Home > Economics & Finance > Ratio Analysis (Part II)

Ratio Analysis (Part II)

4. Common Size Analysis = Entity / Total Entity

Indicates the proportion of an asset/liability/expense is as a function of total assets/liabilities/revenue.

Things to remember

    * Compares what proportion that an expense reduces sales, especially useful when comparing previous years.

    * It is also useful when comparing similar companies of different sizes to see if they have the same financial structure.

Common Size Analysis:
Looking at the chart above you wouldn’t really think that there is anything that useful to compare. That is because Cory’s Tequila Co. has done an excellent job maintaining its pricing and expenditure strategy. Ideally you would like to see Cost of Goods Sold (COGS) go down each year because of increased efficiencies. It also tells us that every $1 of sales contributes 17 cents to the bottom line of Cory’s Tequila Co. – a healthy profit margin.

5. Dividend Payout Ratio = Yearly Dividend per Share / Earnings per Share
Indicates the proportion of earnings that are used to pay dividends to shareholders.

Things to remember

    * A reduction in dividends paid is looked poorly upon by investors, and the stock price usually depreciates as investors seek other dividend paying stocks.

    * A stable dividend payout ratio indicates a solid dividend policy by the company’s board of directors.

Dividend Payout Analysis:
Cory’s Tequila Co. dividend payout ratio is zero, in other words they do not pay a dividend to its shareholders. This is the case for most high growth firms, their profits are better spent by reinvesting in the firms activities rather than as a cash payout to shareholders. In fact a majority of corporations have elected to pay out less of their earnings as dividends, perhaps because corporate rates of return on reinvested capital are higher these days, but it could also be that dividends are doubly taxed in some jurisdictions.

6. Earnings Per Share : EPS = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares

The most widely used ratio, it tells how much profit was generated on a per share basis.

Things to remember

    * Diluted EPS means that the outstanding shares includes any convertible’s or warrants outstanding.

    * If the company issues more shares then EPS are much harder to compare to previous years.

EPS Analysis:
The earnings per share ratio is mainly useful for companies with publicly traded shares. Most companies will quote the earnings per share in their financial statements saving you from having to calculate it yourself. By itself, EPS doesn’t really tell you a whole lot. But if you compare it to the EPS from a previous quarter or year it indicates the rate of growth a companies earnings are growing (on a per share basis). Cory’s Tequila Co.’s EPS have increased almost 50% since last year, an excellent growth rate.

It should be noted that the 65 cents EPS is the "trailing" number, using the previous 4 quarters of earnings. Some analysts like to use "projected" EPS to analyze a stock’s current value in respect to these estimates.

7. Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue

Indicates what the company’s pricing policy is and what the true mark-up margins are.

Things to remember

    * The results may skew if the company has a very large range of products.

    * This is very useful when comparing against the margins of previous years.

    * A 33% gross margin means products are marked up 50% and so on.

Gross Profit Margin Analysis:
The gross margin is not an exact estimate of the company’s pricing strategy but it does give a good indication of financial health. Without an adequate gross margin, a company will be unable to pay its operating and other expenses and build for the future. Cory’s Tequila Co. has a gross margin of 65% therefore their mark-up is over 100% of the cost. In general, a company’s gross profit margin should be stable. It should not fluctuate much from one period to another, unless the industry it is in has been undergoing drastic changes which will affect the costs of goods sold or pricing policies.

8. Price to Earnings Ratio : P/E Ratio = Market Value per Share / Earnings per Share

One of the most widely used ratios, it compares the current price with earnings to see if a stock is over or under valued.

Things to remember

    * Generally a high P/E ratio means that investors are anticipating higher growth in the future.

    * The average market P/E ratio is 20-25 times earnings.

    * The p/e ratio can use estimated earnings to get the forward looking P/E ratio.

    * Companies that are losing money do not have a P/E ratio.

Price-Earnings Analysis:
Sometimes referred to as the multiple, the idea behind the P/E ratio is that it is a prediction or more likely an expectation of the company’s performance in the future. The P/E ratio for the overall market averages around 20, so as you can see Cory’s Tequila Co. is much higher than this. In other words the market is expecting big things from Cory’s Tequila Co. over the next little while.

One thing to remember is that if a company has a low P/E ratio it doesn’t necessarily mean that it is undervalued. The P/E doesn’t dictate the stock price, in fact a low P/E could mean that the company’s earning are flat or growing slowing, they could also be in financial trouble. In fact the P/E ratio doesn’t tell a whole lot, but it’s useful to compare the P/E ratios of other companies in the same industry, or to the market in general, or against the company’s own historical P/E ratios.

9. Profit Margin = Net Income / Revenue

Indicates what portion of sales contribute to the income of a company.

Things to remember

    * This ratio is not useful for companies losing money, since they have no profit.

    * A low profit margin can indicate pricing strategy and/or the impact competition has on margins.

Profit Margin Analysis:
A profit margin of 17% means that for each dollar of sales that Cory’s Tequila Co. generates it is contributing 17 cents to its bottom line (net income). This ties in with gross profit margin, Cory’s Tequila Co. has a healthy pricing strategy which is evident in both ratios. In cutthroat pricing industries such as retail and gasoline you would expect the profit margin much lower because of the heavy competition. We can interpret that Cory’s Tequila Co. either has exceptional products which customers are willing to pay a substantial premium for, or Cory’s Tequila Co. really doesn’t have much competition therefore they can charge what they wish.

10. Return On Assets : ROA = (Net Income + Interest Expense) / Total Assets

Indicates what return a company is generating on the firm’s investments/assets.

Things to remember

    * The ROA is often referred to as ROI

    * We add the interest expense to ignore the costs associated with funding those assets.

Return on Assets Analysis:
This is an important ratio for companies deciding whether or not to initiate a new project. The basis of this ratio is that if a company is going to start a project they expect to earn a return on it, ROA is the return they would receive. Simply put, if ROA is above the rate that the company borrows at then the project should be accepted, if not then it is rejected. Cory’s Tequila Co.’s ROA is 14% – very high, this is over double the cost of borrowing (at time of writing).

11. Return On Equity : ROE = Net Income / Shareholder’s Equity

Indicates what return a company is generating on the owners’ investment.

Things to remember

    * If new shares are issued then use the weighted average of the number of shares throughout the year.

    * For high growth companies you should expect a higher ROE.

    * Averaging ROE over the past 5-10 years can give you a better idea of the historical growth.

Return on Equity Analysis:
Sometimes ROE is referred to as Stockholder’s return on investment, it tells the rate that shareholders are earning on their shares. Cory’s Tequila Co. is earning a very respectable 18% on shareholder’s equity

Categories: Economics & Finance
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