Financial Ratios and Measures

Corporate finance and valuation are filled with ratios and measures that are often
not only obscure to outsiders but defined in many different (and contradictory)
ways by practitioners and academics. The table below is my attempt to provide
some underlying rationale for wh the measure is used in the first place, the best
way to define each measure and some comments on their use or misuse.

Variables Definition What it tries to Comments

measure
Abnormal Return See Excess Returns
Accounts Payable Accounts Payable/ Sales Use of supplier credit There is a hidden cost.
/Sales (See also days payable) to reduce working By using supplier credit,
capital needs (and to you may deny yourself
increase cash flows). the discounts that can be
gained from early
payments.
Accounts Accounts Receivable/ Ease with which you A focus on increasing
Receivable/Sales Sales grant credit to revenues can lead
customers buying companies to be too
your products and generous in giving credit.
services. While this may make the
revenue and earnings
numbers look good, it is
not good for cash flows.
In fact, one sign that a
company is playing this
short term gain is a surge
in accounts receivable.
Alpha Difference between the Measures whether When portfolio managers
actual returns earned on you are beating the talk about seeking alpha,
a traded investment market, after they are talking about
(stock, bond, real asset) adjusting for risk. In beating the market.
and the return you practice, though, it However, what may look
would have expected to can be affected by like beating the market
make on that what risk and return may just turn out to be a
investment, given its model you use to flaw in the risk and
risk. compute the expected return model that you
Alpha = Actual Return - return. used. (With the CAPM,
Expected return given for instance, small cap
risk and low PE stocks
In the specific case of a consistently have
regression of stock delivered positive alphas,
returns against market perhaps reflecting the
returns for computing fact that the model
the CAPM beta, it is understates the expected
measured as follows: returns for these groups)
 (Jensen’s) Alpha = or sheer luck (In any
Intercept - Riskfree Rate given year, roughly half
(1 - Beta) of all active investors
If the regression is run should beat the market).
using excess returns on
both the stock and the
market, the intercept
from the regression is
the Jensen's alpha.
Amortization See Depreciation &
Amortization
Annual Returns Returns from both price A percentage return The annual return is
appreciation and during the course of a always defined in terms
dividends or cash flow period that can be of what you iinvested at
generated by an then compared to the start of the period,
investment during a what you would have though there are those
year. For stocks, it is made on other who use the average
usually defined as: investments. price during the year.
(Price at end of year - The latter makes sense
Price at start + only if you make the
Dividends during year) / investments evenly over
Price at start of year the course of the year. It
cannot be less than -
100% for most assets
(you cannot lose more
than what you invested)
but can be more than -
100% if you have
unlimited liability. It is
unbounded on the plus
side, making the
distribution of returns
decidedly one-sided (or
asymmetric). Returns can
therefore never be
normally distributed,
though taking the natural
log of returns (the natural
log of zero is minus
infinity) may give you a
shot.
Asset Beta See unlevered beta
(corrected for cash)
Beta (Asset) See unlevered beta
(corrected for cash)
Beta (CAPM) It is usually measured Risk in an investment Regression betas have
using a regression of that cannot be two big problems:
stock returns against diversified away in a (a) Measured right, they
 returns on a market portfolio (Also called give you a fairly
index; the slope of the market risk or imprecise estimate of the
line is the beta. The systematic risk). true beta of a company;
number can change the standard error in the
depending on the time estimate is very large.
period examined, the (b) They are backward
market index used and looking. You get the beta
whether you break the for a company for the last
returns down into daily, 2 or last 5 years. If your
weekly or monthly company has changed its
intervals. business mix or debt
ratio over this time
period, the regression
beta will not be a good
measure of the predicted
beta.
For a way around this
problem, you can try
estimating bottom-up
betas. (See bottom-up
beta)
Beta (Market) See Beta (CAPM)
Beta (Regression) See Beta (CAPM)
Beta (Total) See Total Beta
Book Debt Ratio See Debt Ratio (Book
Value)
Book Value of Book Value of Debt + A measure of the total This is one of the few
Capital Book Value of Equity capital that has been places in finance where
(See book value of invested in the we use book value, not
invested capital) existing assets of the so much because we trust
firm. It is what allows accountants but because
the firm to generate we want to measure what
the income that it the firm has invested in
does. its existing projects.
(Market value includes
growth potential and is
thus inappropriate)
There is a cost we incur.
Every accounting action
and decision (from
depreciation methods to
restructuring and one-
time charges) as well as
market actions (such as
stock buybacks) can have
significant implications
for the book value. Large
restructuring charges and
 stock buybacks can
reduce book capital
significantly.
Finally, acquisitions pose
a challenge because the
premium paid on the
acquisition (classified as
goodwill) may be for the
growth opportunities for
the target firm (on which
you have no chance of
earning money now).
That is why many
analysts net goodwill out
of book capital.
Book Value of Shareholder's equity on A measure of the The book value of equity,
Equity balance sheet; includes equity invested in the like the book value of
original paid-in capital existing assets of the capital, is heavily
and accumulated firm. It is what allows influenced by accounting
retained earnings since the firm to generate choices and stock
inception. Does not the equity earnings buybacks or dividends.
include preferred stock. that it does. When companies pay
large special dividends or
buy back stock, the book
equity will decrease. In
some cases, years of
repeated losses can make
the book value of equity
negative.
Book Value of Book Value of Debt + Invested capital Netting out cash allows
Invested Capital Book Value of Equity - mesures the capital us to be consistent when
Cash & Marketable invested in the we use the book value of
Securities operatinig assets of capital in the
(See book value of the firm. denominator to estimate
capital) the return on capital. The
numerator for this
calculation is after-tax
operating income and the
denominator should
therefore be only the
book value of operating
assets (invested capital).
Bottom-Up Beta Weighted average Beta The beta for the There are two keys to
of the business or company, looking estimating bottom-up
businesses a firm is in, forward, based upon betas. The first is
adjusted for its debt to its business mix and defining the business or
equity ratio. The betas financial leverage. businesses a firm is in
for individual broadly enough to be
businessess are usually able to get at least 10 and
 estimated by averaging preferably more firms
the betas of firms in that operate in that
each of these businesses business. The second is
and correcting for the obtaining regression
debt to equity ratio of betas for each of these
these firms. firms.
Bottom up betas are
generally better than
using one regression beta
because (a) they have
less standard error; the
average of 20 regressions
betas will be more
precise than any one
regression beta and (b)
they can reflect the
current or even expected
future business mix of a
firm.
Cap Ex/ Estimated by dividing
Depreciation the capital expenditures
by depreciation. For the
sector, we estimate the
ratio by dividing the
cumulated capital
expenditures for the
sector by the cumulated
depreciation and
amortization.
Capital (Book This is the book value of
Value) debt plus the book value
of common equity, as
reported on the balance
sheet.
Capital Capital Spending + Investment intended The accounting measure
Expenditures Investments in R&D, to create benefits over of cap ex (usually found
exploration or human many years; a factory in the statement of cash
capital development + built by a flows under investing
Acquisitions manufacturing firm, activities) is far too
for instance. narrow to measure
investment in long term
assets. To get a more
sensible measure, we
therefore convert
expenses like R&D and
exploration costs (treated
as operating expenses by
most firms) into capital
expenditures. (See R&D
 (capitalized) for more
details) and acquisitions,
including those funded
with stock. After all, if
we want to count the
growth from the latter,
we have to count the cost
of generating that
growth.
Cash Cash and Marketable Cash and close-to- At most firms, cash and
Securities reported in cash investments held marketable securities are
the balance sheet. by a firm for a variety invested in short term,
of motives: close to riskless
precautionary (as a investments. As a
cushion against bad consequence, they earn
events), speculative fairly low returns.
(to use on new However, since that is
investments) and what you would require
operational (to meet them to earn cash usually
the operating needs of is a neutral investment; it
the company). does not hurt or help
anyone. Investors,
though, may sometimes
discount cash in the
hands of some managers,
since they fear that it will
be wasted on a bad
investment.
Correlation with This is the correlation of Measures how closely The beta for a stock can
the market stock returns with the a stock moves with actually be written as:
market index, using the the market. Beta = Correlation of
same time period as the stock with market *
beta estimation (see Standard deviation of
beta) . Bounded stock/ Standard deviation
between -1 and +1. of the market
As a consequence,
holding all else constant,
the beta for a stock will
rise as its correlation
with the market rises. If
we do not hold the
standard deviation of the
stock fixed, though, it is
entirely possible (and
fairly common) for a
stock to have a low
correlation and a high
beta (if a stock has a very
high standard deviation)
 or a high correlation and
a low beta (if the stock
has a low standard
deviation.
Cost of Capital The weighted average of Measures the current The cost of capital is a
the cost of equity and long-term cost of market-driven number.
after-tax cost of debt, funding the firm. That is why we use
weighted by the market market value weights
values of equity and (that is what you would
debt: pay to buy equity and
Cost of Capital = Cost debt in the firm today
of Equity (E/(D+E)) + and the current costs of
After-tax Cost of Debt debt and equity are based
(D/(D+E)) upon the riskfree rate
today and the expected
risk premiums today.
When doing valuation or
corporate finance, you
should leave open the
possibility that the inputs
into cost of capital (costs
of debt and equity,
weights) can change over
time, leading your cost of
capital to change.
If you have hybrids (such
as convertible bonds),
you should try to break
them down into debt and
equity components and
put them into their
respective piles. For what
to do with preferred
stock, see Preferred
stock.
Cost of Debt After-tax cost of debt = Interest is tax The marginal tax rate
(After-tax) Pre-tax Cost of debt (1 deductible and it will almost never be in
—marginal tax rate) saves you taxes on the financial statements
(See pre-tax cot of debt your last dollars of of a firm. Instead, look at
and marginal tax rate) income. Hence, we the tax code at what
compute the tax firms have to pay as a tax
benefit using the rate.
marginal tax rate. Note, though, that the tax
benefits of debt are
available only to money
making companies. If a
money losing company is
computing its after-tax
cost of debt, the marginal

Cost of Debt This is estimated by
(Pre-tax) adding a default spread
to the riskfree rate.
Pre-tax cost of debt =
Riskfreee rate + Default
spread
The default spread can
be estimated by (a)
finding a bond issued by
the firm and looking up
its current market
interest rate or yield to
maturity (b) finding a
bond rating for the firm
and using that rating to
estimate a default spread
or (c) estimating a bond
rating for the firm and
using that rating to
come up with a default
spread.
Cost of Equity In the CAPM: Cost of
Equity = Riskfree Rate
+ Beta (Equity Risk
Premium)
In a multi-factor model:
Cost of Equity =
Riskfree Rate + Beta for
factor j * Risk premium
for factor j (across all j)
Cost of preferred Preferred dividend yield The rate of return that The cost of preferred
stock = Preferred (annual) preferred
tax rate for the next year
and the near-term can be
zero.
The rate at which the A company's pre-tax cost
firm can borrow long of debt can and will
term today. The key change over time as
words are long term - riskfree rates, default
we implicitly assume spreads and even the tax
that the rolled over rate change over time.
cost of short term We are trying to estimate
debt converges on the one consolidated cost of
long term rate- and debt for all of the debt in
today - we really don't the firm. If a firm has
care about what rate senior and subordinated
the firm borrowed at debt outstanding, the
in the past (a book former will have a lower
interest rate). interest rate and default
risk than the former, but
you would like to
estimate one cost of debt
for all of the debt
outstanding.
The rate of return that Different investors
stockholders in your probably have different
company expect to expected returns, siince
make when they buy they see different
your stock. It is amounts of risk in the
implicit with equities same investment. It is to
and is captured in the get around this problem
stock price. that we assume that the
marginal investor in a
company is well
diversified and that the
only risk that gets priced
into the cost of equity is
risk that cannot be
diversified away.
The cost of equity can be
viewed as an opportunity
cost. This is the return
you would expect to
make on other
investments with similar
risk as the one that you
are investing in.
stock should lie
 dividends per share/ stockholders demand somewhere between the
Preferred stock price for investing in a cost of equity (which is
company riskier) and the pre-tax
cost of debt (which is
safer). Preferred
dividends are generally
not tax deductible; hence,
not tax adjustment is
needed.
In Latin America,
preferred stock usually
refers to common stock
with no voting rights but
preferences when it
comes to dividends.
Those shares should be
treated as common
equity.
D/(D+E) See Debt Ratio
D/E Ratio See Debt/Equity Ratio

Debt Interest bearing debt + Borrowed money For an item to be

Off-balance sheet debt used to fund categorized as debt, it
operations needs to meet three
criteria: (a) it should give
rise to a fixed
commitment to be met in
both good and bad times,
(b) this commitment is
usually tax deductible
and (c) failure to meet
the commitment should
lead to loss of control
over the firm. With these
criteria, we would
include all interest
bearing liabilities (short
term and long term) as
debt but not non-interest
bearing liabilities such as
accounts payable and
supplier credit. We
should consider the
present values of lease
commitments as debt.
Debt (Market Estimated market value Market's estimate of At most companies, debt
value) of book debt the value of debt used is either never traded (it

Debt Ratio (Book Book value of debt/
Value) (Book value of debt +
Book value of equity)
Debt Ratio Market value of debt/
(Market Value) (Market value of debt + of the total market
Market value of equity) capital of the firm that
to fund the business is bank debt) or a
significant portion of the
debt is not traded.
Analysts consequently
assume that book debt =
market debt. You can
convert book debt into
market debt fairly easily
by treating it like a bond:
the interest payments are
like coupons, the book
value is the face value of
the bond and the
weighted maturity of the
debt is the maturity of the
bond. Discounting back
at the pre-tax cost of debt
will yield an approximate
market value for debt.
This is the It is a poor measure of
accountant's estimate the true financial
of the proportion of leverage in a firm, since
the book capital in a book value of equity can
firm that comes from not only differ
debt. significantly from the
market value of equity,
but can also be negative.
It is, however, often the
more common used
measure and target for
financial leverage at
firms that want to
maintain a particular debt
ratio.
This is the proportion The market value debt
ratio, with debt defined
to include both interest
comes from debt. bearing debt and leases,
will never be less than
0% or higher than 100%.
Since a signfiicant
portion or all debt at
most firms is non-traded,
analysts often use book
value of debt as a proxy
for market value. While
this is a resonable
approximation for most
firms, it will break down
 for firms whose default
risk has changed
significantly since the
debt issue. For these
firms, it makes sense to
convert the book debt
into market debt by
treating the aggregate
debt like a coupon bond,
with the interest
payments as coupons and
discounting back to today
using the pre-tax cost of
debt as the discount rate.
Debt/Equity Debt/ Equity This measures the The debt to equity ratio
Ratio number of dollars of and the debt to captial
debt used for every ratio are linked. In fact,
dollar of equity. Debt/Equity =
(D/(D+E))/ (1- D/(D+E))
Thus, if the debt to
capital is 40%, the debt
to equity is 66.667%
(.4/.6)
In practical terms, the
debt to capital ratio is
used in computing the
cost of capital and the
debt to equity to lever
betas.
Default spread Default spread: Measures the The default spread
Difference between the additional premium should always be greater
pre-tax cost of debt for a demanded by lenders than zero. If the riskfree
firm and the riskfree to compensate for risk rate is correctly defined,
rate that a firm will no firm, no matter how
default. safe, should be able to
borrow at below this rate.
The default spread can be
computed in one of three
ways:
a. Finding a traded bond
issued by a company and
looking up the yield to
maturity or interest rate
on that bond.
b. Finding a bond rating
for a firm and using it to
estimate the default
spread
c. Estimating a bond
 rating for a firm and
using it to estimate the
default spread
Deferred Tax Deferred Tax asset (on Measures the credit For this asset to have
(Asset) balance sheet) that the firm expects value, the firm has to
to get in future anticipate being a going
periods for concern, profitable and
overpaying taxes in being able to claim the
current and past overpayments as tax
periods. The credit deduction in future time
will take the form of periods. In other words,
lower taxes in future there would be no value
periods (and a lower to this asset if the firm
effective tax rate) were liquidated today.
Deferred Tax Deferred tax laibility Measures the liability It is not clear that this is a
(Liability) (on balance sheet) that the firm sees in liability in the
the future as a conventional sense. If
consequences of you liquidated the firm
underpaying taxes in today, you would not
the current or past have to meet this liablity.
perios. The liability Consequently, it should
will take the form of not be treated like debt
higher taxes in future when computing cost of
periods (and a higher capital or even when
effective tax rate) going from firm value to
equity value. The most
effective way of showing
it in a valuaton is to build
it into expected tax
payments in the future
(which will result in
lower cash flows)
Depreciation and Accounting write-off of Reflects the depletion Accounting depreciation
Amortization capital investments from in valuation of and amortization usually
previous years. existing assets - is not a good reflection of
depreciation for economic depletion,
tangible and since the depreciation
amortization for choices are driven by tax
intangible. rules and considerations.
Consequently, you may
be writing off too much
of some assets and too
little of others. While
depreciation is an
accounting expense, it is
not a cash expense.
However, it can affect
taxes because it is tax
deductible. The tax
 benefit from depreciation
in any given year can be
written as:
Tax benefit from
depreciation =
Depreciation * Marginal
tax rate
Amortization shares the
same effect, if it is tax
deductible but it often is
not. For instance,
amortization of goodwill
generally does not create
a tax benefit.
One final point. Most US
firms maintain different
sets of books for tax and
reporting purposes. What
you see as depreciation
in an annual report will
deviate from the tax
depreciation.
Dividend Payout Dividends/ Net Income Measures the The dividend payout
Usually cannot be proportion of earnings ratio is widely followed
compute for money paid out and proxy for a firm's growth
losing companies and inversely, the amount prospects and place in
can be greater than retained in the firm. the life cycle. High
100%. growth firms, early in
their life cycles,
generally have very low
or zero payout ratios. As
they mature, they tend to
return more of the cash
back to investors causing
payout ratios to increase.
In many markets, as
companies have chosen
to switch to stock
buybacks as an
alternative to dividends,
this ratio has become less
meaningful. One way to
adapt it to switch to an
augmented payout ratio:
Augmented Payout Ratio
= (Dividends +
Buybacks)/ Net Income
Dividend Yield Dividends per share/ Measures the portion The dividend yield is the
Stock Price of your expected cash yield that you get
 return on a stock that from investiing in stocks.
will come from Generally, it will be
dividends; the balance lower than what you can
has to be expected make investing in bonds
price appreciation. issued by the same
company because you
will augment it with
price appreciation. There
are some stocks that have
dividend yields that are
higher than the riskfree
rate. While they may
seem like a bargain, the
dividends are not
guaranteed and may not
be sustainable. Studies of
stock returns over time
seem to indicate that
investing in stocks with
high dividend yields is a
strategy that generates
positive excess or
abnormal returns.
Finally, the oldest cost of
equity model is based
upon adding dividend
yield to expected growth:
Cost of equity =
Dividend yield +
Expected growth rate
This is true only if you
assume that the firm is in
stable growth, growing at
a cosntant rate forever.
Dividends Dividends paid by firm Cash returned to Dividends are
to stockholders stockholders discretionary and firms
do not always pay out
what they can afford to in
dividends. This is
attested to by the large
and growing cash
balances at firms. Models
that focus on dividends
often miss two key
components: (a) Many
companies have shifted
to return cash to
stockholders with stock
buybacks, instead of
 dividends and (b) The
potential dividends can
be very different from
actual dividends. For a
measure of potential
dividends, see Free
Cashflow to Equity.
Earnings Yield Earnings per share/ This is the inverse of Analysts read a lot more
Stock price the PE ratio and into earnings yields than
mesures roughly what they should. There are
the firm generates as some who use it as a
earnings for every measure of the cost of
dollar invsted in equity; this is true only
equity. It is usually for mature companies
compared to the with no growth
riskfree or corporate opportunities with
bond rate to get a potential excess returns.
measure of how One nice feature of
attractive or earnings yields is that
unattractive equity they can be computed
investments are. and used even if earnings
are negative. In contrast,
PE ratios become
meaningless when
earnings are negative.
EBITDA Earnings before interest Measures pre-tax cash EBITDA is used as a
expenses(or income), flow from operations crude measure of the
taxes, depreciation and before the firm makes cash flows from the
amortization any investment back operating assets of the
to either maintain firm. In fact, there are
existing assets or for some who argue that it is
growth the cash available to
service interest and other
debt payments. That
view is misguided. Firms
that have large
depreciaton charges often
have large capital
expenditure needs and
they still have to pay
taxes. In fact, it is
entirely possible for a
firm to have billions in
EBITDA and no cash
available to service debt
payments (See Free Cash
Flow to the Firm for a
more complete measure
of operating cash flow)
Economic Profit, (Return on Invested Measures the dollar To the degree that the
Economic Value Capital - Cost of excess return book value of invested
Added or EVA Capital) (Book Value of generated on capital capital measures actual
Invested Capital) invested in a capital invested in the
(See Excess Returns) company operating assets of the
firm and the after-tax
operating is a clean
mesure of the true
operating income, this
captures the quality of a
firm's existing
investments. As with
other single measures,
though, it can be easily
gamed by finding ways
to write down capital
(one-time charges), not
show capital invested (by
leasing rather than
buying) or overstating
current operating income.
Effective tax rate Taxes payable/ Taxable Measures the average Attesting to the
income tax rate paid across all effectiveness of tax
of the income lawyers, most companies
generated by a firm. It report effective tax rates
thus reflects both that are lower than their
bracket creep (where marginal tax rates. The
income at lower difference is usually the
brackets get taxed at a source of the deferred tax
lower rate) and tax liability that you see
deferral strategies that reported in financial
move income into statements. While the
future periods. effective tax rate is not
particularly useful for
computing the after-tax
cost of debt or levered
betas, it can still be
useful when computing
after-tax operating
income (used in the Free
Cashflow to the Firm and
return on invested capital
computations) at least in
the near term. It does
increasingly dangerous to
assume that you can
continue to pay less than
your marginal tax rate for
longer and longer
 periods, since this
essentially allows for
long-term or even
permanent tax deferral.
Enterprise Value Market value of equity Measures the market's In practice, analysts often
+ Market value of debt - estimate of the value use book value of debt
Cash + Minority of operating assets. because market value of
Interests We net out cash debt may be unavailable
because it is a non- and the minority interest
operating assets and item on the balance
add back minority sheet. The former
interests since the practice can be
debt and cash values troublesome for
come from fully distressed companies
consolidated financial where the market value
statements. (See of debt should be lower
Minority Interests for than book value and the
more details) latter practice is flawed
because it measures the
book value of the
minority interests when
what you really want is a
market value for these
interests.
This computation can
also sometimes yield
negative values for
companies with very
large cash balances.
While this represents a
bit of puzzle (how can a
firm trade for less than
the cash on its balance
sheet?), it can be
explained by the fact that
it may be impossible to
take over the firm and
liquidiate it or by the
reality that the cash
balance you see on the
last financial statment
might not be the cash
balance today.
Enterprise Value/ (Market value of equity Market's assessment By netting cash out of the
Invested Capital + Debt - Cash + of the value of both the numerator and
Minority Interests)/ operating assets as a the denominator, we are
(Book value of equity + percentage of the trying to focus attention
Debt - Cash + Minority accountant's estimate on just the operating
Interests) of the capital invested assets of the firm. This
 (See descriptions of in these assets ratio, which has an equity
Enterprise value and analog in the price to
Invested Capital ) book ratio, is determined
most critically by the
return on invested capital
earned by the firm; high
return on invested capital
will lead to high
EV/Capital ratios.
Enterprise Value/ (Market value of equity Multiple of pre-tax, Commonly used in
EBITDA + Debt - Cash + pre-reinvestment sectors with big
Minority Interests)/ operating cash flow infrastructure
EBITDA that the firm trades at investments where
(See descriptions of operating income can be
Enterprise Value and depressed by
EBITDA) depreciation charges.
Allows for comparison of
firms that are reporting
operating losses and
diverge widely on
depreciation methods
used. It is also a multiple
used by acquirers who
want to use significant
debt to fund the
acquisition; the
assumption is that the
EBITDA can be used to
service debt payments.
Cash is netted out from
the firm value because
the income from cash is
not part of EBITDA.
However, the same can
be said of minority
holdings in other
companies - the income
from these holdings is
not part of EBITDA -
and the estimated value
of these holdings should
be netted out as well.
With majority holdings,
the consolidation that
follows creates a
different problem: the
market value of equity
includes only the portion
of the subsidiary owned
 by the parent but all of
the other numbers in the
computation reflect all of
the subsidiary. This
should explaiin why
minority interests are
added back to the
numerator.
Enterprise Value/ (Market value of equity Market's assessment While the price to sales
Sales + Debt - Cash + of the value of ratio is a more widely
Minority Interests)/ operating assets as a used multiple, the
Revenues percentage of the enterprise value to sales
revenues of the firm. ratio is more consistent
because it uses the
market value of operating
assets (which generate
the revenues) in the
numerator.
Equity EVA (Return on Equity - Cost Measures the dollar To the degree that the
of Equity) (Book Value excess return inputs into the equation
of Equity) generated on equity are reasonable estimates,
(See Excess Returns (on invested in a this becomes a measure
Equity)) company of the success a company
has shown with its
existing equity
investments. However,
both the return on equity
and book value of equity
are accounting numbers,
and can be skewed by
decisions (such as stock
buybacks and
restructuring charges). At
the limit, it becomes
meaningless when the
book value of equity
becomes negative.
Equity ((Capital Expenditures - Measures the The conventional
Reinvestment Depreciation) - Change proportion of net measure of equity
Rate in non-cash Working income that is reinvestmnt is the
Capital - (Principal reinvested back into retention ratio, which
repaid - New Debt the operating assets of looks at the proportion of
Issued))/ Net Income the firm earnings that do not get
paid out as dividends.
The equity reinvestment
is both more focused and
more general. It is more
focused because it looks
at the portion of the
 earnings held back that
get invested into the
operating assets of the
firm and more general
because it can be a
negative value (for firms
that are letting their
assets run down) or
greater than 100% (for
firms that are issuing
fresh equity and
investing it back into the
business).
Equity Risk Expected Returns on Premium over the The ERP is a key
Premium (ERP) Equity Market Index - riskfree rate component of the cost of
Riskfreee Rate demanded by equity for all companies,
investors for investing since it is multiplied by
the average risk stock the beta to get to the cost
of equiity. If you over
estimate the ERP, you
are going to under value
all companies.
Equity Risk Average Annual Return Actual premium The historical risk
Premium - on Stocks - Average earned by investors premium is usually
Historical Annual Return on on stocks, relative to estimated by looking at
Riskfree investment riskfree investment, long time period. For
over the time period instance, in the United
States, it is usually
estimated over eight
decades (going back to
1926). There are two
dangers in using this
historical risk premium.
The first is that the long
time period
notwithstanding, the
historical risk premium is
an estimate with a
significant standard error
(about 2% for 80 years of
day). The second is that
the market itself has
probably changed over
the last 80 years, making
the historical risk
premium not a good
indicator for the future.
Equity Risk Growth rate implied in Reflects the risk that The implied equity risk
Premium - today's stock prices, investors see in premium moves
Implied given expected cash equities rght now. If
flows and a riskfree rate. investors think
(Think of it as a internal equities are riskier,
rate of return for they will pay less for
equities collectively). stocks today.
Excess Returns Return on Invested Measure the returns
Capital - Cost of capital earned over and
above what a firm
needed to make on an
investment, given its
risk and funding
choices (debt or
equity).
Excess Returns Return on Equity - Cost Measures the return
(on equity) of Equity earned over and
above the required
return on an equity
investment, given its
risk. It can be at the
level of the firm
making real
investments and at the
level of the investor
picking individual
stocks for her
portfolio.
Firm Value Market Value of Equity Measures the market Since the value of the
+ Market Value of Debt value of all assets of a firm includes both
inversely with stock
prices. When stock prices
go up, the implied equity
risk premium will be
low. When stock prices
go down, the implied
premium will be high.
Notwithstanding the fact
that you have to use an
expected growth rate for
earnings and a valuation
model, the implied equity
risk premium is both a
forward looking number
(relative to historical
premiums) and
constantly updated.
Excess returns are the
source of value added at
a firm; positive net
present value
investments and value
creating growth come
from excess returns.
However, excess returns
themselves are
reflections of the barriers
to entry or competitive
advantages of a firm. In a
world with perfect
competition, no firm
should be able to
generate excess returns
for more than an instant.
To generate excess
returns. you have to bring
something special to the
table. For firms, this may
come from a brand name,
economies of scale or a
patent. For investors, it is
more difficult but it can
be traced to better
information, better
analysis or more
discipline than other
investors.
 firm, operating as operating and non-
well as non-operating. operating assts, it will be
greater than enterprise
value. To the extent that
we are looking at how
value relates to operating
items (operating income
or EBITDA), you should
not use firm value but
should use enterprise
value instead; the income
from cash is not part of
operating income or
EBITDA.
Fixed Fixed Assets/ Total Measures how much This ratio should be
Assets/Total Assets of a firm's higher for manufacturing
Assets investments are in firms than for service
tangible assets. firms and reflects the
bias in accounting
towards tangible assets.
Many lenders seem to
share this bias and are
willing to lend more to
firms with significant
fixed assets.The ratio can
also be affected by the
age of the assets, since
older assets, even if
productive, will be
written down to lower
values.
Free Cash Flow FCFE = Net Income - Measures cash flow This is a post-debt cash
to Equity (FCFE) (Capital Expenditures - left over for equity flow. When it is positive,
Depreciation) - Change investors after taxes, it measures what can be
in non-cash Working reinvestment needs paid out by the firm
Capital - (Principal and debt needs are without doing any
repaid - New Debt met. For a growing damage to its operations
Issued) firm, debt cash flows or growth opportunities.
can be a source of In other words, it is the
positive cash flows; potential dividend and
new debt brings cash can be either paid out as
to equity investors. such or used to buy back
stock. When it is
negative, it indicates that
the firm will have raise
fresh equity. When we
discount FCFE in a
valuation model, we are
implicitly assuming that
 no cash builds up in the
firm and the present
value will already
incorporate the effect of
future stock issues.
(Discounting negative
FCFE in the early years
will push down the value
per share today; think of
that as the dilution effect)
Free Cash Flow FCFF = EBIT(1-t) - Measures cash flow This is a pre-debt cash
to Firm (FCFF) (Capital Expenditures - left over for all flow. That is why we
Depreciation) - Change claimholders in the start with operating
in non-cash Working firm (lenders and income, rather than net
Capital equity investors) after income (which is after
taxes and interest expenses) and act
reinvestment needs like we pay takes on
have been met. operating income. In
effect, we are acting like
we have no interest
expenses or tax benefits
from these interest
expenses when
computing cash flows.
That is because these
cash flows are discounted
back at a cost of capitatl
that already reflects the
tax benefits of borrowing
(through the after-tax
cost of debt).
A positive free cash flow
to the firm is cash
available to be used to
make payments to debt
(interest expenses and
prinicipal payments) and
to equity (dividends and
stock buybacks).
A negative free cash flow
to the firm implies that
the firm faces a cash
deficit that has to be
covered by either issuing
new stock or new debt
(the debt ratio used in the
cost of capital determines
the mix).
Fundamental Retention Ratio * Expected growth in Since the retention ratio
growth in EPS Return on Equity earnings per share if cannot exceed 100%, this
(See definitions of both the firm maintains caps the growth in
items) this return on equity earnings per share at the
on new investment return on equity, if the
and invests what it return on equity is stable.
does not pay out as However, this formula
dividends in these will yield an incomplete
new investments. measure of growth when
the return on equity is
changing on existing
assets. In that case, there
will be an additional
component to growth that
we can label efficiency
growth. Thus, doubling
the return on equity on
existing assets from 5%
to 10% will generate a
growth rate of 100%
even if the retentiion
ratio is zero.
Fundamental Equity Reinvestment Measures the growth Since the equity
growth in net Rate * Non-cash Return rate in net income reinvestment rate can be
income on Equity from operating assets, greater than 100% or less
(See definitions of both if the equity than 0%, this measures
items) reinvestment rate and implies that the growth in
return on equity net income can exceed
remain unchanged. growth in earnings per
share (for firms that issue
new stock to reinvest) or
be negative (for firms
with negative equity
reinvestment rates). As
with the other
fundamental growth
measures, this one
measures growth only
from new investments;
there can be an additional
component that can be
traced to improving or
dropping return on equity
on existing investments.
Fundamental Reinvestment Rate * Measures the growth The growth in operating
growth in Return on Capital rate in after-tax income is a function of
operating income operating income, if both how much a firm
the reinvestment rate reinvests back
and return on capital (reinvestment rate) and
remain unchanged. how well it reinvests its
 money (the return on
capital). As a general
rule, growth created by
reinvesting more at a
return on capital that is
more (less) than the cost
of capital will create
(destroy) value. A firm's
growth rate in the short
term can be higher or
lower than this number,
to the extent that the
return on capital on
existing assets increases
or decreases.
Goodwill Price paid for equity in Measures the In reality, goodwill is not
an acquisition - Book intangible assets of an asset but a plug
value of equity in the target company variable used to balance
acquired company the balance sheet after an
acquisiton. It is
composed of three parts -
the value of the growth
assets of the target firm
(which would not have
been reflected in the
book value), the value of
synergy and control and
any overpayment made
by the firm. How we deal
with goodwill will vary
depending on its source.
If it is for growth assets,
it creates inconsistencies
in balance sheets since
we do not allow firms to
record growth assets that
may be generated
internally. If it is for
synergy and control, it
should be reflected as
additional value in the
consolidated balance
sheet, but that value has
to be reassessed, given
the actual numbers. If it
is an overpayment, it is
money wasted. When we
do return on invested
capital, for instance, we
 clearly want to subtract
out the first from
invested capital but we
should leave the last two
elements in the number.
Gross Margin Gross Profit/ Sales
(See Gross Profit)
Gross Profit Revenues - Cost of Measures the profits The line between gross
Goods Sold generated by a firm and operating profit is an
after direct operating artifical one. For the
expenses but before most part, the expenses
indirect operating that are subtracted out to
expenses, taxes and get to gross profit tend to
financial expenses. be costs directly
traceable to the product
or service sol and the
expenses that are treated
as indirect are expenses
such as selling, general
and administrative costs.
If we treat the latter as
fixed costs and the
former as variable, there
may be some information
in the gross profit.
Historical Equity See Equity Risk
Risk Premium Premium (Historical)
Historical Growth Growth rate in earnings Measures how Historical growth rates
Rate in the past. quickly a firm's can be sensitive to
(Earnings earnings have grown starting and endiing
(today)/Earning (n years in the past. periods and to how the
ago))^(1/n)-1 average is estimated -
arithmetic averages will
generally yield higher
growth rates than
geomteric averages.
While knowing past
growth makes us feel
more comfortable about
forecasting future
growth, history suggests
that past growth is not a
good predictor of future
growth.
Hybrid secuity A security that Capital invested (not Hybrid securities are best
combines the features of current market value) dealt with, broken up into
debt and equity of issued security. debt and equity
components. For
 convertible bonds, for
instance, the conversion
option is equity and the
rest is debt. Preferred
stock is tougher to
categorize and may
require a third element in
the cost of capital.
Implied Equity See Equity Risk
Risk Premium Premium (Implied)
Insider Holdings Shares held by insiders/ Measures how much If we assume that
% Shares outstanding of the stock is held by insiders are or are allied
insiders in a with the incumbent
company. The SEC managers of the firm, this
definition of insdiers ratio becomes an inverse
includes those who measure of how much
hold more than 5% of influence outside
the shares. stockholders have over
this firm. The higher this
ratio, the less of a role
outside investors willl
have in the management
of a company...
This can also have an
effect in how we think
about and measure risk.
If the insdier holdings are
high, the assumption we
make about marginal
investors being well
diversifed in risk and
return models may come
under assault.
Institutional Shares held by Measures how much If institutional investors
Holding % institutions/ Shares of the stock is held by hold a substantial
outsanding mutual funds, pension proportion of a firm, the
funds and other assumption we make
institutional investors. about investors being
well diversifed is well
founded. Conseqently,
we can safely assume
that only non-
diversifiable risk has to
be priced into the cost of
equity and ignore risk
that can be diversified
away.
Interest coverage Interest coverage ratio = Measures the margin There are a number of
ratio EBIT / Interest Expense for error the firm has ratios that measure a
in making its interest firm's capacity to meet its
expenses. If this ratio debt obligatiion. The
is high, the firm has fixed charges ratio, for
much more margin instance, is the ratio of
for error and is EBITDA to total fixed
therefore safer (from charges. In estimating
the lender's this ratio, you should try
perspective) to get a measure of the
operating income that the
firm can generate in a
normal year (this may
require looking at
operating income over an
economic cycle or over a
period of time) relative to
its interest expenses.
Other things remaining
equal, the higher this
ratio, the higher the
rating and the lower the
default spread for a firm.
Inventory/ Sales Estimated by dividing Measures how much When this ratio is high, a
the cumulated inventory inventory the firm firm will find that its
for the sector by the needs to hold to cash flows lag its
cumulated sales for the sustain its revenues. earnings. The magnitude
sector of this number will vary
across businesses.
Generally, businesses
that sell high priced
products where sales
turnover ratios are low
(luxury retailers, for
instance) will have to
maintain high inventory.
Invested Capital See Book Value of
Invested Capital
Leases Expense for current year Measured the While accountants and
(Operating) is shown as part of reduction in income tax authorities draw a
operating expenses; created by having to distinction between
commitments for future meet lease obligations operating and capital
years are shown in in current period. leases, they look much
footnotes. the same from a financial
perspective. They are
both the equivalent of
borrowing, though lease
commitment can be
viewed as more focused
borrowing (because it is
 tied to an individual asset
or site) and more flexible
(a firm can abandon an
individual lease without
declaring bankruptcy)
than conventional debt.
The best approach is to
use the pre-tax cost of
debt as the discount rate
and discount future lease
commitments back to
today to get a debt value
for operating leases. This
will also create a leased
asset, which has to be
depreciated. As a result,
operating income will
have to be restated:
Adjusted Operating
Income = Operating
Income + Current year's
lease expense -
Depreciation on leased
asset
Leases (Capital) Commitments converted Measures the debt Accountants do for
into debt (by equivalent of lease capital leases what we
discounting at a pre-tax commitments. suggested that they need
cost of debt) and shown to do for operating
on balance sheet. leases. One cost of
Imputed interest having them do it (rather
expenses and than yourself) is that you
depreciation shown on do not control when the
income statement. present value is
computed (usually at the
time of the financial
statement) and the pre-
tax cost of debt used.
Marginal tax rate Tax rate on last dollar or Measures the taxes The marginal tax rate is
next dollar of income. you will have to pay best located in the tax
on additional income code for the country in
that you will generate which a company
on new investments operates. In the United
and the savings that States, for instance, the
you will obtain from a marginal federal tax rate
tax deduction. is 35%. With state and
local taxes added on, this
number will increase (to
38-40%). For companies
operating in multiple
 countries, we can use one
of two approximations.
One (the easier one) is to
assume that income will
eventually have to make
its way to the company's
domicile and use the
marginal tax rate for the
country in which the
company is incorporated.
The other is to use a
weighted average tax
rate, with the weights
based on operating
income in each country,
of the marginal tax rates.
Market Estimated market value Market's estimate of When a firm has non-
Capitalization of shares outstanding, what the common traded or multiple clssses
obtained by multiplying stock in a firm is of shares, the market
the number of shares worth. capitalization should
outstanding by the share include the value of all
price. shares and not just the
most liquid class of
shares. This may require
assuming a market price
for non-traded shares.
Market Debt See Debt Ratio (Market
Ratio value)
Market value of Market value of Market's estimate of Most analyses assume
equity common shares what the equity in a that market capitalization
outstanding + Market firm is worth. = market value of equity.
value of other equity However, when a firm
claims on the firm has used warrants,
convertible bonds or
even management
options, it has issued
equity claims in the form
of options. In theory, at
least, these options
should be valued and
treated as part of the
market value of equity.
Minority Interests Minority interests Accountant's estimate Minoerity interests are a
(liability on balance of the value of the logical outgrowth of full
sheet) portion of a fully consolidation. When you
consolidated own 60% of a subsidiary,
subsidiary that does you are forced to fully
not belong to the consolidate and show
 parent company. 100% of the subsidiary's
earnings and assets as
belonging to the parent
company. Since the
parent company owns
only 60%, the accounting
conventiona requires you
to show the 40% of the
subsidiary that does not
belong to you as a
minority interests. The
problem, though, is that
most computations
requiring minority
interests (enterprise
value, for instance)
require an estimated
market value for this
minority interest. To
convert the book value of
minority interests into a
market value, you could
try to estimate a price to
book ratio and apply this
to the minority interests.
Net Capital Capital Expenditures - Measures the net Your assumptions about
Expenditures Depreciation investment into the net capital expenditures
(See description of each long term assets of a will largely determine
item) business. what happens to your
capital base over time. If
you assume that net
capital expenditures are
zero and you ignore
working capital needs,
your book capital will
stay frozen over time. If
you concurrently assume
that the operating income
will go up 2 or 3% every
year, you will very
quickly find your return
on capital rising to
untenable levels. That is
why, in stable growth,
we assume that the
capital base increases in
lock-step with the
operating income (thus
keeping return on capital
 fixed).
In any given year, for a
firm, the net capital
expendiure number can
be negative. This can
often be a reflection of
the lumpiness of capital
expenditures, where
firms invest a lot in one
year and not very much
in subsequent years In
special cases, it may
represent a deliberate
strategy on the part of the
firm to shrink itself over
time, in which case teh
growth rate should be
negative.
Net Margin Net Income/ Sales Measures the profit Net margins vary widely
mark-up on all costs across sectors and, even
(operating and within a sector, widely
financila) on the across firms as a
products and services reflection of the pricing
sold by the firm. strategy adopted by the
firm. Some firms adopt
low-margin, high volume
strategies whereas others
go for high-margin, low
volume strategies. Much
as we would like to get
the best of both worlds -
high margins and high
volume - it is usually
infeasible.
Net margins will also be
affected by how much
debt you choose to use to
fund your operations.
Higher debt will lead to
higher interest expenses
and lower net income
and net margins.
Non-cash ROE (Net Income - Interest Measures the return For firms with substantial
income from cash) / earned on the equity cash balances, the non-
(Book value of equity - invested in the cash ROE provided a
Cash and Marketable operating assets of the cleaner measure of the
securities) firm. It eliminates performance of the firm.
cash from the mix in After all, cash is usually
both the numerator invested in low-return,
 and the denominator. close to riskless assets
and including it (as we
do in return on equity)
can depress the return on
equity.
Non-Cash Non-cash Working Total Investment in When service oriented
Working Capital Capital = Inventory + short term assets of a and retail firms want to
Other Current Assets + business. grow, their invstment is
Accounts Receivable - often in short term assets
Accounts Payable - and the non-cash
Other Current Liabilities working capital measures
[Current assets this reinvestment. We
excluding cash - Current exclude cash from
liabilities excluding current assets because it
interest bearing debt) is not a wasting assets if
it is invested to earn a
fair market return (which
may be the riskless rate if
the investment in is
treasury bills) and short
term interest bearing debt
from current liabilities,
because we include it
with other interest
bearing debt in
computing the cost of
capital.
Non-cash Change in non-cash New investment in An increase in non-cash
Working Capital working capital from short term assets of a working capital is a
(Change) period to period business. negative cash flow since
it represents new
investment. A decrease
in non-cash working
capital is a positive cash
flow and represents a
drawing down on
existing investment.
This is a volatile number
and it is not uncommon
to see a year with a large
increase followed by a
year with a large
decrease. It makes sense
to look at either averages
over time or at the total
non-cash working capital
as a percentage of
revenues or operating
income.
Operating Income Operating income or Income generated A good measure of
Earnings before interest before financial and operating income will
and taxes capital expenditures. subtract only operating
expenses from revenues.
In practice,, though,
acountants routines treat
capital expenditures in
some businesses as
operating expenses
(R&D at technology
firms, exploration costs
at natural resource
companies, training
expenses at consulting
firms) and financial
expenses also as
operating expenses
(operating leases for all
firms). To measure
operating expenses
correctly, we have to
correct for these errors.
Operating Income Earnings before interest After-tax earnings To prevent double
(After-tax) and taxes (1 - tax rate) generated by a firm counting the tax benefit
from its operating from interest expenses,
assets befroe financial you should estimate
and capital expenses. hypothetical taxes on the
operating income and not
use actual or cash taxes
paid. (See definiton of
effective tax rate for
discussion of whether to
use the marginal or
effective tax rate).
Operating Margin After-tax Operating Measures the post-tax Unlike net profit margins
(After-tax) Margin = EBIT(1-t) / mark-up on operating which are affected by
Sales costs for products and debt ratios and financial
services sold by the leverage, operating profit
firm. margins can be compared
across firms with very
different debt ratios. The
return on invested capital
for a firm can be stated in
terms of the after-tax
operating margin and the
sales turnover ratio
(Sales/ Book Value of
Invested Capital)
Return on capital =
 Operating
Operating Margin Operating Margin = Measures the pre-tax Operating margins can be
(Pre-tax) Operating Income/ Sales mark-up on operating compared across
costs for products and companies with different
services sold by the debt ratios and tax rates,
firm. since it is prior to
financial expenses and
taxes.
Preferred Stock Book value of Preferred Capital raised from Preferred stock shares
Stock preferred stock features with debt (fixed
dividends that are often
cumulative) and equity
(failure cannot push you
into bankruptcy. This is
one of the few casts
where you will allow for
a third component in the
cost of capital, with its
own cost.
Price Earnings Price per share/ Market value of The conventional
Ratio (PE) Earnings per share (or) equity as a multiple of computation of PE ratios
Market Capitalization/ equity earnings is based upon per share
Net Income values, but this can be
problematic when there
(See Earnings Yield) are options outstanding;
some analysts use diluted
earnings per share while
others use primary
earnings per share. In
reality, neither approach
does a good job of
dealing with options,
since an option is either
counted as a share or not.
A far more consistent
definition of PE ratio
would be based on
aggregate numbers and
reflect the value of the
options outstanding:
PE corrected for options
= (Market Capitalization
+ Value of Options)/ Net
Income
The PE ratio for a firm
will be determined by its
risk (cost of equity),
growth (in equity
earnings) and efficiency
 of growth (payout ratio).
If the earnings are
negative, the PE ratio is
not meaningful.
Price to Book Price per share/ Book Market value of The price to book ratio is
Ratio (PBV) value of equity per share equity as a multiple of used as a simple measure
(or) the accountant's of undervaluation; in
Market Capitalization/ estimate of equity fact, investors who buy
Book value of equity value low price to book ratios
are categorized as value
investors. The most
critical determinant of
the price to book ratio for
a firm is the return on
equity, with high return
on equity stocks trading
at high price to book
ratios.
Price to Sales Market Capitalization/ Market value of While this multiple is
Ratio Revenues equity as a multiple of used frequently with
revenues generated by technology firms
a firm (especially if they are not
making money) and with
retail firms, it is
internally inconsistent.
The numerator measures
equity value but the
denominator, revenues,
does not accrue to equity
investors alone. A more
consistent version of this
multiple is the enterprise
value to sales ratio.
The price to sales ratio is
determined most
critically by the net profit
margin; high margin
companies will tend to
have high price to sales
ratios.
Provision for Accounting charge to Smoothed out A provision is not a cash
____ (Bad debts, income to cover measure of lumpy expense. In the period
Litigations costs potential or likely expenses that that the provisional
etc.) expenses in future otherwise would charge is made, no cash
periods. make earnings much expense is incurred, and
more volatile. the reported earnings will
be lower than cash
earnings. In subsequent
periods, when the
 expected expense
materializes, it is offset
against the provision and
the effect on earnings in
those periods will be
muted. If all firms were
consistent about how
they set provisions and
set them equal to
expected, provisional
charges are useful
because they smooth
earnings for a good
reason. However, if some
companies are aggressive
about their loss estimates
(set provisions too low)
and others are too
conservative (set
provisions too high), we
will overstate the
earnings of ther former
and understate earnings
for the latter.
R&D See Research and
Development Expenses
R-squared Beta^2* Variance of the Proportion of a While the R-squared and
(Market market/ Variance of the stock's (asset's) risk the correlation of a stock
regression) stock (asset) that can be explained with the market seem to
(Usually output from by the market. measure the same thing
regression of stock R-squared = (how a stock moves with
(asset) returns against Correlation of the the market), there are two
market returns) stock with the market key differences. The first
^2 is that the R-squared is
always a positive number
whereas the correlation
can be positive or
negative. In other words,
a high R-squared can
indicate either a stock
that moves with the
market or against it. The
second is that the R-
squared is the more
consistent number to use
when talking about
varriances whereas the
correlation coefficient is
more relevant when
 talking about standard
deviations or betas.
Reinvestment Reinvestment Rate = Proportion of a firm's The reinvestment rate is
Rate (Net Capital after-tax operating the firm analog to the
Expenditures + Change income that is put equity reinvestment rate
in Non-cash Working back into the business (which measures how
capiital) / EBIT (1-t) to create future much of equity earnings
growth. is reinvested back into
the business). The key
difference is that you
look at total reinvestment
rather than just the equity
portion of that
reinvestment and the
after-tax operating
income, rather than net
income.
Like the equity
reinvestment rate, this
number can be negative,
in which case the firm is
shrinking the capital
invested in the business,
or greater than 100%, in
which case it is raising
fresh capital.
Research and Operating expense item Investment in basic If we stay true to the
Development in the income statement research that may or definitiion of capital
Expenses (R&D) includes the current may not pay off as expenditures (as
year's R&D expense. products in the future. expenses designed to
generate benefits over
many years), R&D is
clearly a capital
expenditure. However,
accountants have used
the uncertainty of
potential benefits as a
rationale for expensing
the entire amount spent,
arguing that this is the
conservative thing to do.
In reality, it is not
conservative because it
also means that the
biggest asset on the
books for some
companies - money
invested in developing
new drugs in
 pharmaceutical
companies or new
technolgy at technology
company - will not be on
the books. As a result, we
skew upwards the return
on equity can capital
calculations for these
firms. It is best to
capitalze R&D, using an
amortizable life for
research (the expected
number of yars, on
average, between doing
R&D and a product
emerging) and R&D
expenses from the past.
Retention Ratio 1 - Dividend Payout Proportion of net The retention ratio looks
Ratio income not paid out at retained earnings in a
as dividends and firm. While analysts
invested in either often assume that these
operating assets or earnings are being
held as cash. reinvested, that
assumption does not
always hold, since the
firm may just hold cash
balances. That is part of
the reason we compute
an equity reinvestment
rate, which measures
more directly equity
investment in operating
assets (rather than cash).
The retention ratio
cannot be less than 0% or
greater than 100%.
Return on Assets EBIT (1-t)/ Book value Return generated by While some analysts use
of total assets existing assets this ratio interchangeably
with the return on capital,
there is one key
difference:
Capital Invested = Debt
+ Equity - Cash = Total
Assets - Cash - Non-debt
Current liabilities
In effect, capital invested
does not include all
assets; it explicitly
eliminates cash and
 includes non-cash
working capital (which is
the difference between
non-cash current assets
and non-debt current
liabilities). If you plan on
comparing a return to the
cost of capital, the more
consistent measure is the
return on invested
capital
Return on Capital EBIT (1-t) / (BV of Return earned on the As with return on equity,
(ROC) Debt + BV of Equity- existing assets or we revert back to the
Cash) projects of a firm. book value of debt and
The operating income is Often used as a equity in this
usually from the most measure of the quality computation (rather than
recent time period and of existing use market value)
the numbers in the investments and because we are trying to
denominator are either compared to the cost get a sense of the returns
from the start of that of capital. that a firm is generating
period or an average on the investments it has
value over the period. already made.
Consequently, we are
assuming that the book
value of invested capital
is a good measure of
capital invested in
existing assets. This
assumption can be
violated if a firm grows
through acquisitions
(goodwill may reflect
growth assets) or takes
accounting write-offs
(thus shrinking book
capital and making
projects look better than
they really are).
Return on Equity Net Income/ Book Return earned on The book value of equity
(ROE) Value of Equity equity invested in is assumed to be a good
The net incomeis existing assets. measure of equity
usually from the most Compared to the cost invested in existing
recent time period and of equity to make assets. This assumption
the numbers in the judgments on whether may not be appropriate if
denominator are either the firm is creating that number is skewed by
from the start of that value. Cannot be acquisitions (goodwill
period or an average computed if book will inflate book equity)
value over the period. equity is negative. or write-offs (which tend
(See Non-cash ROE for to deflate book equity).
 a variation) If a company has a large
cash balance, the return
on equity will be affected
by its presence. The
denominator will include
the cash balance and the
numerator wil include the
income from that cash
balance. Since cash
usually earns low, close
to riskless rates, the
return on equity will drop
because of the presence
of cash.
Return on See Return on Capital
Invested Capital
(ROIC)
Selling, General Expense item in the Indirect or allocated Selling, general and
and income statement that cost in a company. administrative costs is a
Administrative captures selling, Comparing across loosely defined pot
Expenses advertising and general companies (as a ratio where accountants tend
(SG&A) administrative costs that of sales) may provide to throw in whatever
cannot be directly traced an indicator of costs they cannot fit into
to individual produts or corporate bloat and conventional line items.
services sold. efficiency. This makes comparisons
across companies
difficult to do. If you
view these costs as fixed
and all other operating
costs as variable, this
may be useful in
computing operating
leverage, but that is a
strong assumption.
SG&A See Selling, General and
Administrative
Expenses
Standard The standard deviation Variation in the For traded stocks, this
deviation in in either stock returns or market's estimate of can be computed fairly
equity ln(stock prices) over the value of the equity easily with two caveats.
time. in a firm over time. The first is that the
standard deviation
obtained will reflect the
time intervals for the
returns; in other words,
the standard deviation in
weekly stock returns will
be a weekly standard
 deviation. It can be
annualized by
multiplying by the square
root of 52. The second is
that the standard
deviations obtained over
a period of time are still
historical standard
deviations and may not
be appropriate forward
looking estimates for
firms that have changed
their business mix or
financial leverage.
Standard Standard deviation in Variation in the Since debt is often not
deviation in firm total firm value (market market's estimate of traded and equity is, at
value value of debt plus the value of the assets least for publicly traded
equity) (existing and growth) firms, this number is
owned by the firm usually obtained by
over time. adding the book value of
debt to the market value
of equity each period and
then computing the
standard deviation in the
combined value over
time; you can either
compute the percentage
change in value each
period or use the
ln(value). An alternative
approach is to use the
standard deviations in
stock and bond prices (if
both the stock and the
bonds are traded) and to
take a weighted average
of the two (allowing for
the covariance between
the two).
Tax Rate See Effective Tax Rate
(Effective)
Tax Rate See Marginal Tax rate
(Marginal)
Total Beta Total Beta = Market Relative volatility or The total beta computes
Beta / Correlation standard deviation of the risk of an asset, based
between stock and an investment on the assumption that
market (relative to the investors in that asset are
This measure is market) exposed to all risk in the
 equivalent to dividing asset rather than just the
the standard deviation of non-diversifiable or
a stock by the standard market risk.
deviation of the market.
For an undiversified
investor, it may be a
better measure of risk
than the traditional
market beta.
Unlevered Beta Unlevered Beta = Beta of the assets or The unlevered beta for a
Levered Beta / (1 + (1- businesses that a firm firm reflects the beta of
tax rate) (Debt/Equity is invested in. As a all of the investments
Ratio)) consequence, is also that a firm has made
often labelled as the (including cash). If this is
asset beta of a firm. obtained from a
regression of the stock
against the market, it will
reflect the business mix
over the period of the
regression. If it is
computed based upon the
business mix of the
company (see Bottom-up
Beta), you gain much
more flexibility. This is
the appropriate number
to start with if you are
trying to estimate a cost
of equity for use with net
income (which includes
the income from cash).
Unlevered beta Unlevered Beta/ (1 - Beta of operating This unlevered beta
corrected for cash Cash/ (Market Value of assets that a firm is reflects only the
Equity + Market Value invested in. We are operating assets of the
of Debt))) excluding cash and firm. It is the appropriate
assuming that the beta number to use (as a
of cash is zero. starting number) if you
are trying to compute a
cost of equity for a cost
of capital computation.
Value/ Book (Market Value of Equity Market's assessment The key difference
+ Market Value of of the value of the between this multiple and
Debt)/ (Book value of assets of a firm as a the EV/Invested Capital
Equity + Book Value of multiple of the multiple is that cash is
Debt) accountant's estimate incorporated into both
See Enterprise Value/ of the same value. the numerator and
Invested Capital denominator. If we make
the assumption that a
dollar in cash trades at
 close to a dollar, this will
have the effect of
pushing Value/Capital
ratios closer to one than
EV/Invested Capital.
Value/EBITDA See Enterprrise
Value/EBITDA
Value/Sales See Enterprise
Value/Sales
Variance in Standard deviation in Variation over time in Variance in equity value
equity values equity value^2 market value of is usually computed
(See Standard deviation equity using either returns or the
in equity value) ln(price). The variance, if
computed with weekly or
monthly returns, can be
annualized by
multiplying by 52 or 12.
Variance in firm Standard deviation in Variation over time in Since the market value of
values firm value^2 market value of firm debt is usually difficult to
(See Standard deviation (debt + equtiy) obtain, analysts often use
in firm value) book value of debt in
conjunction with the
market value of equity to
obtain firm value over
time.