Forecasting using ratio analysis
Analysing ratios shows how income and expenditure items behave and how they relate to one another, and analysts use that insight to forecast. But a forecast from historical data assumes past behaviour fairly represents the future, which need not hold, so analysts apply judgement and adjust for changes in the scenario. The future of a business can be significantly different from its past.
Suzlon was the only wind turbine manufacturer in India with great pricing power until it faced tremendous competition from domestic and offshore rivals starting in the mid-2000s. Projecting its financials at that point purely from its historical performance would have been a blunder. Analysts must spend time thinking about how the future of a business will differ from its past in view of its changing dimensions, and only then draw projections on assumptions.
Warren Buffett: he has no use whatsoever for projections or forecasts, which create an illusion of apparent precision; the more meticulous they are, the more concerned you should be; he looks very deeply at track records, and will miss a company with a lousy track record but a very bright future. Charlie Munger: projections do more harm than good, being put together by people with an interest in a particular outcome and a subconscious bias, their apparent precision fallacious, reminding him of Mark Twain's saying that a mine is a hole in the ground owned by a liar. Graham and Dodd: a trend shown in the past is a fact, a future trend only an assumption; the past, or even careful projections, are only a rough index to the future.
Peer comparison
A company's financials explain its past; comparing them with other participants in the industry shows its competitive position. All the ratios above, and those in the valuation units, compared across companies of the same sector, show where the company stands against peers. Databases provide quick snapshots of these numbers. Peer comparison is critical for analysts to investigate while making any research report.
History of equity expansion
Corporate finance actions affect shareholder value, and fund raising is critical among them. When a company raises fresh funds, the business bears their cost, so raising at competitive pricing creates value while raising at high cost is eventually borne by existing investors. Debt's impact is easy to understand because its cash flows are contractual; equity issuance is more challenging. Companies issue additional shares to raise funds or to meet obligations such as sweat equity or ESOPs.
- 1Rights issue: shares to existing shareholders in proportion to their holding.
- 2Public issue: IPO or further public offering.
- 3Private placement: preferential issue, or qualified institutional placement.
- 4Issue of shares on exercise of warrants.
- 5Issue of shares on exercise of ESOPs or under a sweat equity programme.
Any issue other than a rights issue reduces the ownership stake of existing shareholders because more shares are outstanding, which bears on their wealth. Investors should factor in potential dilution; future events are hard to predict, but the history of equity expansion shows how the company is likely to conduct itself. Companies that finance growth from strong internal accruals create very little dilution concern. Where fresh equity is used, check whether it was done without diluting value for existing holders.
| Route | Dilution reading | |
|---|---|---|
| Rights issue | Offered pro rata to existing holders | No major dilution; only holders who do not exercise are diluted |
| Preferential allotment | Shares to one or more selected investors | Raises the preferential investor's stake and cuts everyone else's: a dilution risk, but also a sign that some investors could bail the company out in a crisis; read the circumstances and the valuation. Regulators set minimum prices; allotment at a premium is value accretive to minorities and poses less dilution risk |
| Qualified institutional placement | Shares to institutional investors | Dilutes, but likely points to institutional confidence in fundamentals |
Dividend and earnings history
Dividends return money to shareholders and form part of total return with capital gains, so an analyst studies the dividend policy and the history of profit distribution, reading them against the business phase. Growth-phase companies pay little or nothing because they need funds, and shareholders may not mind while the company earns more on its funds than their expected return. As the business matures and incremental returns decline, shareholders expect timely dividends. For matured companies dividend yield matters, and so does the predictability or stability of the dividend; high-yield companies attract long-term investors seeking periodic income. Matured companies in defensive industries offer more predictable dividends because the business itself is predictable, and most pay interim dividends: Colgate Palmolive and Britannia regularly do. In other industries some companies manage dividends actively, building reserves in good years to pay in bad years; the dividend policy or historical data reveals this.
Share buybacks, other than those meeting stock-based compensation, are also a means of distributing profit and belong in the dividend study. Companies may prefer buybacks when the tax treatment is favourable for investors or the company, and a buyback lets investors choose between encashing the offer and increasing their stake.
Dividends and buybacks signal outlook and strategy, but the reading needs context. A well-performing company retaining more than usual may be planning a major investment, or expecting a challenging environment. A high-growth company increasing its dividend may foresee reduced growth opportunities. When a dividend announcement deviates significantly from the past, understand the reason from management.
Corporate actions, ownership and insiders
Dividends, bonuses, splits and rights issues affect the share price in various ways, covered in the dedicated corporate actions unit. Owners are closest to the business and best informed about its performance, and they trade the company's shares under SEBI's defined guidelines, so their market actions give analysts insight. Peter Lynch: insiders can sell for a variety of reasons and it does not necessarily ring alarm bells, but if insiders are buying there can be only one reason, that the company is likely to make huge profits in future.
- Ratio behaviour and inter-relationships let analysts forecast, but projections from history assume the past represents the future, which need not hold. Analysts apply judgement and adjust for scenario changes: Suzlon had pricing power as the only wind turbine maker until competition arrived in the mid-2000s, so purely historical projections would have been a blunder. Buffett has no use for projections and studies track records; Munger says projections do more harm than good and quotes Mark Twain's mine owned by a liar; Graham and Dodd call a past trend a fact and a future trend an assumption, a rough index at best.
- Peer comparison against companies in the same sector, across every ratio and valuation metric, shows competitive position; databases provide snapshots, and it is critical for any research report.
- Equity expansion history: shares are issued through rights issues, public issues (IPO or FPO), private placements (preferential issues and qualified institutional placements), warrant exercise, ESOPs and sweat equity. Any issue except a rights issue reduces existing holders' ownership; internal accruals avoid dilution. Preferential allotment shows dilution risk but also a potential rescuer, so read the circumstances and valuation; QIPs signal institutional confidence. Funds raised at high cost are borne by existing investors.
- Dividend history must be read against the business phase: growth companies pay little and shareholders do not mind while returns beat their expected return; matured companies are expected to pay timely, predictable dividends, defensive ones often interim (Colgate Palmolive, Britannia), and some smooth dividends through reserves. Buybacks (other than for stock compensation) also distribute profit, may be tax-favoured, and let investors choose between cashing out and raising their stake. Unusual retention may signal a big investment or a tough outlook; a growth company raising dividends may see fewer opportunities; ask management when announcements deviate. Corporate actions affect prices (covered in a later unit). Insiders act under SEBI guidelines and know most; Peter Lynch: insiders sell for many reasons, but buy for only one, expected huge profits.