In this lesson, you will learn about the use of financial statements in benchmarking and trend analysis. Specifically, this lesson will cover the following:
Ratio analysis is a tool for evaluating financial statements. Financial statements are used as a way to disclose the financial position and financial results of a business. With a few exceptions, such as ratios involving stock price, the majority of the data used in ratio analysis come from financial statements. Ratios help put financial statement information in context.
In order to calculate financial ratios, reported financial statements are often reformulated and adjusted by analysts to make the financial ratios more meaningful. One common reformulation method is dividing reported items into recurring or normal items and nonrecurring or special items. This way, earnings can be separated into normal or core earnings and transitory earnings. In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data are inaccurate due to issues like earnings management.
The evaluation of a company’s financial statements is a form of fundamental analysis. While the analysis of a company’s prospects can include a number of factors, including understanding the economic situation or the industry or sentiments about the company or its products, the ratio analysis of a company relies on the specific company’s financials.
term to know
Earnings Management
Fraudulent accounting practices that manipulate the reporting of income, assets, or liabilities with the intent to influence interpretations of the income statements.
2. Industry Comparisons
One advantage of ratio analysis is that it allows comparisons across companies, an activity often called benchmarking. However, comparing the ratios of companies across different industries should be done with caution.
An industry represents a classification of companies by economic activity. At a very broad level, an industry is sometimes classified into three sectors:
Primary or extractive
Secondary or manufacturing
Tertiary or services
did you know
At a very detailed level, there are classification systems like the ISIC (International Standard Industrial Classification).
During comparisons, consider whether the companies being contrasted are similar within the financial metrics being evaluated. Different businesses will have different ratios for different reasons.
A peer group is a set of companies or assets that are selected as being sufficiently comparable to the company or assets being valued (usually by virtue of being in the same industry or by having similar characteristics in terms of earnings growth and return on investment). From an investor perspective, peers can include companies that are not only direct product competitors but also subject to similar cycles, suppliers, and other external factors.
Valuation using multiples involves estimating the value of an asset by comparing it to the values assessed by the market for similar or comparable assets in the peer group. A valuation multiple is typically used as a means of assigning market value. The price-to-earnings ratio, for instance, is a common multiple but can differ across companies that have different capital structures; this could make it difficult to compare this particular ratio across industries.
Additionally, there could be problems with the valuation of an entire industry, making the ratio analysis of a company relative to an industry less useful. The use of multiples only reveals patterns in relative values, not absolute values such as those obtained from discounted cash flow valuations. If the peer group as a whole is incorrectly valued (such as may happen during a stock market “bubble”), then the resulting multiples will also be misvalued.
terms to know
Peer Group
A set of companies that are selected as being sufficiently comparable to the company being valued.
Valuation Using Multiples
Estimation of the value of an asset by comparing it to the values assessed by the market for similar or comparable assets in a peer group.
3. Benchmarking
Financial ratios allow for comparisons and, therefore, are intertwined with the process of benchmarking, comparing one’s business to that of others or of the same company at a different point in time. In many cases, benchmarking involves comparisons of one company to the best companies in a comparable peer group or the average in that peer group or industry.
In the process of benchmarking, an analyst identifies the best firms in their or another similar industry and compares the results to their own results on a specific indicator or a series of indicators.
Benchmarking can be done in many ways:
Many financial ratios are well-established calculations derived from verified data.
Many metrics are common and consistent between compared units and over time.
From an investor perspective, benchmarking can involve comparing a company to peer companies that can be considered alternative investment opportunities.
From a management perspective, benchmarking can help a manager compare their company to peers using externally recognizable, quantitative data.
Types of benchmarking
term to know
Benchmarking
Comparing financial ratios to your own historical data or among other companies.
4. Trend Analysis
Trend analysis involves evaluating past market data to forecast future price movements and inform investment decisions. This method is pivotal in identifying patterns that suggest the direction of asset prices over time. Trend analysis is broadly categorized into technical analysis and fundamental analysis.
Technical analysis focuses on statistical trends derived from trading activity, such as price movement and volume. Analysts utilize tools like moving averages, relative strength index (RSI), and candlestick charts to identify patterns and predict future movements. Key to technical analysis is the belief that historical price data and market sentiment can indicate future price direction.
Fundamental analysis, on the other hand, involves evaluating the intrinsic value of an asset by examining related economic, financial, and other qualitative and quantitative factors. Analysts study financial statements, industry conditions, economic indicators, and management quality to assess an asset’s fair value. This approach is grounded in the idea that while market prices may fluctuate in the short term, they will eventually align with an asset’s fundamental value.
Both methods offer valuable insights: Technical analysis provides short-term trading signals, while fundamental analysis offers long-term investment perspectives. Together, they equip investors with comprehensive tools to make informed decisions, balancing immediate market trends with underlying economic realities. This combined approach can enhance investment strategies and improve the likelihood of achieving the desired financial outcomes.
IN CONTEXT
Suppose we perform a technical analysis of Nike’s stock price data over the past year. Using a moving average, a positive trend moving average indicates a bullish outlook. Also, Nike’s RSI has remained between 30 and 70, suggesting that the stock is neither overbought nor oversold.
Now, let’s take a fundamental analysis approach to Nike’s stock price. Reviewing Nike’s latest quarterly earnings report shows a 10% increase in revenue year over year, driven by strong demand in North America and Asia. The company’s net income has also risen by 12%, indicating improved profitability.
By synthesizing these insights, we conclude that Nike’s stock is in a strong upward trend supported by solid fundamental performance and favorable industry conditions. The technical indicators suggest continued price appreciation in the short term, while fundamental analysis underscores long-term growth potential.
terms to know
Trend Analysis
Evaluation of past market data to forecast future price movements and inform investment decisions.
Technical Analysis
An analysis methodology that attempts to predict future stock price movements based on recently observed trend data.
Fundamental Analysis
An analysis methodology evaluating the intrinsic value of an asset by examining related economic, financial, and other qualitative and quantitative factors.
5. Limitations of Financial Statement Analysis
Ratio analysis using financial statements includes accounting, stock market, and management-related limitations. These limitations can cause faulty analysis, which can lead to making decisions based on bad data. Businesses must be careful when using financial statements to analyze a company. Here are some reasons:
Ratio analysis can be hampered by potential limitations with the accounting methodologies and the efficacy of the data in the financial statements themselves. These figures can include errors and are prone to accounting mismanagement, which involves distorting the raw data used to derive financial ratios.
The efficient-market hypothesis (EMH) asserts that financial markets are informationally efficient; therefore, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. While the weak form of this hypothesis argues that there can be a long-run benefit to information derived from fundamental analysis, stronger forms argue that fundamental analysis, like ratio analysis, will not allow for greater financial returns.
Technical analysts argue that sentiment is as much, if not more, of a driver of stock prices than the fundamental data on a company like its financials. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These audiences also see limits to ratio analysis as a predictor of stock market returns.
At the management and investor levels, ratio analysis using financial statements can also leave out many important aspects of a firm’s success, such as key intangibles like brand, relationships, skills, and culture. These are primary drivers of success over the longer term, even though they are absent from conventional financial statements.
If used alone, it can present an overly simplistic view of the company by distilling a great deal of information into a single number or series of numbers. Also, changes in the information underlying ratios can hamper comparisons across time, and inconsistencies within and across the industry can complicate comparisons.
term to know
Efficient-Market Hypothesis (EMH)
The theory that asserts that financial markets are informationally efficient; therefore, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.
summary
In this lesson, you learned that evaluating financial statements involves calculating financial ratios that can put the information reported by the financial statements into a usable context. Ratio analysis is most useful when making industry comparisons and evaluating companies within the same peer group (an activity also known as benchmarking). It is much less useful when comparisons are made across industries.
Benchmarking using ratio analysis is useful to both investors and management for providing a quantitative basis for comparison between companies or, for a single company, between two points in time. Ratio analysis can also be used in trend analysis, or comparing a company’s performance on certain measures over time in search of patterns, which can be useful in forecasting.
Of course, there are limitations of financial statement analysis that make it an imperfect tool. These include accounting errors or mismanagement, inefficiencies in the stock market (including human emotion and irrational behavior), and the inability of financial statements to account for the intangible aspects of a company’s performance (such as brand or culture).
Comparing financial ratios to your own historical data or among other companies.
Earnings Management
Fraudulent accounting practices that manipulate the reporting of income, assets, or liabilities with the intent to influence interpretations of the income statements.
Efficient-Market Hypothesis (EMH)
The theory that asserts that financial markets are informationally efficient; therefore, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.
Fundamental Analysis
An analysis methodology evaluating the intrinsic value of an asset by examining related economic, financial, and other qualitative and quantitative factors.
Peer Group
A set of companies that are selected as being sufficiently comparable to the company being valued.
Technical Analysis
An analysis methodology that attempts to predict future stock price movements based on recently observed trend data.
Trend Analysis
Evaluation of past market data to forecast future price movements and inform investment decisions.
Valuation Using Multiples
Estimation of the value of an asset by comparing it to the values assessed by the market for similar or comparable assets in a peer group.
