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Leverage Ratios:Interest Burden = EBIT- Interest Expense / EBITInterest Coverage (TImes Interest Earned)= EBIT / Interest ExpenseThe interest coverage ratio (ICR) is a measure of a company's ability to meet its interest payments. Interest coverage ratio is equal to earnings before interest and taxes (EBIT) for a time period, often one year, divided by interest expenses for the same time period. The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its EBIT. It determines how easily a company can pay interest expenses on outstanding debt.The lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default. A lower ICR means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations (i.e. interest payments exceed its earnings (EBIT)).A higher ratio indicates a better financial health as it means that the company is more capable to meeting its interest obligations from operating earnings. On the other hand, a high ICR may suggest a company is "too safe" and is neglecting opportunities to magnify earnings through leverage.Leverage= Assets / Equity = 1+ Debt / EquityCompound Leverage Factor= Interest Burden x LeverageAsset UtilizationTotal Asset Turnover = Sales / Average Total Assets?The asset turnover ratio measures the value of a company's sales or revenues relative to the value of its assets. The asset turnover ratio can be used as an indicator of the efficiency with which a company is using its assets to generate revenue.The higher the asset turnover ratio, the more efficient a company. Conversely, if a company has a low asset turnover ratio, it indicates it is not efficiently using its assets to generate sales. Investors use the asset turnover ratio to compare similar companies in the same sector or group.It is a tool to see which firms are making the most use of their assets and to identify weaknesses in firms.Fixed Asset Turnover = Sales / Average Fixed AssetsThe fixed asset turnover ratio (FAT) is, in general, used by analysts to measure operating performance. This efficiency ratio compares net sales (income statement) to fixed assets (balance sheet) and measures a company's ability to generate net sales from its fixed-asset investments, namely property, plant, and equipment(PP&E).The fixed asset balance is used as a net of accumulated depreciation. In general, a higher fixed asset turnover ratio indicates that a company has more effectively utilized investment in fixed assets to generate revenue. The fixed asset turnover ratio is commonly used as a metric in manufacturing industries that make substantial purchases of PP&E in order to increase output. When a company makes such significant purchases, wise investors closely monitor this ratio in subsequent years to see if the company's new fixed assets reward it with increased sales.Overall, investments in fixed assets tend to represent the largest component of the company’s total assets. The FAT ratio, calculated annually, is constructed to reflect how efficiently a company, or more specifically, the company’s management team, has used these substantial assets to generate revenue for the firm.A higher turnover ratio is indicative of greater efficiency in managing fixed-asset investments, but there is not an exact number or range that dictates whether a company has been efficient at generating revenue from such investments. For this reason, it is important for analysts and investors to compare a company’s most recent ratio to both its own historical ratios and ratio values from peer companies and/or average ratios for the company's industry as a whole.Though the FAT ratio is of significant importance in certain industries, an investor or analyst must determine whether the company under study is in the appropriate sector or industry for the ratio to be calculated before attaching much weight to it.Fixed assets vary drastically from one company type to the next. As an example, consider the difference between an Internet company and a manufacturing company. An Internet company, such as Facebook, has a significantly smaller fixed asset base than a manufacturing giant, such as Caterpillar. Clearly, in this example, Caterpillar’s fixed asset turnover ratio is of more relevance and should hold more weight, than Facebook’s FAT ratio.Inventory Turnover = COGS / Average InventoriesInventory turnover is the number of times a company sells and replaces its stock of goods during a period. Inventory turnover provides insight as to how the company manages costs and how effective their sales efforts have been.The higher the inventory turnover, the better since a high inventory turnover typically means a company is selling goods very quickly and that demand for their product exists.Low inventory turnover, on the other hand, would likely indicate weaker sales and declining demand for a company’s products.Inventory turnover provides insight as to whether a company is managing its stock properly. The company may have overestimated demand for their products and purchased too many goods as shown by low turnover. Conversely, if inventory turnover is very high, they might not be buying enough inventory and may be missing out on sales opportunities.Inventory turnover also shows whether a company’s sales and purchasing departments are in sync. Ideally, inventory should match sales. It can be quite costly for companies to hold onto inventory that isn’t selling, which is why inventory turnover can be an important indicator of sales effectiveness but also for managing operating costs. Alternatively, for a given amount of sales, using less inventory to do so will improve inventory turnover.Days Sales in Receivable = Average Accounts Receivables / Annual Sales x 365The days' sales in accounts receivable ratio (also known as the average collection period) tells you the number of days it took on average to collect the company's accounts receivable during the past year.Example of Calculating Days' Sales in Accounts ReceivableThe days' sales in accounts receivable can be calculated as follows: the number of days in the year (use 360 or 365) divided by the accounts receivable turnover ratio during a past year. For example, if a company's accounts receivable turnover ratio for the past year was 10, the days' sales in accounts receivable was 36 days (360 days divided by the turnover ratio of 10).LiquidityCurrent Ratio = Current Assets / Current Liabilities?The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables. The current ratio compares all of a company’s current assets to its current liabilities. These are usually defined as assets that are cash or will be turned into cash in a year or less, and liabilities that will be paid in a year or less. The current ratio is sometimes referred to as the “working capital” ratio and helps investors understand more about a company’s ability to cover its short-term debt with its current assets. Weaknesses of the current ratio include the difficulty of comparing the measure across industry groups, overgeneralization of the specific asset and liability balances, and the lack of trending information. To calculate the ratio, analysts compare a company's current assets to its current liabilities. Current assets listed on a company's balance sheet include cash, accounts receivable, inventory and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt. ?A current ratio that is in line with the industry average or slightly higher is generally considered acceptable.A current ratio that is lower than the industry average may indicate a higher risk of distress or default. Similarly, if a company has a very high current ratio compared to their peer group, it indicates that management may not be using their assets efficiently. The current ratio is called “current” because, unlike some other liquidity ratios, it incorporates all current assets and liabilities.The current ratio is also called the working capital ratio.Quick Ratio = Cash + Marketable Securities + Receivables / Current Liabilities?The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets.Since it indicates the company’s ability to instantly use its near-cash assets (that is, assets that can be converted quickly to cash) to pay down its current liabilities, it is also called the acid test ratio. An acid test is a quick test designed to produce instant results—hence, the name.Calculate the Quick RatioLocate each of the formula components on a company's balance sheet in the current assets and current liabilities sections. Plug the corresponding balance into the equation, and perform the calculation.While calculating the quick ratio, double-check the constituents you're using in the formula. The numerator of liquid assets should include the assets that can be easily converted to cash in the short-term (within 90 days or so) without compromising on their price. Inventory is not included in the quick ratio because many companies, in order to sell through their inventory in 90 days or less would have to apply steep discounts to incentivize customers to buy quickly. Inventory includes raw materials, components, and finished products.Similarly, only accounts receivable that can be collected within about 90 days should be considered. Accounts receivable refers to the money that is owed to a company by its customers for goods or services already delivered, and some companies give generous credit terms to customers that extend out longer than 90 days.?A higher quick ratio means a more liquid current position.What Does the Quick Ratio Tell You?The quick ratio measures the dollar amount of liquid assets available to the company against the dollar amount of its current liabilities. Liquid assets are the assets that can be quickly converted into cash with minimal impact to the price received in the open market, while current liabilities are a company's debts or obligations that are due to be paid to creditors within one year.Interpreting the Quick RatioA result of 1 is considered to be the normal quick ratio, as it indicates that the company is fully equipped with exactly enough assets to be instantly liquidated to pay off its current liabilities. A company that has a quick ratio of less than 1 may not be able to fully pay off its current liabilities in the short term, while a company having a quick ratio higher than 1 can instantly get rid of its current liabilities. For instance, a quick ratio of 1.5 indicates that the company has $1.50 of liquid assets available to cover each $1 of its current liabilities.While such numbers-based ratios offer insights into certain aspects and viability of businesses, they may not provide a complete picture of the overall health of the business. It is important to additionally look at other associated measures to assess the true picture.Customer Payments Impact the Quick RatioFor instance, a business may have a large amount of money as accounts receivable, which may bump up the quick ratio. However, if the payment from the customer is delayed due to unavoidable circumstances, or if the payment has a due date a long period out, such as 120 days based on terms of sale, the company may not be able to meet its short-term liabilities.This may include essential business expenses and accounts payable that need immediate payment. Despite having a healthy quick ratio, the business is actually on the verge of running out of cash.On the other hand, if the company negotiates rapid receipt of payments from its customers and secures longer terms of payments from its suppliers, it may have a very low quick ratio but could still be fully equipped to pay off its current liabilities.Whether accounts receivable is a source of quick ready cash remains a debatable topic, and depends on the credit terms that the company extends to its customers. A company that needs advance payments or allows only 30 days to the customers for payment will be in a better liquidity position than the one that gives 90 days. Additionally, a company’s credit terms with its suppliers also affect its liquidity position. If a company gives its customers 60 days to pay but has 120 days to pay its suppliers, its liquidity position may be reasonable.The other two components, cash, and marketable securities are usually free from such time-bound dependencies. However, to maintain precision in the calculation, one should consider only the amount to be actually received in 90 days or less under normal terms, as early liquidation or premature withdrawal of assets like interest-bearing securities may lead to penalties or discounted book value.The quick ratio indicates a company's capacity to pay its current liabilities without needing to sell its inventory or get additional financing.The quick ratio is considered a more conservative measure than the current ratio, which includes all current assets as coverage for current liabilities.The higher the ratio result, the better a company's liquidity and financial health; the lower the ratio, the more likely the company will struggle with paying debts.Example of How to Use the Quick RatioPublicly traded companies generally report the quick ratio figure under the “Liquidity/Financial Health” heading in the “Key Ratios” section of their quarterly reports. Another commonly reported ratio is the current ratio, which includes all current assets in its calculation including inventory.Below is the calculation of quick ratio based on the figures that appear on the respective balance sheets of three leading competitors operating in the personal care industrial sector for the fiscal year ending 2017:?(in millions)Procter & GambleJohnson & JohnsonKimberly-Clark Corp.Quick Assets(A)$26,490$43,090$5,210Current Liabilities(B)$30,210$30,540$14,210Quick Ratio(A/B)0.881.410.367With a quick ratio of higher than 1, Johnson & Johnson appears to be well positioned to cover its current liabilities and has liquid assets available to cover each dollar of short-term debt. However, Procter & Gamble and Kimberly-Clark may not be able to pay off their current debts using only quick assets since both companies have a quick ratio below 1.Quick Ratio vs. the Current RatioThe quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which generally are more difficult to turn into cash. The quick ratio considers only assets that can be converted to cash very quickly. The current ratio, on the other hand, also considers inventory and prepaid expense assets. In most companies, inventory takes time to liquidate, although a few rare companies can turn their inventory fast enough to consider it a quick asset. Prepaid expenses, though an asset, cannot be used to pay for current liabilities, so they're omitted from the quick ratio.Cash Ratio=?Profitability RatiosReturn on Assets = EBIT / Average Total Assets?Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company's management is at using its assets to generate earnings. Return on assets is displayed as a percentage.Return on Assets (ROA) is an indicator of how well a company utilizes its assets, by determining how profitable a company is relative to its total assets.ROA is best used when comparing similar companies or comparing a company to its previous performance.ROA takes into account a company’s debt, unlike other metrics, such as Return on Equity (ROE).The Basics of Return on Assets—ROA?Businesses (at least the ones that survive) are ultimately about efficiency: squeezing the most out of limited resources. Comparing profits to revenue is a useful operational metric, but comparing them to the resources a company used to earn them cuts to the very feasibility of that company's’ existence. Return on assets (ROA) is the simplest of such corporate bang-for-the-buck measures.ROA is calculated by dividing a company’s net income by total assets. As a formula, it would be expressed as:Higher ROA indicates more asset efficiency.For example, pretend Spartan Sam and Fancy Fran both start hot dog stands. Sam spends $1,500 on a bare-bones metal cart, while Fran spends $15,000 on a zombie apocalypse-themed unit, complete with costume. Let's assume that those were the only assets each deployed. If over some given time period Sam had earned $150 and Fran had earned $1,200, Fran would have the more valuable business but Sam would have the more efficient one. Using the above formula, we see Sam’s simplified ROA is $150/$1,500 = 10%, while Fran’s simplified ROA is $1,200/$15,000 = 8%.The Significance of Return on Assets—ROA?Return on assets (ROA), in basic terms, tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or against a similar company's ROA.The ROA figure gives investors an idea of how effective the company is in converting the money it invests into net income. The higher the ROA number, the better, because the company is earning more money on less investment.Remember total assets is also the sum of its total liabilities and shareholder's equity. Both of these types of financing are used to fund the operations of the company. Since a company's assets are either funded by debt or equity, some analysts and investors disregard the cost of acquiring the asset by adding back interest expense in the formula for ROA.In other words, the impact of taking more debt is negated by adding back the cost of borrowing to the net incomeand using the average assets in a given period as the denominator. Interest expense is added because the net income amount on the income statement excludes interest expense.Example of How to Use Return on Assets—ROA?ROA is most useful for comparing companies in the same industry, as different industries use assets differently. For example, the ROA for service-oriented firms, such as banks, will be significantly higher than the ROA for capital intensive companies, such as construction or utility companies.Let's evaluate the return on assets (ROA) for three companies in the retail industry:Macy's (M)Kohl’s (KSS)Dillard's (DDS)The data in the table is for the trailing twelve months as of Feb. 13, panyNet IncomeTotal AssetsROAMacy's$1.7 billion$20.4 billion8.3%Kohl's$996 million$14.1 billion7.1%Dillard's$243 million$3.9 billion6.2%Due to the increasing popularity of e-commerce, brick and mortar retail companies have taken a hit in the level of profits they generate using their available assets. Still, every dollar that Macy's has invested in assets generates 8.3 cents of net income. Macy's is better at converting its investment into profits, compared with Kohl’s and Dillard’s. One of management's most important jobs is to make wise choices in allocating its resources, and it appears Macy’s management is more adept than its two peers.Return on Assets—ROA vs Return on Equity—ROE?Both ROA and return on equity (ROE) are measures of how a company utilizes its resources. Essentially, ROE only measures the return on a company’s equity, leaving out the liabilities. Thus, ROA accounts for a company’s debt and ROE does not. The more leverage and debt a company takes on, the higher ROE will be relative to ROA.Limitations of Return on Assets—ROA The biggest issue with return on assets (ROA) is that it can't be used across industries. That’s because companies in one industry—such as the technology industry—and another industry like oil drillers will have different asset bases.Some analysts also feel that the basic ROA formula is limited in its applications, being most suitable for banks. Bank balance sheets better represent the real value of their assets and liabilities because they’re carried at market value (via mark-to-market accounting), or at least an estimate of market value, versus historical cost. Both interest expense and interest income are already factored in. The St. Louis Federal Reserve provides data on US bank ROAs, which have generally hovered around or just above 1% since 1984, the year collection started.For non-financial companies, debt and equity capital is strictly segregated, as are the returns to each: interest expense is the return for debt providers; net income is the return for equity investors. So the common ROA formula jumbles things up by comparing returns to equity investors (net income) with assets funded by both debt and equity investors (total assets). Two variations on this ROA formula fix this numerator-denominator inconsistency by putting interest expense (net of taxes) back into the numerator. So the formulas would be:ROA variation 1: Net Income + [Interest Expense*(1-tax rate)] / Total AssetsROA variation 2: Operating Income*(1-tax rate) / Total AssetsReturn on Equity= Net Income / Average Stockholders’ EquityReturn on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders' equity. Because shareholders' equity is equal to a company’s assets minus its debt, ROE could be thought of as the return on net assets.ROE is considered a measure of how effectively management is using a company’s assets to create profits.Formula and Calculation for ROE?ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. Net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to Income is the amount of income, net of expense, and taxes that a company generates for a given period. Average Shareholders' Equity is calculated by adding equity at the beginning of the period. The beginning and end of the period should coincide with that which the net income is income over the last full fiscal year, or trailing 12 months, is found on the income statement—a sum of financial activity over that period. Shareholders' equity comes from the balance sheet—a running balance of a company’s entire history of changes in assets and liabilities.It is considered the best practice to calculate ROE based on average equity over the period because of this mismatch between the two financial statements. Learn more about how to calculate ROE.What Does ROE Tell You??Return on equity (ROE) deemed good or bad will depend on what’s normal for a stock’s peers. For example, utilities will have a lot of assets and debt on the balance sheet compared to a relatively small amount of net income. A normal ROE in the utility sector could be 10% or less. A technology or retail firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18% or more.A good rule of thumb is to target an ROE that is equal to or just above the average for the peer group. For example, assume a company, TechCo, has maintained a steady ROE of 18% over the last few years compared to the average of its peers, which was 15%. An investor could conclude that TechCo’s management is above average at using the company’s assets to create profits.Relatively high or low ROE ratios will vary significantly from one industry group or sector to another. When used to evaluate one company to another similar company the comparison will be more meaningful. A common shortcut for investors to consider a return on equity near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.Return on equity measures how effectively management is using a company’s assets to create profits.A good or bad ROE will depend on what’s normal for the industry or company peers.?As a shortcut, investors can consider a return on equity near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.Using ROE to Estimate Growth Rates?Sustainable growth rates and dividend growth rates can be estimated using ROE assuming that the ratio is roughly in line or just above its peer group average. Although there may be some challenges, ROE can be a good starting place for developing future estimates of a stock’s growth rate and the growth rate of its dividends. These two calculations are functions of each other and can be used to make an easier comparison between similar companies.To estimate a company’s future growth rate, multiply ROE by the company’s retention ratio. The retention ratio is the percentage of net income that is “retained” or reinvested by the company to fund future growth.ROE and Sustainable Growth Rate?Assume that there are two companies with an identical ROE and net income, but different retention ratios. Company A has an ROE of 15% and returns 30% of its net income to shareholders in a dividend, which means company A retains 70% of its net income. Business B also has an ROE of 15% but returns only 10% of its net income to shareholders for a retention ratio of 90%.For company A, the growth rate is 10.5%, or ROE times the retention ratio, which is 15% times 70%. business B's growth rate is 13.5%, or 15% times 90%.This analysis is referred to as the sustainable growth rate model. Investors can use this model to make estimates about the future and to identify stocks that may be risky because they are running ahead of their sustainable growth ability. A stock that is growing slower than its sustainable rate could be undervalued, or the market may be discounting risky signs from the company. In either case, a growth rate that is far above or below the sustainable rate warrants additional investigation.This comparison seems to make business B look more attractive than company A, but it ignores the advantages of a higher dividend rate that may be favored by some investors. We can modify the calculation to make an estimate of the stock’s dividend growth rate which may be more important to income investors.Estimating the Dividend Growth Rate?Continuing with our example from above, the dividend growth rate can be estimated by multiplying ROE by thepayout ratio. The payout ratio is the percentage of net income that is returned to common shareholders through dividends. This formula gives us a sustainable dividend growth rate, which favors company A.The company A dividend growth rate is 4.5%, or ROE times payout ratio, which is 15% times 30%. Business B's dividend growth rate is 1.5%, or 15% times 10%. A stock that is growing its dividend far above or below the sustainable dividend growth rate may indicate risks that need to be investigated.Using ROE to Identify Problems?It’s reasonable to wonder why an average or slightly above average ROE is good rather than an ROE that is double, triple, or even higher the average of their peer group. Aren’t stocks with a very high ROE a better value?Sometimes an extremely high ROE is a good thing if net income is extremely large compared to equity because a company’s performance is so strong. However, more often an extremely high ROE is due to a small equity account compared to net income, which indicates risk.Inconsistent ProfitsThe first potential issue with a high ROE could be inconsistent profits. Imagine a company, LossCo, that has been unprofitable for several years. Each year’s losses are on the balance sheet in the equity portion as a “retained loss.” The losses are a negative value and reduce shareholder equity. Assume that LossCo has had a windfall in the most recent year and has returned to profitability. The denominator in the ROE calculation is now very small after many years of losses which makes its ROE misleadingly high.Excess DebtSecond is excess debt. If a company has been borrowing aggressively, it can increase ROE because equity is equal to assets minus debt. The more debt a company borrows, the lower equity can fall. A common scenario that can cause this issue occurs when a company borrows large amounts of debt to buy back its own stock. This can inflate earnings per share (EPS), but it doesn’t affect actual growth rates or performance.Negative Net IncomeFinally, there’s negative net income and negative shareholder equity that can lead to an artificially high ROE. However, if a company has a net loss or negative shareholders’ equity, ROE should not be calculated.If shareholders’ equity is negative, the most common issue is excessive debt or inconsistent profitability. However, there are exceptions to that rule for companies that are profitable and have been using cash flow to buy back their own shares. For many companies, this is an alternative to paying dividends and it can eventually reduce equity (buybacks are subtracted from equity) enough to turn the calculation negative.In all cases, negative or extremely high ROE levels should be considered a warning sign worth investigating. In rare cases, a negative ROE ratio could be due to a cash flow supported share buyback program and excellent management, but this is the less likely outcome. In any case, a company with a negative ROE cannot be evaluated against other stocks with positive ROE ratios.ROE vs. Return on Invested Capital?While return on equity looks at how much in profit a company can generate relative to shareholders’ equity, return on invested capital (ROIC) takes that calculation a couple of steps further.The purpose of ROIC is to figure out the amount of money after dividends a company makes based on all its sources of capital, which includes shareholders equity and debt. ROE looks at how well a company utilizes shareholder equity, while ROIC is meant to determine how well a company uses all its available capital to make money.Limitations of Using ROE?A high return on equity might not always be positive. An outsized ROE can be indicative of a number of issues—such as inconsistent profits or excessive debt. As well, a negative ROE, due to the company having a net loss or negative shareholders’ equity, cannot be used to analyze the company. Nor can it be used to compare against companies with a positive ROE.Example of How to Use ROE?For example, imagine a company with an annual income of $1,800,000 and average shareholders' equity of $12,000,000. This company’s ROE would be as follows:Consider Apple Inc. (AAPL)—for the fiscal year ending Sept. 29, 2018, the company generated US$59.5 billion in net come. At the end of the fiscal year, it’s shareholders’ equity was $107.1 billion versus $134 billion at the beginning. Apple’s return on equity, therefore, is 49.4%, or $59.5 billion / (($107.1 billion + $134 billion) / 2).Compared to its peers, Apple has a very strong ROE. Inc. (AMZN) has a return on equity of 27%Microsoft Corp. (MSFT) 23%Google—now know as Alphabet Inc. (GOOGL) 12%Return on Sales (Profit Margin)= EBIT (Operating Margin) / SalesReturn on sales (ROS) is a ratio used to evaluate a company's operational efficiency.This measure provides insight into how much profit is being produced per dollar of sales. An increasing ROS indicates that a company is growing more efficiently, while a decreasing ROS could signal impending financial troubles.ROS is very closely related to a firm's operating profit margin.KEY TAKEAWAYSReturn on sales (ROS) is a measure of how efficiently a company turns sales into profits.ROS is calculated by dividing operating profit by net sales.ROS is only useful when comparing companies in the same line of business and of roughly the same size.How to Calculate ROSThe ROS is calculated as a company's operating profit for a specific period divided by its respective net sales. The ROS equation does not account for non-operating activities and expenses, such as taxes and interest expenses.The calculation shows how effectively a company is producing its core products and services and how its management runs the business. Therefore, ROS is used as an indicator of both efficiency and profitability.Return on SalesWhat Does Return on Sales Tell You?Return on sales is a financial ratio that calculates how efficiently a company is generating profits from its top-line revenue. It measures the performance of a company by analyzing the percentage of total revenue that is converted into operating profits.Investors, creditors, and other debt holders rely on this efficiency ratio because it accurately communicates the percentage of operating cash a company makes on its revenue and provides insight into potential dividends, reinvestment potential, and the company's ability to repay debt.ROS is used to compare current period calculations with calculations from previous periods. This allows a company to conduct trend analyses and compare internal efficiency performance over time. It is also useful to compare one company's ROS percentage with that of a competing company, regardless of scale.The comparison makes it easier to assess the performance of a small company in relation to a Fortune 500 company. However, ROS should only be used to compare companies within the same industry as they vary greatly across industries. A grocery chain, for example, has lower margins and therefore a lower ROS compared to a technology company.Example of How to Use ROSFor example, a company that generates $100,000 in sales and requires $90,000 in total costs to generate its revenue is less efficient than a company that generates $50,000 in sales but only requires $30,000 in total costs.ROS is larger if a company's management successfully cuts costs while increasing revenue. Using the same example, the company with $50,000 in sales and $30,000 in costs has an operating profit of $20,000 and a ROS of 40% ($20,000 / $50,000). If the company's management team wants to increase efficiency, it can focus on increasing sales while incrementally increasing expenses, or it can focus on decreasing expenses while maintaining or increasing revenue.The Difference Between ROS and Operating MarginReturn on sales and operating profit margin are often used to describe a similar financial ratio. The main difference between each usage lies in the way their respective formulas are derived.The standard way of writing the formula for operating margin is operating income divided by net sales. Return on sales is extremely similar, only the numerator is usually written as earnings before interest and taxes (EBIT); the denominator is still net sales.Limitations of Return on SalesReturn on sales should only be used to compare companies that operate in the same industry, and ideally among those that have similar business models and annual sales figures. Companies in different industries with wildly different business models have very different operating margins, so comparing them using EBIT in the numerator could be confusing.To make it easier to compare sales efficiency between different companies and different industries, many analysts use a profitability ratio which eliminates the effects of financing, accounting and tax policies: earnings before interest, taxes, depreciation and amortization (EBITDA). For example, by adding back depreciation, the operating margins of big manufacturing firms and heavy industrial companies are more comparable.EBITDA is sometimes used as a proxy for operating cash flow, because it excludes non-cash expenses, such as depreciation. But EBITDA does not equal cash flow. That’s because it does not adjust for any increase in working capital or account for capital expenditure that is needed to support production and maintain a company’s asset base – as operating cash flow does.Market Price RatiosPrice (Market) to Book = Price Per Share / Book Value Per ShareCompanies use the price-to-book ratio to compare a firm's market to book value by dividing the price per share by book value per share (BVPS). An asset's book value is equal to its carrying value on the balance sheet, and companies calculate it netting the asset against its accumulated depreciation.Book value is also the net asset value of a company calculated as total assets minus intangible assets (patents, goodwill) and liabilities. For the initial outlay of an investment, book value may be net or gross of expenses, such as trading costs, sales taxes, and service charges.Some people may know this ratio by its less common name, price-equity ratio.P/B Formula and CalculationIn this equation, book value per share is calculated as follows: (total assets - total liabilities) / number of shares outstanding). Market value per share is obtained by simply looking at the share price quote in the market.A lower P/B ratio could mean the stock is undervalued. However, it could also mean something is fundamentally wrong with the company. As with most ratios, this varies by industry.The P/B ratio also indicates whether you're paying too much for what would remain if the company went bankrupt immediately.KEY TAKEAWAYSThe P/B ratio measures the market's valuation of a company relative to its book value.P/B ratio is used by value investors to identify potential investments.P/B ratio can be used to compare companies with one another.Learning From Price-To-BookThe P/B ratio reflects the value that market participants attach to a company's equity relative to its book value of equity. A stock's market value is a forward-looking metric that reflects a company's future cash flows. The book value of equity is an accounting measure based on the historic cost principle and reflects past issuances of equity, augmented by any profits or losses, and reduced by dividends and share buybacks.It is difficult to pinpoint a specific numeric value of a "good" price-to-book (P/B) ratio when determining if a stock is undervalued and therefore a good investment. Ratio analysis can vary by industry. A good P/B ratio for one industry might be a poor ratio for another.The price-to-book ratio compares a company's market value to its book value. The market value of a company is its share price multiplied by the number of outstanding shares. The book value is the net assets of a company.In other words, if a company liquidated all of its assets and paid off all its debt, the value remaining would be the company's book value. P/B ratio provides a valuable reality check for investors seeking growth at a reasonable price and is often looked at in conjunction with return on equity (ROE), a reliable growth indicator. Large discrepancies between P/B ratio and ROE often send up a red flag on companies. Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios. If a company's ROE is growing, its P/B ratio should also be growing.It's helpful to identify some general parameters or a range for P/B value, and then consider various other factors and valuation measures that more accurately interpret the P/B value and forecast a company's potential for growth.The P/B ratio has been favored by value investors for decades and is widely used by market analysts. Traditionally, any value under 1.0 is considered a good P/B for value investors, indicating a potentially undervalued stock. However, value investors may often consider stocks with a P/B value under 3.0 as their benchmark.Equity Market Value vs. Book ValueDue to accounting conventions on the treatment of certain costs, the market value of equity is typically higher than the book value of a company, producing a P/B ratio above a value of 1. Under certain circumstances of financial distress, bankruptcy or expected plunges in earnings power, a company's P/B ratio can dive below a value of 1.Because accounting principles do not recognize intangible assets such as the brand value, unless the company derived them through acquisitions, companies expense all costs associated with creating intangible assets immediately.For example, companies must expense research and development costs, reducing a company's book value. However, these R&D outlays can create unique production processes for a company or result in new patents that can bring royalty revenues going forward. While accounting principles favor a conservative approach in capitalizing costs, market participants may raise the stock price because of such R&D efforts, resulting in wide differences between the market and book values of equity.P/B vs. Price-to-Tangible-Book RatioClosely related to the P/B ratio is the price to tangible book value (PTBV). The latter is a valuation ratio expressing the price of a security compared to its hard, or tangible, book value as reported in the company's balance sheet. The tangible book value number is equal to the company's total book value less the value of any intangible assets.Intangible assets can be items such as patents, intellectual property, and goodwill. This may be a more useful measure of valuation when the market is valuing something like a patent in different ways or if it is difficult to put a value on such an intangible asset in the first place.Limitations of the P/B RatioInvestors find the P/B ratio useful because the book value of equity provides a relatively stable and intuitive metric they can easily compare to the market price. The P/B ratio can also be used for firms with positive book values and negative earnings since negative earnings render price-to-earnings ratios useless, and there are fewer companies with negative book values than companies with negative earnings.However, when accounting standards applied by firms vary, P/B ratios may not be comparable, especially for companies from different countries. Additionally, P/B ratios can be less useful for service and information technology companies with little tangible assets on their balance sheets. Finally, the book value can become negative because of a long series of negative earnings, making the P/B ratio useless for relative valuation.Other potential problems in using the P/B ratio stem from the fact that any number of scenarios, such as recent acquisitions, recent write-offs, or share buybacks, can distort the book value figure in the equation. In searching for undervalued stocks, investors should consider multiple valuation measures to complement the P/B ratio.Example of Using the P/B RatioAssume that a company has $100 million in assets on the balance sheet and $75 million in liabilities. The book value of that company would be calculated simply as $25 million ($100M - $75M). If there are 10 million shares outstanding, each share would represent $2.50 of book value. If each share sells on the market at $5, then the P/B ratio would be 2x (5 ÷ 2.50). This illustrates that the market price is valued at twice its book value.Price- Earnings Ratio = Price Per Share / Earnings Per ShareThe price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.P/E ratios are used by investors and analysts to determine the relative value of a company's shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.KEY TAKEAWAYSThe price-earnings ratio (P/E ratio) relates a company's share price to its earnings per share.A high P/E ratio could mean that a company's stock is over-valued, or else that investors are expecting high growth rates in the panies that have no earnings or that are losing money do not have a P/E ratio since there is nothing to put in the denominator.Two kinds of P/E ratios - forward and trailing P/E - are used in practice.P/E Ratio Formula and CalculationAnalysis and investors review a company's P/E ratio when they determine if the share price accurately represents the projected earnings per share. The formula and calculation used for this process followTo determine the P/E value, one simply must divide the current stock price by the earnings per share (EPS). The current stock price (P) can be gleaned by plugging a stock’s ticker symbol into any finance website, and although this concrete value reflects what investors must currently pay for a stock, the EPS is a slightly more nebulous figure.EPS comes in two main varieties. The first is a metric listed in the fundamentals section of most finance sites; with the notation "P/E (TTM)," where “TTM” is a Wall Street acronym for “trailing 12 months.” This number signals the company's performance over the past 12 months. The second type of EPS is found in a company's earnings release, which often provides EPS guidance. This is the company's best-educated guess of what it expects to earn in the future.Sometimes, analysts are interested in long term valuation trends and consider the P/E 10 or P/E 30 measures, which average the past 10 or past 30 years of earnings, respectively. These measures are often used when trying to gauge the overall value of a stock index, such as the S&P 500 since these longer term measures can compensate for changes in the business cycle. The P/E ratio of the S&P 500 has fluctuated from a low of around 6x (in 1949) to over 120x (in 2009). The long-term average P/E for the S&P 500 is around 15x, meaning that the stocks that make up the index collectively command a premium 15 times greater than their weighted average earnings.Forward Price-To-EarningsThese two types of EPS metrics factor into the most common types of P/E ratios: the forward P/E and the trailing P/E. A third and less common variation uses the sum of the last two actual quarters and the estimates of the next two quarters.The forward (or leading) P/E uses future earnings guidance rather than trailing figures. Sometimes called "estimated price to earnings," this forward-looking indicator is useful for comparing current earnings to future earnings and helps provide a clearer picture of what earnings will look like – without changes and other accounting adjustments.However, there are inherent problems with the forward P/E metric – namely, companies could underestimate earnings in order to beat the estimate P/E when the next quarter's earnings are announced. Other companies may overstate the estimate and later adjust it going into their next earnings announcement. Furthermore, external analysts may also provide estimates, which may diverge from the company estimates, creating confusion.Trailing Price-To-EarningsThe trailing P/E relies on past performance by dividing the current share price by the total EPS earnings over the past 12 months. It's the most popular P/E metric because it's the most objective – assuming the company reported earnings accurately. Some investors prefer to look at the trailing P/E because they don't trust another individual’s earnings estimates. But the trailing P/E also has its share of shortcomings – namely, a company’s past performance doesn’t signal future behavior.Investors should thus commit money based on future earnings power, not the past. The fact that the EPS number remains constant, while the stock prices fluctuate, is also a problem. If a major company event drives the stock price significantly higher or lower, the trailing P/E will be less reflective of those changes.The trailing P/E ratio will change as the price of a company’s stock moves, since earnings are only released each quarter while stocks trade day in and day out. As a result, some investors prefer the forward P/E. If the forward P/E ratio is lower than the trailing P/E ratio, it means analysts are expecting earnings to increase; if the forward P/E is higher than the current P/E ratio, analysts expect a decrease in earnings.Valuation From P/EThe price-to-earnings ratio or P/E is one of the most widely-used stock analysis tools used by investors and analysts for determining stock valuation. In addition to showing whether a company's stock price is overvalued or undervalued, the P/E can reveal how a stock's valuation compares to its industry group or a benchmark like the S&P 500 Index.In essence, the price-to-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings. This is why the P/E is sometimes referred to as the price multiple because it shows how much investors are willing to pay per dollar of earnings. If a company was currently trading at a P/E multiple of 20x, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.The P/E ratio helps investors determine the market value of a stock as compared to the company's earnings. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E could mean that a stock's price is high relative to earnings and possibly overvalued. Conversely, a low P/E might indicate that the current stock price is low relative to earnings.?Example of the P/E RatioAs a historical example, let's calculate the P/E ratio for Walmart Stores Inc. (WMT) as of November 14, 2017, when the company's stock price closed at $91.09. The company's profit for the fiscal year ending January 31, 2017, was US$13.64 billion, and its number of shares outstanding was 3.1 billion. Its EPS can be calculated as $13.64 billion / 3.1 billion = $4.40.Walmart's P/E ratio is, therefore, $91.09 / $4.40 = 20.70x.Investor ExpectationsIn general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends. When a company has no earnings or is posting losses, in both cases P/E will be expressed as “N/A.” Though it is possible to calculate a negative P/E, this is not the common convention.The price-to-earnings ratio can also be seen as a means of standardizing the value of one dollar of earnings throughout the stock market. In theory, by taking the median of P/E ratios over a period of several years, one could formulate something of a standardized P/E ratio, which could then be seen as a benchmark and used to indicate whether or not a stock is worth buying.P/E vs. Earnings YieldThe inverse of the P/E ratio is the earnings yield (which can be thought of like the E/P ratio). The earnings yield is thus defined as EPS divided by the stock price, expressed as a percentage.If Stock A is trading at $10, and its EPS for the past year was 50 cents (TTM), it has a P/E of 20 (i.e., $10 / 50 cents) and an earnings yield of 5% (50 cents / $10). If Stock B is trading at $20 and its EPS (TTM) was $2, it has a P/E of 10 (i.e., $20 / $2) and an earnings yield of 10% ($2 / $20).The earnings yield as an investment valuation metric is not as widely used as its P/E ratio reciprocal in stock valuation. Earnings yields can be useful when concerned about the rate of return on investment. For equity investors, however, earning periodic investment income may be secondary to growing their investments' values over time. This is why investors may refer to value-based investment metrics such as P/E ratio more often than earnings yield when making stock investments.The earnings yield is also useful in producing a metric when a company has zero or negative earnings. Since such a case is common among high-tech, high growth, or start-up companies, EPS will be negative producing an undefined P/E ratio (sometimes denoted as N/A). If a company has negative earnings, however, it will produce a negative earnings yield, which can be interpreted and used for comparison.P/E vs. PEG RatioA P/E ratio, even one calculated using a forward earnings estimate, don't always tell you whether or not the P/E is appropriate for the company's forecasted growth rate. So, to address this limitation, investors turn to another ratio called the PEG ratio.A variation on the forward P/E ratio is the price-to-earnings-to-growth ratio, or PEG. The PEG ratio measures the relationship between the price/earnings ratio and earnings growth to provide investors with a more complete story than the P/E on its own. In other words, the PEG ratio allows investors to calculate whether a stock's price is overvalued or undervalued by analyzing both today's earnings and the expected growth rate for the company in the future. The PEG ratio is calculated as a company’s trailing price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock's value based on trailing earnings while also taking the company's future earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. For example, a low P/E ratio may suggest that a stock is undervalued and therefore should be bought – but factoring in the company's growth rate to get its PEG ratio can tell a different story. PEG ratios can be termed “trailing” if using historic growth rates or “forward” if using projected growth rates.Although earnings growth rates can vary among different sectors, a stock with a PEG of less than 1 is typically considered undervalued since its price is considered to be low compared to the company's expected earnings growth. A PEG greater than 1 might be considered overvalued since it might indicate the stock price is too high as compared to the company's expected earnings growth.Absolute vs. Relative P/EAnalysts may also make a distinction between absolute P/E and relative P/E ratios in their analysis.Absolute P/EThe numerator of this ratio is usually the current stock price, and the denominator may be the trailing EPS (TTM), the estimated EPS for the next 12 months (forward P/E) or a mix of the trailing EPS of the last two quarters and the forward P/E for the next two quarters. When distinguishing absolute P/E from relative P/E, it is important to remember that absolute P/E represents the P/E of the current time period. For example, if the price of the stock today is $100, and the TTM earnings are $2 per share, the P/E is 50 ($100/$2).Relative P/EThe relative P/E compares the current absolute P/E to a benchmark or a range of past P/Es over a relevant time period, such as the past 10 years. The relative P/E shows what portion or percentage of the past P/Es the current P/E has reached. The relative P/E usually compares the current P/E value to the highest value of the range, but investors might also compare the current P/E to the bottom side of the range, measuring how close the current P/E is to the historic low.The relative P/E will have a value below 100% if the current P/E is lower than the past value (whether the past high or low). If the relative P/E measure is 100% or more, this tells investors that the current P/E has reached or surpassed the past value.Limitations of Using the P/E RatioLike any other fundamental designed to inform investors on whether or not a stock is worth buying, the price-to-earnings ratio comes with a few important limitations that are important to take into account, as investors may often be led to believe that there is one single metric that will provide complete insight into an investment decision, which is virtually never the case. Companies that aren't profitable, and consequently have no earnings – or negative earnings per share, pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E, others assign a P/E of 0, while most just say the P/E doesn't exist (not available - N/A) or is not interpretable until a company becomes profitable for purposes of comparison.One primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due both to the differing ways companies earn money and to the differing timelines during which companies earn that money.As such, one should only use P/E as a comparative tool when considering companies in the same sector, as this kind of comparison is the only kind that will yield productive insight. Comparing the P/E ratios of a telecommunications company and an energy company, for example, may lead one to believe that one is clearly the superior investment, but this is not a reliable assumption.Other P/E ConsiderationsAn individual company’s P/E ratio is much more meaningful when taken alongside P/E ratios of other companies within the same sector. For example, an energy company may have a high P/E ratio, but this may reflect a trend within the sector rather than one merely within the individual company. An individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.Moreover, because a company’s debt can affect both the prices of shares and the company’s earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they take on. The one with more debt will likely have a lower P/E value than the one with less debt. However, if business is good, the one with more debt stands to see higher earnings because of the risks it has taken.Another important limitation of price-to-earnings ratios is one that lies within the formula for calculating P/E itself. Accurate and unbiased presentations of P/E ratios rely on accurate inputs of the market value of shares and of accurate earnings per share estimates. While the market determines the value of shares and, as such, that information is available from a wide variety of reliable sources, this is less so for earnings, which are often reported by companies themselves and thus are more easily manipulated. Since earnings are an important input in calculating P/E, adjusting them can affect P/E as well.Earnings Yield = Earnings Per Share / Price Per ShareThe earnings yield refers to the earnings per share for the most recent 12-month period divided by the current market price per share. The earnings yield (which is the inverse of the P/E ratio) shows the percentage of how much a company earned per share. This yield is used by many investment managers to determine optimal asset allocations and is used by investors to determine which assets seem underpriced or overpriced.How Earnings Yield WorksMoney managers often compare the earnings yield of a broad market index (such as the S&P 500) to prevailing interest rates, such as the current 10-year Treasury yield. If the earnings yield is less than the rate of the 10-year Treasury yield, stocks as a whole may be considered overvalued. If the earnings yield is higher, stocks may be considered undervalued relative to bonds.Economic theory suggests that investors in equities should demand an extra risk premium of several percentage points above prevailing risk-free rates (such as rates on Treasury bills) in their earnings yield to compensate them for the higher risk of owning stocks over bonds.KEY TAKEAWAYSEarnings yield is 12-month earnings divided by the share price.Earnings yield is the inverse of the P/E ratio.Earnings yield is one indication of value, as a low ratio may indicate an overvalued stock or a high value may indicate an undervalued stock.Growth prospects for a company are critical to consider when using earnings yield, as stocks with high growth potential are typically higher valued and thus may have a low earnings yield even as their stock prices are rising.Earnings Yield vs. P/E RatioEarnings yield as an investment valuation metric is not as widely used as the P/E ratio. Earnings yield can be useful when concerned about the rate of return on an investment. For equity investors, however, earning periodic investment income may be secondary to growing their investments' values over time. This is why investors may refer to value-based investment metrics such as P/E ratio more often than earnings yield when making stock investments. That said, the metrics provide the same information, just in a different way.Earnings Yield and Return MetricFor investors looking to invest in stocks with stable dividend income, earnings yield can offer a direct look into the level of return such dividend stocks may generate. In this case, earnings yield is more of a return metric about how much an investment may earn for investors, rather than a valuation metric of how the investment is valued by investors. However, a valuation metric such as P/E ratio can affect a return metric like earnings yield.An overvalued investment can lower earnings yield and, conversely, an undervalued investment can raise earnings yield. This is because the higher the stock price goes, without a comparable rise in earnings, the earnings yield will drop. If the stock price falls, but earnings stay the same or rise, the earnings yield will increase. Value investors look for the latter scenario.The inverse relationship between earnings yield and P/E ratio indicates that the more valuable an investment is, the lower the earnings yield may be, and the less valuable an investment is, the higher the earnings yield may be. In reality, however, investments with strong valuations and high P/E ratios might generate more earnings over time and eventually boost up their earnings yield. This is what growth investors are looking for. On the other hand, investments with weak valuations and low P/E ratios might generate less earnings over time and, in the end, drag down their earnings yield.Examples of Earnings YieldEarnings yield is one metric investor can use to assess whether they want to buy or sell a stock.In April of 2019 Facebook (FB) was trading near $175 with 12-month earnings of $7.57. This gives a earnings yield of 4.3%. This was historically quite high, as prior to 2018 the yield had been 2.5% or lower. Between 2016 and the end of 2017 the stock increased by more than 70% while the earnings yield increased from about 1% to 2.5%.The stock fell more than 40% off its 2018 high while the earnings yield was near its highest historical level, about 3%. After the decline the earnings yield continued to creep higher as the price fell, reaching over 5% in early 2019 when the stock started to bounce back higher.The increased earnings yield may have played a role in driving the stock higher, mainly because investors expected earnings to increase going forward. Yet a high earnings yield (relative to prior readings) didn't prevent the stock from seeing a significant decline in 2018.Earnings yield may also be useful in a stock that is older and has more consistent earnings. Growth is expected to be low for the foreseeable future, so the earnings yield can be used to determine when it is a good time to buy the stock in its cycle. A higher than normal earnings yield indicates the stock may be oversold and could be due for a bounce. This assumes nothing negative has happened with the company. (For related reading, see "Understanding P/E Ratio vs. EPS vs. Earnings Yield") ................
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