Financial Ratios Formulas and Analysis

financial ratios

We are going to discuss following financial ratio's ( key valuation ratio's )which are very Important for valuing stocks-
1. Price Earnings Ratio
2. Price–To–Book Ratio
3. Net Current Asset Value
4. Earnings Yield
5. Dividend Yield
6. Return on Invested Capital
7. Return on Equity
8. Margin of Safety


1) PRICE EARNINGS RATIO-

 Price/Earnings (P/E) Ratio =
𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐e/𝐿𝑎𝑠𝑡 3 𝑦𝑒𝑎𝑟 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

P/E is a measure of the amount of $'s an investor would invest, in order to receive $1 of earnings in the company.
A high P/E is ‘perceived’ to indicate investors are expecting are a high earnings growth amount compared to a company with a low P/E.
Note above we refer to historic P/E NOT forward-looking P/E.


2) PRICE-TO-BOOK RATIO-

Price/Book (P/B) Ratio =𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 /𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

What is Net Asset Value (NAV)?
1. NAV, also known as the Book Value, Balance Sheet Value or Tangible Asset Value, is a measure the company’s net worth.
2. 𝑁𝐴𝑉=𝑆ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦−𝐼𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝐴𝑠𝑠𝑒𝑡𝑠  
3. 𝑁𝐴𝑉 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒=𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 /𝐹𝑢𝑙𝑙𝑦 𝑑𝑖𝑙𝑢𝑡𝑒𝑑 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

 The P/B ratio gives a measure of whether you are paying too much for what would be left were the company to go bankrupt immediately.
 A LOW P/B ratio may be a sign the company is undervalued


3) NET CURRENT ASSET VALUE-

𝑁𝑒𝑡 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒=𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠−𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

A RARE but IMPORTANT indicator of an undervalued stock, is a situation whereby a company sells for less than its Net Current Asset Value:

𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 < 𝑁𝑒𝑡 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 /𝐹𝑢𝑙𝑙𝑦 𝐷𝑖𝑙𝑢𝑡𝑒𝑑 𝑁𝑜. 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

This would mean the company’s shares are selling BELOW their net liquidation value, and are therefore UNDERVALUED.
Net Current Asset Value is also known as Net Working Capital, but NOT the same as Working Capital (which equals Current Assets minus Current Liabilities)

everything about ratios

4) EARNINGS YIELD-

Earnings Yield =𝐿𝑎𝑠𝑡 3 𝑦𝑒𝑎𝑟 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 /share 𝑃𝑟𝑖𝑐𝑒

Note that it is the inverse of the P/E Ratio.
A HIGHER Earnings Yield means you are gaining a higher percentage of earnings for every $ invested in the stock, vs another company with a lower Earnings Yield.
The Earnings Yield is usually compared to the interest rates in government bonds. It should reflect within it the necessary risk premium.


5) DIVIDEND YIELD-

Dividend Yield =𝑇𝑜𝑡𝑎𝑙 𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒/ 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒

The Dividend Yield is a measure of how much cash flow you receive for each $ you have invested in the company.
Although not used as much when evaluating value proposition, it does form an important metric when evaluating a company’s dividend proposition.
In the absence of any meaningful capital gain, the dividend yield is a useful indicator of your Return on Capital.

6) RETURN ON INVESTED CAPITAL-

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑂𝑤𝑛𝑒𝑟𝑠′ 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 /𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

The Return on Invested Capital (ROIC) gives an indication of how much you as an owner, are truly earning on the capital the company deploys in its business.

So what are Owners’ Earnings and Invested Capital?
What are Owners’ Earnings?
𝑂𝑤𝑛𝑒𝑟𝑠′ 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠=𝑁𝑒𝑡𝑃𝑟𝑜𝑓𝑖𝑡 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 +𝐴𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝑂𝑝𝑡𝑖𝑜𝑛𝑠 𝑖𝑠𝑠𝑢𝑎𝑛𝑐𝑒 − 𝐶𝐴𝑃𝐸𝑋 𝑠𝑝𝑒𝑛𝑑 −𝑖𝑛𝑐𝑜𝑚𝑒 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑒𝑑 𝑓𝑟𝑜𝑚 𝑜𝑣𝑒𝑟 𝑝𝑒𝑟𝑓𝑜𝑟𝑚𝑖𝑛𝑔 𝑝𝑒𝑛𝑠𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑠 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

The Owner’s Earnings give a more practical figure to the amount of cash flow you would receive if you were the sole owner of the company.
A conservative approach to stock evaluation, made more famous as an approach used by Warren Buffet.

What is Invested Capital?
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑎𝑠ℎ + 𝑝𝑎𝑠𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 cℎ𝑎𝑟𝑔𝑒𝑠

Invested Capital represents a conservative indicator of the value of capital the company has deployed in its business.

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑂𝑤𝑛𝑒𝑟𝑠′ 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 /𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Efficient and well run business will deploy less capital in producing each unit of earnings. Therefore a higher ROIC represents a better run business.
Note that some industry’s e.g. Banks tend to have much higher capital needs and therefore lower ROICs.
The ROIC should also be compared to the interest rate on 10 year government bond yields.
The ROIC approach for comparison of various investment opportunities is applicable in other forms of non stock investments e.g. property, etc.


7) RETURN ON EQUITY-
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦=𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 /𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦

Return on Equity (ROE) is a useful guide in comparing the profitability of a company with that of other companies e.g. in the same industry.
It is a less conservative approach than ROIC, but can be modified by using Owners’ Earnings (in place of Net Profit) to evaluate % of owners earnings generated from invested equity.



8) MARGIN OF SAFETY PRINCIPLE-

𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑌𝑖𝑒𝑙𝑑 − 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝐵𝑜𝑛𝑑𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒

The Margin of Safety is the difference between the percentage rate of earnings on the stock at the price you pay for it (i.e. your earnings yield) and the rate of interest on risk free bonds.

financial ratios formula

Benjamin Graham developed the Margin of Safety approach when selecting stock investments, as a quantifiable margin which would absorb ‘unsatisfactory developments’.




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