Oh! the WONDERFUL ratios

My classmates and i recently created a group for young value investors to discuss,debate and disgust with each other. Among some of the topics, i feel that relearning all the useful finanical ratios is important. Hences the following..

#EPS
Calculated as:
(Net income -dividends on preferred stocks)/average outstanding shares

Understanding: The portion of a company's profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company's profitability

Examples: Assume that SMART has a net income of $25 million. If the company pays out $1 million in preferred dividends and has 10 million shares for half of the year and 15 million shares for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from the net income to get $24 million, and then a weighted average is taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).

Application: Investors also need to be aware of earnings manipulation that will affect the quality of the earnings number. It is important not to rely on any one financial measure, but to use it in conjunction with statement analysis and other measures


#Simple PE ratio
Calculated as: Market value per share/Earnings per share

Understanding: This ratio basically shows how much investors are willing to pay per dollar of earnings. If a company was currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for every $1 of current earnings.

Examples: Your chicken rice stall currently trading at $43 a share in the stock market and earnings over the last 12 months was $1.95 per share which is your EPS, the P/E ratio for the stock would be 22 times.

Application: A low PE ratio is considered as below 20. A high PE ratio is 20 and above in general. However it is best to compare it with another company of the same nature of business.


#PBV
As known as price to book or price book value
Calculated as: PBV= STOCK PRICE* ALL OUTSTANDING SHARES/ (TOTAL ASSETS-INTANGIBLE ASSETS+ ALL LIABILITIES)

Understanding: A ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share. This ratio also gives some idea of whether you're paying too much for what would be left if the company went bankrupt immediately.

Examples: Companies with a regular inflow of new assets, such as capital expenditures in the case of capital commercial trust bought on march 2009 , the share price was trading at $0.70, if the trust delist and give back all the asset back to its shareholder, it would be roughly $1.40 per share. So we take 0.70/1.40 we have a book value of 0.5. So in other words, good value could be found if the company is trading way below its PBV (Below 1)

Application:
P/B is best used for asset-heavy companies, such as financial institutions, manufacturing companies, and other capital-intensive industries. However, this ratio has a weakness, it does tell you whether the assets are really worth that much (asset bubbles), moreover companies that have super low PBV are usually entities with bad management.


#ROA
Calculated as: ROA = Net income / Total Assets
Understanding: The Return on Assets (ROA) percentage shows how profitable a company's assets are in generating revenue. This number tells you "what the company can do with what it's got", i.e. how many dollars of earnings they derive from each dollar of assets they control. It's a useful number for comparing competing companies in the same industry.
Application: Return on assets is not useful for comparisons between industries because of factors of scale and peculiar capital requirements (such as reserve requirements in the insurance and banking industries). Since the figure for total assets of the company depends on the carrying value of the assets, some caution is required for companies whose carrying value may not correspond to the actual market value.


#ROE
Return on Equity (ROE, Return on average common equity, return on net worth)

Calculated as: Net income / average share holder equity

Understanding: This ratio measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth.

Application:
But not all high-ROE companies make good investments. Some industries have high ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are better investments than refiners just because of their ROE. Generally, capital-intensive businesses have high barriers to entry, which limit competition. But high-ROE firms with small asset bases have lower barriers to entry.

Limitations: ROE is presumably irrelevant if the earnings are not reinvested.
• The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the 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 be only 'that fraction' of ROE (ROE/3).
• New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"
• 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, always recalculate on a 'per share' basis, i.e. earnings per share/book value per share.

#ROI
Return on investment (ROI)
Calculated as: Net income/ total investment by the company (looking under cash flow investment)

Understanding: Also known as the rate of profits; the amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment.

Examples: A $1,000 investment that earns $50 in interest obviously generates more cash than a $100 investment that earns $20 in interest, but the $100 investment earns a higher return on investment.
• $50/$1,000 = 5% ROI
• $20/$100 = 20% ROI

Application: It is common practice in finance to estimate monetary returns by averaging periodic rates of return; these estimations are most useful when the averaged periodic returns are all positive, all negative, or have low variances.


#Profit margins
Calculated as: Net income/ Sales

Understanding: Refers to a measure of profitability. It is calculated using a formula and written as a percentage or a number. The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses' operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure, so that comparison of one with another can have little meaning

Examples: China Milk product limited business has many segments, one of its segment which is the bull semen trade & sales has a profit margin of 35%, as investors you want this margin to be stable or go higher.

Application: Many a times, new investors get tricked into investing companies with super high margins such as Sino tech fibre which sells cloths, since margins is highly dependent on the business outlook and competition, it is wise to find companies whose profit margins have been sustained or increasing throughout the years (say about 5-8 years)

#Current ratio

Calculated as: Current assets/ Current liabilities

Understanding: A liquidity ratio that measures a company's ability to pay short-term obligations

Examples: The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt - as there are many ways to access financing - but it is definitely not a good sign

Application: The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies within the same industry.