Financial Ratios Flashcards
What is Return on Equity (ROE) and how is it calculated?
ROE is a measure of profitability that shows how much net income is generated per unit of shareholders’ equity. It is calculated as: net income / shareholders’ equity.
Why is a ROE > 15% considered good?
A ROE > 15% is considered high because it indicates that the company is efficiently generating profit relative to shareholders’ equity, suggesting strong profitability.
What does Earnings Per Share (EPS) represent?
EPS represents the amount of profit a company makes per share of stock it has issued. It is calculated as: net income / shares outstanding.
Why is a higher EPS generally considered better?
A higher EPS is generally better because it indicates greater profitability, making the company more valuable to investors.
How can EPS be used in conjunction with the P/E ratio?
EPS is used in conjunction with the Price/Earnings (P/E) ratio to assess whether a stock is overvalued or undervalued. A high P/E ratio may indicate high growth expectations or an over-priced stock.
What is the Debt-to-Earning ratio and what should it be?
The Debt-to-Earning ratio measures a company’s long-term debt relative to its net earnings. It is calculated as: long-term debt / net earnings. A D/E ratio should be less than 5.
How does Warren Buffett calculate the Rate of Return (ROR)?
Warren Buffett calculates ROR by comparing the stock price to earnings, viewing stocks like bonds with increasing returns over time. The initial rate of return is calculated as: earnings per share / price paid per share.
Why is EPS Growth important?
EPS Growth is important because it reflects management’s ability to grow earnings per share, which is key to the growth in the company’s stock price over time.
How do you calculate EPS Growth over a five-year period?
EPS Growth over a five-year period can be calculated using the compound growth rate formula, where you use the earnings of the starting year as the present value and the earnings of the ending year as the future value.
What does Warren Buffett mean by “Value Relative to Treasury Bonds”?
“Value Relative to Treasury Bonds” refers to comparing a company’s EPS to the return on treasury bonds to determine if the stock offers a better return than bonds. It is calculated as: EPS / Return on Treasury Bonds.
How do you interpret the Debt-to-Equity Ratio?
The Debt-to-Equity ratio indicates the relative proportion of shareholders’ equity and debt used to finance a company’s assets. A ratio below 0.5 is generally preferred by value investors as it suggests lower financial risk.
What does the Current Ratio indicate?
The Current Ratio indicates whether a company can meet its short-term obligations with its short-term assets. It is calculated as: current assets / current liabilities. A healthy current ratio is typically > 2.
What is Free Cash Flow (FCF) and why is it important?
Free Cash Flow (FCF) is the cash generated by a company after accounting for capital expenditures. It’s important as it indicates the cash available for distribution to investors or reinvestment in the business.
How do you calculate Free Cash Flow (FCF)?
Free Cash Flow (FCF) is calculated as: cash flows from operating activities - capital expenditures.
What does a positive FCF indicate?
A positive FCF indicates that a company is generating more cash than it needs to maintain its operations, which can be used for dividends, reducing debt, or reinvestment.
What is Net Margin and how is it calculated?
Net Margin is a profitability metric calculated as: net income / revenue. It represents the percentage of sales that ends up as net income.
Why is an increasing Net Margin over time a good sign?
An increasing Net Margin over time indicates that a company is becoming more profitable and managing its costs effectively, which is a positive sign for investors.
What is Gross Margin and how is it calculated?
Gross Margin is calculated as: (Revenue - Cost of Goods Sold) / Revenue × 100%. It shows how efficiently a company produces and sells its products.
Why is a high Gross Margin important for value investing?
A high Gross Margin indicates operational efficiency and pricing power, which can suggest a competitive advantage and financial health, making the company attractive to value investors.
What does the Price/Earnings (P/E) ratio measure?
The P/E ratio measures the price investors are willing to pay for a stock per dollar of income. It is calculated as: current stock price / earnings per share.
Why is the P/E ratio not always reliable for assessing a company’s value?
The P/E ratio is not always reliable because it varies greatly by industry and does not account for differences in growth potential or the company’s intrinsic value.
What are some general guidelines for interpreting the Debt-to-Equity (D/E) ratio?
- Below 1: May indicate a stable company with low risk, but possibly not utilizing debt strategically.
- 1-2: Generally acceptable, indicating a balance between growth and stability.
- Above 2: Could indicate financial risk, especially for non-growth companies.
How does the industry affect the interpretation of the Debt-to-Equity (D/E) ratio?
Some industries, like utilities or real estate, typically have higher D/E ratios due to their reliance on leverage. In contrast, growth companies or those in cyclical industries might be riskier with a high D/E ratio.
Why might a value investor be concerned with a company that has a high D/E ratio?
A high D/E ratio might concern value investors because it suggests the company has a significant debt burden, which could limit its potential for future growth and expose it to financial risk during downturns.
What is a healthy Current Ratio?
A healthy Current Ratio is typically greater than 2, indicating that the company has sufficient assets to cover its short-term liabilities.
What does a declining Free Cash Flow (FCF) indicate?
A declining FCF could indicate that a company is struggling to generate cash, which might suggest issues with sales, cost management, or capital expenditures.
Why is it important to compare EPS among similar companies?
Comparing EPS among similar companies within the same industry helps assess which company is more efficient at using its capital to generate profits, offering insights into relative profitability.
Why should you be cautious of companies with inconsistent EPS?
Inconsistent EPS can indicate unstable earnings, which could be a warning sign of financial instability or poor management.
What is the significance of Gross Margin in assessing a company’s competitive advantage?
A consistently high or improving Gross Margin suggests that the company may have a competitive advantage, such as strong brand power or cost leadership, which is crucial for long-term profitability.
