Chapter 2
In this Part
Measuring efficient use of capital with investor analytics
Assessing liquidity and financial risk with bank analytics
Zeroing in on property and long-term debt with asset-management analytics
Sizing Up Shareholders
The analytics used by investors are highly valuable for businesses. Since owning stock equates to owning a portion of the company, investor analytics typically focus on profitability in earnings, efficient capital use, and effective asset management. Because company management is legally required to maximize shareholders' wealth, executive compensation is often tied to the company's performance, as measured by these investor analytics. (Shareholders are the company's owners.) The following sections guide you on how to apply these analytics.
Financial leverage
Imagine you're considering investing in a company's stock. Now, assume this company has borrowed funds to obtain capital. The proportion of the company funded by fixed-repayment financing, like loans, represents the company's financial leverage. Investors, whether real or hypothetical, calculate leverage using this formula:
Earnings before interest and tax (EBIT) / Financial leverage = Net income (pre-tax)
Here’s how to apply this formula:
Locate both EBIT and net income near the bottom of the income statement.
Divide EBIT by net income to calculate financial leverage.
This measure helps determine the extent to which a company's earnings are consumed by interest payments on its loans. Investors earn income through dividends or increased stock value. If a company's earnings are significantly reduced due to poor debt management, it’s a negative signal for investors. However, debt isn't always detrimental. If a company generates more earnings from the capital raised through loans than the cost of interest payments, the earnings-to-interest ratio improves, reducing financial leverage. Conversely, if debt payments exceed the earnings generated by the borrowed capital, financial leverage increases. Thus, financial leverage is a key indicator of how effectively a company uses debt.
Earnings per common share (EPS)
When you solely own a company, the company’s earnings are your earnings. However, when you own a share of stock, you share the company’s earnings with other shareholders. To determine how much investors earn per share, calculate the earnings per common share (EPS):
(Net income - Preferred dividends) / Earnings per common share = Average outstanding common shares
Follow these steps to apply this formula:
Find net income and preferred dividends near the bottom of the income statement; preferred dividends are typically below net income.
Use the current and previous year’s balance sheets to calculate the average outstanding common shares: Add the common shares outstanding from both periods and divide the sum by 2.
Subtract the dividends paid to preferred shareholders from net income.
Divide the result from Step 3 by the result from Step 2; this gives you EPS.
Companies report their EPS near the bottom of the income statement, but understanding this ratio’s significance is crucial. For both investors and corporations, this ratio reflects how value is distributed by the corporation. However, the EPS ratio doesn’t indicate the quality of earnings. Two companies with identical EPS may have used different amounts of capital to generate those earnings, making one more efficient. Moreover, since executive pay is often linked to EPS, management may focus on generating low-quality earnings in the short term. This is why it’s essential not to rely solely on one or two metrics when analyzing a company.
Operating cash flows per share
While EPS is a popular metric for measuring investor returns, operating cash flows per share is a more reliable indicator of a company’s financial strength. Here’s the formula:
(Operating cash flows - Preferred dividends) / Operating cash flows per share = Average outstanding common shares
Here’s how to apply this formula:
Locate operating cash flows in the statement of cash flows and preferred dividends near the bottom of the income statement.
Use the balance sheets from the current and previous year to calculate the average outstanding common shares: Add the number of outstanding common shares from both periods and divide by 2.
Subtract the preferred dividends from operating cash flows.
Divide the result from Step 3 by the result from Step 2; this gives you operating cash flows per share.
Operating cash flows per share only measures the company’s core operations without considering other cash flow sources, making it a better reflection of long-term operational strength. However, it doesn’t fully capture profitability like EPS does. Therefore, using both metrics provides a comprehensive view of a company’s operations and profitability. The difference between cash flows per share and EPS can indicate how resources are being allocated. A large difference might suggest inefficiency or earnings manipulation.
Price to earnings ratio (P/E)
When investors want to assess how a stock’s price compares to its value, they calculate the price-to-earnings ratio (P/E). This ratio helps estimate whether a stock is overpriced or underpriced relative to its value. The formula is:
Market price per common share / Price to earnings ratio = Earnings per share
Here’s how to calculate the P/E:
Check the stock market or consult your broker for the market price per common share, then calculate EPS as explained in the earlier section “Earnings per common share.”
Divide the market price per common share by the EPS to obtain the P/E ratio.
Investors often view the P/E in the context of future growth potential. A high P/E compared to industry peers suggests that investors expect significant growth, while a low P/E might indicate expectations of low or negative growth. However, investor predictions can be unreliable, so it’s important to consider other metrics, especially those related to the balance sheet, for additional context.
Percentage of earnings retained
When a corporation earns money, it can either distribute it to shareholders as dividends or retain it to reinvest in the company’s growth. The percentage of earnings retained measures how effectively a company uses retained earnings to generate shareholder value. Here’s the formula:
(Net income - All dividends) / Percentage of earnings retained = Net income
Here’s how to use this formula:
Find net income and all dividends on the income statement.
Add up all the dividends paid and subtract that amount from net income.
Divide the result from Step 2 by net income to find the percentage of earnings retained.
The interpretation of this percentage varies. A high percentage of retained earnings in a growing company suggests a focus on future growth, while a high percentage in a stagnant company might signal potential problems. Conversely, a low percentage of retained earnings in a small company with growth potential could indicate future challenges or missed opportunities.
Dividend payout
When a company earns money, one option is to distribute those earnings to shareholders as dividends. The dividend payout ratio measures the percentage of earnings paid to common shareholders. Here’s the formula:
Dividends per common share / Dividend payout = Earnings per share
Here’s how to apply this formula:
Find dividends per common share on the income statement and calculate EPS as described earlier.
Divide dividends per common share by EPS to calculate the dividend payout ratio.
This ratio indicates the percentage of earnings paid out as dividends. It’s important because higher dividend payout ratios are attractive to investors seeking steady income, and the ratio also provides insight into a company’s growth strategy. High payouts with no expansion might indicate trouble, while low payouts in a growing company could suggest reinvestment in growth.
Dividend yield
Dividend yield measures the income investors generate from dividends relative to the price they paid for the stock. This metric is crucial for income-focused investors. Here’s the formula:
Dividends per common share / Dividend yield = Market price per common share
Here’s how to use this formula:
Find dividends per common share near the bottom of the income statement and check the market price per common share.
Divide dividends per common share by the market price per common share to calculate the dividend yield.
The dividend yield indicates the percentage of the stock price returned to investors as dividends in the last year. Keep in mind that dividend payouts can change, so the dividend yield may vary unless the company consistently maintains its payouts.
Book value per share
Book value per share reflects the value of a share of stock based on the company’s assets, excluding earnings and market speculation. It estimates the value of each share if the company were liquidated. Here’s the formula:
(Total shareholders’ equity - Preferred stock equity) / Book value per share = Total outstanding common shares
Here’s how to apply this formula:
Find total shareholders' equity, preferred stock equity, and total outstanding common shares on the balance sheet.
Subtract preferred stock equity from total shareholders' equity to calculate total common equity.
Divide total common equity by the total outstanding common shares to get the book value per share.
The book value per share indicates the asset value associated with each share, based on the book value rather than market value. It shows what the company is worth to investors after all debts are paid off.
Cash dividend coverage ratio
One way to help determine the stability of a company’s dividends is by estimating the company’s ability to meet its dividend payouts using only operating cash flows. The use of operating cash flows helps indicate whether a company’s core operations are contributing to financial strength, which, in turn, helps investors estimate whether related metrics are stable. To determine how stable a company’s dividends are, investors calculate the cash dividend coverage ratio:
Operating cash flows / Cash dividend coverage ratio = Cash dividends
Follow these steps to use this equation:
Find the operating cash flows in the operating cash flows portion of the statement of cash flows and the cash dividends near the bottom of the income statement.
Divide the operating cash flows by the cash dividends to find the cash dividend coverage ratio.
For investors who prefer stocks that issue dividends, this ratio can help them determine whether a company will continue to have stable dividends. It also doubles as a way for other investors, as well as management, to calculate the competitive strength and financial efficiency of the company. After all, in a way, the cash dividend coverage ratio represents the company’s ability to generate earnings beyond what’s required for the current rate of growth using only its core operations.
Banking on Metrics
Banks rely on a unique type of asset management to make money: They generate the majority of their earnings by charging interest on assets they lend out that were freely given to them in the form of deposits, which they pay interest on. In other words, banks make money by generating more interest income in loans than they pay to their depositors, which is called the spread.
As a bank lends out a higher percentage of its total assets, it generates more income along with a much higher financial risk. This unique set of core operations has led to the development of a number of metrics, which I cover in the following sections, that are very powerful in terms of assessing liquidity, financial risk, and effective asset management. That’s not to say that bank management actually uses these metrics to make effective decisions, but the information is available to them just as it’s available to analysts from any industry.
Earning assets to total assets ratio
Of all the assets that a company owns (referred to as total assets), analysts want to know what percentage of them are generating income. Earning assets usually include any assets that are directly generating income, such as interest-generating investments or income-generating rentals, but in some cases, they include other forms of assets that directly contribute to income, such as machinery, computers, or anything that is directly involved in producing goods and services that will be sold to customers. You calculate the earning assets to total assets ratio by using this equation:
Average earning assets / Earning assets to total assets ratio = Average total assets
Follow these steps to put this equation to use:
Use the balance sheets from the current year and previous year to find the average earnings assets and the average total assets:
Add the earning assets from the current year and previous year and divide the answer by 2; this is the average earning assets.
Add the total assets from the current year and previous year and divide the answer by 2; this is the average total assets.
Divide the average earning assets by the average total assets to get the earning assets to total assets ratio.
For companies that generate their income from loans and rentals, such as banks, a high ratio indicates a very efficient use of assets. A low ratio may indicate a poor use of assets and a need to either decrease their asset costs or improve volume. For all other companies, analysts can use this ratio to determine how effectively the companies are generating earnings with their underutilized assets. Companies in any industry can also include any assets that are directly involved in the production of their products as an earning asset to evaluate their asset management.
Net interest margin
A good way to determine whether a company is effectively using its earning assets is to look at the proportion of income that’s being generated for the value of the company’s assets. In other words, you want to know if the earning assets are making enough money to justify the interest expense or if the company would’ve been better off just paying off its debts to decrease the interest expense. To find out, analysts use the net interest margin:
Interest returns - Interest expense / Net interest margin = Average earning assets
Use the following steps to work through this equation:
Find the interest returns and interest expense on the income statement.
Use the balance sheets of the current year and previous year to calculate the average earning assets: Add the earning assets from the current year and previous year and divide the answer by 2.
Subtract the interest expense from the interest returns.
Divide your answer in Step 3 by the answer in Step 2 to find the net interest margin.
A negative ratio means that the company is paying more in interest than it’s generating. For banks and rental companies, this means the company would be better off using its assets to pay off its loans than attempting to loan them out. For these same companies, any positive ratio is better than a negative one, but a higher ratio represents a more effective use of assets.
For all other companies that don’t generate a significant proportion of their income from interest, analysts can still use this ratio to supplement other asset-management ratios, but it isn’t very effective on its own because interest expenses are typically related to total earnings rather than just interest returns.
Loan loss coverage ratio
Your “rainy day fund” is the money you set aside in case you lose your job and stop making money. Companies have a rainy day fund, too, and they measure it by using the loan loss coverage ratio:
Pretax income + Provision for loan losses / Loan loss coverage ratio = Net charge-offs
To use this equation, follow these steps:
Find the pretax income near the bottom of the income statement, the provision for loan losses in the assets portion of the balance sheet, and the net charge-offs in the expenses portion of the income statement.
Add the pretax income and the provision for loan losses.
Divide the answer in Step 2 by the net charge-offs to get the loan loss coverage ratio.
If a bank lends someone money and that person doesn’t pay it back, then the bank has lost that money. Likewise, if a company sells a customer a product and the customer never pays the bill, then the company loses that money, too. How much money should a company keep on hand to cover these losses? If a company has too much money on hand to cover losses, it isn’t using its assets efficiently, but if it has too little on hand, it risks insolvency. Of course, decreasing the net charge-offs is the best option, but a company should always have potential losses covered, as well.
Equity to total assets ratio
Some companies are particularly interested in the proportion of their total assets that’s comprised of equity ownership because this ratio can decrease the amount that they have to borrow in order to generate the same amount of earnings. Maintaining a high ratio of equity to total assets provides a degree of protection against the risk that interest payments will exceed earnings, particularly for companies that generate their earnings from interest on loans or rentals. Analysts calculate the equity to total assets ratio using this equation:
Average equity / Equity to total assets ratio = Average total assets
Here’s how to put this equation to use:
Use the balance sheets from the current year and previous year to calculate the average equity and average total assets:
Add the total equity of the current year and previous year and divide the answer by 2; this is your average equity.
Add the total assets of the current year and previous year and divide the answer by 2; this is your average total assets.
Divide the average equity by the average total assets to get the equity to total assets ratio.
Investors like to calculate this ratio because it provides indications that are similar to the debt to equity ratio. A lower ratio may mean that the company is funding its assets inefficiently if it’s paying a very high amount on interest expenses. A lower ratio may also mean that the company has very low net value for investors.
Deposits times capital
Deposits are the primary way a bank borrows money. A customer deposits money, and the bank must pay that money back on request with interest. The primary difference between deposits and the loans taken by any other corporation is that deposits are loans that must be repaid on request and are often subject to cyclical fluctuations. An effective way to determine the number of times over total equity that deposits cover is to calculate deposits times capital:
Average deposits / Deposits times capital = Average stockholders’ equity
Use these steps to work through this equation:
Use the income statement from the current year and previous year to calculate the average deposits: Add the deposits from the current year and previous year and divide the answer by 2.
Use the balance sheets from the current year and previous year to calculate the average stockholders’ equity: Add the stockholders’ equity from the current year and previous year and divide