33 Financial Ratios - Part 3

From "Magic Numbers: The 33 Key Ratios That Every Investor Should Know" by Peter Temple.
See Part 1 and Part 2

Cash flow statement ratios

23. Free Cash Flow (FCF)
= Operating cash flow - interest - tax - maintenance capital spending
FCF subtracts those items that a company cannot avoid paying if it wants to maintain its fixed assets. It represents the amount of cash left over after all essential deductions have been made. How a company spends its free cash flow can be revealing about its view of future events.

24. Fixed asset spending / depreciation
= gross spending on fixed assets / annual depreciation charge
An indicator of the degree to which a company is investing for the long term health of business. Amortization of goodwill is excluded. Examine the company's depreciation policies at the same time and compare with those of its peer. More meaningful to compare over time or with ROCE or ROE.

There are companies to which this ratio does not apply, specifically those operating "people business" that run with relatively low fixed assets relative to their turnover (eg. advertising agencies, consultany companies, software businesses, any business involved in licensing rather than manufacturing, etc).

25. Operating cash flow / operating profit
= operating cash flow / operating profit
Shows how changes in working capital and the size of depreciation charge produce the difference between operating profit and operating cash flow. Measures the efficiency with which profits are converted to cash. As depreciation and other non-cash charges are added back to operating cash flow, the ratio should be greater than 1. Otherwise, it usually means there has been deteriorating in working capital ratios. The more this ratio exceed 100%, the more "hidden profits".

This ratio works for all types of companies. It is also good to compare the ratio over time to make sure that the figures are consistent and not simply showing an unsustainable one-off improvement.

26. Price to free cash flow ratio (P/CF)
= share price / (free cash flow / weighted average shares in issue)
A more objective measure of worth of company than P/E as it is less likely to be "fudged" or "smoothed". It enables companies to be compared irrespective of their size.

Risk, return and volatility ratios

27. Redemption yield / risk-free rate of return
= running yield + interest-on-interest + gain or loss on maturity
Running yield is the price of the bond expressed as a percentage of the market price.
Redemption yield is sometimes called "yield to maturity" (YTM), is to be calculated with a financial calculator due to its complexity in calculation.

3 major uses for redemption yield on government bonds :
1. As an indicator of economic health (inverse yield curve is usually considered a sign of imminent recession.)
2. As a measure of the risk-free rate of return
3. As a measure of credit quality

28. Internal rate of return (IRR)
Calculates the overall annual percentage rate of return on an investment. IRR is normally used to express the return required to equate the cost of an investment with the proceeds when it is sold.

29. Weighted average cost of capital (WACC)
= (cost of equity * market cap/EV) + (cost of debt * debt/EV)
Cost of equity is the risk-free rate of return plus equity risk premium adjusted for the systematic risk (beta) involved in equity.

This ratio is usually compared with the actual return on capital earned by the company to work out how much value the management is adding for shareholders.

30. Discounted cash flow (DCF)
= free cash flow year 1 * (d year 1) + ... + free cash flow year n * (d year n) + PV of perpetuity
d = discount factor for each year as determined by the chosen discount rate.
This ratio is useful in comparing valuations across companies in a relatively stable sector where underlying growth rates can be reasonably confidently assumed. It works less well with cyclical stocks, recovery situations, or companies that do not have a particularly predictable pattern of sales growth.

31. Reinvested ROE
Average ROE is calculated and adjusted to reflect the proportion of profits retained. This is used to calculate year 5 value for the company, based on profits implied from the growth generated in shareholders' equity. A market multiple (capitalization rate) is then applied to year 5 profits to arrive at the year 5 company value. After factoring in the value of dividends over the period, this is compared with the current market cap. A compound rate of return is calculated that equates the two. For a sufficient margin of safety, this return should probably be at least 25% p.a.

This approach gives due weight to the importance of ROE in generating value for shareholders. It rewards companies that retain high proportion of profits for reinvestment in the business and allows market-tested yields to be incorporated into the valuation. However, it works well only with companies that have relatively straightforward balance sheets and steadily growing business.

32. Volatility
= standard deviation of the stock price
Quick way to estimate: [(period high - period low) / 2] * (100 / current share price)
The greater volatility a particular share, the more likely it is that a move will occur that will result in showing a loss.

33. Sharpe ratio
= (annualized return on investment - risk-free rate of return) / volatility
To calculate the true risk-adjusted return on an investment.