## Financial Ratios — Profitability and Market Value Ratios

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

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very good teaching 😀

Hi sir. Where did you find the no of shares outstanding and dividend per share in yahoo finance?

Which ratio do you think the most important to evaluate the company ?

very good video. thank you!

Can you do AFFO on Reits?

Good video.

thanks a lot. 🙂

thank you ! thats very helpful