Retail Investor .org


#1 Overview
#2 Book Value Per Share
#3 Debt and Leverage
#4 Return on Assets
#5 Working Capital
#6 Industry Specific Metrics
#7 Operating Earnings

#1 Overview

There are lots of metrics used to judge a company. The earnings are most important, but all others must be factored into your evaluation of stability and growth. The metrics you use will differ depending on your objectives. Be clear where your profit will come from - dividend income, business growth, or stock price correction.

All the companies you analyze will have some very good metrics and other very bad ones. Nobody's perfect. Each is just a piece of the puzzle. The trick is to figure out WHY the metric is good or bad. They cannot be downloaded from some website and looked at in isolation. They must be part and parcel of an analysis of the actual financial statements. Put together the complete package and develop your own 'story' about the business.

Consider the analogy of a doctor. Would he be able to determine if you are healthy or sick just by looking at a chart with your body temperature, heart rate and weight? No. He needs to see you in person, poke and prod, and ask questions. The metrics that make their way into your chart only formalize a small part of his findings. Similarly, to understand a business you must read and understand the language of business - the financial statements. Just looking up the basic metrics won't clue you in at all.

Always keep in mind that investors only benefit from future events. Looking at historical data gives you the best base for that projection, but it is not an end in itself.

But What Criteria ?
Get ideas from stock screening programs. Look at lists of investment ratios. A set of criteria to fit a value investor might include:

  1. Stock price 20% below peak.
  2. P/E at low end of historical range.
  3. Comprehensive earnings at least 90% of quoted EPS.
  4. Earnings and EPS growth.
  5. Revenue growth not just a one-time spurt.
  6. Margins not declining.
  7. Goodwill not greater than 50% of equity.
  8. Debt to Equity less than 1.
  9. Interest coverage greater than 5 times.
  10. ROE greater than 15.

This is just an example. There is no 'right and wrong'. These are your own value judgements. You are also free to calculate the ratios and define the data as you please - as long as you apply the same definitions to all companies. The following presumes you already know how to calculate the ratios.

#2 Book Value Per Share Top

The biggest problem today using Book Value is the amount of goodwill and intangibles. Goodwill does not pretend to measure an asset. It measures a past payment to buy another's business. Intangibles are past operating costs that have been capitalized instead of expensed. These have the same problem as goodwill ... their value can disappear in the blink of management's eye. The solution is to measure the Book Value after subtracting goodwill and intangibles. See also the discussion of Goodwill on the Evaluating Growth page.

No one disputes that Current Assets and Current Liabilities are correctly valued at market. By definition they will be converted to cash within a year, so an discrepancy would be short lived. Similarly the valuation of Long Term Debt is justified by hard market facts that are not disputed.

During the days of high inflation in the 1970s - 1980s, investors complained that Book Value was inaccurate because the historical cost of Plant & Equipment understated its current market value. Since The Great Moderation inflation has been muted. Inflation's mispricing only appears if assets are owned for extended periods of time. Today, purchased equipment has a shorter lifespan because of faster technology changes and lower quality workmanship. See the average age of fixed assets held by a variety of Canadian businesses below - much lower than you probably thought.

age of assets held by companies

Inflation is not the only cause of rising prices. Newer models have bells and whistles that reduce maintenance and other operating costs. You cannot conclude that the equipment inside the company are worth a lot more just because their replacement with a new models would cost more. Companies may scrap existing equipment that is still usable in order to get new, efficient models, proving the old have little value.

There is less mispricing of company assets on the Balance Sheets of today because service businesses need few physical assets. Also equipment is frequently leased, so the asset showing is really only the present value of financial contract (not a depreciating asset). The following graph uses the US Federal Reserve Flow of Funds data that isolates tangible assets after subtracting intangibles like goodwill and financial assets.

taken from

The point being made here is that today's Book Value (excluding goodwill and intangibles) is not far different from the assets' current market values.

Value-in-use is a whole different matter. Assets put to work inside a business have more value than when held outside the business. Their value-in-use is higher than their stand-alone market price. Most stocks are now valued at a multiple of book value even when the assets are marked-to-market. 43% of the Nasdaq and NYSE stocks (in Oct 2011) were priced higher than 1.5 time book value. And those percentages make no allowance for goodwill on the Balance Sheets.

Because of this issue a lot of people will dismiss many of the 'proofs' on this website that track stock prices over time assuming they trade at a steady book value. For example detractors would argue that existing shareholders of a company issuing new shares will not realize any 'gain from the share-issue-premium'. They would say that the 'value' per share does not change because the 'value' received for the new shares only equals the 'value-in-use' of the pre-existing assets. But the added financing is valued in dollars, which will purchase assets valued at their stand-alone price. When these are put to productive use inside a company they will have a higher value-in-use to shareholders. It is this transformation of $$ to value-in-use that creates the share-issue-premium.

Similarly when $$ are spent on share buy-backs at any price higher than book value. Even assuming book value approximates the stand-along replacement price of the company's net assets, chances are the stock is trading at a higher value. The cost to the company (in lost value-in-use) is higher than the $$ spent on the stocks purchased.

The modern corporation is a wonderful thing. It takes different assets and differently skilled workers, combines them with technology, and creates a entity that is many times more productive than its individual parts. A dollar invested inside the corporation is worth many times the same dollar invested outside. This is not an argument that has ever been 'proved'. It is very much a POV where both sides have valid arguments - with the POV of this site being rarely argued.

#3 Debt and Leverage Top

Debt is important when evaluating the risk within any company. Financing with fixed costs can magnify profits. It can also magnify losses and reduce returns when the Return on Assets (or ROIC) is less than the interest rate on the debt. If you don't understand the two edged sword of leverage and the concept of a 'hurdle rate' read the top section of the Math for Leverage page. Read also the lower section of that page called Leverage Within Operations.


How Much? : Too little debt may not be optimal. Especially when interest rates are low and profitability high. You can leverage your own stock holdings personally to correct for this - but not as effectively as the company can. If the stock is priced at book value this is true. But the shareholder may pay multiples of that value (in price-to-book-value terms). That premium will destroy any benefits from leverage in your own hands.

Management and investors may have different opinions on the correct amount of debt. Management may want a cushion for 'the bad times' while investors want a leveraged play during 'the good times'. Management may have long-term interests (a pension) while investors want a quick profit. Canadians see this played out clearly in resource stocks.

Increased risk from too much debt should cause you to demand a greater expected return from your investment. Since the earnings yield is the flip side of the P/E equation, you should LOWER the P/E at which you would buy the stock. Unfortunately, in good times leverage increases a company's returns and growth. As a result investors feel they should be prepared to pay a HIGHER P/E for that growth. You must ask "How much of these returns/growth is due to leverage (risk) and how much due to good management or the economy?".


The debt / equity ratio measures the leverage within the company. The equity should be measured 'less goodwill', because only tangible assets will be used to pay off the obligation. The debt measure should include lease obligations because there is little economic difference between lease buybacks and purchasing with debt. When the business has a stable financing ratio, the current portion of debt should also be included with the long portion, because it will be refinanced, not paid off. It is can be argued that unfunded pension liabilities should be included in debt, because the company is using the pension fund for leverage. The unfunded balance accrues 'interest' just like debt does. Some quotations used by websites include ALL the current liabilities in the measure of debt. Others do not include any of the current debt. Etc. Much better to decide on your own calculation and make it yourself.

Businesses with higher capital asset requirements will be able to support greater debt. 1:1 is a good rule of thumb for a cut-off. In recent years (2005) lenders have lowered their collateral requirements. It is becoming more common to see debt greater than the physical assets. It is a subjective opinion whether this increases the risk to the equity owners, or just the debt owners. (See Canadian government's list of D/E by industry)

The interest coverage ratio measures your degree of safety that earnings will cover the interest payments. The more variable the company's operating margin the higher the coverage should be. Four times coverage, or more, is reasonable but there is no magic number. Utilities usually carry a lot more debt than normal and may cover their interest only 2 times or less. They may be able to sustain the situation because of the stable monopoly revenues and government-guaranteed profit margins.

Debt / EBITDA measures the payback period (in years) it would take the cash earnings to cover the debt. This metric is popular, but ignores the interest rate, and the risks of it changing. It ignores the ability of the business to pay the interest. It ignores the reality that the cash flow to payback the principal will be reduced by taxes. It ignores the leverage imposed by debt. It is a useless ratio.

ROA measures the good management of assets. The difference between ROA and ROE is due to leverage. A small difference may mean the company has little debt. Check the Debt/Equity metric. The small difference may also be due to the fact that the interest rate of the debt is very close to the ROA. In this case the company is very risky because it operates close the hurdle rate.

ROA divided by the Weighted Average Interest Rate shows you the financing risk more clearly. Sometimes the Notes to the Financial Statements gives you the weighted average interest rate of the total debt. Otherwise you must do the math yourself. When the metric is less than 1, the leverage is having negative effects on earnings. The higher the multiple the safer the company.

#4 Return on Assets ROA (or return on invested capital ROIC) Top

This site uses the term ROA and ROIC to refer to the same thing - what most people think of as ROIC. How you define this metric depends on who you want to include in your list of long-term financiers of the business:

  • common share equity
  • preferred share equity
  • minority interest (other shareholders of subsidiary businesses controled)
  • long-term debt and capitalized leases
  • short-term debt that is essentially a permanent liability.
  • Some people include the Government's 'financing' of long-term tax liabilities (net of assets).
These Balance Sheet amounts are totaled to form the 'invested capital'. This total will always equal what you consider the company's net assets - long-term assets plus working capital (without short-term debt). (See Canadian government's list of ROCE by industry)

Next you calculate the profits these assets generated - before any allocation of the profits to the individual financiers. This is from the Income Statement, backing out any deductions for

  • common share dividends
  • preferred share dividends
  • minority shareholders' allocation of income.
  • interest payments and financing costs of leases
  • If you included the taxman in the list above, then you would also reverse out any tax expense. If you did not include him, then you would reverse out only the tax savings attributable to the interest expense.

There are two purposes for calculating ROA.

1) Company analysis must distinguishing between measuring the effective use of company net assets, and the returns due to leverage or financing decisions. The Company Analysis spreadsheet has a section calculating both ROE, ROA and the spread in rates between operating returns and the cost of financing. The spread indicates the safety of the leverage - how much the operating returns can fall before leverage starts working against you.

2) When comparing companies with different leverage, ROA provides a 'level playing field' for evaluating their productive use of assets. Private equity and leveraged buyout firms use this metric to evaluate different targets because they will have the control to impose the leverage they want after purchase. The retail investor buys the complete package, with no control over financing, so this basis of comparison is less useful. But still it allows you to measure and rank two different parameters (operations and risk).

#5 Working Capital Top

Today, most companies maintain strict control over their working capital, so that the liabilities fund the assets (CA:CL = 1:1). Historically, companies kept larger working capital. Some of the old 'investing bibles' say to set limits of 2:1. But the financial markets are much more efficient today. Companies can access debt to cover unexpected shortfalls within a few hours. The old-fashioned metrics are no longer valid. Manufacturing and retail businesses though, must stock inventory and so need higher ratios than service businesses.

Debt : If the ratio is low, check if the liabilities include part of long-term debt that is maturing. Then go to management's discussion to see whether the company has agreements to renew the debt. If not, insolvency is possible. The ratio can also be low when the company has decided to source its long term financing with short term money. This happened at GE when short term interest rates were extremely low after the tech crash. That was a smart move at the time, but would be risky for any company without easy access to changing its financing later. In the 2008 liquidity crises many good companies were cut off at the knees because they were in this situation when the money dried up.

Receivables :The ratio may be high because receivables are piling up. The ratio of receivables to sales should stay pretty stable. If the company has been pumping up sales by selling to customers who don't pay, this is a red flag. When the economy is bad, suppliers may help support their customers by offering longer credit. This is an economic 'good thing'. They are in a good position to determine the customer's financial health. And the credit will earn them loyalty when the economy gets better. But there is risk involved.

Check NOTES:1 of the Financial Statements for the policy regarding when a 'sale' is booked. Sometimes an agreement with their sales force says that a sale (and A/R) is recognized when the item is received by the salesman, but he can return it at any time, and need not pay for it until he sells it. So both Sales and A/R are overstated.

Inventories : If inventories are growing faster than the rate of sales, consider if they may require a write-off or write-down. Find out if a new warehouse has been built. Management always promises lower distribution costs from a warehouse, but it must be stocked with inventory that requires financing to buy and maintain.

Cash : It is important to analyze the cash balance. Excess cash can make the business a take-over target. Or it can raise expectations of a special distribution to owners. Or maybe the company has sold their A/R to a factor for instant cash. To see if the cash balance is static, or just reporting window-dressing, check the interest income line of the income statement. Would the cash balance have generated that interest?

Some stock analysts say the cash balance should be calculated "per share" and added to the value derived using P/E. But this procedure values cash in the company at the same worth as cash in your own pocket. Only when management has committed to pay out a dividend, and when you are assured that its absence will not impair the company's ability to earn income, should you make those adjustments.

The impact of cash is the same when valuing the business with Price/Book. Most service businesses trade at many multiples of book value. But cash does not generate those same high rate of return. It is only worth a fraction of itself, not a multiple of it. Apply the P/B multiple to the productive assets and then add the value of the cash.

#6 Industry Specific Metrics Top
Insurance: Combined ratio

Claims ratio
Money Managers: Assets under management
Retail: Same store sales growth

Revenue per square foot

Gasoline margin spread
Real Estate: Square feet per share

Revenue per square foot

Spread between Return on Assets and Borrowing Costs
Oil&Gas Exploration: Reserves per share

Production BOE per day per share

Reserve life

Replacement cost per BOE
Oil Integrated: Crack spread

Western Canadian oil prices (PAR)

Alberta Nat Gas prices (AECO)

Alberta Nat Gas transaction prices
Oil&Gas Services: Rig counts,Canadian
Banks: Bad Debt percent
Manufacturing: Contract backlog
Telecoms: Number of customers

Churn rate
Airlines: Load factor
Utility: Spark spread
Transportation: rail traffic

truck tonnage index

air cargo revenues

#7 Operating Earnings Top

The point of calculating and using 'operating earnings' instead of reported GAAP earnings is to remove the noise, to remove the volatility, to measure the long-run trending earnings. Supposedly, the stock market is forward-thinking and can see past quarterly, or even yearly, abnormal events. So the analysts devised this measure and everyone feels very superior to investors who react to one-time write-downs.

But do operating earnings measure what they claim to? It is common sense to expect companies to isolate bad news, calling it a 'one-time event' even while they bury any windfall profits out of sight. Management will always manage earnings. They will smooth earning to give investors a false sense of stability. And when the accumulation of smoothing transactions becomes overwhelming, they take a big bath to get rid of all the bad news at once and label it a 'one-time' charge. If operating earnings DOES capture true trending earnings you would expect it to understate reported earnings just as frequently as it overstates reported earnings?

The Standard and Poors index people keep track of both measures. Below is their reported results. Over twenty years 'operating earnings' has overstated reported earnings by 15% on average. And never, ever understated results. The use of this metric has no validity. It is a promotional tool.

The media implies that professionals use the operating earnings metric instead of reported earnings because they are more sophisticated. Or are they just trapped in an industry practice? Ignoring GAAP earnings leads to three errors.

  • You stop appreciating that there are two different steps in a company analysis, measuring the past performance and estimating the future performance. You must do the first before you can succeed with the second. Different metrics apply to each step. GAAP earnings measure the whole truth about the past. (Well yes, there are problems). Only then, with eyes wide open, can you project the future with your own estimate of normalized earnings.
  • Without recognizing the (supposedly) one-time items you will not be able to evaluate their frequency, or their probability of recurring in the future. Many companies are serial offenders. Here is a quote from Financial Statement Analysis "A search of the Capital IQ database revealed that 487 of the companies represented in the Standard & Poor’s 500 Index reported unusual items in at least half of the years from 2002 to 2009. Nearly half (230) recorded unusual items in all eight years of that span."
  • Even if you accept that an expense is 'one-time' it has still reduced the value of a company. Since it takes money to make money, this reduction of assets will reduce future earnings. It is harder to earn $10,000 from an asset base of $50,000, than from a base of $100,000. If you ignore GAAP write-downs you will overstate the possible future earnings.

Warning! The definitions of operating earning (at May 09) on Wikipedia and Investopedia are sort-of wrong. There is some confusion because the word 'operating' is also used in measuring 'Operating Margin' (between Gross Margin and Net Margin). That metric uses the Income Statement subtotal above interest and taxes (EBIT). You can also find a line-item labeled 'operating income' below interest, but above taxes, in old textbooks. But when used as a pro-forma measure of Net Income 'operating earnings' is measured AFTER interest and tax.

Standard and Poors found that the exact implementation of the generally accepted idea was so variable, that they gave up and devised their own new metric called "core earnings". But within the original proposal is the best definition you can find for operating earnings.