8.17 Investment Measures and Ratios

Valuations need to compare like with like, and these are the common measurements applying to US companies. The measurements also apply to companies operating under other reporting regulations, but tax provisions may differ.

Bonds

Companies raise capital by taking out a loan, and/or by issuing shares and bonds. Bonds run for a set period of time at a stated interest rate. Upon maturity the loan (bond principal) is returned. Interest is usually paid every six months. {8} Bonds are also issued by municipalities, states and (most importantly) by sovereign governments. {9}

Bonds are traded. If a $1 bond yielding 1.5% interest is sold at 80 cents, reflecting doubts on its future value, the interest is effectively $1.5/0.8 or 1.875%, the acquirer being rewarded with an increased yield for accepting a higher risk. Many factors enter into risk assessment (interest rates, maturity of the obligation, credit risk, liquidity, embedded options; and tax treatment of the obligation). {10} Spreads are the differences between two stated prices or other variables, and provide a measure of market concerns. In money markets, for example, the TED spread, a difference between T-bill and Eurodollar rates, compares the difference between a 'risk free' Treasury rate and a comparable commercial rate. Spreads between Libor (rate at which banks lend money to each other) for different currencies also indicate their relative strengths, and may determine forward exchange rates. {11}

Revenue

The money a company receives during a specific period from its business activities, including discounts and deductions for returned merchandise. Often shown as the top line or 'gross income' in financial accounts, it is the figure from which costs are subtracted to determine net income. In the case of charities the revenue may come from donations and fundraising events. Revenue is the amount of money that is brought into a company by its business activities. In the case of government, revenue comes from taxation, fees, fines, intergovernmental grants or transfers, securities sales, sale of resource rights and government assets.

Net Revenue

Net income is the revenue adjusted for the cost of doing business, including depreciation, interest, taxes and other expenses. In UK income statements, the net income is often shown as the 'profit attributable to shareholders'.

Economic Value Added (EVA)

EVA is difference between the revenue received from the sale of an output and the opportunity cost of the inputs used. It is not the accounting profit, but a measure of how assets are used. A company that closed factories that generated $5 million per year in sales and used the savings to invest in new products that generated $8 million per year in sales would have an EVA of $3 million.

Return on Investment (ROI)

Return on investment evaluates the performance of a company by dividing its net profit by net worth. The latter will be the assets shown on the balance sheet: cash, plant, property, inventories, goodwill, and balance owed by debtors or creditors.

Stockholder's Equity

Stockholders' equity (or shareholder's equity) is that part of the balance sheet which represents stock (paid-in capital), donated capital and retained earnings. Stockholders' equity is the stake currently held on the books by a firm's equity investors. It is calculated as:

A company's total assets minus its total liabilities, or
Share capital plus retained earnings minus treasury shares.

Debt to Equity Ratio

Ratio of the company's total liabilities to its total shareholders' equity. Among liabilities are bank and other loans, creditors and other obligations. A lower figure indicates a company less vulnerable to sudden losses or loans being called in.

Dividend Yield

A stock's dividend yield is the company's annual cash dividend per share divided by the current price of the share. The figure is given in the stock quotes of dividend-paying companies, but may refer to the latest quarterly declared dividend rather than the annual figure.

Payout Ratio

Percentage of earnings (net income) per common share that are allocated to paying cash dividends to shareholders. Or the dividends per share divided by earnings per share. The ratio is an indicator of how well earnings support the dividend payment.

Current Ratio

Ratio of current assets available to cover current liabilities. Current assets are cash, cash equivalents, marketable securities, receivables and inventory. Current liabilities are notes payable, current portion of long-term debt, payables, accrued expenses and taxes. In general, a higher figure indicates a stronger company.

Price to Book Ratio

Price-to-book value (P/B) is the ratio of market price of a company's shares (share price) over its book value of equity. The latter is the value of a company's assets shown on the balance sheet, less any intangible assets or liabilities. The ratio indicates how much shareholders are paying for the net assets of a company.

Earnings Per Share

EPS is the profit that a company has made over the last year divided by how many shares are on the market. Most financial websites provide the figure. Preferred shares are not included in the calculation. {1}

Return on Equity (ROE)

Return on stockholders equity, ROE, is calculated as net income/ stockholder's equity. Net income is the net income of the preceding fiscal year. Since stockholder's equity does not include preferred shares, the net income figure will be the reported net income less the preferred dividends, and the stockholder's equity will be the reported equity less the preferred share equity. {1} Financial websites generally provide this figure.

Price/Earnings

Ratio of a company's current share price compared to its earnings (net revenues) per share. It is calculated as the price per share / earnings per share (EPS). The EPS is usually taken from the last four quarters (trailing P/E), but may sometimes be an estimates of earnings expected in the next four quarters (projected or forward P/E). {1}

A high P/E may indicate that a stock is overpriced, or that investors are expecting future high growth. P/E ratios need to be considered over some period of time, compared with those of other companies in a similar market sector, and the earnings figure examined carefully as it may be subject to various accounting adjustments (as far as accounting regulations {3} {4} allow).

Price/Sales

Ratio of a company's current share price compared to its reported revenue per share for the previous twelve months. It is calculated as the market value of equity / total revenues. {5} The ratio varies across industries, and does not take into account the company's debt and expenses.

Sales/Share

Ratio of the total revenue earned per share over a 12-month period. It is calculated as total revenue earned in a fiscal year / the weighted average of shares outstanding for that fiscal year.

A higher ratio indicates a more active company.

Attractive Indications

There are no hard and fast rules, but successful investors often prefer companies that:

1. They thoroughly understand, especially those that dominate a market sector and have products people need to keep buying.

2. Are 'fortunate and able', i.e. have a good product and solid management, so being able to grow sales and profits at rates above the industry average.

3. Are low cost producers: i.e. their low break-even points and high profit margins will enable them to survive hard times.

4. Are relatively secure, possessing low long-term debt and high cash reserves.

5. Are currently underpriced, with market capitalizations below their NPVs, a stock price/book value not exceeding two thirds, and a low P/E ratio, preferably under 15.

There are many strategies. Seasoned investors often devise their own, disregard newspaper tips and gossip, and ensure they gave can give full and cogent reasons for an acquisition.

Points to Note

1. Differences between shares and bonds.
2. Important investment measures and ratios.
3. What makes a company worth investing in.

Questions

1. Compare bonds to shares. Which would you invest in?
2. Describe the importance of six investment measures.
3. What rules would guide your creation of an investment portfolio?

Sources and Further Reading

1. 8 Simple Investing Ratios You Need To Know. Investopedia. June 2012.
2. Earnings Quality: Introduction. Investopedia. June 2012. Extended tutorial on understanding financial reports, focusing on accruals.
3. Generally Accepted Accounting Principles in the United States. CPAClass. Detailed exposition of regulations and standards.
4. Financial Accounting Standards Board. FASB. Detailed codifications in pdf format.
5. Prices Sales Ratio. New York University. Powerpoint-like presentation, with uses of ratio and examples.
6. Return on Investment. Entrepreneur. June 2012.
7. Return on Equity. Investopedia. June 2012. Includes various refinements.
8. Definition of 'Bond' Investopedia. June 2012. Part of extended tutorial.
9. Bonds and Rates. FT Marketsdata. July 2012. Bond rates for the USA, UK, Japan and the Eurozone.
10. InterestRate Spreads. Risk Glossary. Introduction.
11. Spreads. Risk Glossary. Concise but technical treatment.
12. The Neatest Little Guide to Stock Market Investing by Jason Helly. Penguin, 2010.
13. Balance sheet. Wikipedia. September 2012. Wikipedia has many entries on finance and investment ratios: some detailed and not to be despised.