This is the third and final video in our
three part sequence on looking at financial ratios In the first video what we did is took a look at Pepsi’s income statement, balance sheet,
and statement of cash flows from the guided tutorial handout and again those financial statements are
available online through Google docs if you don’t have the full handout We gathered the necessary data to
calculate our ratios things from the balance sheet income statement statement cash flows as well as a few extra items that we would
need for some of our ratios. So in the second video, we went through take a look at the
liquidity ratios — things like the current and quick ratio; asset management ratios such as inventory
turnover or total asset turnover; and then the debt management ratios things like total debt to total assets or times
interest earned. In this third video we’re going to take a
look at profitability ratios as well has market value ratios. Let’s go ahead and start with some of our
profitability ratios. We’ve got several different ratios that we’re going to use
to take a look at profitability. The first looks at the gross profit
margin. Gross profit margin looks at just
how much is left over after paying for our cost of goods sold. So we
take sales minus cost of goods sold divide by our sales and record that as percentage. So we go to our dataset. We need that sales data Sales are \$66.504 billion Remember all these values are in billions of
dollars for Pepsi and they come from the 2011 financial statements So our gross profit margin is equal to 66.504 Then we need to take out the cost of
goods sold. Cost of goods sold is \$31.593 billion and divide again by the sales which was
\$66.504 billion So then we get our calculator Go ahead and punch those values in 66.504 minus 31.593 five nine three Divided by 66.504 and that gives us a gross profit margin
of 52.49 percent. And again, typically we don’t want to write that down as a decimal, we want to write it down as a percent So 52.49% as our gross profit margin Gross profit margins like all of our profit margins are going to vary
quite a bit from industry to industry In order to make comparisons such as is
this a good number or is it a bad number what we really need to do is evaluate it
to you industry standard. So we can compare it to the industry average, compare it to some of the major
competitors Another way to look at it is see
what’s happened over time — trend analysis. Has it been declining over the last few
years in which case it’s not as good Or has it been trending up over the last few
years in which case that same number will look a little bit better. As with all our ratios, context is key. We have to
think about what the number means and what is the story behind it as much as
the actual number itself. Next up we have our operating profit
margin, which pulls out not only our cost of
goods sold but also our operating expenses Let’s go ahead and calculate that Operating profit margin We need our operating income Now sometimes you’ll just have earnings
before interest in taxes and use that is operating income but in
Pepsi’s case they have both in operating income and and earnings before interest
in taxes, so if we’ve got that operating income let’s go ahead and use it \$9.633 was our
operating income and remember that’s in billions and our sales again were \$66.504 billion Again, we want to express that value as a percent so we’re going to take 9.633 divided by 66.504 and that gives us 14.48 percent for our operating profit margin Now notice that’s quite a bit below our gross
profit margin. That’s going to be the case you’re operating profit margin,
because it pulls out more expenses should always be below the gross profit margin and again we need that same context
comparing to industry average or looking at trends over time to determine if that 14.48%
is a good or bad number. Our next way to describe profit margins is the net profit margin and this is probably the most commonly
cited way to measure profit margin, sometimes people just refer to it as
profit margin and not even bother with the net strictly talking about profit margin but because we have a gross and operating
profit margins here I want to make sure we clarified here
we’re talking about net profit margin This is just net income — what’s left over after all our
expenses. Not just our cost of goods sold or operating
expenses but also pulling out any taxes, interest, all the expenses. What’s left
over as the bottom line So our net profit margin — we need net
income and I just realized in my collecting the
data that was one piece of information that I forgot to capture So let me go back to the income
statement for Pepsi I’ve still got that handy The net income was down here — net income applicable to to common shares for Pepsi And remember these numbers are in thousands
so that is \$6.443 billion So let me go ahead and add that that to my Gathering the Data sheet Income for Pepsi \$6.443 billion So now I can use that to calculate my net profit margin \$6.443 over my sales and we used that for our last couple
ratios but just a reminder sales were \$66.504 billion Do that calculation 6.443 divided by 66.504 gives us a net profit margin of 9.69% Again, good or bad is all relative the number itself doesn’t tell us a
whole lot. We’ve got to put it in the context. Compare it to what Coca-Cola is
doing; compared it to what Pepsi has done over the last few years Ideally we want to see that trending up and better than the industry
average. Now that’s not going to happen all the time, but that’s the ideal situation
we would like to see. Different industries are going to have
very different profit margins. Retailers tend to have lower profit
margins. Companies like software companies often will have higher profit
margins That’s going to vary a lot based on
industry. That’s why we really need the context. Then we’ve got return on assets All these other margins that we’ve been calculating and profitability ratios have been using sales as the denominator. Now we’re going to change it assets. How well are we doing at using our assets
to generate profits or net income. In a way this is kind of like our asset
management ratios but now instead of using sales in the numerator we’re focusing on our assets. How well are we doing at generating profits
are net income from those assets? So our ROA is equal to our net income, which remember was \$6.443 billion divided by our assets total assets from the balance sheet \$72.882 billion Go ahead and do the calculation 6.443 divided by 72.882 And again we want to express that as a
percent so Pepsi’s return on assets is 8.84% Now our last profitability ratio is going to be return on equity which looks at how well the company is
doing at generating net income based on owners’ equity We want to be a little bit careful there (the focus is going in and out — hopefully that will
fix it) We want to be a little bit careful here
with return on equity because this is not necessarily what the equity
costs the new shareholder. This is what the equity is based on the accounting statements, kind of a book value measure of owners equity instead of a market value
measure. So return on equity is definitely useful
information of how well the company is using the shareholders assets, but for a new
shareholder or even existing shareholders thats
looking at what is the value of my investment right now, this common equity doesn’t capture it as
well as the current stock price. So let’s go ahead and calculate the return
on equity Return on equity is just our net income again \$6.443 billion divided by our common equity, sometimes referred to has
shareholders equity or owners equity. And that is \$20.704 billion. And do our calculations 6.443 divided by 20.704 and that gives us 31.12%. Now I want to come back to our return on assets and talk about that relative to our
return on equity. Remember our return on assets was 8.84% The return on equity is 31.12% — quite a bit of difference. What drives that difference between the
return of on assets and return on equity? And I just realized that I need to write ROE there and not ROA. But, the return on equity is always going to be greater than
or equal to the return on assets The reason that is true is because it comes from
financial leverage. The greater the amount of debt financing
we use, the greater this differential is going
to be. If you remember from our second
video when we were talking about Pepsi’s total debt to total assets ratio, we mentioned
that was quite high. They were using quite a bit of leverage. That’s why we see that huge
differential here between Pepsi’s return on equity of
31.12% and the return on assets of 8.84% That’s why I said we don’t want to think of told that the high total assets as bad instead think of it is a risk level and
as we increase our risk we increase the potential return from that investment. So Pepsi is using lots of financial
leverage to magnify their potential returns to shareholders. That’s a riskier strategy but for a
company like Pepsi that’s got a very stable, predictable cash flow stream, it’s not
quite as risky as it would be for some other companies such as auto
manufacturers or maybe a pharmaceutical company
that’s trying to develop some new medication streams, things like that. That covers our profitability ratios. The
next thing that we want to look at is our market value ratios. Market value ratios are a way to look at
it from the investors’ perspective. How expensive are how cheap is the stock? What am I I earning as far as the dividend
yield? Things like that. The first ratio we’re going to look at
is the price-earnings ratio Or oftentimes just referred to as the PE
ratio or PE multiple That PE is just the market price divided by the earnings per share — so
what is the current stock price divided by the earnings per share Now you can get the stock price from any
number of places Yahoo!Finance, CNBC.com, your broker, Wall Street Journal (online.wsj.com). There are tons of places that have that data. I went ahead and used a historical price
for this from the end of 2011, but you’d probably want to use whatever
your current financial statements are and a current stock price for this calculation. Our market price is \$66.35 and now we need the earnings per share Now, we’re not given the earnings per share in
this calculation instead we have the number of shares
outstanding and our net income So we have to calculate the earnings per share. Earnings per share is just the net income divided by the number of shares Now a little side note — technically it’s a little more complex
than that. We want to use the net income available to common shareholders and divide by a weighted average number
of shares outstanding. But for the purposes of our class we’re just going to use a simple net income divided by number of shares So our net income was \$6.443 billion and the number of shares outstanding we
had as 1.564 billion Go ahead and calculate our earnings per share now 6.443 divided by 1.564 And that gives us an earnings per
share of \$4.12 So plug that into our PE ratio formula Stock price divided by earnings per
share Take the stock price of \$66.35 divided by \$4.12 earnings per share And that gives us a PE ratio of 16.10 PE ratios are on of the more commonly cited
ratios associated with stocks and stock valuation but it’s a very difficult one to
interpret. A lot of people are a little bit to lax with their PE ratio and just say “Well high is expensive, low is cheap.” But there are so many things that go into
the price-earnings ratio Is this last year’s earnings or is it
next year’s forecast earnings? How fast are earnings growing? Lots of different things are going to
affect that And so we want to be really careful. Interest rates are going to affect that PE ratio. The company’s risk levels
can affect that PE ratio. So we want to be very careful when you’re
interpreting PE as to what the high or expensive PE is or a low or cheap PE is. The next ratio we’re going to look at is the
market to book ratio sometimes people refer to it as a market
value-book value (MV/BV) ratio. And again this is one that’s going to require us to take a couple intermediate
steps where you go ahead and start with the market price which like we saw from our previous
example is \$66.35 But now we need the book value Book value per share is just the owners
equity or common equity divided by the number of shares
outstanding So common equity divided by number of
shares outstanding is going to give us our book value Go ahead and calculate or go ahead and find our common equity Common equity was given as 20.704 billion and the number of shares outstanding same as it was when we calculated our earnings
per share 1.564 billion shares outstanding Go ahead and do that calculation 20.704 divided by 1.564 and that’s going to give us a book value
per share of \$13.24. That’s the accounting value of the
company So from the balance sheet that’s what
the accountants are telling us each share of stock is worth Now that tends to understate the true value
of the company. There are several reasons for that. One accounting does not do a great job of
capturing the true value of intangible assets That’s not necessarily a fault of accounting, its by design. They try to be a little more conservative. Also accounting is based on historical
cost for assets not necessarily the market value those
assets. So in most cases book value is going to be less than the
financial value or market value of the company. So our market value to book value ratio will
often be greater than one How much greater is going to depend a lot on
characteristics of the company. So let’s go ahead and calculate. We’ve got \$66.35 divided by \$13.24 gives us a market value to book value ratio of 5.01 Again, does that mean the stock is cheap or does that mean the stock is expensive? It’s hard to tell That market value to book value ratio, all else equal, the higher it is the more
expensive the stock is. The cheaper it is the more of a value the
stock is. Sometimes you hear people refer to value stocks versus growth stocks.
Value stocks typically have a low market value to book value ratio. But just like the PE ratio there’s
lots of things that are going to affect that. Growth rates, intangible assets, risk of the company —
all those things are going to determine what that fair market value to book
value should be Lots of people use this ratio, but you
want to be real careful in understanding exactly what the ratio is telling us and why you think that ratio is high
or low instead of just arbitrarily deciding
well that’s higher than the market average that’s high or that’s lower the market average that’s a
cheap stock. Our last ratio we’re going to calculate is the
dividend yield. Dividend yield just looks at dividends
per share divided by the market price. Typically there are two ways investors
turn rates of return from stocks. One is through dividends and one is through capital gains. Capital gains depends on the change in
the stock price from when you purchase it to when you sell it. Well since we don’t know what we’re
going to be able to sell it at, it’s hard to know exactly what our capital gains
is but our dividend yield is just based on
what is the current value of the stock and the dividends per share. How much are
we making for owning the share divided by its current value. So when we calculate the dividend yield we need to find the stock’s dividends — and here we had \$2.03 on our dividends per share from Pepsi and our market price \$66.35 Go ahead and calculate our dividend yield \$2.03 dividend divided by the \$66.35 stock price gives us a dividend yield of 3.06%. Again is that good or bad? The answer is it depends Some companies, typically older companies or
more stable cash cow type companies like a Pepsi are going to be able to pay
out higher dividends. They are going to have a little bit higher dividend yields Typically faster growing companies that are
reinvesting a lot of their money into the company are going to have lower
dividend yields But it’s also going to vary depending on management strategy. Some companies prefer to use stock buybacks return money to investors
instead of pay dividends. Lots of different things are gonna affect
that dividend yield. 3.06%, as of the time
recording that, is a reasonably good dividend yield. It’s not
at the highest end; it’s not at the lowest end. It’s a little bit above the
current market average and that makes sense for a company
like Pepsi. Again this is not your total rate
of return from owning the stock but just one component. The capital gain, or
potentially capital loss if stock price goes down, is also going to determine your rate of
return. This should give you an overview of some
of the ratios out there; how to calculate them as well as some interpretation of
the ratios. How do we use those ratios. Again this is not designed to be a complex, overly-sophisticated look at
financial statement analysis. Ratios are hard to use because there’s a
lot that goes into it. Context is everything a lot of times
people take a very simplistic view of ratios — think “well I can calculate some numbers
and determine whether or not this is a good company or a bad company from
management or an investment perspective.” It’s not that simple. We have to know the story behind the
numbers. Ratios provide us a starting point they
don’t really give us — this is a good company or this is a bad company Instead they say “Hey, here’s something
that needs to be looked at in a little more detail…does this make sense?” And they give us a
starting point to begin our analysis