Ratios Can’t Always Tell if a Stock is Undervalued

Financial ratios are an integral part of a value investor’s arsenal.

But, they do not always tell the full story. Or even the right story.

As an investor, you need to consider the ratio analysis as a part of what you do. The other part is to try and build a story around your investment and then see if the story checks out.

Limitations of Financial Ratios

Limitations of financial ratios are well documented on this site.

Earlier we discussed how too high or too low multiples such as Price to Earnings and Price to Book can actually indicate an anomaly that needs to be investigated. I took specific examples to illustrate the point, so please read that post to learn the reasons.

Here, I will provide some guidance on how to research a stock and corroborate what the ratios are telling you.

Check the Following 5 Indicators when Ratios Appear to be Atypical

1. Did the company have an accounting charge or a write-off? – This can make the earnings look small (or negative) and will cause the P/E ratio to go very high. However, the charge may be one-off and not a typical business expense
2. Did the company sell a large asset? – If the company spun off a subsidiary or sold property, they may book a part of the proceeds as gains. This inflate the earnings and will cause the P/E ratio to be abnormally low for the period. Even the book value is changed when a tangible asset is disposed off.
3. Has the company taken on new debt? – This will for sure change the leverage ratios considerably. When you are looking at the trends, this can be alarming. However, it may not be negative change. So be aware and look for these.
4. Has the inventory turnover decreased alarmingly? – This may mean the business is slowing down. The earnings may not reflect this yet as the revenue recognition lags the inventory turns. Keep this in mind when you judge the valuation
5. Are Days Sales Outstanding getting longer? – This may mean the buyers are unable to pay on time. This can mean a stress in the industry. Perhaps some buyers are struggling to make payments. A bankruptcy can have a domino effect and can harm the company revenues and profits down the line.

Ratios are Very Useful But Use Them with Open Eyes

Financial ratios help make the analysis quick and help you review the key indicators of a business or a stock. They are very useful in judging the stock valuations. However, always read the annual reports and look at the special charges, events, and trends to paint a complete picture. Ratios should not be used in isolation.