Financial Ratio Analysis and Investment Valuation

Posted on Sep 10, 2024 in Economy

Income Statement

A summary of revenues and expenses, and an analysis before and after income tax. EPS (Earnings Per Share) = Earnings available for common shareholders / Number of shares of common stock outstanding = (Net Income – Cash dividends on preferred stock) / Number of common shares outstanding.

Balance Sheet

Assets = Liabilities + Shareholders’ Equity

Statement of Cash Flow

The flow of cash into and out of the firm in terms of:

  • Operating activities: Wages, materials
  • Investing activities: Working capital
  • Financing activities: Interest/dividends

Financial Ratio Analysis

Liquidity Ratios

Measure a firm’s ability to meet its short-term obligations.

  • Current Ratio: Current Assets / Current Liabilities (Standard of comparison: >2 indicates the ability of the firm to meet current obligations, <1 indicates potential financial difficulties)
  • Quick Ratio: (Current Assets – Inventory) / Current Liabilities (<1 is not alarming, high values may indicate excess cash)

Asset Management Ratios

  • Inventory Turnover: Cost of Goods Sold / Inventory (High values indicate efficient inventory management). Measures the number of times a year the firm turns over its inventory.
  • Long-term Asset Turnover: Sales / Long-term Assets
  • Total Asset Turnover: Sales / Total Assets

Debt Management Ratios

  • Total Debt to Total Assets: Total Debt / Total Assets (High values indicate the use of financial leverage to magnify earnings, low values indicate relatively low use of credit funds)
  • Times Interest Earned: EBIT / Interest (Measures the firm’s ability to meet its interest requirements. High values are considered safe)
  • Fixed Charges Ratio: (EBIT + Lease Expense) / (Interest + Lease Expense) (Measures the firm’s ability to meet its legal financing obligations. High values are desirable)

Profitability Ratios

  • Net Profit Margin: Net Income / Sales
  • Return on Total Assets: Net Income / Total Assets
  • Return on Equity: Net Income / Stockholders’ Equity (Measures the return on the owner’s investment in the firm. Not a reliable measure of return because it does not focus on actual returns for cash dividends)

Market Ratios

  • Price/Earnings (P/E) Ratio: Market Price per Share / Earnings per Share (Indicates how much investors are willing to pay for the firm’s current earnings. Helpful to look at trends for the company and stock market. High P/E ratios may indicate good growth opportunities, safe earnings, or a low capitalization rate)
  • Dividend Yield: Dividends per Share / Market Price per Share (Firms with high growth typically have low cash dividends and high market prices)
  • Dividend Payout Ratio: Dividends per Share / Earnings per Share (High-growth firms tend to reinvest earnings rather than pay them out as dividends). Indicates how the firm is splitting its earnings between returning them to common shareholders and reinvesting them in the firm.

Disadvantages of Financial Ratio Analysis

  • Reliance on historical cost
  • Alternative treatment of numerous transactions
  • Potential for window dressing
  • Difficulty in hiding individual division performance
  • Impact of inflation
  • Limited usefulness of industry averages

Time Value of Money

  • Future Value (FV): FV = Present Value (PV) * (1 + interest rate (r))^number of periods (t)
  • Effective Annual Rate (EAR): EAR = (1 + (Annual Percentage Rate (APR) / number of compounding periods per year (m)))^m – 1
  • Present Value (PV): PV = FV / (1 + r)^t
  • Rate of Return (ROR): ROR = Profit / Investment = (Cash flow in period 1 (C1) + Cash flow in period 0 (C0)) / -C0
  • Net Present Value (NPV): NPV = C0 + C1 / (1 + r) + C2 / (1 + r)^2 + …
  • Perpetuities: PV = C / r (where C is the constant cash flow received each period)
  • Annuities: PV = C * ((1 / r) – (1 / (r * (1 + r)^t)))

Stock Valuation

  • Single-Period Return: r = (Dividend in period 1 (DIV1) + Price in period 1 (P1) – Price in period 0 (P0)) / P0
  • Multi-Period Valuation: P0 = DIVt / (1 + r)^t + PH / (1 + r)^H (where H is the valuation horizon)
  • Constant Growth Model: P0 = DIV1 / (r – growth rate (g))
  • Required Rate of Return: r = DIV1 / P0 + g
  • Payout Ratio: DIV1 / EPS1
  • Plowback Ratio: 1 – Payout Ratio
  • Return on Equity (ROE): EPS1 / Book Equity per Share
  • Sustainable Growth Rate: g = Plowback Ratio * ROE
  • Growth Stock: Purchased for the expectation of capital gains based on future growth and earnings
  • Income Stock: Purchased for cash dividends
  • Expected Return (Dividend Yield): DIV1 / P0 = EPS1 / P0
  • Present Value of Growth Opportunities (PVGO): P0 = (EPS1 / r) + PVGO => EPS1 / P0 = r * (1 – PVGO / P0); PVGO = NPV1 / (r – g). For growth stocks, PVGO is typically high, and the earnings-price ratio is low.

Business Valuation

  • Free Cash Flow (FCF): The amount of cash that the firm can pay out to investors after paying for all investments.
  • Valuation Horizon (H): The terminal value. PV = FCF1 / (1 + r) + FCF2 / (1 + r)^2 + … + FCFH / (1 + r)^H + PVH / ((1 + r)^H)

Bond Valuation

  • Bond Value: Value = Ct / (1 + i)^t + Pn / (1 + i)^n (where Ct is the coupon payment at time t, i is the yield to maturity (YTM), Pn is the par value, and n is the number of periods)
  • Yield to Maturity (YTM): i = (Coupon (t) + (Par Value (Pn) – Market Value (V)) / number of periods (n)) / (0.6 * Market Value (V) + 0.4 * Par Value (Pn))
  • Callable Bonds (Yield to Call – YTC): Can be redeemed or paid off by the issuer prior to the bond’s maturity date.
  • Spot Rate: The price for immediate delivery.
  • Forward Rate: The interest rate on a transaction that will take place in the future.
  • Relationship between Spot Rate and YTM: Example: Assume r1 = 8%, rate = 5%, years = 2, FV = $1000. PV = 50 / 1.08 + 1050 / (1.02)^2 = $914. Single rate: 914 = … r = y.
  • Forward Rate Calculation: fn = ((1 + rn)^n / (1 + rn-1)^n-1) – 1, where r is the spot rate.
  • Term Structure of Interest Rates (Yield Curve): The relationship between spot rates with different maturities. Reflects current competitive conditions in the money and capital markets, expected inflation, and changes in economic conditions.
  • Liquidity Premium Theory: Long-term rates should be higher than short-term rates because short-term securities have greater liquidity and are less subject to large price changes, and investors are willing to pay a higher price for short-term securities.
  • Market Segmentation Theory: Focuses on the demand side of the market (short-term – bankers, intermediate-term – savings and loans, long-term – insurance companies). Different phases of the business cycle affect the yield curve.
  • Expectations Hypothesis: Long-term interest rates hold a forecast for short-term interest rates in the future. Higher expected interest rates mean longer maturities will carry higher yields.
  • Bond Duration: A function of maturity, coupon rate, and market rate of interest. % change in the value of a bond = Duration * % change in interest rate. A measure to judge bond price sensitivity to interest rate changes. Duration of a perpetual bond that makes an equal payment each year in perpetuity: (1 + yield) / yield.
  • Immunization Strategy: Minimizes the impact of interest rates on net worth.

Risk and Return

  • Expected Return: A measure of central tendency.
  • Variance: An average deviation measure of dispersion, obtained by averaging the squares of deviations of individual observations from the mean.
  • Standard Deviation: An average deviation measure of dispersion equal to the positive square root of the variance.
  • Covariance: An absolute measure of the extent to which two sets of variables move together over time.
  • Positive Covariance: When one stock produces a return above its mean, the other tends to do as well.
  • Correlation Coefficient: A normalized measurement of joint movement between two variables, ranging from -1 to 1.
  • Correlation of Determination: Tells us the fraction of the variability in the returns on one investment that can be associated with variability in the returns on the other.
  • Characteristic Line: Describes the relationship between returns on the stock and the market portfolio. The slope of the characteristic line is the stock’s beta factor. Beta > 1 indicates high volatility.
  • Diversification: Reduces risk because returns of different investments do not move exactly together.
  • Portfolio Analysis: Variance is a function of the variance of each investment included in the portfolio as well as the covariance between investments’ returns (2 stocks example).
  • Beta: An indicator of the degree to which a stock responds to changes in the return produced by the market.