Financial Ratio & Leverage

8/6/2019 Financial Ratio & Leverage

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FINANCIAL RATIOS

&

LEVERAGES


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Financial Ratios.

In finance, a financial ratio or accounting ratio is a ratio of selected values on an enterprise's financialstatements. There are many standard ratios used to evaluate the overall financial condition of acorporation or other organization. Financial ratios are used by managers within a firm, by current andpotential stockholders (owners) of a firm, and by a firm's creditors. Security analysts use financial ratios to

compare the strengths and weaknesses in various companies. If shares in a company are traded in afinancial market, the market price of the shares is used in certain financial ratios.

Values used in calculating financial ratios are taken from the balance sheet, income statement, cash flowstatement and (rarely) statement of retained earnings. These comprise the firm's "accounting statements"or financial statements.

Ratios are always expressed as a decimal value, such as 0.10, or the equivalent percent value, such as10%.

Financial ratios quantify many aspects of a business and are an integral part of financial statementanalysis. Financial ratios are categorized according to the financial aspect of the business which the ratiomeasures. Liquidity ratios measure the availability of cash to pay debt.[2] Activity ratios measure how

quickly a firm converts non-cash assets to cash assets. [3] Debt ratios measure the firm's ability to repaylong-term debt.[4] Profitability ratios measure the firm's use of its assets and control of its expenses togenerate an acceptable rate of return.[5] Market ratios measure investor response to owning a company'sstock and also the cost of issuing stock.[6]

Financial ratios allow for comparisons

between companies between industries between different time periods for one company between a single company and its industry average.

The ratios of firms in different industries, which face different risks, capital requirements, and competitionare not usually comparable.

1 Profitability ratios 2 Liquidity ratios 3 Activity ratios 4 Debt ratios 5 Market ratios 6 Other measures 7 Derivative valuation 8 See also 9 References

10 External links
http://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Stockholderhttp://en.wikipedia.org/wiki/Creditorhttp://en.wikipedia.org/wiki/Financial_analysthttp://en.wikipedia.org/wiki/Financial_markethttp://en.wikipedia.org/wiki/Balance_sheethttp://en.wikipedia.org/wiki/Income_statementhttp://en.wikipedia.org/wiki/Cash_flow_statementhttp://en.wikipedia.org/wiki/Cash_flow_statementhttp://en.wikipedia.org/wiki/Statement_of_retained_earningshttp://en.wikipedia.org/wiki/Financial_ratio#_note-1http://en.wikipedia.org/wiki/Financial_ratio#_note-2http://en.wikipedia.org/wiki/Financial_ratio#_note-3http://en.wikipedia.org/wiki/Financial_ratio#_note-4http://en.wikipedia.org/wiki/Financial_ratio#_note-5http://en.wikipedia.org/wiki/Financial_ratio#_note-5http://en.wikipedia.org/wiki/Financial_ratio#Profitability_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Liquidity_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Activity_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Debt_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Market_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Other_measureshttp://en.wikipedia.org/wiki/Financial_ratio#Derivative_valuationhttp://en.wikipedia.org/wiki/Financial_ratio#See_alsohttp://en.wikipedia.org/wiki/Financial_ratio#Referenceshttp://en.wikipedia.org/wiki/Financial_ratio#External_linkshttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Financial_statementhttp://en.wikipedia.org/wiki/Stockholderhttp://en.wikipedia.org/wiki/Creditorhttp://en.wikipedia.org/wiki/Financial_analysthttp://en.wikipedia.org/wiki/Financial_markethttp://en.wikipedia.org/wiki/Balance_sheethttp://en.wikipedia.org/wiki/Income_statementhttp://en.wikipedia.org/wiki/Cash_flow_statementhttp://en.wikipedia.org/wiki/Cash_flow_statementhttp://en.wikipedia.org/wiki/Statement_of_retained_earningshttp://en.wikipedia.org/wiki/Financial_ratio#_note-1http://en.wikipedia.org/wiki/Financial_ratio#_note-2http://en.wikipedia.org/wiki/Financial_ratio#_note-3http://en.wikipedia.org/wiki/Financial_ratio#_note-4http://en.wikipedia.org/wiki/Financial_ratio#_note-5http://en.wikipedia.org/wiki/Financial_ratio#Profitability_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Liquidity_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Activity_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Debt_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Market_ratioshttp://en.wikipedia.org/wiki/Financial_ratio#Other_measureshttp://en.wikipedia.org/wiki/Financial_ratio#Derivative_valuationhttp://en.wikipedia.org/wiki/Financial_ratio#See_alsohttp://en.wikipedia.org/wiki/Financial_ratio#Referenceshttp://en.wikipedia.org/wiki/Financial_ratio#External_links


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Profitability Ratios

Profitability ratios measure the firm's use of its assets and control of its expenses to generate anacceptable rate of return.

Gross margin Profit margin Operating margin Net margin Gross profit margin = (Sales - Cost of goods sold) / Sales[7]

Operating profit margin orReturn on Sales (ROS) = Earnings before interest and taxes / Sales[8][9]

Net profit margin = Net profits after taxes / Sales[10]

Return on equity (ROE)

= Net profits after taxes / Stockholders' equity or tangible net worth [11]

= Net profit / Equity[12]

Return on investment (ROI ratio or Du Pont ratio) = Net income / Total assets[13]

Asset turnover= Sales / Assets[14] Return on assets (ROA) Return on net assets (RONA) Return on capital (ROC) Risk adjusted return on capital (RAROC) Return on capital employed (ROCE) Cash flow return on investment (CFROI) Efficiency ratio

Gross Margin

Gross margin is an ambiguous phrase that expresses the relationship between gross profit and sales

revenue. The ambiguity arises because it can be expressed in absolute terms:

Or as the ratio of gross profit to sales revenue, usually in the form of a percentage:

In everyday speech the word 'percentage' is sometimes omitted and this can create confusion.

Note: "Cost of goods sold" are the costs directly linked to the product, variable costs, e.g. costs formaterial and labor. They do not include fixed costs like office expenses, rent, administrative costs, etc.

Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income.For a retailer it will be their markup over wholesale.

Larger gross margins are generally good for companies, with the exception of discount retailers. Theyneed to show that operations efficiency and financing allows them to operate with tiny margins.
http://en.wikipedia.org/wiki/Gross_marginhttp://en.wikipedia.org/wiki/Profit_marginhttp://en.wikipedia.org/wiki/Operating_marginhttp://en.wikipedia.org/wiki/Net_marginhttp://en.wikipedia.org/wiki/Gross_profit_marginhttp://en.wikipedia.org/wiki/Financial_ratio#_note-6http://en.wikipedia.org/w/index.php?title=Operating_profit_margin&action=edithttp://en.wikipedia.org/wiki/Return_on_Saleshttp://en.wikipedia.org/wiki/Earnings_before_interest_and_taxeshttp://en.wikipedia.org/wiki/Financial_ratio#_note-7http://en.wikipedia.org/wiki/Financial_ratio#_note-8http://en.wikipedia.org/wiki/Net_profit_marginhttp://en.wikipedia.org/wiki/Financial_ratio#_note-9http://en.wikipedia.org/wiki/Return_on_equityhttp://en.wikipedia.org/wiki/Financial_ratio#_note-10http://en.wikipedia.org/wiki/Financial_ratio#_note-11http://en.wikipedia.org/wiki/Return_on_investmenthttp://en.wikipedia.org/wiki/Financial_ratio#_note-12http://en.wikipedia.org/wiki/Asset_turnoverhttp://en.wikipedia.org/wiki/Financial_ratio#_note-13http://en.wikipedia.org/wiki/Return_on_assetshttp://en.wikipedia.org/wiki/Return_on_net_assetshttp://en.wikipedia.org/wiki/Return_on_capitalhttp://en.wikipedia.org/wiki/Risk_adjusted_return_on_capitalhttp://en.wikipedia.org/wiki/Return_on_capital_employedhttp://en.wikipedia.org/wiki/Cash_flow_return_on_investmenthttp://en.wikipedia.org/wiki/Efficiency_ratiohttp://en.wikipedia.org/wiki/Gross_profithttp://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/wiki/Cost_of_goods_soldhttp://en.wikipedia.org/wiki/Gross_marginhttp://en.wikipedia.org/wiki/Profit_marginhttp://en.wikipedia.org/wiki/Operating_marginhttp://en.wikipedia.org/wiki/Net_marginhttp://en.wikipedia.org/wiki/Gross_profit_marginhttp://en.wikipedia.org/wiki/Financial_ratio#_note-6http://en.wikipedia.org/w/index.php?title=Operating_profit_margin&action=edithttp://en.wikipedia.org/wiki/Return_on_Saleshttp://en.wikipedia.org/wiki/Earnings_before_interest_and_taxeshttp://en.wikipedia.org/wiki/Financial_ratio#_note-7http://en.wikipedia.org/wiki/Financial_ratio#_note-8http://en.wikipedia.org/wiki/Net_profit_marginhttp://en.wikipedia.org/wiki/Financial_ratio#_note-9http://en.wikipedia.org/wiki/Return_on_equityhttp://en.wikipedia.org/wiki/Financial_ratio#_note-10http://en.wikipedia.org/wiki/Financial_ratio#_note-11http://en.wikipedia.org/wiki/Return_on_investmenthttp://en.wikipedia.org/wiki/Financial_ratio#_note-12http://en.wikipedia.org/wiki/Asset_turnoverhttp://en.wikipedia.org/wiki/Financial_ratio#_note-13http://en.wikipedia.org/wiki/Return_on_assetshttp://en.wikipedia.org/wiki/Return_on_net_assetshttp://en.wikipedia.org/wiki/Return_on_capitalhttp://en.wikipedia.org/wiki/Risk_adjusted_return_on_capitalhttp://en.wikipedia.org/wiki/Return_on_capital_employedhttp://en.wikipedia.org/wiki/Cash_flow_return_on_investmenthttp://en.wikipedia.org/wiki/Efficiency_ratiohttp://en.wikipedia.org/wiki/Gross_profithttp://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/wiki/Cost_of_goods_sold


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H ow to use Gross Margin in Sales ?

Sales people often need to determine how much to charge a customer by marking up the cost of aproduct to arrive at the final price. There are two basic methods but both give the same result - anindication of the gross profit of the sale. The two methods express the result differently.

Markup

Markup can be expressed either as a decimal or as a percentage, but is used as a multiplier. Here is anexample:

If a product costs the company $100 to make and they wish to make a 50% profit on the sale of theproduct they would have to use a markup of 1.5 or 50%. To calculate the price to the customer, yousimply take the product cost of $100 and multiply it by the markup arriving at the selling price of $150.

While we understand that we made a $50 profit on the example above, markup does not tell us directlywhat percentage of our selling price is profit. If someone told you that they just sold a product for $339 ata 1.66 markup it is hard to directly understand exactly how many dollars of profit was realized on the sale.

Most people find it easier to work with Gross Margin because it directly tells you how many of your saledollars are profit. In reference to the two examples above:

The $150 price that includes a 50% markup represents a 33% gross margin. As you can see, grossmargin is just the percentage of the selling price that is profit. In this case 33% of our price is profit, or$50.

In the more complex example of $339, a markup of 66% represents approximately a 40% gross margin.This means that 40% of the $339 is profit. Again, gross margin is just the direct percentage of profit inyour sale price.

In accounting, the gross margin refers to sales minus cost of goods sold. It is not necessarily profit as

other expenses such as sales, administrative, and financial must be deducted.

Converting between Gross Margin (GM) and Markup

The formula to convert a Markup to Gross Margin is:

Gross Margin (GM) = 100% - (100% /(100% + Markup))

Examples:

Markup = 100% GM = 100% - ( 100% / 200% ) = 50%

Markup = 66% GM = 100% - ( 100% / 166% ) = 39.8%

Using Gross Margin to calculate your selling price

Sometimes a salesperson will be asked to use gross margin in their sales. For example, your salesmanager may ask that all sales offers be a 40% gross margin minimum. This means that you as the salesperson need to calculate the selling price using the cost of the product and the required GM.
http://en.wikipedia.org/wiki/Markup_(business)http://en.wikipedia.org/wiki/Markup_(business)


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Formula to calculate Selling price using Gross Margin

Selling Price = Cost / (1-GM%)

For example, if your product costs $100 and the required gross margin is 40%, then your Selling Price =$100/(1-0.4) = $100/0.6 = $166.6

Profit Margin

Profit margin, Net Margin or Net Profit Ratio all refer to a measure ofprofitability. It is calculated using aformula and written as a percentage or a number.

Margin is mostly used for internal comparison. It is difficult to compare accurately the net profit ratio fordifferent entities. Individual business' operating and financing arrangements vary so much that entities arebound to have different levels of expenditure, that comparison of one with another can have little

meaning.

For example, suppose a company produces a loaf of bread and sells it for 10 units of currency. It coststhe company 6 units of currency to produce the bread and it also had to pay an additional 2 units ofcurrency in tax.

That makes the company's net income 2 units of currency (10 - 6, before tax, then minus 2 for tax). Sinceits revenue is 10 units of currency, the profit margin would be (2 / 10) or 20%.

Profit margin is an indicator of a company's pricing policies and its ability to control costs. Differences incompetitive strategy and product mix cause profit margin to vary among different companies.

Operating margin

In business, operating margin is the ratio ofoperating income (operating profit in the UK) divided by netsales, usually presented in percent.

Example The Coca Cola CompanyConsolidated Statements of Income(In millions)

Net Operating Revenues $ 24,088Gross Profit $ 15,924

Operating Income $ 6,308

Income Before Income Taxes $ 6,578

Net Income $ 5,080

(Relevant figures in italics)
http://en.wikipedia.org/wiki/Profitabilityhttp://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Taxhttp://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/wiki/Businesshttp://en.wikipedia.org/wiki/Operating_incomehttp://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/w/index.php?title=Net_Operating_Revenues&action=edithttp://en.wikipedia.org/wiki/Gross_Profithttp://en.wikipedia.org/wiki/Operating_Incomehttp://en.wikipedia.org/wiki/Net_Incomehttp://en.wikipedia.org/wiki/Profitabilityhttp://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Taxhttp://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/wiki/Businesshttp://en.wikipedia.org/wiki/Operating_incomehttp://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/w/index.php?title=Net_Operating_Revenues&action=edithttp://en.wikipedia.org/wiki/Gross_Profithttp://en.wikipedia.org/wiki/Operating_Incomehttp://en.wikipedia.org/wiki/Net_Income


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GROSS PROFIT MARGIN

Gross profit margin is a financial ratio used to assess the profitability of a firm's core activities, excludingfixed costs.

The general calculation is

The gross profit margin is related to the net profit margin, which assesses the profitability of anorganisation after including fixed costs.

Indicates the relationship between net sales revenue and the cost of goods sold,A high gross profitmargin indicates that a business can make a reasonable profit on sales, as long as it keeps overheadcosts in control.

Return on equity

[1]

But not all high-ROE companies make good investments. Some industries have high ROE because theyrequire no assets, such as consulting firms. Other industries require large infrastructure builds before theygenerate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are betterinvestments than refiners just because of their ROE. Generally, capital-intensive businesses have highbarriers to entry, which limit competition. But high-ROE firms with small asset bases have lower barriersto entry. Thus, such firms face more business risk because competitors can replicate their successwithout having to obtain much outside funding. As with many financial ratios, ROE is best used tocompare companies in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings pershare (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate,which in turn gives the company a high growth rate.

ROE is presumably irrelevant if the earnings are not reinvested.

The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. Ifthe dividend payout is 20%, the growth expected will be only 80% of the ROE rate. The growth rate will be lower if the earnings are used to buy back shares. If the shares are

bought at a multiple of book value (say 3 times book), the incremental earnings returns will beonly 'that fraction' of ROE (ROE/3).

New investments may not be as profitable as the existing business. Ask "what is the companydoing with its earnings?"
http://en.wikipedia.org/wiki/Financial_ratiohttp://en.wikipedia.org/wiki/Profitabilityhttp://en.wikipedia.org/w/index.php?title=Core_activities&action=edithttp://en.wikipedia.org/wiki/Fixed_costshttp://en.wikipedia.org/wiki/Profit_marginhttp://en.wikipedia.org/wiki/Return_on_equity#_note-0http://en.wikipedia.org/wiki/Consultinghttp://en.wikipedia.org/wiki/Oil_refineryhttp://en.wikipedia.org/wiki/Financial_ratiohttp://en.wikipedia.org/wiki/Financial_ratiohttp://en.wikipedia.org/wiki/Profitabilityhttp://en.wikipedia.org/w/index.php?title=Core_activities&action=edithttp://en.wikipedia.org/wiki/Fixed_costshttp://en.wikipedia.org/wiki/Profit_marginhttp://en.wikipedia.org/wiki/Return_on_equity#_note-0http://en.wikipedia.org/wiki/Consultinghttp://en.wikipedia.org/wiki/Oil_refineryhttp://en.wikipedia.org/wiki/Financial_ratio


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Remember that ROE is calculated from the company's perspective, on the company as a whole.Since much financial manipulation is accomplished with new share issues and buyback, alwaysrecalculate on a 'per share' basis, i.e. earnings per share/book value per share.

The DuPont Formula

The DuPont formula, also known as the strategic profit model, is a common way to break down ROE intothree important components. Essentially, ROE will equal net margin multiplied by asset turnovermultiplied by financial leverage. Splitting return on equity into three parts makes it easier to understandchanges in ROE over time. For example, if the net margin increases, every sale brings in more money,resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more salesfor every dollar of assets owned, again resulting in a higher overall ROE. Finally, increasing financialleverage means that the firm uses more debt financing relative to equity financing. Interest payments tocreditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion ofdebt in the firm's capital structure leads to higher ROE. Financial leverage benefits diminish as the risk ofdefaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises ascreditors demand a higher risk premium, and ROE decreases. [2] Increased debt will make a positivecontribution to a firm's ROE only if the firm's Return on assets (ROA) exceeds the interest rate on thedebt. [3]

Rate of return

In finance, rate of return (ROR) or return on investment (ROI), or sometimes just return, is the ratio ofmoney gained or lost on an investment relative to the amount of money invested. The amount of moneygained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The moneyinvested may be referred to as the asset,capital, principal, or the cost basis of the investment.

ROI is also known as rate of profit. Return can also refer to the monetary amount of gain or loss. ROI isthe return on a past or current investment, or the estimated return on a future investment. ROI is usuallygiven as a percent rather than decimal value.

ROI does not indicate how long an investment is held. However, ROI is most often stated as an annual orannualized rate of return, and it is most often stated for a calendar or fiscal year. In this article, ROIindicates an annual or annualized rate of return, unless otherwise noted.

ROI is used to compare returns on investments where the money gained or lost -- or the money invested are not easily compared using monetary values. For instance, a $1,000 investment that earns $50 ininterest obviously generates more cash than a $100 investment that earns $20 in interest, but the $100investment earns a higher return on investment.

$50/$1,000 = 5% ROI $20/$100 = 20% ROI

Since rates of return are percentages, negative rates cannot be averaged with positive rates for purposesof calculating monetary returns. However, it is common practice in finance to estimate monetary returnsby averaging periodic rates of return; these estimations are most useful when the averaged periodicreturns are all positive, all negative, or have low variances.
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Measuring rate of return

The initial value of an investment does not always have a clearly defined monetary value, but forpurposes of measuring ROI, the initial value must be clearly stated-- along with the rationale for this initialvalue. The final value of an investment also does not always have a clearly defined monetary value, butfor purposes of measuring ROI, the final value must be clearly stated-- along with the rationale for thisfinal value.

Return on investment is a rate of profit or income (realized or unrealized). The return is sometimesadjusted for taxes in geographical areas or historical times in which taxes consumed or consume asignificant portion of profits or income. Taxes are an expense which may or may not be considered whencalculating ROI. Similarly, a return may be adjusted for inflation to better indicate its true value inpurchasing power.

Cash flow (income stream)

ROI is a measure of cash (or potential cash) generated by aninvestment, or the cash lost due to the investment. Itmeasures the cash flow or income stream from theinvestment to the investor. Cash flow to the investor can be inthe form of profit, interest, dividends, or capital gain/loss.Capital gain/loss occurs when the market value or resale value of the investment increases or decreases.Cash flow here does not include the return of invested capital.

To the right is a simple example of cash flow on a $1,000 investment.

Annual returns

An Annual Rate of Return is the return on an investment over a one-year period, such as January 1stthrough December 31st, or June 3rd 2006 through June 2nd 2007. Each ROI in the cash flow exampleabove is an annual rate of return. An Annualized Rate of Return is the return on an investment over aperiod other than one year (such as a month, or two years) multiplied or divided to give a comparableone-year return. For instance, a one-month ROI of 1% could be stated as an annualized rate of return of12%. Or a two-year ROI of 10% could be stated as an annualized rate of return of 5%.

In the cash flow example above, the dollar returns for the four years add up to $265. The annualized rateof return for the four years is $265 ($1,000 x 4 years) = 6.625%.

Arithmetic return

In mathematical terms, the arithmetic return is defined as the following:

where

Cash Flow Example on $1,000 Investment

Year 1 Year 2 Year 3 Year 4

Dollar Return $100 $55 $60 $50

ROI 10% 5.5% 6% 5%
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Vi is the initial investment value and Vf is the final investment value

This return has the following characteristics:

ROIArith = + 1.00 = + 100% when the final value is twice the initial value ROIArith > 0 when the investment is profitable ROIArith < 0 when the investment is at a loss ROIArith = 1.00 = 100% when investment can no longer be recovered

Yield

In financial economics, the term yield indicates a rate of return that is based on compounding,reinvestment, and/or the changing market value of a security. Yield indicates that the value of theinvestment increases or decreases during the investment period.

Effective annual rate (EAR) orAnnual percentage yield (APY) indicates an annual yield from compoundinterest. The yield depends on the frequency of compounding.

Effective Annual Rate Based on Frequency of Compounding

Rate Semi-Annual Quarterly Monthly Daily Continuous

1% 1.002% 1.004% 1.005% 1.005% 1.005%

5% 5.062% 5.095% 5.116% 5.127% 5.127%

10% 10.250% 10.381% 10.471% 10.516% 10.517%

15% 15.563% 15.865% 16.075% 16.180% 16.183%

20% 21.000% 21.551% 21.939% 22.134% 22.140%

30% 32.250% 33.547% 34.489% 34.969% 34.986%

40% 44.000% 46.410% 48.213% 49.150% 49.182%

50% 56.250% 60.181% 63.209% 64.816% 64.872%

Logarithmic or continuously compounded return

Academics use in their research natural log return called logarithmic return orcontinuously compoundedreturn. The continuously compounded return is asymmetric thus clearly indicating that positive andnegative percent returns are not equal. A 10% return results in 9.53% continuously compounded returnwhile a -10% results in -10.53%. This clearly indicates that the investment will result in a dollar amountloss corresponding to the difference between the absolute values of the two numbers: 1% (this is anapproximate equality).

Vi is the initial investment value Vf is the final investment value

.

ROILog > 0 is profit ROILog < 0 is a loss

Doubling occurs when

Total loss occurs when .
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ROI calculations for various uses

ROI values typically used for personal financial decisions include Annual Rate of Return and AnnualizedRate of Return. For risk-free investments such as savings accounts or Certificates of Deposit, thepersonal investor considers the effects of reinvesting/compounding on increasing savings balances overtime. For investments in which capital is at risk, such as stock shares, mutual fund shares and home

purchases, the personal investor considers the effects of price volatility and capital gain/loss on returns.

Profitability ratios typically used by financial analysts to compare a companys profitability over time orcompare profitability between companies include Gross Profit Margin, Operating Profit Margin, ROI ratio,Dividend yield,Net profit margin, Return on equity, and Return on assets. ( Barron's Finance, 442-456. )

During capital budgeting, ROI values typically used within a company to select which risk-free projects topursue in order to generate maximum return or wealth for the company's stockholders include Averagerate of return, Payback period, Net present value, Profitability index, and Internal rate of return. ( Barron'sFinance, 151-163. ).

In many countries, it is also important to consider the after-tax rate of return.

After-tax returns

The after-tax rate of return is calculated by multiplying the rate of return by the tax rate, then subtractingthat percentage from the rate of return.

A return of 5% taxed at 15% gives an after-tax return of 4.25%

0.05 x 0.15 = 0.00750.05 - 0.0075 = 0.0425 = 4.25%

A return of 10% taxed at 25% gives an after-tax return of 7.5%

0.10 x 0.25 = 0.0250.10 - 0.025 = 0.075 = 7.5%

Cash or potential cash returns

Time value of money

Investments generate cash flow to the investor to compensate the investor for the time value of money.

A dollar in cash is worth less today than it was yesterday, and worth more today than it will be worthtomorrow. The main factors that are used by investors to determine the rate of return at which they arewilling to invest money include:

estimates of future inflation rates estimates regarding the risk of the investment (e.g. how likely it is that investors will receive

regular interest/dividend payments and the return of their full capital) whether or not the investors want the money available (liquid) for other uses.

The time value of money is reflected in the interest rates that banks offer for deposits, and also in theinterest rates that banks charge for loans such as home mortgages. The risk-free rate is the rate on U.S.Treasury Bills, because this is the highest rate available without risking capital.
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The rate of return which an investor expects from an investment is called the Discount Rate. Eachinvestment has a different discount rate, based on the cash flow expected in future from the investment.The higher the risk, the higher the discount rate (rate of return) the investor will demand from theinvestment.

Any investment with a return less than the annual inflation rate represents a loss of value, even though

the return might well be greater than 0%. When ROI is adjusted for inflation, the resulting return isconsidered an increase or decrease in purchasing power. If an ROI value is adjusted for inflation, itsstated explicitly, such as The return, adjusted for inflation, was 2%. Investors usually seek a higher rateof return on taxable investment returns than on non-taxable investment returns.

Compounding or reinvesting

Compound interest or other reinvestment of cash returns (such as interest and dividends) does not affectthe discount rate of an investment, but it does affect the Annual Percentage Yield, becausecompounding/reinvestment increases the capital invested.

For example, if an investor put $1,000 in a 1-year Certificate of Deposit (CD) that paid an annual interestrate of 4%, compounded quarterly, the CD would earn 1% interest per quarter on the account balance.

The account balance includes interest previously credited to the account.

Compound Interest Example

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Capital at the beginning of the period $1,000 $1,010 $1,020.10 $1,030.30

Dollar return for the period $10 $10.10 $10.20 $10.30

Account Balance at end of the period $1,010.00 $1,020.10 $1,030.30 $1,040.60

Quarterly ROI 1% 1% 1% 1%

The concept of 'income stream' may express this more clearly. At the beginning of the year, the investortook $1,000 out of his pocket (or checking account) to invest in a CD at the bank. The money was still his,but it was no longer available for buying groceries. The investment provided a cash flow of $10.00,

$10.10, $10.20 and $10.30. At the end of the year, the investor got $1,040.60 back from the bank. $1,000was return of capital.

Once interest is earned by an investor it becomes capital. Compound interest involves reinvestment ofcapital; the interest earned during each quarter is reinvested. At the end of the first quarter the investorhad capital of $1,010.00, which then earned $10.10 during the second quarter. The extra dime wasinterest on his additional $10 investment. The Annual Percentage Yield orFuture value for compoundinterest is higher than for simple interest because the interest is reinvested as capital and earns interest.The yield on the above investment was 4.06%.

Bank accounts offer contractually guaranteed returns, so investors cannot lose their capital.Investors/Depositors lend money to the bank, and the bank is obligated to give investors back their capitalplus all earned interest. Since investors are not risking losing their capital on a bad investment, they earn

a quite low rate of return. But their capital steadily increases.
http://en.wikipedia.org/wiki/Discount_Ratehttp://en.wikipedia.org/wiki/Inflation_ratehttp://en.wikipedia.org/wiki/Purchasing_powerhttp://en.wikipedia.org/wiki/Compound_interesthttp://en.wikipedia.org/wiki/Annual_Percentage_Yieldhttp://en.wikipedia.org/wiki/Capitalhttp://en.wikipedia.org/wiki/Annual_Percentage_Yieldhttp://en.wikipedia.org/wiki/Future_valuehttp://en.wikipedia.org/wiki/Discount_Ratehttp://en.wikipedia.org/wiki/Inflation_ratehttp://en.wikipedia.org/wiki/Purchasing_powerhttp://en.wikipedia.org/wiki/Compound_interesthttp://en.wikipedia.org/wiki/Annual_Percentage_Yieldhttp://en.wikipedia.org/wiki/Capitalhttp://en.wikipedia.org/wiki/Annual_Percentage_Yieldhttp://en.wikipedia.org/wiki/Future_value


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Returns when capital is at risk

Average returns

There are three common ways investmentreturns are calculated over multiple periods oftime

Arithmetic Average Rate of Return Arithmetic mean Geometric Average Rate of Return (Time-Weighted Average Return) Dollar-Weighted Average Return Internal rate of return

These calculations use averages of periodic percentage returns. None will accurately translate to dollargains or losses if percent losses are averaged with percent gains. [1]A 10% loss on a $100 investment isa $10 loss, and a 10% gain on a $100 investment is a $10 gain. When percentage returns on investmentsare calculated, they are calculated for a period of time not based on original investment dollars, butbased on the dollars in the investment at the beginning and end of the period. So if an investment of $100loses 10% in the first period, the investment amount is then $90. If the investment then gains 10% in thenext period, the investment amount is $99.

A 10% gain followed by a 10% loss is a 1%dollar loss. The order in which the loss and gainoccurs does not affect the result. A 50% gainand a 50% loss is a 25% loss. An 80% gainplus an 80% loss is a 64% loss. To recoverfrom a 50% loss, a 100% gain is required. Themathematics of this are beyond the scope of this article, but since investment returns are published as"Average Returns", its important to note that average returns do not always translate into dollar returns.

To the right and below are some examples of what can happen to a 4-year $100 investment with anArithmetic Average Rate of Return of 5%.

Example #3 Highly Volatile Rates of Return, including losses


Rate of Return -95% 0% 0% 115%

Geometric Average -95% -77.6% -63.2% -42.7%

Capital at End of Year $5.00 $5.00 $5.00 $10.75

Dollar Profit/(Loss) ($89.25)

Compound Yield -22.3%

Capital gains and losses

Many investments carry significant risk that the investor will lose some or all of the invested capital. Forexample, investments in company stock shares put capital at risk.

A stock share is partial ownership of a company, and the value of the stock depends on many factors,including the likelihood that the company will pay a dividend (a distribution of profit to shareholders).When stock shares are first offered for sale, the company receives the capital from the stock purchaserand uses the capital to operate its business. Once stock shares are sold to investors, the investors can

Example #1 Level Rates of Return


Rate of Return 5% 5% 5% 5%

Geometric Average 5% 5% 5% 5%


Dollar Profit/(Loss) $21.55

Compound Yield 5.4%

Example #2 Volatile Rates of Return, including losses


Rate of Return 50% -20% 30% -40%

Geometric Average 50% 9.5% 16% -1.6%


Dollar Profit/(Loss) ($6.40)

Compound Yield -1.4%
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sell the shares to other investors. Publicly-traded companies stock shares are bought and sold (traded)on the stock markets.

The value of a stock share depends on what someone is willing to pay for it at a certain point in time.Unlike capital invested in a savings account, the capital value (price) of a stock share constantly changes.If the price is relatively stable, the stock is said to have low volatility. If the price often changes a great

deal, the stock has high volatility. All stock shares have some volatility, and the change in price directlyaffects ROI for stock investments.

Stock returns are usually calculated for holding periods such as a month, a quarter or a year.

Holding period return

The holding period return (ref:Bodie, p.132), an arithmetic return, is calculated:

Holding-Period Return = (Ending Price Beginning Price + Cash Dividend) /Beginning Price.

To the right is an example of a stockinvestment of one share purchased atthe beginning of the year for $100. Atthe end of the first quarter the stockprice is $98. This is a capital loss. The stock share bought for $100 can only be sold for $98, which is thevalue of the investment at the end of the first quarter. The first quarter return is:

($98 - $100 + $1) / $100 = -1%

Since the final stock price is $99, the annual ROI is:

($99 ending price - $100 beginning price + $4 dividends) / $100 beginning price = 3% ROI.

If the final stock price had been $95, the annual ROI would be:

($95 ending price - $100beginning price + $4dividends) / $100beginning price = -1%ROI.

Reinvestment whencapital is at risk:rate of return andyield

Yield is the compound rate of return that includes the effect of reinvesting interest or dividends.

To the right is an example of a stock investment of one share purchased at the beginning of the year for$100.

The quarterly dividend is reinvested at the quarter-end stock price. The number of shares purchased each quarter = ($ Dividend)/($ Stock Price).

Example: Stock with low volatility and a regular quarterly dividend

End of: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Dividend $1 $1 $1 $1

Stock Price $98 $101 $102 $99

Quarterly ROI -1% 4.08% 1.98% -1.96%

Annual ROI 3%

Example: Stock with low volatility and a regular quarterly dividend, reinvested

End of: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Dividend $1 $1.01 $1.02 $1.03

Stock Price $98 $101 $102 $99

Shares Purchased 0.010204 0.01 0.01 0.010404

Total Shares Held 1.010204 1.020204 1.030204 1.040608

Investment Value $99 $103.04 $105.08 $103.02

Quarterly ROI -1% 4.08% 1.98% -1.96%
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The final investment value of $103.02 is a 3.02% Yield on the initial investment of $100. This isthe compound yield, and this return can be considered to be the return on the investment of $100.

To calculate the rate of return, the investor includes the reinvested dividends in the total investment. Theinvestor received a total of $4.06 in dividends over the year, all of which were reinvested, so theinvestment amount increased by $4.06.

Total Investment = Cost Basis = $100 + $4.06 = $104.06. Capital gain/loss = $103.02 - $104.06 = -$1.04 (a capital loss) ($4.06 dividends - $1.04 capital loss ) / $104.06 total investment = 2.9% ROI

The disadvantage of this ROI calculation is that it does not take into account the fact that not all themoney was invested during the entire year (the dividend reinvestments occurred throughout the year).The advantages are: (1) it uses the cost basis of the investment, (2) it clearly shows which gains are dueto dividends and which gains/losses are due to capital gains/losses, and (3) the actual dollar return of$3.02 is compared to the actual dollar investment of $104.06.

For American income tax purposes, if the shares were sold at the end of the year, dividends would be$4.06, cost basis of the investment would be $104.06, sale price would be $103.02, and the capital losswould be $1.04.

Since all returns were reinvested, the ROI might also be calculated as a continuously compounded returnor logarithmic return. The effective continuously compounded rate of return is the natural log of the finalinvestment value divided by the initial investment value:

Vi is the initial investment ($100) Vf is the final value ($103.02)

.

Mutual fund returns

Mutual Funds and exchange-traded funds (ETFs) hold portfolios of various companies' stock shares.When the companies pay a dividend, and when the fund trades shares, dividends and capital gains aredistributed to the mutual fund shareholders. Mutual funds trade at the net asset value of the stock shares.

Total returns

Mutual funds report total returns based on reinvestment factors. Reinvestment factors are based on totaldistributions (dividends plus capital gains) during each period.

Asset Turn Over Ratio.
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Asset turnover is a financial ratio that measures the efficiency of a company's use of its assets ingenerating sales revenue or sales income to the company.[1]

"Sales" is the value of "Net Sales" or "Sales" from the company's income statement "Assets" is the value of "Total assets" from the company's balance sheet

Return on assets

The Return on Assets (ROA) percentage shows how profitable a company's assets are in generatingrevenue.

ROA can be computed as:

ROA = Net income / Total Assets

This number tells you "what the company can do with what it's got", i.e. how many dollars of earnings theyderive from each dollar of assets they control. It's a useful number for comparing competing companies inthe same industry. The number will vary widely across different industries. Return on assets gives anindication of the capital intensity of the company, which will depend on the industry; companies thatrequire large initial investments will generally have lower return on assets.

Usage

Return on assets is an indicator of how profitable a company is before leverage, and is compared withcompanies in the same industry. Since the figure for total assets of the company depends on the carryingvalue of the assets, some caution is required for companies whose carrying value may not correspond tothe actual market value. Return on assets is a common figure used for comparing performance of

financial institutions (such as banks), because the majority of their assets will have a carrying value that isclose to their actual market value.

Return on assets is one of the elements used in financial analysis using the Du Pont Identity.

Return on capital

In economics, return on capital, also known as return on invested capital, is a non- GAAP financialmeasure that quantifies how well a company generates cash flow relative to the capital it has invested inits business. It is defined as Net operating profit less adjusted taxes divided by invested capital and isusually expressed as a percentage. In this calculation, capital invested includes all monetary capitalinvested: shareholders' equity plus financial debt.

When the return on capital is greater than the cost of capital (usually measured as the weighted averagecost of capital), the company is creating value; when it is less than the cost of capital, value is destroyed.

Return on Invested Capital (ROIC) can be computed as:

ROIC = (Net Operating Profit - Taxes) / (Total Capital)
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Return on capital employed

Return on Capital Employed (ROCE) is used in finance as a measure of the returns that a company isrealizing from its capital employed. The ratio can also be seen as representing the efficiency with whichcapital is being utilized to generate revenue. It is commonly used as a measure for comparing theperformance between businesses and for assessing whether a business generates enough returns to pay

for its cost of capital.

The formula

ROCE compares earnings with capital invested in the company. It is similar to Return on Assets, buttakes into account sources of financing. In the denominator we have net assets or capital employedinstead of total assets (which is the case of Return on Assets). In the numerator we have Pretax operatingprofit orEBIT. EBIT [Earnings Before Interest and Tax].

Capital Employed has many definitions. In general it is the capital investment necessary for a business tofunction. It is commonly represented as total assets less current liabilities or fixed assets plus workingcapital.

ROCE is used to prove the value the business gains from its assets and liabilities, a business which ownslots of land but has little profit will have a similar ROCE to a business which owns little land but makeslarge profit.

It basically can be used to show how much a bussiness is gaining for its assets, or how much it is losingfor its liabilities.

Drawbacks of ROCE

The main drawback of ROCE is that it measures return against the book value of assets in the business.As these are depreciated the ROCE will increase even though cash flow has remained the same. Thus,older businesses with depreciated assets will tend to have higher ROCE than newer, possibly betterbusinesses. In addition, while cash flow is affected by inflation, the book value of assets is not.Consequently revenues increase with inflation while capital employed generally does not (as the bookvalue of assets is not affected by inflation).

Additional and alternative definitions

A different way to calculate ROCE is ROACE, Return on AVERAGE Capital Employed. Instead of usingthe capital as reported, it uses the average of opening and closing capital for the time period.
http://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Returns_(economics)http://en.wikipedia.org/wiki/Capital_employedhttp://en.wikipedia.org/wiki/Ratiohttp://en.wikipedia.org/wiki/Capital_(economics)http://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/wiki/EBIThttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Returns_(economics)http://en.wikipedia.org/wiki/Capital_employedhttp://en.wikipedia.org/wiki/Ratiohttp://en.wikipedia.org/wiki/Capital_(economics)http://en.wikipedia.org/wiki/Revenuehttp://en.wikipedia.org/wiki/EBIT


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Liquidity Ratios

Liquidity ratios measure the availability of cash to pay debt.

Current ratio = Current assets / Current liabilities[15]

Acid-test ratio (Quick ratio) = (Current assets - Inventories) / Current liabilities[16]

Current ratio

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay itsdebts over the next 12 months. It compares a firm's current assets to its current liabilities. It is expressedas follows:

For example, if WXY Company's current assets are $50,000,000 and its current liabilities are$40,000,000, then its current ratio would be $50,000,000 divided by $40,000,000, which equals 1.25. Itmeans that for every dollar the company owes it has $1.25 available in current assets. A current ratio ofassets to liabilities of 2:1 is usually considered to be acceptable (ie., your assets are twice your liabilities).[1]

The current ratio is an indication of a firm's market liquidity and ability to meet short-term debt obligations.Acceptable current ratios vary from industry to industry. If a company's current assets are in this range,then it is generally considered to have good short-term financial strength. If current liabilities exceedcurrent assets (the current ratio is below 1), then the company may have problems meeting its short-termobligations. If the current ratio is too high, then the company may not be efficiently utilizing its currentassets.

Quick ratio

In finance the Acid-test or quick ratio measures the ability of a company to use its near cash orquickassets to immediately extinguish its current liabilities. Quick assets include those current assets thatpresumably can be quickly converted to cash at close to their book values. Such items are cash,marketable securities, and some accounts receivable. This ratio indicates a firm's capacity to maintainoperations as usual with current cash ornear cash reserves in bad periods. As such, this ratio implies aliquidation approach and does not recognize the revolving nature of current assets and liabilities. Theratio compares a company's cash and short-term investments to the financial liabilities the company isexpected to incur within a year's time.

OR

Ideally the acid test ratio will be 1:1, but 0.8:1 is acceptable, with less the business could suffer financialdifficulties.
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Activity Ratios

Activity ratios measure how quickly a firm converts non-cash assets to cash assets.

Average collection period = Accounts receivable / (Annual credit sales / 360 days)[17]

Collection period (period end) Average payment period = Accounts payable / (Annual credit purchases / 360 days)[18]

Inventory turnoverratio = Cost of goods sold / Average inventory[19]

Inventory conversion ratio = Inventory conversion to cash period (days) = 360 days / Inventoryturnover[20]

days Inventory

Debt Ratios

Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financial leverage.

Debt ratio = Total assets / Total liabilities[21] Debt to assets ratio Debt to equity ratio = (Long-term debt + Value of leases) / Stockholders' equity[22]

Long-term debt/Total asset (LD/TA) ratio = long-term debt / Total assets[23]

Times interest-earned ratio = Earnings before interest and taxes EBIT / Annual interestexpense[24]

Overall coverage ratio = Cash inflows divided by

Lease expenses plusInterest charges plusDebt repayment / (1-t) plusPreferred dividend / (1-t)

Debt service coverage ratio = Net operating income / Total debt service

Market Ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.

Payout ratio = Dividend / Earnings[25], or

= Dividend per share / Earnings per share[26]Note:Earnings per share is not a ratio, it is a value in currency. Earnings per share = Expectedearnings / Number of outstanding shares[27]

P/E ratio = Price / Earnings per share Cash flow ratio orPrice/cash flow ratio = Price of stock / present value of cash flow per share[28]

Price to book value ratio (P/B or PBV) = Price of stock / Book value per share[29]

Price/sales ratio PEG ratio

.
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P/E What is it all about?

The most commonly used valuation metric by investors is the price to earnings ratio or commonly referredto as the P/E ratio. Though commonly used, it is also misunderstood for various reasons. Here is anattempt to simplify this valuation metric.

How is P/E calculated?

It is calculated by dividing market price of a stock by EPS (earnings per share). EPS in turn is calculatedby dividing the net profit of the company by the number of shares outstanding.

Having calculated the P/E, what does it stand for?

Lets assume a stock is trading at Rs 100 and its EPS is Rs 20. The P/E multiple is 5 (100 upon 20).Assuming that the companys EPS is likely to be Rs 20 each year, it will take 5 years for the investor to

realize Rs 100. Of course, the assumption here is that the companys EPS is not growing at all.

Now taking the example of commonly traded stocks like Infosys and Tisco. While the former trades at aP/E multiple of 25 times, the latter trades at 7 times. Why is it so? It is believed that the stock price of acompany tracks its long-term earnings growth potential. In an economy, some companies (or sectors) arelikely to grow at a faster (like say software or pharma) rate. So, the P/E multiple of companies from thesesectors are likely to be higher and vice versa. Depending upon growth expectations, the P/E multiplecould vary.

There is one crucial factor here i.e. expectations. Though Infosys may be trading at 25 times earnings, ifEPS is expected to grow by 25% per annum, the investor could realize the money in four years.

P/E Is it a discount or a multiple?

There are two ways of quoting P/E valuations:

1. Tisco is currently trading at Rs 350 discounting its earnings by 5.5 times

2. Tisco is currently trading at Rs 350 at a P/E multiple of 5.5 times

Which is right? The answer to this lies in the formula for calculating P/E itself.

P/E is Market price divided by EPS. If we were to reverse the formula,

Market price = P/E multipliedby EPS. Stock prices reflect future earnings potential and not pastperformance. Discounting the current price with historical EPS is not a right way to analyse companies.

Take a hypothetical case. If Tiscos EPS for the next year is expected at Rs 50 and the growth in EPS isaround 15%, the market price is calculated by multiplying Rs 50 with 15 times i.e. Rs 750. Whendetermining the stock price, one does not discount earnings but multiply earnings.


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What is the right P/E multiple for a stock?

The answer to this question is not easy. In the previous example, we have assigned a P/E multiple of 15times because EPS is expected to grow by 15% in the immediate year. Is this the right way? Notnecessarily. Here, it is important to understand industry characteristics of the company.

For a commodity stock like Tisco, EPS tends to grow at a faster rate when steel prices are recovering orare at the peak and the EPS is likely to decline at a faster rate during downturns. To qualify thisstatement, if we look at EPS growth of Tisco from 1994 to 2004, the compounded growth in earnings is17%. However, the CAGR growth in the last three years was 193% (the recovery phase). So, if onebelieves that steel demand is likely to trace long-term economic growth and that 15% growth isunsustainable, the P/E multiple should be ideally much lower than 15 times. Similarly, the long-termgrowth prospects for software companies could be much higher than commodities. So, the P/E multiplefor software stocks could be at a premium.

Determining the P/E multiple for a stock/sector also depends on:

1. Historical performance Why does Infosys trade at a higher P/E multiple compared to Satyam?By historical performance, we mean, focus of the management (without unrelated

diversifications), ability to outperform competitors in downturn/upturns and promise vsperformance. This can be gauged if one looks at the last three to five year annual reports of acompany.

2. The sector characteristics Margin profile, whether it is asset intensive and intensity ofcompetition. Less asset intensive sectors (say, FMCG) are considered defensive and therefore,could trade a premium to the overall market.

3. And more importantly, expectations. Take the case of textile stocks. Expectations of significantgrowth opportunities post the 2005 quote regime phase out has resulted in upgradation of P/Emultiple of the textile sector.

When is P/E not useful?

1. Economic cycles - In FY02, Tisco was trading at a P/E multiple of 20.5 times its FY02 earnings.Was it expensive? Based on FY05 expected earnings, Tisco is trading at a P/E multiple of 5 timesits earnings (at Rs 250). Is it cheap? If one ignored Tisco in FY02 on the basis that it wasexpensive on the P/E multiple in FY02, the opportunity loss is as much as 350%. Businessesoperate in cycles. During downturn, EPS will be low but P/E will be inflated and vice versa. At thesame time, during expansionary phase, corporates invest in capacities. In this case, highdepreciation costs suppress earnings. P/E, in this context, may mislead investors.

2. Not actively tracked There are number of companies in the Indian stock market that are notactively tracked by investors, analyst and institutions. For example, Infosys average price was Rs2 in FY94 and the P/E multiple was 17 times. At times, P/E multiple may be lower because some

sectors/stocks are not in the limelight.

3. Expectations On the downside, some stocks may be trading at a significant premium becauseearnings expectations are higher. High P/E also does not mean a good stock to buy. What if theexpectations are unrealistic? One needs to exercise caution to this extent.

4. Means little as a standalone number P/E, as a standalone number, means little. Besides P/E,it is also important to look at margins, return on net worth, cash generating ability and consistencyin performance over the years to assign a value to a stock.


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5. Market sentiment During bear phases or when interest in stocks is low, valuations could bedepressed. Since equities are considered less attractive during these periods, valuations arelikely to be below historical average or below earnings growth prospects.

When is P/E useful?

A powerful metric Unlike metrics like discounted cash flow method and so on, P/E is relatively asimple and at the same time, a powerful metric from a retail investor perspective. Though the factorsbehind determining the right P/E multiple are important, a historical perspective of a stocks P/E couldmake this exercise less complex.

To conclude, valuation of stocks involves subjectivity. A person X may assign a higher P/E multiple to thestock as compared to a person Y depending on the risk profile and growth expectations. In the end, it allboils down to how the company is likely to perform.

It is not that stock market is always right when it comes to valuing a stock! As Mr. Benjamin Graham putsit in the short term, the market is a 'voting' machine whereon countless individuals register choices thatare product partly of reason and partly of emotion. However, in the long-term, the market is a 'weighing'machine on which the value of each issue (business) is recorded by an exact and impersonal

mechanism. Watch the earnings!

Various interpretations of a particular P/E ratio are possible, and the historical table below is justindicative and cannot be a guide, as current P/E ratios should be compared to current real interest rates:

N/AA company with no earnings has an undefined P/E ratio. By convention, companies with losses(negative earnings) are usually treated as having an undefined P/E ratio, although a negative P/Eratio can be mathematically determined.

010Either the stock is undervalued or the company's earnings are thought to be in decline.Alternatively, current earnings may be substantially above historic trends.

1017 For many companies a P/E ratio in this range may be considered fair value.

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Either the stock is overvalued or the company's earnings have increased since the last earnings

figure was published. The stock may also be a growth stock with earnings expected to increasesubstantially in future.

25+A company whose shares have a very high P/E may have high expected future growth in earningsor the stock may be the subject of a speculative bubble.

It is usually not enough to look at the P/E ratio of one company and determine its status. Usually, ananalyst will look at a company's P/E ratio compared to the industry the company is in, the sector thecompany is in, as well as the overall market (for example the S&P 500 if it is listed in a US exchange).Sites such as Reuters offer these comparisons in one table. Example of RHAT Often, comparisons willalso be made between quarterly and annual data. Only after a comparison with the industry, sector, andmarket can an analyst determine whether a P/E ratio is high or low with the above mentioned distinctions(i.e., undervaluation, over valuation, fair valuation, etc).

P/B ratio

The Price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's book value to itscurrent market price. Book value is an accounting term denoting the portion of the company held by theshareholders; in other words, the company's total assets less its total liabilities. The calculation can beperformed in two ways, but the result should be the same each way. In the first way, the company'smarket capitalization can be divided by the company's total book value from its balance sheet. Thesecond way, using per-share values, is to divide the company's current share price by the book value pershare (i.e. its book value divided by the number of outstanding shares).
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As with most ratios, be aware this varies a fair amount by industry. Industries that require higherinfrastructure capital (for each dollar of profit) will usually trade at P/B much lower than the P/B of (e.g.)consulting firms. P/B ratios are commonly used for comparison of banks, because most assets andliabilities of banks are constantly valued at market values. P/B ratios do not, however, directly provide anyinformation on the ability of the firm to generate profits or cash for shareholders.

This ratio also gives some idea of whether an investor is paying too much for what would be left if thecompany went bankrupt immediately. For companies in distress, the book value is usually calculatedwithout the intangible assets that would have no resale value. In such cases, P/B should also becalculated on a 'diluted' basis, because stock options may well vest on sale of the company or change ofcontrol or firing of management.

Also known as the "price/equity ratio" (which should not be confused with P/E or price/earnings ratio) orthe market-to-book ratio.

In finance, leverage (or gearing) is using given resources in such a way that the potential positive ornegative outcome is magnified. It generally refers to using borrowed funds, ordebt, so as to attempt toincrease the returns to equity.

Other Measures

This section does not cite any references or sources.Please improve this section by adding citations to reliable sources. Unverifiable material may bechallenged and removed. (tagged since July 2007)

Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) (Interest coverageratio)

Payback period: How many years of operating earnings are needed to pay off the debt :Debt/EBITDA

Operating leverage

1. Percentage Gross Profit on Turnover = (Gross Profit) / (Sales) x 100.

2. Percentage Gross Profit on Cost of Sales = (Gross Profit) / (Cost of Sales) x 100.

3. Percentage Net Income on Turnover = (Net Income) / (Sales) x 100.

4. Percentage Total Expenses on Turnover = (Total Expenses) / (Sales) x 100.

5. Percentage Operating Profit on Turnover = (Operating profit) / (Sales) x 100.

6. Percentage Operating Profit on Cost of Sales = (Operating Profit) / (Cost of Sales) x 100.

7. Net Assets = (Total Assets) - (Total Liabilities).

8. Solvency Ratio = (Total Assets) / (Total Liabilities).

9. Net Current Assets = (Current Assets) - (Current Liabilities).

12. Rate of Stock Turnover = (Cost of Sales) / (Average Stock).
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13. Period for which Ample Stock is on Hand = (Average Stock) / (Cost of Sales) x (365 days or 12months).

14. Debtors Average Collection Period = (Average Debtors) / (Credit Sales) x (365 days or 12 months).

15. Creditors Average Payment Period = (Average Creditors) / (Credit Purchases) x (365 days or 12

months).

16. Debt/Equity Ratio = (Total Liabilities) / (Shareholders Equity). This is also known as Risk or Gearing,the extent to which a company is financed by borrowed funds; for example, if a company is highly geared,it borrows a lot.

17. Return on Total Capital Employed = ((Net Profit before Tax) + (Interest on Loan)) / (Average CapitalEmployed) x 100.

18. Return on Shareholders' Equity = (Net Profit after Tax) / (Average Shareholders' Equity) x 100.

19. Earnings per Share = (Net Profit after Tax) / (Number of Shares Issued) x 100.

20. Dividends per Share = (Dividends on Ordinary Shares) / (Number of Shares Issued) x 100.

21. Net Asset Value per Share = (Shareholders' Equity) / (Number of Shares Issued) x 100.

22. Net Profit before Tax on Turnover = (Net Profit before Tax) / (Turnover) x 100.

Types of leverage

Financial leverage

Financial leverage takes the form of a loan or other borrowings (debt), the proceeds of which are

reinvested with the intent to earn a greater rate of return than the cost of interest. If the firm's return onassets (ROA) is higher than the interest on the loan, then its return on equity (ROE) will be higher than if itdid not borrow. On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will belower than if it did not borrow. Leverage allows greater potential return to the investor than otherwisewould have been available. The potential for loss is also greater, because if the investment becomesworthless, the loan principal and all accrued interest on the loan still need to be repaid.

Margin buying is a common way of utilizing the concept of leverage in investing. An unlevered firm can beseen as an all-equity firm, whereas a levered firm is made up of ownership equity and debt. A firm's debtto equity ratio (measured at market value orbook value, depending on the purpose of the analysis) istherefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm isdescribed in the Modigliani-Miller theorem. As is true ofoperating leverage, degree of financial leveragemeasures the effect of a change in one variable on another variable. Degree of financial leverage (DFL)may be defined as the percentage change in earnings (Earnings per share) that occurs as a result of apercentage change in earnings before interest and taxes.

Measures of financial leverage

Debt-to-equity

Debt to equity is generally measured as the firm's total liabilities (excluding shareholders' equity) dividedby shareholders' equity, where D = liabilities, E = equity and A = total assets:
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D / E = Debt-to-equity ratioD / (D + E) = Debt-to-value ratio

For different applications of leverage, analysts may include or exclude certain items, such as non-tangiblebalance sheet items, non-financial liabilities, and similar items, or may adjust the carrying value of otheritems. It is not uncommon to use only financial liabilities (long-term and short-term borrowings), thereby

excluding, for example, accounts payable.

Gearing and Du Pont Analysis

Use of the Du Pont Identity requires that leverage be measured in terms of total assets divided byshareholders' equity (which is further decomposed in the traditional analysis), and this is sometimesreferred to as gearingor simply leverage:

Leverage (gearing) = A / E

The two measures are related. Since the terms used are the same throughout, debt-to-equity is equal togearing times debt over assets (as the asset term cancels out):

D / E = (A / E) * (D / A)

Operating leverage

Operating leverage reflects the extent to which fixed assets and associated fixed costs are utilized in thebusiness. Degree of operating leverage (DOL) may be defined as the percentage change in operatingincome that occurs as a result of a percentage change in units sold. To the extent that one goes with aheavy commitment to fixed costs in the operation of a firm, the firm has operating leverage.

Combined stand-alone leverage

If both operating and financial leverage allow us to magnify our returns, then we will get maximum

leverage through their combined use in the form of combined leverage. Operating leverage affectsprimarily the asset and operating expense structure of the firm, while financial leverage affects the debt-equity mix. From an income statement viewpoint, operating leverage determines return from operations,while financial leverage determines how the fruits of labor will be divided between debt holders (in theform of payments of interest and principal on the debt) and stockholders (in the form of dividends).Degree of combined leverage (DCL) uses the entire income statement and shows the impact of a changein sales or volume on bottom-line earnings per share. Degree of operating leverage and degree offinancial leverage are, in effect, being combined.

Correlation leverage

Correlation leverage is a third concept that captures the degree to which the variability in the firm'srevenue is correlated with that of other firms. If the correlation is low or negative, investors who hold a

diversified portfolio will not see that variability as bad, and the firm will be able to carry a higher level ofcombined stand-alone leverage than if the variability in its revenue were highly correlated with that ofother firms.

The measure known as the Beta coefficient captures all three of the components of leverage in a singlemeasure.
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Derivatives

Derivatives allow leverage without borrowing explicitly, though the 'effect' of borrowing is implicit in thecost of the derivative.

Buying a futures contract magnifies your exposure with little money down.

Options do the same. The purchase of a call option on a security gives the buyer the right topurchase the underlying security at a given price in the future. If the price of the underlyingsecurity rises, the value of the call option will rise at a rate much greater than the value of theunderlying security. However if the rate of the call option falls or does not rise, the call option maybe worthless, involving a much greater loss than if the same money had been invested in theunderlying instrument.

Structured products that exist as either closed-ended funds, or public companies, or incometrusts are responding to the public's demand for yield by leveraging. This is frequently notdisclosed anywhere other than far down in the Prospectus.

Risk

Employing leverage amplifies the potential gain from an investment or project, but also increases thepotential loss. Interest and principal payments (usually certain ex ante) may be higher than the investmentreturns (which are uncertain ex ante). This increased risk may still lead to the optimal outcome for theentity or person making the investment. In fact, precisely managing risk utilizing strategies includingleverage and security purchases, is the subject of a discipline known

Documents

Financial Ratio & Leverage