The Hindu Business Line : Before you trade, say abracadabra

ALL numbers are not equal. Some are magical, others just plain. There are the ones that reveal truths, and those hiding behind veils. After the Enron tragedy and WorldCom worries, nobody looks at columns of numbers with any great respect. For them, annual reports are a giant jigsaw, and financial statements a sadistic puzzle. They know, as the auditors are programmed to say, that all is true and fair, but the problem is that truth is just hiding somewhere in the maze. Fair enough. So what? They pick up the calculators, and punch numbers, do math and find out the ratios that will spill the beans.

Peter Temple's "Magic Numbers for Stock Investors" from Wiley (www.wiley.com), is about how one can calculate 25 key ratios for "investing success". Mark Mobius of Templeton writes in his foreword: "Each ratio is clearly explained with definition, formulas, components, where to find the data, the calculation theory, a specific company example, and how to interpret the results." More magic follows:

The price to sales ratio (PSR) is sometimes known as the "revenue multiple". It is the market capitalisation of the shares divided by the company's annual sales. Companies that have a PSR of significantly less than one can be considered cheap; those that haven't are expensive.

Enterprise value (EV) is the aggregate market value of a company's listed shares, plus its debt and minus its cash. By comparing enterprise value with sales, we get a measure of value that appears to have a good record at predicting future share price performance.

Price to research ratio compares the company's market value with the amount it spends on R&D to try and gauge whether the stock market is putting a high or low value on this spending. Microsoft spends three times as much as Sony in terms of R&D as a percentage of sales. Microsoft's PRR is approximately 10 times that of Sony.

Gearing, sometimes called the debt-equity ratio, is usually defined as net borrowings (that's to say total borrowings minus cash) divided by tangible shareholders' equity, with the result expressed as a percentage. Gearing provokes more debate than almost any other financial ratio. A high gearing ratio may simply be an indicator that assets are undervalued. Equally, assets can be overvalued and gearing therefore understated. High gearing will exaggerate falling profits, and highly geared companies may suffer if interest rates rise.

Rather like the PE ratio, the price to free cash flow ratio (PCF) compares the share price with free cash flow per share (rather than EPS). It represents the number of years of free cash flow at the current rate before the price of the shares is recouped. More meaningful is the concept of the "free cash flow yield"; this is simply the reciprocal of the PCF ratio. An investment with a PCF of 12.5 times, for example, would have a free-cash-flow yield of 8 per cent. This can be compared with the cash return on other investments.

Sales and profit per employee are ratios that take the normal measures of turnover and profit, and divide them by the average number of employees in the company. The results are measures of employee productivity. They are a particularly good way of measuring the efficiency of `people' businesses, financial organisations, retailer, consultant, software company, ad agency, and so on. Look at the ratios over a period of years to study the trends.

A book that can make you a wizard in a world of "muggles".

BookValue@hotmail.com

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