There are many ways to measure how leverage a company can be.
For bond holders, they will typically be interested to know the liquidation value of the company since bondholders are senior to equity in their claim for assets on liquidation. The debt ratio will provide such a measure:-
Debt Ratio = Total Liabilities / StockHolder' Equity
To get a measure of the amount of leverage taken on by a company relative to its size, the Debt-to-Equity or Leverage ratio would provide such a measure. It disregard current liabilities as such liabilities are day-to-day related and short-term.
Leverage Ratio = Long Term Debt / StockHolder's Equity
To get a measure of whether a company can service its debt, the interest cover ratio will be useful. Because earnings rise and fall depending on market and economic conditions, it would be preferable if the company’s earnings were much higher than interest expense in most years; otherwise, investing in the company would incur significant risk when the economy falters, as it always does eventually
Interest Cover Ratio = EBIT / Interest Expense of Long Term Debt
Some companies use EBITDA to calculate interest cover ratio, but you should be careful in those circumstances as the usual claim is always Depreciation and Amortization is not actual cash expense and does not affect the ability to pay debt interest.
Showing posts with label Performance Metrics. Show all posts
Showing posts with label Performance Metrics. Show all posts
Monday, September 6, 2010
Sunday, September 5, 2010
Cash Flow
I like to make a note here on Cash Flow because it is such an important item to be looked at when someone is evaluating a company, but more often than not, it is typically not highlighted in the press releases when reporting quarterly or annual results.
The cash flow of a business is the total amount of cash actually received in a given period minus the total amount of cash actually paid out in that same period. Positive cash flow is the receipt of more cash than was paid out; negative cash flow results from paying out more cash than receiving.
Cash Flow = Cash Received - Cash Paid
In accrual accounting, which most companies use, income is listed when it is earned, even before it is actually received, and expenses are recorded before the money is actually paid out. Depreciation or amortization, for instance, is an expense that doesn't require the immediate payout of cash. Thus, net income alone, which is the income after all expenses are subtracted from all income in a given time period is not an accurate representation of how much cash a company has, or even how much it is generating.
Cash Flow = Net Income + Depreciation + Other Noncash Expenses
For companies in matured or regulated industries, the main evaluation should really be the stability of their cash flow generation since at the end of the day, when you invest in these companies, what you really are investing is in the cash generating power of these businesses.
Watch out for the company Cash Flow from Operating Activities figure every quarter if you have significant investment in these companies. If you see major deviation in the trend, you should really find out why.
Additional concept you may encounter is Free Cash Flow (FCF)
Free Cash Flow (FCF) = Cash Flow from Operating Activities - Capex
FCF is a measure of how much value can be extracted from the company without altering the cash generating power of the company. You need not be alarmed if you see in certain quarter where the company may be running into negative FCF because it may need to make major capital expenditure during those times to upgrade the business. But consistent negative FCF over many quarters should be investigated thoroughly. If you consistently track these numbers with those companies you own, you will start to understand their businesses.
The cash flow of a business is the total amount of cash actually received in a given period minus the total amount of cash actually paid out in that same period. Positive cash flow is the receipt of more cash than was paid out; negative cash flow results from paying out more cash than receiving.
Cash Flow = Cash Received - Cash Paid
In accrual accounting, which most companies use, income is listed when it is earned, even before it is actually received, and expenses are recorded before the money is actually paid out. Depreciation or amortization, for instance, is an expense that doesn't require the immediate payout of cash. Thus, net income alone, which is the income after all expenses are subtracted from all income in a given time period is not an accurate representation of how much cash a company has, or even how much it is generating.
Cash Flow = Net Income + Depreciation + Other Noncash Expenses
For companies in matured or regulated industries, the main evaluation should really be the stability of their cash flow generation since at the end of the day, when you invest in these companies, what you really are investing is in the cash generating power of these businesses.
Watch out for the company Cash Flow from Operating Activities figure every quarter if you have significant investment in these companies. If you see major deviation in the trend, you should really find out why.
Additional concept you may encounter is Free Cash Flow (FCF)
Free Cash Flow (FCF) = Cash Flow from Operating Activities - Capex
FCF is a measure of how much value can be extracted from the company without altering the cash generating power of the company. You need not be alarmed if you see in certain quarter where the company may be running into negative FCF because it may need to make major capital expenditure during those times to upgrade the business. But consistent negative FCF over many quarters should be investigated thoroughly. If you consistently track these numbers with those companies you own, you will start to understand their businesses.
Thursday, September 2, 2010
Understanding ROA/ROE/ROIC
When you go through company annual or quarterly reports, you will encounter things like ROA/ROE and ROIC. It is important to have an inkling what they are especially when you have thousands of dollars vested in them.
Return of Assets (ROA). It is basically a measure of a company efficieny in translating assets into profits.
ROA = Net Margin * Asset Turnover where
Net Margin = Net Income / Sales and
Asset Turnover = Sales / Assets
Net Margin tells you how much each dollar of sales a company keeps as earnings after paying all the cost of doing business
Asset Turnover tells us roughly how efficient a company is at generating sales from each dollar of asset.
With ROA, there are two routes to operation profitability either by charging higher prices (high net margin) or turning over assets quickly. But ROA if fine if companies are just a pile of assets but in reality, many companies are partially finance by debt, which gives their return a leverage component which need to be taken into account.
Return on Equity (ROE)
Return on Equity is a measure of a company's profitability based on its efficiency with which the company is using shareholder's equity.
ROE = ROA * Financial Leverage where
Financial Leverage = Assets / Shareholder's Equity
Financial Leverage is a measure of how much debt a company carries relative to shareholder's equity.
Hence, ROE = Net Margin * Asset Turnover * Financial Leverage
There are three levers that can boost ROE - Net Margin, Asset Turnover an Financial Leverage. Utilities, is a good example of companies using Financial Leverage to boost ROE (CitySpring, SP Ausnet in my portfolio are all classic examples)
Return on Invested Capital (ROIC)
ROIC improves on ROA and ROE because it put the debt and equity financing on an equal footage. It removes the debt-related distortion that can make highly leveraged company looks very profitable when using ROE.
ROIC = Net Operating Profit After Taxes (NOPAT) / Invested Capital
Invested Capital = Total Assets - Non-interest bearing current liabilities (ie A/P) - Excess Cash (not needed in day-to-day ops) - Goodwill
Return of Assets (ROA). It is basically a measure of a company efficieny in translating assets into profits.
ROA = Net Margin * Asset Turnover where
Net Margin = Net Income / Sales and
Asset Turnover = Sales / Assets
Net Margin tells you how much each dollar of sales a company keeps as earnings after paying all the cost of doing business
Asset Turnover tells us roughly how efficient a company is at generating sales from each dollar of asset.
With ROA, there are two routes to operation profitability either by charging higher prices (high net margin) or turning over assets quickly. But ROA if fine if companies are just a pile of assets but in reality, many companies are partially finance by debt, which gives their return a leverage component which need to be taken into account.
Return on Equity (ROE)
Return on Equity is a measure of a company's profitability based on its efficiency with which the company is using shareholder's equity.
ROE = ROA * Financial Leverage where
Financial Leverage = Assets / Shareholder's Equity
Financial Leverage is a measure of how much debt a company carries relative to shareholder's equity.
Hence, ROE = Net Margin * Asset Turnover * Financial Leverage
There are three levers that can boost ROE - Net Margin, Asset Turnover an Financial Leverage. Utilities, is a good example of companies using Financial Leverage to boost ROE (CitySpring, SP Ausnet in my portfolio are all classic examples)
Return on Invested Capital (ROIC)
ROIC improves on ROA and ROE because it put the debt and equity financing on an equal footage. It removes the debt-related distortion that can make highly leveraged company looks very profitable when using ROE.
ROIC = Net Operating Profit After Taxes (NOPAT) / Invested Capital
Invested Capital = Total Assets - Non-interest bearing current liabilities (ie A/P) - Excess Cash (not needed in day-to-day ops) - Goodwill
Monday, August 30, 2010
P/E Ratio
The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company's earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don't.
Typically, P/E ratio can be trailing (based on the last 12 months earning results) or forward (based on analyst expection of the next 12 earning results).
If the last twelve months have been a bumper year for the company (especially if there one-time gains), the trailing P/E ratio may look very good, but you have to discount it quite a bit if you are considering to buy at this stage.
If the last twelve months have been very bad for everybody (like March 2009), the trailing P/E ratio may look worse than they really are. If the company is fundamentally sound, this may be a good buy opportunity though P/E may look lousy.
As for forward P/E ratio, the general rule will be to always discount it to some degree when the mood is bullish. Analysts are always too bullish or pessimistic. How come few analyst cry out for "Buy" in march 2009??
P/E ratios fell sharply during the Great Recession (2009/2009), Sars and 1997/1998 crisis.
If corporate borrowing costs remain at record lows and specific stock prices remain lower than expected, companies will start issuing debt to buy back shares from the market. Recently, you would SingPost doing a lot of share-back after raising fund from the debt market.
Always remember, a stock is only worth its future earnings, but it involves uncertainty. This explains the need to have a "margin of safety" in value stock investing.
Typically, P/E ratio can be trailing (based on the last 12 months earning results) or forward (based on analyst expection of the next 12 earning results).
If the last twelve months have been a bumper year for the company (especially if there one-time gains), the trailing P/E ratio may look very good, but you have to discount it quite a bit if you are considering to buy at this stage.
If the last twelve months have been very bad for everybody (like March 2009), the trailing P/E ratio may look worse than they really are. If the company is fundamentally sound, this may be a good buy opportunity though P/E may look lousy.
As for forward P/E ratio, the general rule will be to always discount it to some degree when the mood is bullish. Analysts are always too bullish or pessimistic. How come few analyst cry out for "Buy" in march 2009??
P/E ratios fell sharply during the Great Recession (2009/2009), Sars and 1997/1998 crisis.
If corporate borrowing costs remain at record lows and specific stock prices remain lower than expected, companies will start issuing debt to buy back shares from the market. Recently, you would SingPost doing a lot of share-back after raising fund from the debt market.
Always remember, a stock is only worth its future earnings, but it involves uncertainty. This explains the need to have a "margin of safety" in value stock investing.
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