Many readers have requested additional material to supplement their classroom ratio and stock presentations.
My text Accounting for Hospitality Managers contains several comprehensive chapters that are useful in the teaching of business performance analysis; namely, Chapters 7 to 11 and 12. These chapters cover financial statements, ratios, and interim/annual reports.
This special report expands this coverage with popular ratios used by investment analysts and coverage of other material not found in a managerial accounting text. This report contains the following topics:
Ancillary Investment Glossary
Ancillary Investment Ratios
U.S. Financial Market Indexes
International Financial Market Indexes
Ancillary Investment Glossary
Alpha: A coefficient measuring the risk-adjusted performance, considering the risk due to the specific security, rather than the overall market. A large alpha indicates that the stock or mutual fund has performed better than would be predicted given its beta (volatility).
Beta: A quantitative measure of the volatility of a given stock, mutual fund, or portfolio, relative to the overall market, usually the S&P 500. Specifically, the performance the stock, fund or portfolio has experienced in the last 5 years as the S&P moved 1% up or down. A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile.
Big Board: A nickname for the New York Stock Exchange.
Capitalization: The price per share of a company’s stock multiplied by the number of shares outstanding representing the total market value of a company based on its trading on a stock exchange.
Cyclical Industry: A term describing an industry that is sensitive to the business cycle and price changes. Many cyclical industries produce durable goods such as raw materials and heavy equipment. The airline industry is an another cyclical example; when the economy is slow, people tend to travel less.
Golden Parachute: Lucrative benefits given to top executives in the event that a company is taken over by another firm resulting in the loss of their job. Benefits include items such as bonuses, severance pay, etc. A golden parachute can be used as a measure to discourage an unwanted takeover attempt.
Gray Knight: A second, unsolicited bidder in a corporate takeover attempt. A gray knight enters the scene in order to take advantage of any problems between the first bidder and the target company.
Index: A statistical indicator providing a representation of the value of the securities that constitute it. Indexes (Indices) serve as barometers for a given market or industry and benchmarks against which financial performance is measured.
Small cap stock: Refers to a company with a $250 million to $1 billion capitalization (General guideline).
Mid cap stock: Refers to a company with a $1 billion to $5 billion capitalization (General guideline).
Large cap stock: Refers to a company with capitalization over $5 billion (General guideline).
Synergy: The idea that the value and performance of two companies combined will be greater than the sum of the separate individual parts. This term is used mostly in the context of mergers and acquisitions.
Ancillary Investment Ratios
Price to Earning (P/E)
This is the oldest and probably the most widely used valuation ratio. It is an indication of how much investors are willing to pay per dollar of earnings. The P/E ratio is helpful to determine whether a company is over or under-valued. The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, a $20stock with a P/E of 40 is much more "expensive" than a $100 stock with a P/E of 25.
The ratio can be calculated using current earnings, past earnings, and forward earnings (projected earnings).
Market Price per Share_ EPS (Earnings per Share)
EPS is total earnings divided by the number of shares outstanding. Companies often use a weighted average of shares outstanding for the period analyzed. EPS can be calculated for the previous year ("trailing EPS"), for the current year ("current EPS"), or for the coming year ("forward EPS").
Interpretation: In general, a high P/E means high projected earnings in the future. Growth companies tend to have higher P/Es than the market because of their expected above-average earning power. Value companies, including dividend-paying stocks, tend to have lower P/Es. A P/E ratio of 18 suggests that investors are willing to pay $18 for every $1 of earnings generated. This is a simplistic analysis because it fails to consider the company's growth prospects.
If a company has a P/E higher than the market or industry average, it means investors believe the company’s earnings will grow at a better rate than the market or industry. If a company with a high P/E ratio does not meet expectations, its stock price will likely decrease; sometimes significantly. Comparing the P/Es of two different companies to determine which is a better value requires more analysis such as its growth rates and its industry’s growth rates.
Growth rate refers to how fast has a company has been growing in the past. If its EPS (earnings per share) is not growing and yet the P/E ratio is still high, the stock may be overpriced. It is only useful to compare companies in the same industry. You can find P/E ratios by industry on Yahoo Finance: http://biz.yahoo.com/p/industries.html
Limitation: Although a simple indicator to calculate, the P/E is actually quite difficult to interpret. It can be extremely informative or almost meaningless. The P/E ratio actually doesn't tell us a whole lot by itself. It's usually only useful to compare the P/E ratios of companies in the same industry, or to the market in general, or against the company's own historical P/E. Some factors that can impair the usefulness of the P/E ratio are that (1) earnings can be affected by differences in accounting policy even though in accordance with GAAP and (2) by differences in depreciation and amortization methods.
P/E to Growth (PEG)
The PEG (price/earnings to growth) ratio is a tool that can help investors find undervalued stocks. It provides information on how the market views a stock's growth potential in relation to EPS growth.
PE Ratio_____ Annual EPS Growth
The calculation can be made for one year or a several year span. Actual or forward numbers can be used. EPS growth is a percentage growth from a previous year. For example, a company earning $1.00 EPS in year 1 and $1.20 in year 2 will have an annual EPS growth of 20% calculated by dividing the .20 increase in EPS by the previous year’s 1.00 EPS. Its current stock price is $30, yielding a P/E ratio for year 2 of 25 ($30/$1.20). Its PEG is calculated as follows:
25 = 1 PEG 25%
Interpretation: A fairly priced stock should generate a PEG ratio of 1.0. A PEG ratio of less than one can signal that a stock may be a good value. Value stocks usually have a PEG ratio of less than one because the stock's earnings expectations have risen and the market has not yet recognized its growth potential; but it could also indicate that earnings expectations have fallen faster than analysts could issue new forecasts. If the PEG ratio is greater than one, it could indicate s possibly overvalued stock. However, it is common for growth stocks to have a PEG greater than 1 because the market consensus expects future EPS growth to be dynamic and investors are willing to pay a premium for growth stocks.
Limitation: As with all financial ratios, additional information must be used to assess the investment potential of a company. Study of the operating trends, fundamentals, and other ratios is required. To properly determine if the stock is overvalued or undervalued, a company's P/E and PEG ratios in relation to its peer group and the overall market should be analyzed.
Price to Sales (PSR)
The PSR measures the value that investors place on each dollar of a company’s revenue or sales. It’s important to compare companies within the same industry because investors pay more for the sales of a high profit-margin industry than for a low margin one. PSR can be helpful in analyzing cyclical companies because their earnings volatility can distort P/E ratios. The price-to-sales ratio (PSR) can be a handy measure to use, instead of a price-to-earnings (P/E) ratio, if you're dealing with a company that has no earnings. The lack of earnings makes it impossible to calculate a P/E ratio, but as long as a company has sales, the PSR can be calculated to evaluate a stock. Some fantastic growth companies do not presently have earnings but have great potential.
It is calculated by dividing a stock's current price by its revenue per share.
Stock Market Price Revenue per Share
Alternative Calculation: Because the sales number is rarely expressed as a per-share figure, an identical PSR ratio result can be calculated by dividing a company's total market value by its total sales for the last 12 months. (Market value = stock price x shares outstanding; also called market capitalization or simply "capitalization".)
Interpretation: Generally the lower the ratio, the more attractive the investment. A low price to sales ratio (for example, below 1.0) is believed to be a better investment since an investor would be paying less for each unit of sales. In theory, a PSR of 0.8 means that an investor is paying only 80 cents for each dollar of sales. Perhaps the company is unprofitable, but it might be an overlooked bargain.
Limitation: This ratio is definitely not a number to be used by itself to make an investment decision. Sales are only one part of the measure of a company’s potential; these revenues must eventually become meaningful and rising earnings. Low price-to-sales ratios can indicate unrecognized value potential but other criteria such as high profit margins, low debt levels, growth prospects, and cash flow must be considered.
The PSR ratio ignores capital structure and therefore favors companies with high levels of debt. The PSR can be useless in many cases because there is no simple ratio that qualifies which stocks are expensive and which are good buys.
Dividend Payout Ratio (DPR)
The payout ratio measures in a percentage amount how much of earnings are paid out in dividends. This ratio reveals what a company is doing with its net income. For example, if a company is returning 80% of its earnings to shareholders, then only 20% is being reinvested in operations. A company with a high payout ratio is appealing to investors who desire higher income returns rather than growth in the share price.
This ratio can be calculated by two methods, each yielding the same result:
Common Stock Dividends Paid Net Income
Annual dividend rate_ Latest 12 months' EPS
Esample: If a company’s annual dividend rate is $2 per and its EPS is $6, the DPR is 33%. ($2 / $6 = 33%)
Interpretation: Growing companies will typically retain more net income to fund its growth by paying low or no dividends; this policy usually focuses on company growth and appreciation in the stock’s market price. If a company is earning less than it is paying out in dividends, it will be unable to raise dividends and the regular dividend itself could be in jeopardy for future payouts. Even though earnings may cover dividends, a high percentage payout indicates the company is reinvesting only a small amount for its growth; such a policy could hinder the price per share appreciation.
Real estate investment trusts usually pay out 90% of their earnings because of a provision in the law that exempts them from taxes if they do so. Utilities also have high payout rates.
Limitation: Like most ratios, the DPR one varies with industry. The DPR must be evaluated for the company and its industry. By itself, it tells you very little because, for example, a 50% payout ratio may or may not be beneficial to the company or its shareholders and is subject to interpretation. Is the payout detrimental to growth? Doses the absence of a dividend indicate growth or lack of earnings? What is management doing with the earnings not paid out as dividends?
Long-term Debt to Total Capital
One major difference between the debt-to-equity ratio and this ratio is that debt-to-capital includes long-term debt as part of the denominator. "Capital", for this ratio, is defined as the total amount of Long Term Debt (bonds, long term loans, etc.) and Owner's Equity.
The long-term Debt to Total Capital ratio indicates how much financial leverage a company has. It measures a company’s long-term financial strength.
It is calculated by dividing total debt by total invested capital as follows:
Total Liabilities Equity + Long-term Debt
Interpretation: General - The higher the ratio, the greater the chance a company will not be able to pay its debts in the future. Rising debt leverage in the absence of a rise in ROE might be a warning signal of potential cash flow problems. Generally a ratio above 50% could be a warning if high interest payments might limit future earnings growth and restrict financing for maintenance or expansion. Despite its implications debt can be an important part of doing business. Companies borrow to create new opportunities or to make a strategic acquisition. Highly leveraged industries are common for lodging, utilities and cable operators. Generally, the lodging industry is dependent on significant debt financing but with valuable realty as the collateral.
Limitation: Further analysis of a company's working capital and current / quick ratios should be addressed before labeling a company with a financial weakness or strength. If a business can earn a higher rate of return than the interest rate at which it borrows, it isprofitable for the business to incur debt. A cash flow analysis can determine its ability to service the debt.
Return on Equity (ROE)
ROE provides a convenient measurement of management performance. ROE is own of the best ways to judge a CEO on his/her ability to make favorable use of shareholders' funds. ROE measures the investment returns management has earned from investing funds from loans, retained earnings, and stock issued and sold. Management has three key tools at its disposal to affect the returns of the business: pricing, asset management, and financial leverage. ROE is more than just a measure on equity; it also measures how successfully management has been in running the business.
The calculation for ROE can be done in a couple of different ways, but all methods basically divide net income by shareholder equity. Some of the methods to calculate ROE are as follows
Net Income – Preferred Dividends OR Net Income OR similar modifications Average Total Equity Equity
Regardless of the method used, proper analysis is possible if the formula application is consistent from period to period.
Interpretation: Generally stated: "The higher the number, the better." A continued percentage above 20% is considered above average. For example, if the return on equity is 20%, then twenty cents of assets are created for each dollar that was originally invested and earnings retained by the business. Consistently low percentages might indicate that heavy debt is limiting financial flexibility or earnings are unsatisfactory measured against the equity invested.
Limitation: Accounting practices may distort results in comparing one period to another or one company to its industry or direct competitors. ROE for one industry should not be used as a yardstick for another industry. Shareholder equity is equal to total assets minus total liabilities.
U.S. FINANCIAL MARKET INDEXES
Investment strategies make considerable use of market barometers called financial market indexes. An index is a tool used to measure a particular financial market and consists of stocks believed to represent the general, overall behavior of a specific financial market sector. Different indexes measure different markets and their day to day movement reflects not a particular stock but the particular index market as a whole. Indexes are important to understand and every investor must know how to use and interpret them. There are a considerable number of financial indexes. This section describes some of the more popular stock indexes.
Dow Jones Industrial Average (DJI)
The Dow Jones Industrial Average, also known as the Dow is the best known and most widely quoted stock index in the financial markets. The Dow is perhaps the most quoted and followed index in the world. The Dow Jones Corporation, the administrators of the index, changes the stocks in the index from time to time. The Dow consists of 30 stocks that represent the largest and most widely traded stocks in the United States:
3M Exxon Mobil Johnson & Johnson Alcoa General Electric McDonald's American Express General Motors Merck & Co. AT&T Hewlett-Packard Microsoft Boeing Home Depot Philip Morris Caterpillar Honeywell Procter & Gamble Citigroup Intel SBC Communications Coca-Cola IBM United Technologies E.I. DuPont de Nemours International Paper Wal-Mart Eastman Kodak J.P. Morgan Chase Walt Disney Together they account for a significant amount of the value of the market. Although not as reflective of the whole market as other indexes, the Dow is watch earnestly.
The Dow Jones Industrial Average is computed by taking the average price of the 30 stocks and dividing that figure by a divisor that takes into account stock splits and mergers. Otherwise the index would decrease whenever a stock split took place. The divisor is determined by weights placed on all the stocks (due to these mergers and acquisitions) and changes quite often; at November 22, 2002 the divisor was equal to 0.14585278.
This divisor can also be used to measure how an individual stock influences the average. If the price of International Paper increases by two points, the DJI would increase by 13.7 points assuming none of the other stock values changed (13.7 = 2 / 0.14585278).
The Dow Jones Industrial Average should be considered as a price in itself. When the Dow Jones goes up 35 points, it just means that to buy these stocks it would have cost 35 more dollars than it would have cost to buy the stocks the day before.
The S&P 500 (SPX)
This index tracks 500 companies in leading industries: transportation, utilities, financial services, technology, health care, energy, communications, services, capital goods, basic materials, consumer products, cyclicals and more. It is a market weighted index because the calculation equals the price of each stock multiplied by the number of shares held by the public; therefore the companies with the most shares make the greatest impact.
The S&P 500 is considered the most accurate reflection of the U.S. stock market and is widely used as a benchmark to evaluate the performance of personal and mutual fund portfolios. Part of the index's popularity is due to its close association with the largest mutual fund in the world, the Vanguard 500 Index Fund.
[Dow Jones] Wilshire 5000 Composite Index (DWC)
The Wilshire 5000 is often referred to as the Total Stock Market Index because it seeks to track the returns of practically all publicly traded stocks with U.S. headquarters that trade on the major exchanges. Although this index is less well known than the others are, it is in fact the largest index by market value in the world.
The Wilshire 5000 is currently composed of more than 6000 companies, last count was 6307 but the number changes frequently. Penny stocks and stocks of extremely small companies are excluded. The top 10 weighted companies are:
American International Group
Similar to the S&P 500, the Wilshire 5000 is market-cap weighted giving larger companies more influence over the index movements. It is a total market index; an index of all U.S.-based companies traded on the New York, American, and NASDAQ stock exchanges making the Wilshire 5000 the most diverse of any U.S.-based index. However, it is not as popular as some other indexes. The Wilshire 5000 does not contain any foreign companies, and thus measures economic performance in the United States only.
Russell 2000 (RUT)
The Russell 2000 Index is a comprehensive and unbiased measurement of the small-company (small caps) segment of the U.S. equity market. It consists of 2,000 of the smaller stocks from the Russell 3,000 Index. The Russell 2000 Index is reconstructed annually so that larger stocks do not distort the performance and characteristics of this true small-cap index. The Russell 2000 is the most widely quoted measure of the overall performance of the small- to mid-cap company shares.
The top 10 in the index are:
NEW CENTURY FINANCIAL
TESORO PETROLEUM CORP
PLAINS EXPLORATION & PRO
LANDSTAR SYSTEMS INC
ATMOS ENERGY CORP
HEALTHCARE REALTY TRUST
EAST WEST BANCORP INC
REALTY INCOME CORP
VALEANT PHARMA INTL
The index is weighted by market capitalization, similar to the S&P 500 and the Wilshire 5000.
The Russell 2000 serves as a good benchmark for small-cap investments, but it is quite volatile in composition and in valuation. Small-cap companies do not tend to be the leaders in their respective industries.
S&P SmallCap 600 (SML)
The S&P SmallCap 600 Index is composed of 600 small-cap stocks. Unlike the larger Russell 2000, which also tracks small-cap stocks, the S&P 600 has more stringent requirements for inclusion. Standard & Poor's adds new stocks to the index based not only on size, but also on financial viability, liquidity, adequate float size, and other trading requirements. Therefore, the index is comprised of higher-quality firms than its larger counterpart. Since the index contains only small firms, it represents a mere 3% of the value of the overall market. The S&P SmallCap 600 Index is market value weighted, meaning that larger firms have a greater influence on the index's performance than smaller firms. The index is relatively evenly distributed, as the top 10 holdings represent only 5% of the index’s value.
The index is not as widely followed as the Russell 2000 but The S&P SmallCap 600 Index has been gaining popularity among investment managers as an efficient way to track or invest in a largely illiquid market segment.
The S&P MidCap 400 Index consists of 400 domestic stocks chosen for market size, liquidity, and industry group representation. This index covers about 7% of the U.S. equities market consisting of solid firms with good track records that are not large enough to include in the S&P 500 index. It is a market value weighted index. The S&P MidCap 400 is the most widely used index for mid-sized companies, an independent asset class with risk/reward profiles that differ considerably from both large-caps and small-caps.
The Standard & Poor's 100 Stock Index measures large-cap company U.S. stock market performance. This market capitalization-weighted index is made up of 100 major, blue chip stocks across diverse industry groups and is a subset of the S&P 500.
In addition to the broad U.S. market indexes there are a large number of international indexes that measure the markets of various countries, regions and continents. Due to space limitations, not every country or region can be represented. A listing of the major world indexes is available at: http://quote.yahoo.com/m2?u
Dow Jones Global Titans 50: The Dow Jones Global Titans tracks large international companies and includes only the largest and most-established blue-chip companies. All of the stocks in the index do business around the world, but eight of the top 10 holdings in this index are US-based.
Morgan Stanley Capital International's Europe, Australasia, Far East Index (EAFE): The EAFE is composed of companies considered representative of 21 European and Pacific Basin countries.
TSX Group is a cornerstone of the Canadian financial system and is at the center of Canada's equity capital market. TSX Group owns and operates Canada's two national stock exchanges. Its Toronto Stock Exchange serves the senior equity market, and its TSX Venture Exchange serves the public venture equity market.
TSX Venture Exchange, Canada's venture capital marketplace, provides emerging companies with access to capital, while offering investors a well-regulated market for making venture investments. TSX Venture listed issuers are active in mining, oil and gas, manufacturing, technology, financial services and other sectors. . For listed issuers information, go to:
Hong Kong - Hang Seng: The Hang Seng index has 33 companies representing 70% of the market capitalization of the Stock Exchange of Hong Kong. These companies are grouped into four sub-indexes: Commerce/Industry, Finance, Properties, and Utilities. http://www.hsi.com.hk/
Japan - Nikkei 225: The most widely watched stock average in Japan. It is a price-weighted index of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The calculation method is based on the same one used by the Dow Jones Industrial Average. These actively traded stocks are chosen from a pool of 450 companies with the highest liquidity. They are divided into six sectors based on industry and reflect the current trends on the Japanese market. http://www.nni.nikkei.co.jp/
London - FTSE 100: (pronounced "footsie 100"): The FTSE 100 is the British equivalent of the Dow Jones Industrial Average. It is an index of the top 100 most highly capitalized companies traded on the London Stock Exchange. A sampling of those companies includes British Airways, Cadbury-Schweppes, Rolls-Royce, and GlaxoSmithKline. Although the companies are British, they tend to conduct significant portions of their business outside of the U.K. http://www.ftse.com/
Malaysia: In 2004, the Kuala Lumpur Stock Exchange became a demutualized exchange and was re-named Bursa Malaysia. MESDAQ is a stock exchange targeted specifically to growth and technology companies. It creates a new vista for companies seeking investors and vice-versa. Through a listing on MESDAQ, companies can now have access to public funds. The KLSE Composite Index Components are available at: http://www.twincitytradecom.com/klse_composite_index_components.htm
Netherlands: Amsterdam European Options Exchange Index AEX: The European Options Exchange (EOE) publishes four indexes: The Amsterdam EOE Index AEX, the Eurotop 100 Index, the Amsterdam MidKap Index, and the Dutch Top 5 Index . The EOE Index is generally viewed as the representative index for the price dynamics of the Dutch stock market, and it serves as an underlying for options and futures trading. The EOE Index is constructed as a capitalization-weighted arithmetic average. For information on components, go to: http://www.ihs.ac.at/fin/finix/aex_list_9706.html
Singapore Financial Markets: The Straits Times Index, which is compiled by the newspaper of the same name, is Singapore’s premier equity index. The index is comprised of 55 of the exchange’s most valuable firms. It is a modified value-weighted index, which is complicated in calculation, but ensures that the largest firms have the greatest impact on the index’s value. The index's 55 components represent about 60% of the total market value of all issues traded on the Singapore Stock Exchange. http://www.geoinvestor.com/statistics/singapore/financial.htm