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Understanding Ratios for Stock Market Decisions

27 February 2007 - Features - Editor

How much does the stock market trust ratios? Well, business management schools and courses in Finance may pay more obeisances to concepts of gearing, profitability, liquidity, and other information that ratios try to convey, than stock market players of today are willing to concede.

It is not a universal phenomenon: the stock market still attaches due importance to the P/E or Price to Earnings ratio, but bitter experience shows that Quick Ratios may cover up any number of potential losses in physical inventories, payment disputes, and sheer bad debts.

Concepts of gearing have also changed. Funds now chase projects in many markets, and the stock market investor is not concerned with the scale of debt, provided that he or she is on the borrowing side! Investors may be content to make a buck out of an initial public offer, and have no commitment to the long term well bring of an enterprise.

The most unreliable part of most ratios is that they depend so much on the past. The stock market of today derives strength from concepts of free markets and capitalism which are entirely new for many countries. The result is that we have new breeds of stock market winners, even as yesterday’s heroes drop below the radar.

The stock market has started to attach more importance to guidance, the ability to meet projected targets, and the agility to respond to fluid business conditions. Many ratios have become irrelevant because of yawning discontinuities in the stock market space. Qualitative dialogue with key executives carries more weight than the arithmetic of analysts!

Disaggregated data has become more valuable in the new stock market environment. Are there some brands and territories which drain cash? Is there some major confrontation brewing with a stakeholder that can shock the accounts of provisions? Is the company putting too much at stake in chasing a pet mirage of the Chairperson? Are fixed costs creeping in to books of account even as customers are drawn to the shores of competitors? Ratios, at the end of the day, are based on financial statements, and the latter conceal many subtle changes in a business. Who wants to be the last to know?

 


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