## Sunday, 23 June 2013

### Intrinsic Value Calculation - Net Current Asset Value (NCAV) Approach

The Net Current Asset Value (NCAV) approach was developed and tested by Benjamin Graham between 1930 and 1932. This is not exactly a method of determining the intrinsic value of companies but a strategy for identifying deep value stocks.

Graham includes only current assets in the computation of NCAV. While ignoring long-term assets, he includes everything that appears in the liabilities column of the balance sheet. In addition, Graham viewed that preferred stock belongs on the liability side of the balance sheet, not as part of capital and surplus.

Formula : NCAV = Current Assets - [Total Liabilities + Preferred Stock]

Graham's NCAV strategy calls for buying stocks trading at not more than two-third of their net current asset value. This is a stringent requirement, but Graham was looking for companies trading so cheap that there was little danger of falling further.

Graham was well aware that some investments in companies that meet his NCAV criteria would fail, so he recommended buying a large number of stocks to diversify the risk. He suggested holding at least 30 stocks at a time. In addition, only companies with positive earnings in the last 12 months period are included in the portfolio. Graham would hold the investments until he had a 50% gain or until he had held them for two years.

In analyzing companies that were selling below net asset value in 1932, 1933, 1938 and 1939, Graham concluded that "stocks selling below working capital and showing a fair record of earning and dividends are likely to be 'bargain' issues and are likely to turn out to be unusally satisfactory purchases".

A research done by the State University of New York has shown that from the period of 1970 to 1983, an investor could have earned an average return of 29.4% by purchasing stocks that fulfilled Graham's requirement and holding them for one year.

### Screening for Graham NCAV Stocks

Finding stocks meeting the Graham NCAV requirements require some digging. It is a time consuming and yet simple and rewarding process. There are no tools that are available on the web that can be used to screen for NCAV stocks. I have created a simple spreadsheet that I use to screen for NCAV stocks, you can download it here.

The criteria that I use to screen for NCAV stocks are as follows:

1) Net current asset value per share must be less than 66.7% of the current share price.

2) Must have positive earnings for the trailing 12 months.

3) Total shareholder's equity must be greater than total of current liabilities and long-term debt.

4) Must have positive operating cash flow over the last 12 months.

5) Capitalization ratio less than 0.1

6) Total liabilities must not be more than 50% of total assets (Debt ratio <0.5)

7) Interest coverage ratio must be more than 2.

Do note that not all companies that passed the above criteria are worthy investment candidates, it is important to do your due diligence check and limit your risk in individual stocks.

## Saturday, 22 June 2013

### Intrinsic Value Calculation - The Graham Number

Graham Number is a way to estimate the intrinsic value of a company based on its book value and earnings power. It is the upper bound of the price range that a defensive investor should pay for a stock. Any stock price below the Graham Number is considered undervalued and thus worth investing in.

Formula : Square root of (22.5 x Earnings per Share x Book Value per Share)

Graham Number is based on the criteria No. 6 and 7 of "Stock Selection for the Defensive Investor" (The Intelligent Investor, chapter 14), which state that:

• Moderate Price/Earnings ratio - Current price should not be more than 15 times average earnings of the past three years.
• Moderate Ratio of Price to Assets - Current price should not be more than 1.5 times the book value last reported.

As a rule of thumb, Graham suggests that the product of the multiplier times the ratio of price to book value should not exceed 22.5.

The remaining 5 criteria for "Stock Selection for the Defensive Investor" are:
• Adequate Size - Steer clear of stocks with a total market value of less than \$2 billion (2003 figure).
• Strong Financial Condition - Current assets should be at least twice current liabilities (Current ratio =>2). Also the long term debt should not exceed the net current assets.
• Earnings Stability - Some earnings for the common stocks in each of the  past ten years.
• Dividend Record - Uninterrupted payments for at least the past 20 years.
• Earning Growth - A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.

Graham Number is a very simple and conservative way to valuate a company, but it does have its limitation.

• It does not take growth into the valuation and tends to underestimates the values of the companies that have good earnings growth.
• It can only be applied to companies with positive earnings and positive book values.
• It punishes companies that have temporarily low earnings and underestimates medium-to-large-cap companies that are low with book value.

Example of Graham Number Calculation :

The EPS and Book Value per Share for Cisco is 1.51 and 9.60 respectively. The Graham Number is calculated as follows:

Graham Number = Square root of (22.5 x 1.51 x 9.60) = Square root (326.16) = \$18.06 per share.

Graham Number should not be used alone while evaluating a stock for defensive investment, it should be used along with the other 5 criteria as outlined above. If a stock does not meet any one of the 7 criteria, then it should be checked against the 5 criteria for "Stock Selection for the Enterprising Investor" (The Intelligent Investor, chapter 15).
• Financial Condition - a) Current assets at least 1.5 times current liabilities and b) Debt not more than 110% of net current assets.
• Earning Stability - No deficit in the last five years covered in the Stock Guide.
• Dividend Record - Some current dividend.
• Earnings Growth - Last year's earnings more than those of 1966. (Note : The revised edition of The Intelligent Investor was updated by Benjamin Graham in 1971-72, therefore we should compare the last year's earnings against those of 2008).
• Price - Less than 120% net tangible assets.
Source :
The Intelligent Investor, by Benjamin Graham

## Friday, 21 June 2013

### Price/Earnings Ratio - P/E Ratio

Price / Earnings Ratio is defined as market price per share divided by annual earnings per share.

Formula : Price / Earnings Ratio = Stock Price per share / Earnings per share

In general, a high P/E ratio suggests that investors are expecting higher earnings growth in the future. Conversely, a low P/E may indicate a “vote of no confidence” by the market. Historically, the average P/E ratio for the broad market has been around 15. Companies that are losing money do not have a P/E ratio.

Looking at P/E ratio alone is meaningless. While evaluating prospective stock, it is useful to look at the current P/E ratio for the overall market (S&P500), the company's  industry segment and those of direct competitor company to determine if the prospective stock is in the high, low or moderate range .

The P/E is also referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay \$20 for \$1 of current earnings.

It is important to note that investors should avoid basing an investment decision on this ratio alone. The earnings are based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

### Trailing Price/Earnings Ratio - Trailing P/E

When you divide a stock's price by the sum of company's earnings over the past twelve months, you get the Trailing P/E ratio.

Formula : Trailing P/E Ratio = Stock Price per share / Trailing Twelve Month's Earnings per share

This ratio values the company based on the past. It is the most commonly used P/E measurement as it is based on actual earnings and, therefore, is the most accurate.

#### Example :

The earnings for Cisco is \$8,041 millions and the total outstanding share is 5,340 millions, therefore the trailing twelve month's earning per share is 8,041/5,340 = \$1.51 and the trailing P/E ratio is \$24.43/\$1.51 = 16.18 (as at 21/6/2013).

### Forward Price/Earnings Ratio - Forward P/E

When you substitute the past twelve month's earnings with estimated earnings for the next year, you get the forward P/E ratio.

Formula : Forward P/E Ratio = Stock Price per share / Estimated Earnings per share

The forward P/E ratio looks at what the P/E ratio would be a year from now, assuming that the share price remains the same. If earnings are expected to grow in the future, the forward P/E will be lower than the current P/E. A company who’s earnings are growing very fast would have a lower forward P/E than a company with slower earnings growth. The primary limitation of forward P/E is that future earnings are only an estimate, and the resulting P/E is only as accurate as the projection.

#### Example :

The average earnings per share estimates for Cisco from msn money for FY(7/13) is 1.83. Therefore the forward P/E ratio of Cisco as at 21/6/2013 is 24.43/1.83 = 13.34.

The forward P/E for Cisco is lower than the trailing P/E, this means that the earnings for Cisco is expected to grow going forward.

### Price/Earnings to Growth Ratio - PEG Ratio

Price/Earnings Growth ratio is calculated by dividing the P/E by the projected earnings growth rate.

Formula : Price/Earnings to Growth Ratio = P/E Ratio / Earnings per share Growth

The P/E ratio used in the calculation may be forward or trailing, and the annual growth rate may be the expected growth rate for the next year or the next five years.

The PEG ratio is a refinement of the P/E ratio and factors in a stock's projected earnings growth into its current valuation. It is considered to provide a more complete picture than the P/E ratio. In general, the P/E ratio is higher for a company with a higher growth rate. Thus using just the P/E ratio would make high-growth companies appear overvalued relative to others. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.

According to Peter Lynch, "The P/E ratio of any company that's fairly priced will equal its growth rate", i.e., a fairly valued company will have its PEG equal to 1. If the PEG ratio is less than 1, the stock's price is undervalued, If it is more than 1, the stock is overvalued. Companies with PEG values between 0 to 1 may provide higher returns. The PEG Ratio can also be a negative number, for example, when earnings are expected to decline.This may be a bad signal, but not necessarily so. Under many circumstances a company will not grow earnings while its free cash flow improves substantially.

The PEG ratio's when used with low-growth companies is highly questionable. It is generally only applied to so-called growth companies (those growing earnings significantly faster than the market). The PEG ratio is another way to try and identify undervalued high growth stocks through a technical screen. It should not be used alone to select stocks, and should instead be complemented with a fundamental analysis of the market and company to value the stock properly.

The PEG ratio is a rough rule of thumb, and it's accuracy depends very much on the analyst estimates which are rarely correct. When calculating the PEG ratio, it is best to use a very conservative long-term estimate for growth and the current P/E ratio.

#### Example :

We will be using trailing P/E to calculate the PEG ratio. The trailing P/E is 16.18 as calculated above and the growth estimates for Cisco as per msn money is 9.70%. Therefore, the PEG ratio is 16.18 / 9.70 = 1.67.

If you are using Yahoo Finance, the growth estimate is 8.33% and the PEG ration will be 1.94 instead. As mentioned, the PEG ratio depends very much on the analysts estimates and the difference could be quite a lot. You can perform your own estimates on the earnings growth rate and compare against that of analysts estimtates to decide on a conservative estimates to calculate the PEG. Do remember that analysts estimates are only estimates and they are no guarantee that their estimates is more accurate than yours, and its better to err on the conservative side.

## Thursday, 20 June 2013

### How to estimate future EPS growth rates

For most valuation techniques, the future EPS growth rate is the most important and influential factor in arriving at an accurate valuation. There are a few simple methods we can use to estimate the future EPS growth rate.

1) Obtain Data from Stock Research Website
Future EPS growth rate is estimated by professional analysts on a quarterly basis at a minimum. This estimate is available on most popular stock research websites such as Yahoo Finance, MSN Money, Google Finance and Bloomberg.
Steps :
a)      Go to the Yahoo Finance.
b)      Enter the ticker of the stock you are searching
c)       Click on Analyst Estimates in the menu bar on the left side of the screen
d)      At the bottom of the page is a section titled “Growth Est” – Look for Next 5 Years value.
We use Cisco Systems, Inc. (CSCO) as example.

The 8.33% is the number we’re after, and what it means is that CSCO is expected to grow at an average rate of 8.33% each year over the next 5 years.

## 2) Estimating future EPS growth rates yourself

The professionals don’t often agree with each other and if you were to actually look at the numbers from msn Money, the estimated growth rate is 9.70%. You can perform a sanity check and attempt to estimate the EPS growth rate yourself to see how it compares. The first step is to look at the past 10 years of earnings and sales data to estimate future earnings. You can obtain the necessary inputs from msn Money by clicking on 10-YR Summary. This provides us with EPS numbers (earnings) and revenue (sales) for each of the last 10 years.

Screenshot of 10-year summary from msn Money.
Using a financial calculator, enter 0.50 (EPS for 2003) as PV (present value), 1.49 (EPS for 2012) as FV (future value), 9 as N (no. of Years) and you will get a growth rate of 12.9%
Although there are 10 EPS value from 2003 to 2012, we have only 9 growth period, therefore the value of N should be 9.
Note that the point-to-point growth rate could change radically if we used two different points. For example, if we calculated the 5-year EPS growth rate from 2004 to 2009, we would obtain 8.45%, but the five-year rate from 2006 to 2011, is 5.62%. This radical change occurs because the point-to-point rate is extremely sensitive to the beginning and ending years chosen.

To alleviate the problem of beginning and ending year sensitivity, we use an average-to-average calculation. For example, to calculate CSCO’s EPS growth rate over the period 2006 to 2011, we would (1) get the average EPS over the years 2005 to 2007 and use this value (\$0.98) as the beginning year, (2) get the average EPS over the years 2010 to 2012 and use this value (\$1.33) as the ending year, and (3) calculate a growth rate of 6.30% based on these data. This procedure is superior to the simple point-to-point calculation for purposes of estimating growth.

You can perform the calculation using free online financial calculator here.

Our estimated growth rate of 6.30% is lower than that of the analyst (8.33% from Yahoo Finance and 9.7% from msn Money). In this case we might opt to err on the conservative side and take the middle road between the analyst estimates and past history, and predict say a 8% growth rate moving forward.

## Wednesday, 19 June 2013

### Return On Equity and DuPont Analysis

The Return on Equity ratio measures how well the shareholders' investment in the company are generating net income. It is one of the most important indicators of a company's profitability and potential growth and one of Warren Buffett favourite calculations for finding quality companies.

Generally, a high ROE means that the rate of return on shareholders' equity is rising, a high and consistent ROE indicates that the management is putting the shareholders' money to good use and  growing profits without adding new equity into the company.

However, this ratio can be misleading as ROE can be easily manipulated. A high ROE can be produced without increasing the performance of the company by manipulating the equity portion of the ROE formula. The formula for ROE is Net Income / Shareholders' Equity, shareholders' equity being the denominator, any decrease in the shareholders' equity will result in higher ROE even with no increase or even an decrease in net income. While using debt to finance a company growth can often produce higher returns, it can also place the company in a riskier position especially during down markets.

DuPont Analysis provides a way to breakdown the components of ROE and a much better understanding of how ROE is achieved. DuPont Analysis is also known as DuPont Identity, DuPont Formula, DuPont Model or the DuPont Method. It is a method of performance measurement that was created by DuPont corporation back in the 1920s.

The DuPont Analysis breaks down the ROE into three distinct components:

1) Profitability - measured by profit margin (Net Income / Sales)
2) Operating efficiency - measured by asset turnover (Sales / Total Assets)
3) Financial leverage - measured by equity multiplier (Total Assets / Shareholders' Equity)

The basic formula for DuPont Analysis is:
ROE = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Shareholders' Equity)

With ROE broken down into three components, it becomes clearer how ROE is achieved. If the increase in ROE is the results of increase in profit margin or asset turnover, it is a very positive sign. However, if the equity multiplier is the source of increase and the company is already appropriately leveraged, then it is a warning sign.

Looking at DuPont Analysis for a single company over a single year, the result would be meaningless. The best way is to use the DuPont Analysis is to compare against competitors in the same industry over some period of time. This will show trend of the company against itself and against that of the competitors.

#### Example of DuPont Analysis

I will be comparing Cisco Systems, Inc. (CSCO) against Juniper Networks, Inc. (JNPR), its direct competitor in the Networking & Communication Devices industry, to provide an example of using the DuPont Analysis.

All the above data can be obtain from Yahoo Finance.

The asset turnover and Equity Multiplier for Cisco have been consistent over the three years period, the drop in ROE from 2010 to 2011 and increase in ROE from 2011 to 2012 is due mainly to the changes in profit margin.

The asset turnover for Juniper remain consistent over the three years period, the equity multiplier increase from 2010 to 2011 and maintain the same in 2012. We can see from the Balance Sheet that this is due to the increase in long term debt in the year 2011. The ROE for Juniper has been decreasing since 2010 and this is mainly due to the decrease in the net income.

Cisco is obviously the superior of the two companies. The changes in the ROE is due to the changes in the profit margin and there is no warning sign of ROE being manipulated.

## Tuesday, 18 June 2013

### Investment Valuation Ratios

The Investment Valuation Ratios compare a company current share price against its performance.or profitability. The seven Investment Valuation Ratios that will be discussed are:

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

#### 1) Price / Book Ratio

The Price / Book ratio, or P/B ratio, is used to compare a company's current market price to its book value. It is an indication of how much shareholders are paying for the net assets of a company. Book value is how much a company is worth after all liabilities have been paid, it is an estimation of the value of a company if it were to be liquidated. This ratio provides investors a mean to compare what they are paying for each share (the market value), to a conservative measure of the value of the company.

Formula : Price / Book Ratio = Stock Price per share / Shareholders' Equity per share

Benchmark : As with most ratios, it varies a fair amount by industry. Industries that are capital-intensive will usually trade at P/B ratios much lower than that of non-capital-intensive industries. P/B ratio of less than 1, then the company is selling below its book value and could represent an attractive buying opportunity at a bargain price, provided that the company's positive fundamentals are still in place.

Note : A higher P/B ratio implies that investors expect management to create more value from a given set of assets while a lower P/B ratio can means two things. The first scenario is that the stock is being unfairly undervalued by investor and could represent a bargain buy. The second scenario is that the market valuation of the company is correct and that something is fundamentally wrong with the company.

Calculation : The Price / Book Ratio for Cisco as at 28 Jul 2012 is 15.69 / (51,286/5,340) = 1.63. The current market price of Cisco is \$24.35 (14/6/2013) and the P/B ratio is 2.54. This means that Cisco's stock is trading at 2.54 times its book value currently.

#### 2) Price / Cash Flow Ratio

The Price / Cash Flow Ratio  or P/CF, is a ratio used to compare a company's market value to its cash flow. It is used by investors to evaluate the investment attractiveness of a company's stock. The price / cash flow ratio is seen by many as a more reliable basis to evaluate the acceptability of a stock's current price. In contrast to earnings, sales and book value, companies have a much harder time manipulating cash flow. While sales, and inevitably earnings, can be manipulated through such practices as aggressive accounting, and book value of assets falls victim to subjective estimates and depreciation methods, cash flow is simply cash flow.

Formula : Price / Cash Flow Ratio = Stock Price per share / Operating Cash Flow per share

Benchmark :  The lower a price / cash flow ratio is, the better value that stock is. According to Investopedia: "A high P/CF ratio indicated that the specific firm is trading at a high price but is not generating enough cash flows to support the multiple - sometimes this is OK, depending on the firm, industry, and its specific operations. Smaller price ratios are generally preferred, as they may reveal a firm generating ample cash flows that are not yet properly considered in the current share price. Holding all factors constant, from an investment perspective, a smaller P/CF is preferred over a larger multiple."

Note : Accounting laws on depreciation vary across jurisdictions, by using cash flow, the effects of depreciation and other non-cash factors are removed. Therefore, the price / cash-flow ratio can allow investors to assess foreign companies from the same industry (ex. mining industry) with a bit more ease.

Calculation : The Price / Cash Flow Ratio for Cisco as at 28 Jul 2012 is 15.69 / (11,491/5,340) = 7.29. The current market price of Cisco is \$24.35 (14/6/2013) and the P/CF ratio is 11.32.

#### 3) Price / Earnings Ratio

Price / Earnings Ratio is defined as market price per share divided by annual earnings per share. It gives an idea of what the market is willing to pay for the company’s earnings. A high P/E ratio suggests that investors are expecting higher earnings growth in the future and has bid up the price. Conversely, a low P/E may indicate a “vote of no confidence” by the market. Value investors read a high P/E as an overpriced stock and a low P/E as a sleeper that the market has overlooked. Companies that are losing money do not have a P/E ratio.

Formula : Price / Earnings Ratio = Stock Price per share / Earnings per share

Benchmark :  Historically, the average P/E ratio for the broad market has been around 15. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. While evaluating prospective stock, it is worthwhile to look at the current P/E ratio for the overall market (S&P500), the company's  industry segment and those of direct competitor company to determine if the prospective stock is in the high, low or moderate range .

Note : It is important that investors avoid basing a investment decision on this ratio alone. The earnings are based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

Calculation : The Price / Earnings Ratio for Cisco as at 28 Jul 2012 is 15.69 / (8,041/5,340) = 10.42. The current market price of Cisco is \$24.35 (14/6/2013) and the P/E ratio is 16.17.

#### 4) Price / Earnings to Growth Ratio

Price/Earnings Growth ratio is calculated by dividing the P/E by the projected earnings growth rate. The PEG ratio is a refinement of the P/E ratio and factors in a stock's projected earnings growth into its current valuation. It is considered to provide a more complete picture than the P/E ratio.

Formula : Price / Earnings to Growth Ratio = P/E Ratio / Earnings per share Growth
The EPS growth can be obtained from Yahoo Finance under Analyst Estimates, or you can estimate your own growth rate.

Benchmark :  The PEG ratio of 1 represent a fair trade-off between the values of cost and the values of growth, indicating that a stock is reasonably valued given the expected growth. If the PEG ratio is less than 1, the stock's price is undervalued, If it is more than 1, the stock is overvalued. Companies with PEG values between 0 to 1 may provide higher returns. The PEG Ratio can also be a negative number, for example, when earnings are expected to decline.This may be a bad signal, but not necessarily so. Under many circumstances a company will not grow earnings while its free cash flow improves substantially.

Note : The PEG ratio's when used with low-growth companies is highly questionable. It is generally only applied to so-called growth companies (those growing earnings significantly faster than the market). The PEG ratio is another way to try and identify undervalued high growth stocks through a technical screen. It should not be used alone to select stocks, and should instead be complemented with a fundamental analysis of the market and company to value the stock properly.

Calculation : The Price / Earnings Growth Ratio for Cisco as at 28 Jul 2012 is 10.42 / 8.33 = 1.25. The current market price of Cisco is \$24.35 (14/6/2013) and the PEG ratio is 1.94.

#### 5) Price / Sales ratio

The Price / Sales Ratio or PSR, measures how many times investors are paying for every dollar of a company's sales. It is use to determine if the market is under or over valuing a stock’s price. Many investor consider a company sales figure a more reliable source than earnings in calculating a stock price multiple.

Formula : Price / Sales Ratio = Stock Price per share / Revenue per share

Benchmark :  Generally speaking, a company trading at a PSR of less than 1 should attract your attention.  Most value investors set their PSR hurdle at 2 and below when looking for undervalued situations. But, as always, you need to compare a company's PSR value to its competitors and its own history. It is important that you only use the PSR to compare companies in the same industry since there will be differences among industry groups.

Note : Investors should exercise caution when using PSR since the numerator, the price of equity, takes a company's leverage into account, whereas the denominator, sales, does not. Comparing PSR carries the implicit assumption that all companies in the comparison have an identical capital structure. This is always a problematic assumption, but even more so when the assumption is made between industries, since industries often have vastly different typical capital structures (for example, a utility vs. a technology company). This is the reason why PSR across industries vary widely.

Calculation : The Price / Sales Ratio for Cisco as at 28 Jul 2012 is 15.69 / (46,061/5,340) = 1.85. The current market price of Cisco is \$24.35 (14/6/2013) and the P/E ratio is 2.82.

#### 6) Dividend Yield

The Dividend Yield or the dividend-price ratio of a share is the company's total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage. Dividend yield is used to calculate the earning on investment (shares) considering only the returns in the form of total dividends declared by the company during the year.

Income investors value a dividend-paying stock, while growth investors have little interest in dividends. Not all stocks pay dividends, nor should they. If a company is growing quickly and can best benefit shareholders by reinvesting its earnings in the business, that's what it should do.

Formula : Dividend Yield = Annual Dividend per share / Stock Price per share

Benchmark :  Ideally, dividend yield should be higher than the yield of any benchmark average such as the ten-year US Treasury note. Historically, a higher dividend yield has been considered to be desirable among many investors. A high dividend yield can be considered to be evidence that a stock is under priced or that the company has fallen on hard times and future dividends will not be as high as previous ones. Similarly a low dividend yield can be considered evidence that the stock is overpriced or that future dividends might be higher.

Note : When you're searching for stocks with high dividend yields, one quick check you should always make is to look at the company's payout ratio. It tells you what percentage of earnings management is doling out to shareholders in the form of dividends. If the number is above 75% consider it a red flag -- it might mean the company is failing to reinvest enough of its profits in the business. A high payout ratio often means the company's earnings are faltering or that it is trying to entice investors who find little else to get excited about.

Calculation : The Dividend Yield for Cisco as at 28 Jul 2012 is (1,501/5430) / 15.69 = 1.79%. The current market price of Cisco is \$24.35 (14/6/2013) and the Dividend Yield is 1.15%.

#### 7) Enterprise Value Multiple

Enterprise value multiple is the comparison of enterprise value and earnings before interest, taxes, depreciation and amortization. This is a very commonly used metric for estimating the business valuations. It compares the value of a company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses. This measurement allows investors to assess a company on the same basis as that of an acquirer.

Formula : EVM = Enterprise Value / EBITDA
Where Enterprise Value = Market Capitalization + Debt + Minority Interest + Preferred Stock - Cash or Cash Equivalent.

Benchmark : A low ratio indicates that a company might be undervalued. Keep in mind that enterprise multiples can vary depending on the industry. Therefore, it's important to compare the multiple to other companies or to the industry in general. Expect higher enterprise multiples in high growth industries (like biotech) and lower multiples in industries with slow growth (like railways).

Note : The Enterprise value multiple will not be affected by this change in capital structure. This means that Enterprise value multiple cannot be manipulated by the changes in capital structure. Therefore, it makes possible fair comparison of companies with different capital structures.

Calculation : The Enterprise Value Multiple for Cisco as at 28 Jul 2012 is ((15.69x5340) + (31+16297) + 15 - 9799) / 10,755 = 8.39. The current market price of Cisco is \$24.35 (14/6/2013) and the Dividend Yield is 12.70.

## Monday, 17 June 2013

### Cash Flow Ratios

The Cash Flow Ratios look at how much cash is being generated and the safety net that it provides to a company. The three most commonly used Cash Flow Ratios are examined below:

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

#### 1) Operating Cash Flow / Sales Ratio

The Operating Cash Flow to Sales Ratio compares a company's operating cash flow to its net sales or revenues, it gives the analysts and investors indications about the ability of a company to generate cash from its sales. In other words, it shows the ability of a company to turn its sales into cash. It is expressed as a percentage. Positive and negative changes in a company's terms of sale and/or the collection experience of its accounts receivable will show up in this indicator.

Formula : Operating Cash Flow / Sales Ratio = Operating Cash Flow / Sales (Revenue)

Benchmark : There is no standard guideline for the operating cash flow/sales ratio, a comparison against previous years ratios provides an indication on whether a company has a positive or negative trend in this ratio. A consistent and/or increasing trend in this ratio is a positive indication of good debtor’s management. Companies with such a trend in this ratio are good investment opportunities.

Note : Ideally there should be a parallel increase in operating cash flows with the increase in sales. If the cash flows do not increase with the increase in sales it may be a result of either a change in terms of sales or inefficient / ineffective management of trade receivables

Calculation : The Operating Cash Flow / Sales Ratio for Cisco as at 28 Jul 2012 is 11,491 / 46,061 = 24.95%.

#### 2) Free Cash Flow / Operating Cash Flow Ratio

The Free Cash Flow/ Operating Cash Flow Ratio measures the relationship between free cash flow and operating cash flow of a company. The more free cash flows are embedded in the operating cash flows of a company, the greater the financial strength of the company. Free cash flow is considered to be an essential outflow of funds to maintain a company's competitiveness and efficiency. A company can use the free cash flow for expansion, acquisitions, and/or financial stability to weather difficult market conditions.

Formula : Free Cash Flow / Operating Cash Flow Ratio = Free Cash Flow / Operating Cash Flow
Where Free Cash Flow = Operating Cash Flow - Capital Expenditure - Dividends Paid

Benchmark : There is no standard guideline for this ratio. Higher free cash flows to operating cash flows ratio is desired as it is a indication of financial strength of a company.

Note : The concept of free cash flows is becoming more and more popular among investors. Institutional investment firms rank free cash flow ahead of earnings as the single most important financial metric used to measure the investment quality of a company.

Calculation : The Free Cash Flow / Operating Cash Flow Ratio for Cisco as at 28 Jul 2012 is 8,864 / 11,491 = 77.14%.

#### 3) Dividend Payout Ratio

Dividend Payout Ratio measures the fraction of net income a company pays to its shareholders in dividends, it provides an idea of how well earnings support the dividend payments. Investors seeking high current income and limited capital growth prefer companies with high Dividend payout ratio. However investors seeking capital growth may prefer lower payout ratio because capital gains are taxed at a lower rate. High growth firms in early life generally have low or zero payout ratios. As they mature, they tend to return more of the earnings back to investors.

Investors like to see consistent and/or gradually increasing dividend payout ratio. A stable dividend payout ratio indicates a solid dividend policy by the company's board of directors while a reduction in dividends payout is looked poorly upon by investors and the stock price most likely will take a hit.

Formula : Dividend Payout Ratio = Dividends per Share / Earnings per share

Benchmark : This ratio need to be compared against the company's historical payout or to against dividend payout to its peers'.

Note : Investors need to remember that dividends actually get pad with cash and not earnings. A company with an adequate unrestricted balance in retained earnings will not be able to pay cash dividends if it has inadequate cash. Investor need to check a company's payout ratio against an adequate margin of free cash flow to ensure the sustainability of the payout ratio.

Calculation : The Dividend Payout Ratio for Cisco as at 28 Jul 2012 is (1,501/5,340) / (8,041/5,340) = 18.67%.

## Sunday, 16 June 2013

### Operating Performance Ratios

The Operating Performance Ratios measure how efficiently and effectively a company is using its resources to generate sales and increase shareholder value. The two most commonly used Operating Performance Ratios are explained below:

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

#### 1) Fixed-Asset Turnover

The Fixed-Asset Turnover Ratio measures a company's ability to generate net sales from fixed-asset investments.. This ratio is designed to reflect a company's efficiency in managing its fixed assets investment. A higher fixed-asset turnover ratio shows that the company has been more effective in using the investment in fixed assets to generate revenues.

Formula : Fixed-Asset Turnover Ratio = Net Sales / Property, Plant & Equipment

Benchmark : This ratio is very much industry dependent. Companies in manufacturing industries having heavier fixed-asset base tend to have lower fixed-asset turnover ratio than companies in non-manufacturing industries. Comparing against companies in the same industry is a good way to judge how a company perform in this area.

Note : This ratio is often used as a measure in manufacturing industries, where major purchases are made for PP&E to help increase output. When companies make these large purchases, this ratio is often used to determine whether the new investment in equipment will have a positive effect on revenues.

Calculation : The Fixed Asset Turnover Ratio for Cisco as at 28 Jul 2012 is 46,061 / 3,402 = 13.54.

#### 2) Sales / Revenue per employee

Sales / Revenue per employee is a measure of how efficiently a particular company is utilizing its employees. In general, relatively high revenue per employee is a positive sign that suggests the company is finding ways to generate more sales (revenue) out of each of its workers.

Formula : Sales / Revenue per employee = Revenue / Number of Employees (Average)
Number of employees can be found in the Form 10-K

Benchmark : Labor needs vary from industry to industry, and labor-intensive companies will typically have lower revenue per employee ratios than companies that require less labor. Hence, a comparison of revenue per employee is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made with this in mind.

Note : A company's age can influence its revenue per employee ratio. Young companies may be in the process of escalating their hiring activity to fill key positions, yet their revenues may still be relatively small. Such firms tend to have lower revenue per employee ratios than more established companies that can leverage those same key positions over a larger revenue base.

Calculation : The Sales / Revenue per employee for Cisco as at 28 Jul 2012 is 46,061 / 66,639 = \$691,202

## Saturday, 15 June 2013

### Debt Ratios

Also known as Leverage Ratios or Solvency Ratios. Debt Ratios measure the stability of a company and its ability to repay debt. The five most commonly used Debt Ratios are explained below.

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

#### 1) Debt Ratio

The debt ratio compares a company's total debt to its total assets, it gives an idea to the level of leverage used by the company along with the potential risks the company faces in terms of its debt-load. The higher the ratio, the higher the risk is considered to be taken on by the company. A low ratio indicates conservative financing with an opportunity to borrow in the future at no significant risk.

Formula : Debt Ratio = Total Liabilities / Total Assets

Benchmark : A ratio of less than 0.5 is desirable. Generally, large and well established companies can take on higher percentage of debt component in their balance sheet without getting into trouble. Growth companies which can generate returns above the cost of capital are able to take on more leverage.

Note : This ratio is not a pure measure of a company's debt as it includes also operational liabilities which are used to fund the day-to-day operations of the business. The operational liabilities such as accounts payable and taxes are not really debts in the leverage sense.

Calculation : The Debt Ratio for Cisco as at 28 Jul 2012 is 40,473 / 91,759 = 0.44.

#### 2) Debt-Equity Ratio

The debt-to-equity ratio (D/E) indicates the relative proportion of shareholders' equity and debt used to finance a company's assets. It compares the total liabilities to shareholders' equity as opposed to total assets in the debt ratio. Similar to the debt ratio, a lower the means that a company is using less leverage and has a stronger equity position. If the ratio is less than 1, most of the company's assets are financed through equity and if the ratio is greater than 1, most of the company's assets are financed through debt.

Formula : Debt-Equity Ratio = Total Liabilities / Shareholders' Equity

Benchmark : A ratio of less than 1 is desirable. This ratio also depends on the industry in which the company operates. Generally, companies in the capital-intensive industries tend to have higher debt/equity ratio than companies in the non-capital-intensive industries.

Calculation : The Debt-Equity Ratio for Cisco as at 28 Jul 2012 is 40,473 / 51,286 = 0.79.

#### 3) capitalization Ratio

Capitalization Ratio is a measurement of a company's financial leverage, calculated as the company's long-term debt divided by its total capital. Total capital includes the company's long-term debt and shareholders' equity. This ratio is considered to be one of the more meaningful of the "debt" ratios as it delivers the key insight into a company's use of leverage.

Formula : Capitalization Ratio = Long-Term Debt / (Long-term Debt + Shareholders' Equity)

Benchmark : There is no right amount of debt. Leverage varies according to industries, a company's line of business and its stage of development. Nevertheless, common sense tells us that low debt and high equity levels in the capitalization ratio indicate investment quality.

Calculation : The Capitalization Ratio for Cisco as at 28 Jul 2012 is 16,297 / (16,297+51,286) = 0.24.

#### 4) Interest Coverage Ratio

Interest Coverage Ratio is used to determine how easily a company can pay interest expenses on its outstanding debt. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses.

Formula : Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Benchmark : A ratio of 1.5 is often cited as the standard minimum level for a viable business. This level might have to be adjusted at times depending on the type of business being analyzed. If a business has a steady income flow, then the ratio doesn't need to be extremely high to sustain. A company in an industry that experiences high volatility would probably need a higher interest coverage ratio to withstand the fluctuations.

Calculation : The Interest Coverage Ratio for Cisco as at 28 Jul 2012 is 10,755 / 596 = 18.05.

#### 5) Cash Flow to Debt Ratio

This ratio compares a company's operating cash flow to its total debt, it shows the ability of a company to pay its debt from the cash it generates from its operations.. A higher ratio is seen to be evidence that the company is financially healthy, whereas a lower cash flow is indicative of low revenues or high dependence on credit.

Formula : Cash Flow to Debt Ratio = Operating Cash Flow / Total Debt
Where Total Debt = Long-Term Debt + Short-Term borrowing + Current portion of Long-Term Debt.

Benchmark : Normally, you want to see this ratio above 0.66 - the higher, the better. However, this ratio is more helpful when you compare it with historical data to see how has the ratio changed over the past five years or more? Is it becoming higher or lower? Another useful comparison is against the ratios of other companies in the same industry. Some capital-intensive industries may have a lower cash flow to debt ratio than other industries.

Note : Companies with low cash flow to debt ratios need to be looked at carefully, especially, in difficult economic times cash flow can suffer, but debt doesn't go down. The larger the ratio, the better a company can weather rough economic conditions.

Calculation : The Cash Flow to Debt Ratio for Cisco as at 28 Jul 2012 is 11,491 / (31+16,297) = 0.70.

## Friday, 14 June 2013

### Profitability Ratios

The Profitability Ratios measure how well a company utilized its resources in generating profit and shareholder value. The long term profitability of a company is vital for both the survival of the company as well as the benefits received by shareholders. The four most commonly used Profitability Ratios are discussed below:

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

#### 1) Profit Margin Analysis

There are four level of profit margins; namely the gross profit margin, operating profit margin, pretax profit margin and net profit margin. The objective of the margin analysis is to detect consistency in a company's earnings. Positive profit margin analysis translates into positive investment quality. The margin analysis also helps to measure the management's ability to manage cost and expenses and generate profits. Ultimately, a large growth in sales will amount to nothing if the cost and expenses grow disproportionately.

Formula:
a) Gross Profit Margin = Gross Profit / Net Sales (Revenue)
b) Operating Profit Margin = Operating Profit / Net Sales (Revenue)
c) Pretax Profit Margin = Pretax Profit / Net Sales (Revenue)
d) Net Profit Margin = Net Profit / Net Sales (Revenue)

Where
Gross Profit = Net Sales (Revenue) - Cost of Sales (Cost of Goods Sold)
Operating Profit = Gross Profit - sum of company's Operating Expenses
Pretax Profit = Operating Profit - Interest Expenses
Net Profit Margin = Pretax Profit - Provision for Income Tax + Minority Interest

Benchmark : The profit margin is industry dependent, a comparison of the ratios against historical data to detect consistency and against the industry benchmark to determine under or over performance.

Calculation: The profit margins for Cisco are calculated as follows:
a) Gross Profit Margin = 28,209 / 46,061 = 61.24%
b) Operating Profit Margin = 10,755 / 46,061 = 23.35%
c) Pretax Profit Margin = 10,159  / 46,061 = 22.06%
d) Net Profit Margin = 8,041 / 46,061 = 17.46%

#### 2) Return on Assets (ROA)

This ratio measures how effective a company utilized its assets to generate profits. This ratio is also a measurement of management effectiveness as it illustrate how well management is employing the company's total assets to make a profit. The higher the return, the more efficient is the management in utilizing  the total assets base.

Formula : ROA = Net Income / Average Total Assets
where Average Total Assets = (Previous year-end Total Asset + Current year-end Total Assets) / 2

Benchmark : This ratio is industry dependent. Capital-intensive industries, with a large investment in fixed assets, will generally have a low ROA value as compared to technology or service industries. A comparison against historical data and peers in the same product line is needed in analyzing the ROA of a company.

Calculation :  The ROA for Cisco as at 28 Jul 2012 is 8041 / (91,759+87,095)/2 = 8.99%.

#### 3) Return on Equity (ROE)

The Return on Equity ratio measures how well the shareholders' investment in the company are generating net income. The higher the ratio, the more efficient management is in utilizing its  equity base and the better return is to the investors.

Formula : ROE = Net Income / Average Shareholders' Equity
Where Average Shareholders' Equity = (Previous year-end Shareholders' Equity + Current year-end Shareholders' Equity) / 2

Benchmark : This ratio is industry dependent, however, ROE ratios in the range of 15%-20% is considered  as representing attractive levels of investment. A comparison against historical data and peers in the same product line is needed.

Calculation :  The ROE for Cisco as at 28 Jul 2012 is 8041 / (51,286+47,226)/2 = 16.32%.

Note : Investors cannot look at a company's ROE in isolation. Disproportionate amount of debt can reduce the equity base and thus even a small amount of net income can still produce a high ROE. The ROE needs to be interpreted in the context of a company's debt-equity relationship. Making use of DuPont Analysis can help investors better understand where the movements in ROE come from,

#### 4) Return on Capital Employed (ROCE)

ROCE measures the profitability of a company by expressing its net income as a percentage of its capital employed. Capital employed is the sum of shareholders' equity and long-term finance. ROCE gives investor a clear picture of how the use of leverage impacts a company's profitability. Since ROCE includes long-term finance in the calculation, therefore it is more comprehensive profitability indicator as compared to return on equity (ROE).

Formula : ROCE = Net Income / Capital Employed
where Capital Employed = Average Debt Liabilities + Average Shareholders' Equity

Benchmark : As a general rule of thumb, ROCE should be at least equal to a company's borrowing rate. A higher value of ROCE is favorable indicating that the company generates more earnings per dollar of capital employed.

Calculation : The ROCE for Cisco as at 28 Jul 2012 is 8041 / [(31+588+16,297+16,234)/2 + (51,486+47,226)/2] = 12.21%.

## Thursday, 13 June 2013

### Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term debt obligations. The four most commonly used Liquidity Ratios are explained below.

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

#### 1) Current Ratio

The current ratio is used to test a company's liquidity, also referred to as its working capital position, by deriving the proportion of current assets available to cover current liabilities,

Formula : Current Ratio = Total Current Assets / Total Current Liabilities

Benchmark : A common rule of thumb is a ratio of 2:1.
Too high a current ratio might not be good as it may mean cash is not being utilized in an optimal manner.

Note : The use of current ratio as an indicator of liquidity is both flawed and misleading, conceptually it is based on the liquidation of all the current assets to meet all of the current liabilities. There is usually very little uncertainty about the amount of debts that are due, but there can be considerable doubt about the quality of accounts receivable or the cash value of inventory as well as the time it takes to convert inventory and other current assets into cash.

Calculation : The Current Ratio for Cisco as at 28 Jul 2012 is 61,933 / 17,731 = 3.49.

#### 2) Quick Ratio

Also known as acid-test ratio. It further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. It is more conservative as it excludes inventory and other current assets, which are more difficult to turn into cash. It is a test of whether a company can meets its obligations even if adverse conditions occur.

Formula : Quick Ratio = (Cash & Equivalents + Short-term Investments + Account Receivable) / Total Current Liabilities

Benchmark : In general, quick ratios between 0.5 and 1 are considered good as long as the collection of accounts receivable is not expected to slow.

Note : If the current ratio is much higher than the quick ratio, it means that a company's current assets are rely heavily on its  inventory.

Calculation : The Quick Ratio for Cisco as at 28 Jul 2012 is (9,799+38,917+10,324) / 17,731 = 3.33.

#### 3) Cash Ratio

The cash ratio measures the amount of cash, cash equivalents and short-term investments there are to cover current liabilities.

Formula : Cash Ratio = (Cash & Equivalents + Short-term Investments) / Total Current Liabilities

Benchmark : NA

Note : Cash ratio is the most stringent and conservative of the liquidity ratios. As it is not realistic for a company to maintain high level of cash assets to cover its current liabilities, cash ratio is seldom used in financial reporting or by analyst.

Calculation : The Cash Ratio for Cisco as at 28 Jul 2012 is (9,799+38,917) / 17,731 = 2.75.

#### 4) Cash Conversion Cycle

The cash conversion cycle (CCC) is the length of time that it takes for a company to convert resource inputs into cash flows  It measures the number of days a company's cash is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter the cycle, the less time capital is tied up in the business process, and thus the better for the company's bottom line. The CCC is also known as the "cash cycle", "asset conversion cycle" or "operating cycle".

Formula : Cash Conversion Cycle = DIO + DSO - DPO

DIO = Days Inventory Outstanding = Average Inventory / Cost of Sales per day
Average Inventory = (Previous year-end inventory + current year-end inventory)/2
Cost of Sales per day = Cost of Sales / 365
DIO measures how many days it take for the company's inventory to be converted to Sales, either as cash or accounts receivable.

DSO = Days Sales Outstanding = Average Accounts Receivable / Net Sales per day
Average Accounts Receivable = (Previous year-end AR + current year-end AR)/2
Net Sales per day = Net Sales / 365
DSO measures how many days it takes a company to collect on it's accounts receivable, i.e sales that are on credit.

DPO = Days Payable Outstanding = Average Accounts Payable / Cost of Sales per day
Average Account Payable = (Previous year-end AP + current year-end AP)/2
Cost of Sales per day = Cost of Sales / 365
DPO measures how long it takes a company to pay its obligations to supplier.

Benchmark : The shorter the cycle the better.

Calculation : The Cash Conversion Cycle for Cisco as at 28 Jul 2012 is ((1,663+1,486)/2) / (17,852/365) + ((10,324+10,219)/2) / (46,061/365) - ((4,063+4,159)/2) / (1,7,852/365) = 32 days + 81 days - 84 days =29 days .

## Wednesday, 12 June 2013

### Important Financial Ratios For Analyzing Businesses

Financial ratios are tools used to analyze financial conditions and performance of any businesses. In themselves, the raw numbers on your balance sheet, income statement and cash flow statement have limited value.  Performing a simple comparisons between specific numbers pulled from your balance sheet, income statement and cash flow statement provide meaningful ratios for evaluating your company's financial performance and making critical management decisions,

Financial ratios give you a sense of how a company is faring, or how a company compares in terms of valuation to another company. They are metrics that can be used to help you compare companies across sectors, or companies with competitors, or just get a sense of how companies are performing.

Financial ratios analysis is one of the most important element in the fundamental analysis process. It means different things to different people. Lenders and creditors analyse the liquidity ratios of a company to evaluate credit risk. Business owners and managers use the information to evaluate the company performance, comparing performance against that of the competitors and industry and make critical decisions. Investors make use of the results of the analysis to arrive at their investment decision.

Financial ratios which are relevant to the investing process are categorized into six main areas as follows:

1. Liquidity Ratios
2. Profitability Ratios
3. Debt Ratios
4. Operating Performance ratios
5. Cash Flow Ratios
6. Investment Valuation Ratios
I am using the financial statements of Cisco Systems, Inc. (CSCO) to compute and explain the financial ratios.

#### 1) Liquidity Ratios

The Liquidity Ratios measure a company's ability to pay off its short-term debt obligations. The four most commonly used Liquidity Ratios are:

a) Current Ratio

b) Quick Ratio
c) Cash Ratio
d) Cash Conversion Cycle

#### 2) Profitability Ratios

The Profitability Ratios measure how well a company utilized its resources in generating profit and shareholder value. The four most commonly used Profitability Ratios are:

a) Profit Margin Analysis
b) Return on Assets (ROA)
c) Return on Equity (ROE)
d) Return on Capital Employed (ROCE)

#### 3) Debt Ratios

Also known as Leverage Ratios or Solvency Ratios. Debt Ratios measure the stability of a company and its ability to repay debt. The five most commonly used Debt Ratios are:

a) Debt Ratio
b) Debt-Equity Ratio
c) capitalization Ratio
d) Interest Coverage Ratio
e) Cash Flow to Debt Ratio

#### 4) Operating Performance Ratios

The Operating Performance Ratios measure how efficiently and effectively a company is using its resources to generate sales and increase shareholder value. The two most commonly used Operating Performance Ratios are:

a) Fixed-Asset Turnover
b) Sales / Revenue per employee

#### 5) Cash Flow Ratios

The Cash Flow Ratios look at how much cash is being generated and the safety net that it provides to a company. The three most commonly used Cash Flow Ratios are:

a) Operating Cash Flow / Sales Ratio
b) Free Cash Flow / Operating Cash Flow Ratio
c) Dividend Payout Ratio

#### 6) Investment Valuation Ratios

The Investment Valuation Ratios compare a company current share price against its performance.or profitability. The seven Investment Valuation Ratios that will be discussed are:

a) Price / Book Ratio
b) Price / Cash Flow Ratio
c) Price / Earnings Ratio
d) Price / Earnings to Growth Ratio
e) Price / Sales ratio
f) Dividend Yield
g) Enterprise Value Multiple

When using the financial ratios, please keep in mind that no one ratio or formula should be used in isolation.

Ratios by themselves don’t mean much. Looking at a company's ratios at one point in time is meaningless. Some means of comparison is needed, whether it’s comparison against the historical ratios of the same company, or comparison against the ratios of another company or a set of companies.

Looking at a particular ratio alone is also dangerous. Management can manipulate certain things on the income statement or balance sheet, so they don’t reflect the true state of being. There are ways to defer revenues or expenses into future periods. Management can manipulate these ratios so they appear better than they are, or even worse than they are. Looking at a set or group of ratios instead will provide better understanding of the actual financial state of the company.