2 Value = + + + FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business risk Market risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Net operating profit after taxes Required investments in operating capital − = Determinants of Intrinsic Value: Using Ratio Analysis...
3 Overview Ratios facilitate comparison of: One company over time One company versus other companies Ratios are used by: Managers to identify areas of weakness and strength Lenders to determine creditworthiness Stockholders to estimate future cash flows and risk
Liquidity Ratios Asset Management Ratios Debt Management Ratios Profitability Ratios Market Value Ratios RATIO ANALYSIS
Current Ratio Quick Ratio Liquidity Ratios Can the company meet its short-term obligations using the resources it currently has on hand? CR = QR = CA CL CA - Inv. CL
Inventory Turnover Ratio Days Sales Outstanding (DSO), Average Collection Period (ACP) Fixed Asset Turnover Ratio Total Asset Turnover Ratio Asset Management Ratios How efficiently does the firm use its assets? How much does the firm have tied up in assets for each dollar of sales?
Asset Management Ratios Inv. turnover= Sales Inventories DSO= = Receivables Average sales per day Receivables Sales/365 Fixed assets turnover Sales Net fixed assets = Total assets turnover = Sales Total assets
Total Liabilities to Total Assets, Long Term Debt to Total Assets, Debt to Equity Ratio Times Interests Earned Ratio EBITDA Coverage Ratio Debt Management Ratios Does the company have too much debt? Can the company’s earnings meet its debt servicing requirements?
Profit Margin on Sales Basic Earning Power Return on Total Assets Return on Common Equity Profitability Ratios What is the company’s rate of return on: Sales? Assets?
Profit Margin PM = NI Sales OM = EBIT Sales Net profit margin (PM): Operating profit margin (OM): Sales − COGS Sales GPM = Gross profit margin (GPM):
Basic Earning Power Return on Asset, Return on Equity BEP = EBIT Total assets ROA = NI Total assets ROE = NI Common Equity
Price/Earnings Ratio Price/Cash Flow Ratio Market/Book Value Ratio Market Values Ratios Market value ratios incorporate the: High current levels of earnings and cash flow increase market value ratios High expected growth in earnings and cash flow increases market value ratios High risk of expected growth in earnings and cash flow decreases market value ratios
Market Values Ratios P/E =Price per share EPS Price per share Cash flow per share P/CF = Mkt. price per share Book value per share M/B=
Different divisions in different industries Average is not good enough Inflation Seasonal factors Window dressing Different accounting practices What is a good ratio? Financial statements accuracy Limitations
Dependence on key customer(s) Dependence on key product(s) Dependence on key supplier(s) Competition Future prospects Legal & regulatory environment Qualitative Factors