Applying Ratios

What does a trend reveal? This is the essential question that you will ask constantly as your program evolves. If you do not know, or if a trend reveals nothing conclusively, then it has no real value. The valuable trend reveals some information you need to answer four basic questions:

1.     Does this stock continue to offer the growth potential I sought when I first bought it?

2.     Have the basic indicators changed, so that I now should sell?

3.     Are the indicators continuing to operate within the acceptable range, so that I should continue to hold?

4.     If I am thinking about buying a stock, what does the trend tell me in terms of whether that decision makes sense?

These basic questions (and their answers) ultimately determine all of your actions as an investor. You seek some source of consistently reliable information in order to make the decisions and to take action or to opt for inaction.

In the application of ratios as continuing entries in an ongoing trend, you need to identify a sensible base year or date. Why? Trends are comparative, and a starting point is essential. In the case of the current ratio, your base is a widely accepted standard: 2-to-l. For most other forms of ratio, the base should be a period that identifies your understanding of the stock—the date you purchased shares makes sense, for example. If the company had a major acquisition or merger within the past three to five years, the beginning date of that action may also serve as a base point for many forms of fundamental analysis. Otherwise, a date—such as the ending date of the latest fiscal year—can serve as your base point.

eKEY POINT

Establishing a relevant base point is essential. With the wrong base point, your analysis will not give you the information you need to make good decisions.

In identifying trends from the base point on out, you will want to have some method for judging results graphically. Seeing the result is always more revealing than simply reading it. Just as ratios are easier to comprehend than columns of dollar values, a graphic representation of a trend makes more sense than a mere list of outcomes. (It's the "a picture is worth a thousand words" syndrome.)

A graph helps you to turn ratios into visual aids, showing the direction of movement over time in the collection of data. Graphs are not merely illustrations of what is occurring; it is entirely likely that the graph is the only method by which you can actually see what the trend means. That is because you need the graph to add perspective to the numerical values. While the ratio is a preferred method of expression over columns of numbers—because the ratio expresses the significance rather than the mere dollar amount—it is still a series of numbers. Only when those numbers are expressed in a visual manner can you truly appreciate the importance, degree, and change in an ongoing trend.

Some rales for preparing graphs follow.

For multiple graphs, always use the same scale. Scaling is all-important in making your graph. First of all, the scale has to be practical so that your graph fits in a manageable amount of space. Second, the scale should remain constant when you will be using two or more comparable graphs. That is, if one inch equals a million dollars in one graph, that same scale should prevail in correlated graphs.

r KEY POINT

Pay close attention to the scaling of your graph. Proper scaling ensures reliable information, whereas improper scaling distorts information and the relationships among supposedly similar graphs.

Use the right base line. Too many graphs misrepresent the numerical information because they do not show the relationships between two values. For example, if your graph includes dollar values, it is accurate to have the base line at zero; in too many instances, the range of a graph includes only enough space to show the data. Thus, an increase from $200,000 to $250,000 looks different than it would on a true scale.

This idea is illustrated in Figure 7.1. Note that the first graph shows a range from $190,000 through $260,000 so that the change over time appears to span the entire vertical range of the graph—a dramatic increase, visually. However, the second example shows the entire dollar amount range from zero to $300,000, so that the actual change is put into a more realistic perspective.

Such a dramatic change in information imparted as that shown in the figure is not unusual. If you begin to look critically at graphs as they are published in magazines and textbooks, you will discover that many rudimentary scaling problems distort the message entirely. Rather than clarifying a point, the visual aid distorts it.

t KEY POINT

When it comes to your program of fundamental analysis, you want to ensure that at the very least, you do not deceive yourself.

Keep it simple. The suggestion that you develop your own system of graphic trend analysis does not mean that you need to become a draftsperson. You can do graphs by hand if you want, or on one of the many automated graphics programs such as the one included in many word processing and office suite packages. The intention of producing graphs is to provide yourself with a visual representation of the trend, not a work of art.