for example look at how this crude strategy uses different metrics during different phases of the selection process:

Universe selection:
* Sort universe by market cap and pick the appropriate "size" for your universe.

Filtering stocks for financial distress, fraud, etc:
* Rank universe by ratios which measure leverage (e.g. debt/assets), coverage (e.g. EBIT/interest expense), profitability (e.g. net income/assets), liquidity (e.g. current ratio), volatility (e.g. volatility of EPS) and filter out stocks which score poorly (e.g. filter out 5% of stocks with worst current ratio).

Look for value:
* Rank universe by ratios which measure value (e.g. Price/Earnings, EBIT/TEV, Price/Book, etc) and then select the "value decile" (i.e. 10% of stocks with cheapest value scores).

Look for quality value:
* Rank value decile by ratios which measure quality (e.g. Profitability, ROE, etc) and then select the best scoring 50% of stocks in the value decile.

You can essentially replace the final step "quality" with any number of other metrics, e.g. "value high yield", "value high momentum", "value low volatility", etc.

Hopefully this shows you that it's not just about dumping a whole bunch of ratios together.

sinner said:

I'm interested in the Capital IQ database too, but I'm unsure how to purchase it and what the costs are (googling was quite confusing). If you don't mind me asking, how much did it cost you for the DB and how did you purchase it?

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They offered me a test trial at no cost. I'll PM you with the contact details

sinner said:

Hopefully this shows you that it's not just about dumping a whole bunch of ratios together.

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Thank you Sinner for the reply - yes its not just adding ratios etc. Each combination has an indepth rational behind it. What is the potential problem why a share arent quality, what do you measure and how do you measure that. Getting back to your points.
As you know there are two risk aspects now to consider:

• 
  the position (investment) size (from LT view not trading view) and
  which capitalization category group to select from

If you have $100k and you select 10 shares of $10k each and your maximum stop loss is 10% then the maximum risk per share is 1% of the total portfolio size. A good risk value is 1% to 1.5%. Thus the risk for each share is 1k to 1.5k of portfolio size. Another risk is your total draw down that you can tolerate. If all the shares go peer shape simultaneously before hitting the stop loss the total draw down can be 10% to 15% of total portfolio size. Most people can tolerate up to 20% comfortable. This $20k risk from $100k portfolio.

The capitalization category groups mentioned in my previous post above forms different risk level groups.
Depending on your risk profile you select shares then from those groups or a combination of groups eg:
a. If you young and have many working years left then you can afford higher risk
b. If you middle age with few working year left you risk should be medium
c. If you nearing retirement your risk should be even more low
d. If you orphan or widower the your risk affordability should be close to zero

All the 38 parameters then eventually find their way into various indexes which forms all part of a heat map.




Each group a-d have an average for each parameter. If the share's parameter is better than the group average its coloured green and if worse then the groups average then coloured red.

You select the category group a-d from above according to your risk profile. Then select say the first 15 shares of that group and then check the heat map for those with the most green 'numbers'. From those once you pick the 10 best shares.
Then you know you selected the best from the best.

I have a few tough questions now for you!
1. If you are interested in share investments, how will you decide if this is a good share selection strategy?
2. What will be required to convince you to give such a selection tool a chance?
3. How much are you prepared to pay for such a tool?
4. If a trail is offered, how long must the trail period be?
5. If you want proof of the effectiveness of such a selection tool, over what time period must the proof stretch to establish trust for you?
6. How urgent will such a tool be for you?