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Investors Beware: Financial Ratios Might Not Be Telling You the Whole Story

Investing is both an art and a science. However, the art portion of investing is so hard to accomplish that most investors end up using a predominantly scientific approach to investing. This can then lead to investors focusing too much on the importance of financial ratios.

But, as I shall show below, blind adherence to the common wisdom about financial ratios may cause investors to lose out.

Following ratios blindly

When investing, an often repeated mantra is that investing in shares carrying low price/earnings ratios is the way to go. But if that is the only truth in investing, there would be no reason why shares like Raffles Medical Group Ltd. (SGX: R01) and Silverlake Axis Ltd (SGX: 5CP) could deliver great market-beating returns over the past decade.

At the start of 2004, the former carried a trailing price/earnings ratio (PE) of 22 while the latter was valued at 20 times its trailing earnings. It’s obvious that those aren’t low valuations. But yet, Raffles Medical and Silverlake Axis has delivered capital gains of 956% and 1,008%, respectively, from then till now. In contrast, Singapore’s market barometer, the Straits Times Index (SGX: ^STI), had grown by just 89% in price in the same period.

Another often-repeated idea about investing is that companies with low profit margins do not make for good investments. But if that was entirely true, then shares like BreadTalk Group Limited (SGX: 5DA) and Dairy Farm International Ltd (SGX: D01) would not have been able to see their share prices grow by 441% and 443% respectively since the start of 2004.

Net profit margin for Breadtalk and Dairy Farm

Source: S&P Capital IQ

As you can see in the chart above, BreadTalk and Dairy Farm has really struggled to earn a net profit margin of more than 6% over the last 10 years.

The science… and the art

All these are not meant to say that the numbers aren’t important and that we should totally discard the study of a company’s important financial ratios. Instead, it’s meant to highlight how we should never rely on the financial ratios alone as they can only tell us half the story.

To invest better, we’d still have to ask questions like these:

  1. Is the company’s management honest in their communication with shareholders?
  2. What is the culture of the company like?
  3. Does management have short-term or long-term outlook on the business?
  4. What are the potential threats to the company?
  5. What are some of the areas the company is looking at for future growth and what are our expectations for these new growth areas?

And as you can probably tell, these are questions which cannot be answered through a study of a company’s financials alone.

Foolish Summary

We have to understand that as investors, we will always have more questions than answers when we’re studying a company as a potential investment. We just have to be comfortable with the fact that we will not have a crystal ball which can predict the future of a business with unerring accuracy. On that note, even a company’s management will not be able to make spot-on predictions about the future of their business.

That said, being able to view a company through both a quantitative and qualitative lens will allow us to see a more complete picture of the risks and prospects of the firm. Therefore, even when we invest with incomplete information, we will still have more confidence in being able to hold on to the company’s shares for the long-term and reap the rewards of compounding.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim does not own any companies mentioned above