Now that we’ve taken the time to understand how it is that the various fundamentals within discrete financial statements can be used to build a basic value investing model, I’d like to take our evaluations one last step further. Specifically, I’m going to show you how the evaluation of the different financial statements can blend together into more robust measures of value and return.
By taking into account how assets, incomes, and prices interact with each other, we’ll be able to see how it is that returns can be evaluated as a function of value. The information below describes a few of the basic ratios that can be used to achieve this goal.
The ROA metric helps us to understand how it is that the assets on the balance sheet interact with the income flows of the income statement. It helps us to specifically understand how these assets are benefitting us as investors.
When taken into consideration with profit margins and coverage ratios, ROA allows us to understand if this company’s competitive advantage stems from tangible or intangible value, and whether or not it is susceptible to scale. Of additional note about this metric is the way in which it inherently takes into account the cost of depreciation into account on both sides of the fraction, and therefore also represents the value of the desired outcome accurately.
The ROE metric provides us with a counter-point to the ROA ratio. By illustrating the value created by the equity that fuels the company itself, we are provided with an understanding the effects of dilution. The lower this ratio, the smaller an investors claim on income. Alternatively, a larger number represents an opportunity for growth, as the company is in a position to grow, or to issue a dividend. This is an excellent supporting metric against many asset-based ratios, because of the way in which it is anchored in equity.
The Fixed Asset Turnover ratio is similar to ROA, in that it helps us to understand how it is that assets generate incomes for investors. However, FAT differs from ROA by showing us how assets generate sales, as opposed to incomes. The difference here is that it is a better indicator of the efficiencies of inventory holdings, as well as the sensitivity of the top line to leverage.
In ignoring expenses, this metric is extremely valuable for defining the scalability of a manufacturing or resource based organization. However, it loses a great deal of its value in service-based organizations, or those companies that derive most of their sales through efforts of knowledge. This is an excellent metric to use to infer how justified expenditures on fixed assets might be.
